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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
1998
FORM 10-K
ANNUAL REPORT UNDER SECTION 13 OR 15 (d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 COMMISSION FILE NUMBER 1-13805
HARRIS PREFERRED CAPITAL CORPORATION
(Exact name of registrant as specified in its charter)
MARYLAND 36-4183096
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
111 WEST MONROE STREET, CHICAGO, ILLINOIS 60603
(Address of principal executive offices) (Zip Code)
(312) 461-2121
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
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7 3/8% Noncumulative Exchangeable Preferred New York Stock Exchange
Stock, Series A, par value $1.00 per share
Securities registered pursuant to Section 12(g) of the Act:
NONE
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 [ ]
The number of shares of Common Stock, $1.00 par value, outstanding on March 19,
1999 was 1,000.
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TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 6
Item 3. Legal Proceedings........................................... 6
Item 4. Submission of Matters to a Vote of Security Holders......... 6
PART II
Item 5. Market for the Registrant's Common Equity and Related 7
Security Holder Matters.....................................
Item 6. Selected Financial Data..................................... 7
Item 7. Management's Discussion and Analysis of Financial Condition 8
and Results of Operations...................................
Item Quantitative and Qualitative Disclosure About Market Risk...
7a. 11
Item 8. Financial Statements and Supplementary Data................. 11
Item 9. Changes in and Disagreements with Accountants on Accounting 11
and Financial Disclosure....................................
PART III
Item Directors and Executive Officers of the Company.............
10. 12
Item Executive Compensation......................................
11. 13
Item Security Ownership of Certain Beneficial Owners and
12. Management.................................................. 13
Item Certain Relationships and Related Transactions..............
13. 13
PART IV
Item Exhibits, Financial Statement Schedules, and Reports on Form
14. 8-K......................................................... 14
Signatures............................................................... 15
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PART I
Forward-Looking Information
Forward-looking statements contained in this Annual Report on Form 10-K
("Report") of Harris Preferred Capital Corporation (the "Company") may include
certain forward-looking information statements, within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, including (without limitation) statements with
respect to the Company's expectations, intentions, beliefs or strategies
regarding the future. Forward-looking statements include the Company's
statements regarding tax treatment as a real estate investment trust (a "REIT"),
liquidity, provision for loan losses, capital resources, investment activities
and unforeseen business risks related to year 2000 computer systems issues in
"Management's Discussion and Analysis of Financial Condition and Results of
Operation". In addition, in those and other portions of this document, words
such as "anticipates", "believes", "estimates", "expects", "intends" and other
similar expressions, as they relate to the Company or the Company's management,
are intended to identify forward-looking statements. Such statements reflect the
current views of the Company with respect to future events and are subject to
certain risks, uncertainties and assumptions. It is important to note that the
Company's actual results could differ materially from those described herein as
anticipated, believed, estimated or expected. The Company assumes no obligation
to update any such forward-looking statements.
ITEM 1. BUSINESS
General
Harris Preferred Capital Corporation is a Maryland Corporation incorporated
on September 24, 1997, pursuant to the Maryland General Corporation Law. The
Company's principal business objective is to acquire, hold, finance and manage
assets consisting of a limited recourse note or notes issued by Harris Trust and
Savings Bank (the "Bank") secured by real estate mortgage assets and other
obligations secured by real property, as well as certain other qualifying REIT
assets (the "Mortgage Assets"). The Company expects to qualify as a REIT under
the Internal Revenue Code of 1986 (the "Code"), and will generally not be
subject to federal income tax to the extent that it distributes 95% of its
taxable earnings to its stockholders and maintains its qualification as a REIT.
All of the shares of the Company's common stock, par value $1.00 per share (the
"Common Stock"), are owned by Harris Capital Holdings, Inc. ("HCH"), a
wholly-owned subsidiary of the Bank. The Company was formed by the Bank to
provide investors with the opportunity to invest in residential mortgages and
other real estate assets and to provide the Bank with a cost-effective means of
raising capital for federal regulatory purposes.
On February 11, 1998, the Company through a public offering (the
"Offering") issued 10,000,000 shares of its 7 3/8% Noncumulative Exchangeable
Preferred Stock, Series A (the "Preferred Shares"), $1.00 par value. The
Offering raised $250 million less $7.9 million of underwriting fees. The
Preferred Shares are traded on the New York Stock Exchange under the symbol "HBC
Pr A". Holders of Preferred Shares are entitled to receive, if declared by the
Company's Board of Directors, noncumulative dividends at a rate of 7 3/8% per
annum of the $25 per share liquidation preference (an amount equivalent to
$1.84375 per share per annum). Dividends on the Preferred Shares, if authorized
and declared, are payable quarterly in arrears on March 30, June 30, September
30 and December 30 of each year. Except upon the occurrence of certain events,
the Preferred Shares are not redeemable by the Company prior to March 30, 2003.
On or after such date, the Preferred Shares may be redeemed for cash at the
option of the Company, in whole or in part, at any time and from time to time,
at the principal amount thereof, plus the quarterly accrued and unpaid
dividends, if any, thereon. The Company may not redeem the Preferred Shares
without prior approval from the Board of Governors of the Federal Reserve System
or the appropriate successor federal regulatory agency.
Each Preferred Share will be automatically exchanged for one newly issued
Bank Preferred Share in the event (i) the Bank becomes less than "adequately
capitalized" under regulations established pursuant to the Federal Deposit
Insurance Corporation Improvement Act of 1991, as amended, (ii) the Bank is
placed into conservatorship or receivership, (iii) the Board of Governors
directs such exchange in writing because, in its sole discretion and even if the
Bank is not less than "adequately capitalized", the Board of Governors
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anticipates that the Bank may become less than adequately capitalized in the
near term, or (iv) the Board of Governors in its sole discretion directs in
writing an exchange in the event that the Bank has a Tier 1 risk-based capital
ratio of less than 5%. In the event of an exchange, the Bank Preferred Shares
would constitute a new series of preferred shares of the Bank, would have the
same dividend rights, liquidation preference, redemption options and other
attributes as the Preferred Shares, except that the Bank Preferred Shares would
not be listed on the New York Stock Exchange and would rank pari passu in terms
of cash dividend payments and liquidation preference with any outstanding shares
of preferred stock of the Bank.
Concurrent with the issuance of the Preferred Shares, the Bank contributed
additional capital of $241 million, net of acquisition costs to the Company. The
Company and the Bank undertook the Offering for two principal reasons: (i) the
qualification of the Series A Preferred Shares as Tier 1 capital of the Bank for
U.S. banking regulatory purposes under relevant regulatory capital guidelines,
as a result of the treatment of the Preferred Shares as a minority interest in a
consolidated subsidiary of the Bank, and (ii) the tax deductibility of the
dividends payable on the Series A Preferred Shares, as a result of the Company's
qualification as a REIT. On December 30, 1998, the Bank contributed the common
stock of the Company to HCH, a newly-formed and wholly-owned subsidiary of the
Bank. The Bank is required to maintain direct or indirect ownership of at least
80% of the outstanding Common Stock of the Company for as long as any Preferred
Shares are outstanding.
The Company used the Offering proceeds and the additional capital
contributed by the Bank to purchase $356 million of notes (the "Notes") from the
Bank and $135 million of mortgage-backed securities at their estimated fair
value. The $356 million of Notes are obligations issued by the Bank that are
recourse only to the underlying mortgage loans (the "Securing Mortgage Loans")
and were acquired pursuant to the terms of a loan agreement with the Bank. The
principal amount of the Notes equaled approximately 80% of the principal amounts
of the Securing Mortgage Loans.
Business
The Company was formed for the purpose of raising capital for the Bank. The
Company's principal business objective is to acquire, hold, finance and manage
Mortgage Assets which currently consist of notes from the Bank on Securing
Mortgage Loans. These Mortgage Assets generate interest income for distribution
to stockholders. A substantial portion of the Mortgage Assets consists of Notes
issued by the Bank that are recourse only to Securing Mortgage Loans that are
secured by real property. The Notes mature on October 1, 2027 and pay interest
at 6.4% per annum. Payments of interest are paid to the Company from payments
made on the Securing Mortgage Loans. Pursuant to an agreement between the
Company and the Bank, the Company, through the Bank as agent, receives all
scheduled payments made on the Securing Mortgage Loans, retains a portion of any
such payments equal to the amount due on the Bank obligations and remits the
balance, if any, to the Bank. The Company also retains approximately 80% of any
prepayments of principal in respect of the Securing Mortgage Loans and applies
such amounts as a prepayment on the Bank obligations. The Company has a security
interest in the real property securing the Securing Mortgage Loans and will be
entitled to enforce payment on the loans in its own name if a mortgagor should
default. In the event of such default, the Company would have the same rights as
the original mortgagee to foreclose the mortgaged property and satisfy the
obligations of the Bank out of the proceeds.
The Company may from time to time acquire fixed-rate or variable-rate
mortgage-backed securities representing interest in pools of mortgage loans. The
Bank may have originated a portion of any such mortgage-backed securities by
exchanging pools of mortgage loans for the mortgage-backed securities. The
mortgage loans underlying the mortgage-backed securities will be secured by
single-family residential properties located throughout the United States. The
Company intends to acquire only investment grade mortgage-backed securities
issued by agencies of the federal government or government sponsored agencies,
such as Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National
Mortgage Association ("Fannie Mae") and the Government National Mortgage
Association ("GNMA"). The Company does not intend to acquire any interest-only,
principal-only or similar speculative mortgage-backed securities.
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The Bank may from time to time acquire or originate both conforming and
nonconforming residential mortgage loans. Conventional conforming residential
mortgage loans comply with the requirements for inclusion in a loan guarantee
program sponsored by either FHLMC or Fannie Mae. Nonconforming residential
mortgage loans are residential mortgage loans that do not qualify in one or more
respects for purchase by Fannie Mae or FHLMC under their standard programs. The
nonconforming residential mortgage loans that the Company purchases will be
nonconforming because they have original principal balances which exceed the
limits for FHLMC or Fannie Mae under their standard programs. The Company
believes that all residential mortgage loans will meet the requirements for sale
to national private mortgage conduit programs or other investors in the
secondary mortgage market. At December 31, 1998, the Company did not hold any
residential mortgage loans.
The Company may from time to time acquire commercial mortgage loans secured
by industrial and warehouse properties, recreational facilities, office
buildings, retail space and shopping malls, hotels and motels, hospitals,
nursing homes or senior living centers. The Company's current policy is not to
acquire any interest in a commercial mortgage loan if commercial mortgage loans
would constitute more than 5% of the Company's Mortgage Assets at the time of
its acquisition. Unlike residential mortgage loans, commercial mortgage loans
generally lack standardized terms. Commercial real estate properties themselves
tend to be unique and are more difficult to value than residential real estate
properties. Commercial mortgage loans may also not be fully amortizing, meaning
that they may have a significant principal balance or "balloon" payment due on
maturity. Moreover, commercial properties, particularly industrial and warehouse
properties, are generally subject to relatively greater environmental risks than
non-commercial properties, generally giving rise to increased costs of
compliance with environmental laws and regulations. There is no requirement
regarding the percentage of any commercial real estate property that must be
leased at the time the Bank acquires a commercial mortgage loan secured by such
commercial real estate property, and there is no requirement that commercial
mortgage loans have third party guarantees. The credit quality of a commercial
mortgage loan may depend on, among other factors, the existence and structure of
underlying leases, the physical condition of the property (including whether any
maintenance has been deferred), the creditworthiness of tenants, the historical
and anticipated level of vacancies and rents on the property and on other
comparable properties located in the same region, potential or existing
environmental risks, the availability of credit to refinance the commercial
mortgage loan at or prior to maturity and the local and regional economic
climate in general. Foreclosures of defaulted commercial mortgage loans are
generally subject to a number of complicated factors, including environmental
considerations, which are generally not present in foreclosures of residential
mortgage loans. At December 31, 1998, the Company did not hold any commercial
mortgage loans.
The Company may invest up to 5% of the total value of its portfolio in
assets eligible to be held by REIT's other than those described above. In
addition to commercial mortgage loans and mortgage loans secured by multi-family
properties, such assets could include cash, cash equivalents and securities,
including shares or interests in other REIT's and partnership interests.
The Company intends to continue to acquire Mortgage Assets from the Bank
and/or affiliates of the Bank on terms that are comparable to those that could
be obtained by the Company if such Mortgage Assets were purchased from unrelated
third parties. The Company may also from time to time acquire Mortgage Assets
from unrelated third parties.
The Company intends to maintain at least 90% of its portfolio in
Bank-secured obligations and mortgage-backed securities. The Company may,
however, invest in other assets eligible to be held by a REIT. The Company's
current policy and the Servicing Agreement (defined below) prohibit the
acquisition of any Mortgage Asset constituting an interest in a mortgage loan
(other than an interest resulting from the acquisition of mortgage-backed
securities), which mortgage loan (i) is delinquent (more than 30 days past due)
in the payment of principal or interest at the time of proposed acquisition;
(ii) is or was at any time during the preceding 12 months (a) on nonaccrual
status or (b) renegotiated due to financial deterioration of the borrower; or
(iii) has been, more than once during the preceding 12 months, more than 30 days
past due in payment of principal or interest. Loans that are on "nonaccrual
status" are generally loans that are past due 90 days or more in principal or
interest. The Company maintains a policy of disposing of any mortgage loan which
(i) falls into nonaccrual status, (ii) has to be renegotiated due to the
financial deterioration of the
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borrower, or (iii) is more than 30 days past due in the payment of principal or
interest more than once in any 12 month period. The Company may choose, at any
time subsequent to its acquisition of any Mortgage Assets, to require the Bank
(as part of the Servicing Agreement) to dispose of the mortgage loan for any of
these reasons or for any other reason.
The Bank services the Securing Mortgage Loans and the other mortgage loans
purchased by the Company on behalf of, and as agent for, the Company and is
entitled to receive fees in connection with the servicing thereof pursuant to
the servicing agreement (the "Servicing Agreement"). The Bank receives a fee
equal to 0.25% per annum on the principal balances of the loans serviced.
Payment of such fees is subordinate to payments of dividends on the Series A
Preferred Shares. The Servicing Agreement requires the Bank to service the loans
in a manner generally consistent with accepted secondary market practices, with
any servicing guidelines promulgated by the Company and, in the case of
residential mortgage loans, with Fannie Mae and FHLMC guidelines and procedures.
The Servicing Agreement requires the Bank to service the loans solely with a
view toward the interest of the Company and without regard to the interest of
the Bank or any of its affiliates. The Bank will collect and remit principal and
interest payments, administer mortgage escrow accounts, submit and pursue
insurance claims and initiate and supervise foreclosure proceedings on the loans
it services. The Bank may, with the approval of a majority of the Company's
Board of Directors, as well as a majority of the Company's Independent
Directors, subcontract all or a portion of its obligations under the Servicing
Agreement to unrelated third parties. An "Independent Director" is a director
who is not a current officer or employee of the Company or a current director,
officer or employee of the Bank or of its affiliates. The Bank will not, in
connection with the subcontracting of any of its obligations under the Servicing
Agreement, be discharged or relieved in any respect from its obligations under
the Servicing Agreement. The Company may terminate the Servicing Agreement upon
the occurrence of such events as they relate to the Bank's proper and timely
performance of its duties and obligations under the Servicing Agreement. As long
as any Preferred Shares remain outstanding, the Company may not terminate, or
elect to renew, the Servicing Agreement without the approval of a majority of
the Company's Independent Directors.
The Company entered into an advisory agreement with the Bank (the "Advisory
Agreement") pursuant to which the Bank administers the day-to-day operations of
the Company. The Bank is responsible for (i) monitoring the credit quality of
Mortgage Assets held by the Company, (ii) advising the Company with respect to
the reinvestment of income from and payments on, and with respect to the
acquisition, management, financing and disposition of the Mortgage Assets held
by the Company, and (iii) monitoring the Company's compliance with the
requirements necessary to qualify as a REIT. The Bank may from time to time
subcontract all or a portion of its obligations under the Advisory Agreement to
one or more of its affiliates. The Bank may, with the approval of a majority of
the Company's Board of Directors, as well as a majority of the Company's
Independent Directors, subcontract all or a portion of its obligations under the
Advisory Agreement to unrelated third parties. The Bank will not, in connection
with the subcontracting of any of its obligations under the Advisory Agreement,
be discharged or relieved in any respect from its obligations under the Advisory
Agreement. The Advisory Agreement has an initial term of one year, and may be
renewed for additional one-year periods. The Company may terminate the Advisory
Agreement at any time upon 60 days' prior written notice. As long as any
Preferred Shares remain outstanding, any decision by the Company either to renew
the Advisory Agreement or to terminate the Advisory Agreement must be approved
by a majority of the Board of Directors, as well as by a majority of the
Company's Independent Directors. The Bank will be entitled to receive an
advisory fee equal to $50,000 annually.
The Company may from time to time purchase additional Mortgage Assets out
of proceeds received in connection with the repayment or disposition of Mortgage
Assets, the issuance of additional shares of Preferred Stock or additional
capital contributions with respect to the Common Stock. The Company may also
issue additional series of Preferred Stock. However, the Company may not issue
additional shares of Preferred Stock senior to the Series A Preferred Shares
either in the payment of dividends or in the distribution of assets on
liquidation without the consent of holders of at least 67% of the outstanding
shares of Preferred Stock at that time or without approval of a majority of the
Company's Independent Directors. The Company does not currently intend to issue
any additional shares of Preferred Stock unless it simultaneously
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receives additional capital contributions from HCH sufficient to support the
issuance of such additional shares of Preferred Stock.
Although the Company does not currently intend to incur any indebtedness in
connection with the acquisition and holding of Mortgage Assets, the Company may
do so at any time (although indebtedness in excess of 25% of the Company's total
stockholders' equity may not be incurred without the approval of a majority of
the Company's Independent Directors). To the extent the Company were to change
its policy with respect to the incurrence of indebtedness, the Company would be
subject to risks associated with leverage, including, without limitation,
changes in interest rates and prepayment risk.
Employees
As of December 31, 1998, the Company had no paid employees.
Environmental Matters
In the event that the Company is forced to foreclose on a defaulted
Securing Mortgage Loan to recover its investment in such loan, the Company may
be subject to environmental liabilities in connection with the underlying real
property which could exceed the value of the real property. Although the Company
intends to exercise due diligence to discover potential environmental
liabilities prior to the acquisition of any property through foreclosure,
hazardous substances or wastes, contaminants, pollutants or sources thereof (as
defined by state and federal laws and regulations) may be discovered on
properties during the Company's ownership or after a sale thereof to a third
party. If such hazardous substances are discovered on a property which the
Company has acquired through foreclosure or otherwise, the Company may be
required to remove those substances and clean up the property. There can be no
assurance that in such a case the Company would not incur full recourse
liability for the entire costs of any removal and clean-up, that the cost of
such removal and clean-up would not exceed the value of the property or that the
Company could recoup any of such costs from any third party. The Company may
also be liable to tenants and other users of neighboring properties. In
addition, the Company may find it difficult or impossible to sell the property
prior to or following any such clean-up.
Qualification as a REIT
The Company expects to elect to be taxed as a REIT commencing with its
taxable year ended December 31, 1998 and intends to comply with the provisions
of the Code with respect thereto. The Company does not expect to be subject to
Federal income tax to the extent it distributes 95% of its adjusted REIT taxable
income to stockholders and as long as certain assets, income and stock ownership
tests are met. During 1998, the Company distributed 98.5% of its taxable income
to stockholders. Cash distributions in the amount of $1.6389 cents per Preferred
Share were paid in 1998. A cash dividend on common stock of $9,700,000 was
declared on December 10, 1998 and paid on January 28, 1999.
ITEM 2. PROPERTIES
None as of December 31, 1998.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently involved in any material litigation nor, to
the Company's knowledge is any material litigation currently threatened against
the Company, the Bank or any affiliate of the Bank other than routine litigation
arising in the ordinary course of business. See Note 8 to Financial Statements
on page 25.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 1998.
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PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER
MATTERS
HCH presently owns all 1,000 shares of the common stock of the Company,
which are not listed or traded on any securities exchange. In 1998, the Company
declared $9.7 million in cash dividends on common stock, which were paid in
January 1999.
The Preferred Shares are traded on the New York Stock Exchange under the
symbol "HBC Pr A". During 1998, the Company declared and paid cash dividends to
preferred stockholders of approximately $16.3 million. Although the Company
declared cash dividends on the Preferred Shares for 1998, no assurances can be
made as to the declaration of, or if declared, the amount of, future
distributions since such distributions are subject to the Company's financial
condition and capital needs, the impact of legislation and regulations as then
in effect or as may be proposed, economic conditions, and such other factors as
the Board of Directors may deem relevant. Notwithstanding the foregoing, to
remain qualified as a REIT, the Company must distribute annually at least 95% of
its taxable income to preferred or common stockholders.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the Company and
should be read in conjunction with the Financial Statements and notes thereto
and Management's Discussion and Analysis of Financial Condition and Results of
Operations contained in this Report.
FROM INCEPTION
(JANUARY 2, 1998)
THROUGH
DECEMBER 31, 1998
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(IN THOUSANDS,
EXCEPT PER SHARE DATA)
Statement of Operations Data:
Interest income............................................ $ 27,467
Operating expenses:
Loan servicing fees...................................... 756
Advisory fees............................................ 43
General & administrative................................. 187
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Total operating expenses............................ 986
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Net income................................................. 26,481
Preferred stock dividends.................................. 16,389
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Net income available to common stockholder................. $ 10,092
==========
Basic and diluted net income per common share.............. $10,092.00
==========
Distributions per preferred share.......................... $ 1.6389
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Balance Sheet Data (end of period):
Total assets............................................... $ 503,390
==========
Total liabilities.......................................... $ 9,762
==========
Total stockholders' equity................................. $ 493,628
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Cash Flows Data:
Operating activities....................................... $ 23,897
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Investing activities....................................... $ (497,621)
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Financing activities....................................... $ 474,345
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Financial
Statements and notes thereto appearing later in this Report.
RESULTS OF OPERATIONS FROM INCEPTION THROUGH DECEMBER 31, 1998
The Company's net income for the period from inception (January 2, 1998)
through December 31, 1998 was $26.5 million. Interest income on the Notes for
the year-to-date period ended December 31, 1998 totaled $16.3 million and
yielded 6.4% on average principal outstanding. Interest income on securities
available-for-sale for the same period was $10.2 million, resulting in a yield
of 6.1%. The average Notes and securities available-for-sale for the
year-to-date period ended December 31, 1998 were $288 million and $188 million,
respectively. The average outstanding balance of the Securing Mortgage Loans for
the same period was $329 million. There were no Company borrowings during this
period.
Operating expenses for the period ended December 31, 1998 totaled $986
thousand. Loan servicing expenses for the same period were $756 thousand.
Advisory fees paid to the Bank amounted to $43 thousand and general and
administrative expenses were $187 thousand.
On December 30, 1998, the Company paid a cash dividend of $0.46094 cents
per share on the outstanding Preferred Shares to the stockholders of record on
December 17, 1998. On a year-to-date basis, the Company declared and paid $16.3
million of dividends to holders of Preferred Shares. On December 10, 1998, the
Company declared a cash dividend of $9,700.00 per share on the outstanding
Common Shares to the stockholder of record on December 30, 1998, payable on
January 28, 1999.
At December 31, 1998, there were no Securing Mortgage Loans on nonaccrual
status.
QUARTER ENDED DECEMBER 31, 1998
The Company's net income for the quarter ended December 31, 1998 was $7.5
million.
Fourth quarter interest income on the Notes totaled $3.7 million and
yielded 6.4% on $235 million of average principal outstanding. Interest income
on securities available-for-sale for the quarter was $3.6 million resulting in a
yield of 6.2% on an average balance of $235 million. The average outstanding
balance of the securing mortgage loans for the same period was $286 million.
Fourth quarter operating expenses totaling $177 thousand were comprised of
$133 thousand of loan servicing fees paid to the Bank, $12 thousand of advisory
fees paid to the Bank and $32 thousand of general and administrative expenses.
ALLOWANCE FOR LOAN LOSSES
The Company does not currently maintain an allowance for loan losses due to
the over-collateralization of the Securing Mortgage Loans and the prior and
expected credit performance of the collateral pool.
CONCENTRATIONS OF CREDIT RISK
A majority of the collateral underlying the Securing Mortgage Loans is
located in Illinois and Arizona. The financial viability of customers in these
states is, in part, dependent on the states' economies. The collateral may be
subject to a greater risk of default than other comparable loans in the event of
adverse economic, political or business developments or natural hazards that may
affect such region and the ability of property owners in such region to make
payments of principal and interest on the underlying mortgages. The Company's
maximum risk of accounting loss, should all customers in Illinois and Arizona
fail to perform according to contract terms and all collateral prove to be
worthless, was approximately $161 million and $34 million, respectively, at
December 31, 1998.
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INTEREST RATE RISK
The Company's income consists primarily of interest payments on the
Mortgage Assets it holds. If there is a decline in interest rates during a
period of time when the Company must reinvest payments of interest and principal
with respect to its Mortgage Assets, the Company may find it difficult to
purchase additional Mortgage Assets that generate sufficient income to support
payment of dividends on the Preferred Shares. Because the rate at which
dividends, if, when and as authorized and declared, are payable on the Preferred
Shares is fixed, there can be no assurance that an interest rate environment in
which there is a decline in interest rates would not adversely affect the
Company's ability to pay dividends on the Preferred Shares.
COMPETITION
The Company does not engage in the business of originating mortgage loans.
While the Company will acquire additional Mortgage Assets, it anticipates that
such Mortgage Assets will be acquired from the Bank and affiliates of the Bank.
Accordingly, the Company does not expect to compete with mortgage conduit
programs, investment banking firms, savings and loan associations, banks, thrift
and loan associations, finance companies, mortgage bankers or insurance
companies in acquiring its Mortgage Assets.
LIQUIDITY RISK MANAGEMENT
The objective of liquidity management is to ensure the availability of
sufficient cash flows to meet all of the Company's financial commitments. In
managing liquidity, the Company takes into account various legal limitations
placed on a REIT.
The Company's principal liquidity needs are to maintain the current
portfolio size through the acquisition of additional notes or other qualifying
assets and to pay dividends to its stockholders after satisfying obligations to
creditors. The acquisition of additional notes or other qualifying assets is
funded with the proceeds obtained from repayment of principal balances by
individual mortgagees. The payment of dividends on the Preferred Shares will be
made from legally available funds, principally arising from operating activities
of the Company. The Company's cash flows from operating activities principally
consist of the collection of interest on the Notes and mortgage-backed
securities. The Company does not have and does not anticipate having any
material capital expenditures.
In order to remain qualified as a REIT, the Company must distribute
annually at least 95% of its adjusted REIT taxable income, as provided for under
the Code, to its common and preferred stockholders. The Company currently
expects to distribute dividends annually equal to 95% or more of its adjusted
REIT taxable income.
The Company anticipates that cash and cash equivalents on hand and the cash
flow from the notes and mortgage-backed securities will provide adequate
liquidity for its operating, investing and financing needs.
As presented in the accompanying Statement of Cash Flows, the primary
sources of funds during the period from inception (January 2, 1998) through
December 31, 1998, were $250 million from the issuance of Preferred Shares and
$241 million additional capital contributed by the Bank, net of acquisition
costs. Additional significant sources of funds were $148 million provided by
principal payments on the Notes. The primary uses of funds were $208 million in
purchases of Notes, net of repayments, $259 million in purchases of securities
available-for-sale, net of maturities and $16 million in preferred stock
dividends paid.
YEAR 2000
A critical issue has emerged in the REIT industry and for the economy
overall regarding how existing application software programs, operating systems
and other systems can accommodate the date value for the year 2000. The year
2000 issue is pervasive, as almost all date-sensitive systems will be affected
to some degree by the rollover of the two-digit year from 99 to 00. Potential
risks of not addressing this issue include business interruption, financial
loss, reputation loss and/or legal liability.
9
11
The Company utilizes and is dependent upon the Bank's data processing
systems and software to conduct its business. Management of the Company and the
Bank recognizes the need to ensure that the Company's operations will not be
adversely impacted by year 2000 issues and is managing the related operational
risk accordingly. The Bank and its ultimate parent company, Bank of Montreal,
have undertaken an enterprise-wide initiative to address the year 2000 issue and
have developed a comprehensive plan to prepare, as appropriate, the Bank's
computer and other systems to recognize the date change on January 1, 2000. An
assessment of the readiness of third parties that the Bank interfaces with, such
as vendors, counterparties, customers, payment systems, and others, is ongoing
to mitigate the potential risks that year 2000 poses to the Bank. In addition,
the Bank is assessing the readiness of companies that have borrowed from it to
ensure that incremental year 2000-related credit risks are addressed as part of
the Bank's existing credit risk management framework. The Bank's objective is to
try to ensure that all aspects of the year 2000 issue affecting the Bank,
including those related to the efforts of third parties, will be fully resolved
in time. However, it is not possible to be sure that all aspects of the year
2000 issue that may affect the Bank, including those related to the effects of
customers, suppliers, or other third parties with whom the Bank conducts
business, will not have a material impact on the Bank's operations or financial
condition. The Bank has consistently maintained contingency plans for mission
critical systems and business processes to protect the Bank's assets against
unplanned events that would prevent normal operations. The millennium changeover
presents unique risks, some of which would not be effectively addressed by the
existing plans. The Bank is examining these risks and developing additional
plans to mitigate the effect of potential impacts and ensure continuity of
operation throughout the year 2000 and beyond. The use of the existing
contingency planning infrastructure will assist in providing optimum coverage
and re-usability of existing arrangements and responsibility assignments. The
Bank expects all year 2000-specific contingency plans to be completed by April
30, 1999 and related testing to continue throughout the year.
Emfisys, the Bank's operations group, acting in support of all areas of the
Bank, has overall responsibility for converting systems to accommodate the
calendar change. Each of the Bank's business units is responsible for
remediation of the assets used to conduct its operations and provide services or
products to its clients, while attempting to ensure that both the technical and
the business risks imposed by the year 2000 issue are addressed. A governance
structure has been established to deal with this issue, which includes a Year
2000 Project Office and regular monitoring of progress by the Bank's Risk
Management Committee, Year 2000 Steering Committees and the Board of Directors.
The process for year 2000 compliance is following four major steps:
inventory, impact assessment and plan, implementation and integration testing.
The implementation step includes verification, conversion and replacement or
retirement of the asset. If an asset is not retired, it is tested and verified,
and only once it is verified does it progress to the integration testing step.
Integration testing is to confirm that the business functions work accurately
and without disruption under year 2000-specific dates, with all applications
functioning correctly with interfaces and infrastructure. As of December 31,
1998, the Bank had substantially completed the implementation of critical
systems. The implementation of non-critical business assets and the integration
testing of critical systems is planned to be completed by June 30, 1999. The
costs incurred in addressing the year 2000 problem are borne by the Bank.
ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about
Segments of an Enterprise and Related Information." SFAS No. 131 is effective
for fiscal years beginning after December 31, 1997. The Company adopted SFAS No.
131, as required, without material impact to the Company's financial statements.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits." Because the Company has no
employees, reporting under SFAS No. 132 is not applicable.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." The Statement establishes accounting and
reporting standards for derivative instruments and for
10
12
hedging activities. It requires all derivatives to be recognized as either
assets or liabilities in the statement of financial position and to be measured
at fair value. The Statement is effective for all fiscal quarters of fiscal
years beginning after June 15, 1999. The Company will adopt this Statement in
2000 and does not expect its adoption to have a material effect on its financial
position or results of operations.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". As the company does not engage
in mortgage banking activities nor has securitized mortgage loans that are held
for sale, reporting under SFAS No. 134 is not applicable.
OTHER MATTERS
As of December 31, 1998, the Company believes that it is in full compliance
with the REIT tax rules, and expects to qualify as a REIT under the provisions
of the Code.
The Company expects to meet all REIT requirements regarding the ownership
of its stock and anticipates meeting the annual distribution requirements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
As of December 31, 1998, the Company has $208 million invested in notes
receivable, $261 million invested in mortgage-backed securities and $17 million
of securities purchased from the Bank under agreement to resell. The Company is
subject to exposure for fluctuations in interest rates. Adverse changes in
interest rates could impact negatively the value of mortgage-backed securities,
as well as the levels of interest income to be derived from these assets.
The Company's investments held in mortgage-backed securities are secured by
adjustable and fixed interest rate residential mortgage loans. The yield to
maturity on each security depends on, among other things, the price at which
such security is purchased, the rate and timing of principal payments (including
prepayments, repurchases, defaults and liquidations), the pass-through rate and
interest rate fluctuations. Changes in interest rates could impact prepayment
rates as well as default rates, which in turn would impact the value and yield
to maturity of the Company's mortgage-backed securities.
The Company currently has no outstanding borrowings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Refer to the Index to Financial Statements on page 16 for the required
information.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no changes in or disagreements with accountants on any
matter of accounting principles, practices or financial statement disclosure.
11
13
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The Company's Board of Directors consists of six members. The Company does
not anticipate that it will require any additional employees because it has
retained the Bank to perform certain functions pursuant to the Advisory
Agreement described above. Each officer of the Company currently is also an
officer and/or director of the Bank and/or affiliates of the Bank. The Company
maintains corporate records and audited financial statements that are separate
from those of the Bank or any of the Bank's affiliates. None of the officers,
directors or employees of the Company will have a direct or indirect pecuniary
interest in any Mortgage Asset to be acquired or disposed of by the Company or
in any transaction in which the Company has an interest or will engage in
acquiring, holding and managing Mortgage Assets.
Pursuant to terms of the Preferred Shares, the Company's Independent
Directors will consider the interests of the holders of both the Preferred
Shares and the Common Stock in determining whether any proposed action requiring
their approval is in the best interests of the Company.
The persons who are directors and executive officers of the Company are as
follows:
NAME AGE POSITION AND OFFICES HELD
---- --- -------------------------
Michael D. Williams......................... 43 Chairman of the Board
Paul R. Skubic.............................. 50 President, Director
Pierre O. Greffe............................ 46 Chief Financial Officer
Thomas R. Sizer............................. 60 Secretary, Director
Frank M. Novosel............................ 52 Treasurer, Director
John F. Faulhaber........................... 52 Vice President of Operations
Margaret M. Sulkin.......................... 40 Assistant Treasurer
Delbert J. Wacker........................... 67 Director
David J. Blockowicz......................... 56 Director
The following is a summary of the experience of the executive officers and
directors of the Company:
Mr. Williams has been Senior Vice President, Community Bank Management, of
the Bank since June 1996. Prior to that he was Senior Vice President, Retail
Banking, of Household Bank, f.s.b., a company he joined in April of 1978.
Household Bank's 54 Illinois branches were acquired by the Bank in June 1996.
Mr. Skubic has been Vice President and Controller of the Bank and Chief
Accounting Officer for Harris Bankcorp, Inc., since 1990. Prior to joining
Harris Bankcorp, Inc., Mr. Skubic was employed by Arthur Andersen & Co. He is a
certified public accountant.
Mr. Greffe has been Senior Vice President and Chief Financial Officer of
Harris Bankcorp, Inc. since June 1994. Prior to that he was Vice President of
Finance, Corporate and Institutional Financial Services, of Bank of Montreal in
Toronto. Mr. Greffe has been with the Bank of Montreal group of companies since
November 1974. Mr. Greffe is a member of the Certified Management Accountant
Institute of Canada.
Mr. Sizer has been Vice President and Secretary of the Bank since 1983.
Prior to that time he was a Vice President of the Bank. He holds a Juris Doctor
degree from Fordham University, New York.
Mr. Novosel has been a Vice President in the Treasury Group of the Bank
since 1995. Previously, he served as Treasurer of Harris Bankcorp, Inc.,
managing financial planning. Mr. Novosel is a Chartered Financial Analyst and a
member of the Investment Analysts' Society of Chicago.
Mr. Faulhaber has been Vice President and Division Administrator,
Residential Mortgages, at the Bank since 1994. Prior to this position, he was
Manager, Secondary Mortgage Market, since 1991. He currently serves on the
Bank's Asset/Liability Committee.
Ms. Sulkin has been a Vice President in the Taxation Department of the Bank
since 1992. Ms. Sulkin has been employed by the Bank since 1984. Prior to
joining the Bank, she was employed by KPMG Peat Marwick LLP. She is a certified
public accountant.
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Mr. Wacker retired as a partner from Arthur Andersen & Co. in 1987 after 34
years. From July 1988 to November 1990, he was Vice President -- Treasurer,
Parkside Medical Services -- a subsidiary of Lutheran General Health System.
From November 1990 to September 1993, he completed various financial consulting
projects for Lutheran General.
Mr. Blockowicz is a certified public accountant and is a partner with
Blockowicz & Del Guidicie LLC. Prior to forming his firm, Mr. Blockowicz was a
partner with Arthur Andersen & Co. through 1990.
INDEPENDENT DIRECTORS
The terms of the Preferred Shares require that, as long as any Preferred
Shares are outstanding, certain actions by the Company be approved by a majority
of the Company's Independent Directors. Delbert J. Wacker and David J.
Blockowicz are the Company's Independent Directors. As long as there are only
two Independent Directors, any action that requires the approval of a majority
of Independent Directors must be approved by both Independent Directors.
If at any time the Company fails to declare and pay a quarterly dividend
payment on the Preferred Shares, the number of directors then constituting the
Board of Directors of the Company will be increased by two at the Company's next
annual meeting and the holders of Preferred Shares, voting together with the
holders of any other outstanding series of Preferred Stock as a single class,
will be entitled to elect two additional directors to serve on the Company's
Board of Directors. Any member of the Board of Directors elected by holders of
the Company's Preferred Stock will be deemed to be an Independent Director for
purposes of the actions requiring the approval of a majority of the Independent
Directors.
AUDIT COMMITTEE
The Board of Directors of the Company has established an audit committee
which will review the engagement of independent accountants and review their
independence. The audit committee will also review the adequacy of the Company's
internal accounting controls. The audit committee is comprised of Delbert J.
Wacker and David J. Blockowicz.
COMPENSATION OF DIRECTORS AND OFFICERS
The Company pays the Independent Directors of the Company fees for their
services as directors. The Independent Directors receive annual compensation of
$10,000 plus a fee of $750 for attendance (in person or by telephone) at each
meeting of the Board of Directors.
ITEM 11. EXECUTIVE COMPENSATION
The Company will not pay any compensation to its officers or employees or
to directors who are not Independent Directors.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
None.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(A) TRANSACTIONS WITH MANAGEMENT AND OTHERS
The Bank, through its wholly-owned subsidiary, HCH, indirectly owns 100% of
the common stock of the Company.
As described on page 3 of this report, a substantial portion of the assets
of the Company consists of notes issued by the Bank. The notes mature on October
1, 2027 and pay interest at 6.4% per annum. During 1998, the Company purchased
$356 million of notes and received repayments of $148 million. The Bank paid
interest on the notes in the amount of $16.3 million to the Company in 1998.
13
15
The Company purchases U.S. Treasury and Federal agency securities from the
Bank under agreements to resell identical securities. At December 31, 1998, the
Company held $17 million of such assets and had earned $943 thousand of interest
from the Bank on these transactions in 1998. The Company receives rates on these
assets comparable to the rates that the Bank offers to unrelated counterparties
under similar circumstances.
During 1998, the Company acquired $135 million of GNMA securities from the
Bank at fair value.
The Bank and the Company have entered into a Servicing Agreement and an
Advisory Agreement, the terms of which are described in further detail on page 5
of this Report. In 1998, the Bank received payments of $756 thousand and $43
thousand, respectively, under the terms of these agreements.
(B) CERTAIN BUSINESS RELATIONSHIPS
Michael D. Williams, Chairman of the Board of the Company, and all of its
executive officers, Paul R. Skubic, Pierre O. Greffe, Thomas R. Sizer, Frank M.
Novosel, John F. Faulhaber and Margaret M. Sulkin, are also officers of the
Bank.
(C) INDEBTEDNESS OF MANAGEMENT
None.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed with Report;
(1) Financial Statements (See page 16 for a listing of all financial
statements included in Item 8)
(2) Financial Statement Schedules
All schedules normally required by Form 10-K are omitted since they are either
not applicable or because the required information is shown in the financial
statements or notes thereto.
(3) Exhibits:
*3(a)(i) Articles of Incorporation of the Company
*3(a)(ii) Form of Articles of Amendment and Restatement of the Company
establishing the Series A Preferred Shares
*3(b) Bylaws of the Company
*4 Specimen of certificate representing Series A Preferred
Shares
*10(a) Form of Servicing Agreement between the Company and the Bank
*10(b) Form of Advisory Agreement between the Company and the Bank
*10(c) Form of Bank Loan Agreement between the Company and the Bank
*10(d) Form of Mortgage Loan Assignment Agreement between the
Company and the Bank
24 Power of attorney
27 Financial Data Schedule
- -------------------------
* Incorporated by reference to the exhibit of the same number filed with the
Company's Registration Statement on Form S-11 (Securities and Exchange
Commission file number 333-40257)
(b) No reports on Form 8-K were filed.
14
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Harris Preferred Capital Corporation has duly caused this
Report to be signed on its behalf by the undersigned, thereunto duly authorized
on the 19th day of March, 1999.
/s/ MICHAEL D. WILLIAMS
--------------------------------------
Michael D. Williams
Chairman of the Board
/s/ PIERRE O. GREFFE
--------------------------------------
Pierre O. Greffe
Chief Financial Officer
/s/ PAUL R. SKUBIC
--------------------------------------
Paul R. Skubic
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by Michael D. Williams, Chairman of the Board of the
Company, as attorney-in-fact for the following Directors on behalf of Harris
Preferred Capital Corporation of the 19th day of March 1999.
David J. Blockowicz Paul R. Skubic
Frank M. Novosel Delbert J. Wacker
Thomas R. Sizer
Michael D. Williams
Attorney-In-Fact
Supplemental Information
No proxy statement will be sent to security holders in 1999.
15
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INDEX TO FINANCIAL STATEMENTS
The following financial statements are included in Item 8 of this Annual
Report on Form 10-K:
HARRIS PREFERRED CAPITAL CORPORATION
Financial Statements
Independent Auditors Report
Balance Sheet
Statement of Operations
Statement of Changes in Stockholders' Equity
Statement of Cash Flows
Notes to Financial Statements
HARRIS TRUST AND SAVINGS BANK
Financial Review
Financial Statements
Joint Independent Auditors
Independent Auditors Report
Consolidated Statements of Condition
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Stockholder's Equity
Consolidated Statements of Cash Flows
Notes to Financial Statements
All other schedules are omitted since the required information is not
present or is not present in amounts sufficient to require submission of the
schedule or because the information required is included in the financial
statements and notes hereof.
16
18
INDEPENDENT AUDITORS REPORT
To the Board of Directors
of Harris Preferred Capital Corporation
In our opinion, the accompanying balance sheet and the related statements
of operations and of stockholders' equity and of cash flows present fairly, in
all material respects, the financial position of Harris Preferred Capital
Corporation (the " Company") at December 31, 1998, and the results of its
operations and its cash flows for the period January 2, 1998 (inception) to
December 31, 1998, 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 audit. We conducted our audit 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 audit provides a reasonable basis for the opinion expressed
above.
PricewaterhouseCoopers LLP
Chicago, Illinois
January 25, 1999
17
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HARRIS PREFERRED CAPITAL CORPORATION
BALANCE SHEET
DECEMBER 31, 1998
(IN THOUSANDS
EXCEPT SHARE DATA)
ASSETS
Cash on deposit with Harris Trust and Savings Bank.......... $ 621
Securities purchased from Harris Trust and Savings Bank
under agreement to resell................................. 17,004
Notes receivable from Harris Trust and Savings Bank......... 207,935
Securities available-for-sale:
Mortgage-backed........................................... 261,494
Securing mortgage collections due from Harris Trust and
Savings Bank.............................................. 13,690
Other assets................................................ 2,646
--------
TOTAL ASSETS........................................... $503,390
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accrued expenses due to Harris Trust and Savings Bank....... $ 62
Dividends on common stock payable to parent................. 9,700
--------
TOTAL LIABILITIES...................................... 9,762
--------
Commitments and contingencies
STOCKHOLDERS' EQUITY
7 3/8% Noncumulative Exchangeable Preferred Stock, Series A
($1 par value); liquidation value of $250,000; 20,000,000
shares authorized, 10,000,000 shares issued and
outstanding............................................... 250,000
Common stock ($1 par value); 1,000 shares authorized, issued
and outstanding........................................... 1
Additional paid-in capital.................................. 240,733
Earnings in excess of distributions......................... 392
Accumulated other comprehensive income -- unrealized gains
on available-for-sale securities.......................... 2,502
--------
TOTAL STOCKHOLDERS' EQUITY............................. 493,628
--------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............. $503,390
========
The accompanying notes are an integral part of the financial statements.
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HARRIS PREFERRED CAPITAL CORPORATION
STATEMENT OF OPERATIONS
FROM INCEPTION (JANUARY 2, 1998) THROUGH DECEMBER 31, 1998
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
INTEREST INCOME:
Securities purchased from Harris Trust and Savings Bank
under agreement to resell................................. $ 943
Notes receivable from Harris Trust and Savings Bank......... 16,321
Securities available-for-sale:
Mortgage-backed........................................... 9,771
U.S. Treasury............................................. 432
----------
Total interest income..................................... 27,467
----------
OPERATING EXPENSES:
Loan servicing fees paid to Harris Trust and Savings
Bank................................................... 756
Advisory fees paid to Harris Trust and Savings Bank....... 43
General and administrative................................ 187
----------
Total operating expenses.................................. 986
----------
Net income.................................................. 26,481
Preferred dividends......................................... 16,389
----------
NET INCOME AVAILABLE TO COMMON STOCKHOLDER.................. $ 10,092
==========
Basic and diluted earnings per common share................. $10,092.00
==========
Net income.................................................. $ 26,481
Other comprehensive income -- unrealized gains on
available-for-sale securities............................. 2,502
----------
Comprehensive income........................................ $ 28,983
==========
The accompanying notes are an integral part of the financial statements.
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21
HARRIS PREFERRED CAPITAL CORPORATION
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FROM INCEPTION (JANUARY 2, 1998) THROUGH DECEMBER 31, 1998
ACCUMULATED
ADDITIONAL EARNINGS IN OTHER
PREFERRED COMMON PAID-IN EXCESS OF COMPREHENSIVE
STOCK STOCK CAPITAL DISTRIBUTIONS INCOME TOTAL
--------- ------ ---------- ------------- ------------- -----
(IN THOUSANDS EXCEPT PER SHARE DATA)
Balance at inception............... $ -- $-- $ -- $ -- $ -- $ --
Issuance of common stock......... 1 1
Initial public offering of 7 3/8%
Noncumulative Exchangable
Preferred Stock, Series A, par
value $1, on February 11,
1998........................... 250,000 -- -- -- -- 250,000
Contribution to capital
surplus........................ -- -- 240,733 -- -- 240,733
Net income....................... -- -- -- 26,481 -- 26,481
Other comprehensive income....... -- -- -- -- 2,502 2,502
Dividends declared on common
stock ($9,700.00 per share).... (9,700) (9,700)
Dividends paid on preferred stock
($1.6389 per share)............ -- -- -- (16,389) -- (16,389)
-------- --- -------- -------- ------ --------
Balance at December 31, 1998....... $250,000 $ 1 $240,733 $ 392 $2,502 $493,628
======== === ======== ======== ====== ========
The accompanying notes are an integral part of the financial statements.
20
22
HARRIS PREFERRED CAPITAL CORPORATION
STATEMENT OF CASH FLOWS
FROM INCEPTION (JANUARY 2, 1998) THROUGH DECEMBER 31, 1998
(IN THOUSANDS)
OPERATING ACTIVITIES:
Net Income.................................................. $ 26,481
Adjustments to reconcile net income to net cash provided by
operating activities:
Net increase in other assets.............................. (2,646)
Net increase in accrued expenses due to Harris Trust and
Savings Bank........................................... 62
---------
Net cash provided by operating activities.............. 23,897
---------
INVESTING ACTIVITIES:
Net increase in securities purchased from Harris Trust and
Savings Bank under agreement to resell.................... (17,004)
Purchases of notes receivable from Harris Trust and Savings
Bank...................................................... (356,000)
Repayments of notes receivable from Harris Trust and Savings
Bank...................................................... 148,065
Net increase in securing mortgage collections due from
Harris Trust and Savings Bank............................. (13,690)
Purchases of securities available-for-sale.................. (309,790)
Proceeds from maturities of securities available-for-sale... 50,798
---------
Net cash used by investing activities.................. (497,621)
---------
FINANCING ACTIVITIES:
Proceeds from issuance of preferred stock................... 250,000
Proceeds from issuance of common stock...................... 1
Contribution to additional paid-in capital, net of
acquisition costs......................................... 240,733
Cash dividends paid on preferred stock...................... (16,389)
---------
Net cash provided by financing activities.............. 474,345
---------
Net increase in cash on deposit with Harris Trust and
Savings Bank.............................................. 621
Cash on deposit with Harris Trust and Savings Bank at
January 2, 1998........................................... --
---------
Cash on deposit with Harris Trust and Savings Bank at
December 31, 1998......................................... $ 621
=========
The accompanying notes are an integral part of the financial statements.
21
23
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION
Harris Preferred Capital Corporation (the "Company") is a Maryland
corporation incorporated on September 24, 1997, pursuant to the Maryland General
Corporation Law. The Company's principal business objective is to acquire, hold,
finance and manage qualifying Real Estate Investment Trust ("REIT") assets (the
"Mortgage Assets"), consisting of a limited recourse note or notes issued by
Harris Trust and Savings Bank (the "Bank") secured by real estate mortgage
assets and other obligations secured by real property, as well as certain other
qualifying REIT assets. The Company expects to be subject to tax as a REIT under
sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the
"Code"), and will generally not be subject to Federal income tax to the extent
that it distributes 95% of its taxable earnings to its preferred and common
stockholders and maintains its qualification as a REIT. All of the one thousand
shares of the Company's common stock, par value $1.00 per share (the "Common
Stock"), are owned by Harris Capital Holdings, Inc. ("HCH"), a wholly-owned,
newly-formed subsidiary of the Bank. On December 30, 1998, the Bank transferred
its ownership of the common stock of the Company to HCH. The Bank is required to
maintain direct or indirect ownership of at least 80% of the outstanding Common
Stock of the Company for as long as any 7 3/8% Noncumulative Exchangeable
Preferred Stock, Series A (the "Preferred Shares"), $1.00 par value, are
outstanding. The Company was formed by the Bank to provide investors with the
opportunity to invest in residential mortgages and other real estate assets and
to provide the Bank with a cost-effective means of raising capital for federal
regulatory purposes.
On February 11, 1998, the Company completed an initial public offering (the
"Offering") of 10,000,000 shares of the Company's Preferred Shares, receiving
proceeds of $242,125,000, net of underwriting fees. The Preferred Shares are
traded on the New York Stock Exchange. Concurrent with the issuance of the
Preferred Shares, the Bank contributed additional capital of $250 million to the
Company.
The Company used the proceeds raised from the initial public offering of
the Preferred Shares and the additional capital contributed by the Bank to
purchase $356 million of notes (the "Notes") from the Bank and $135 million of
mortgage-backed securities at their estimated fair value.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents
Cash and cash equivalents include cash on deposit with the Bank and
securities purchased from the Bank under agreement to resell.
Allowance for Possible Loan Losses
The allowance for possible loan losses is maintained at a level considered
adequate to provide for potential loan losses. The allowance is increased by
provisions charged to operating expense and reduced by net charge-offs. Known
losses of principal on impaired loans are charged off. The provision for loan
losses is based on past loss experience, management's evaluation of the loan
portfolio securing the Mortgage Assets under current economic conditions and
management's estimate of anticipated, but as yet not specifically identified,
loan losses. Such estimates are reviewed periodically and adjustments, if
necessary, are recorded during the periods in which they become known. At
December 31, 1998, no allowance for possible loan losses was recorded under this
policy.
Income Taxes
The Company expects to elect to be taxed as a REIT commencing with its
taxable year ended December 31, 1998 and intends to comply with the provisions
of the Code with respect thereto. The Company does not expect to be subject to
Federal income tax because it distributes 95% of its adjusted REIT taxable
income to stockholders and as long as certain assets, income and stock ownership
tests are met. Accordingly, no provision for income taxes is included in the
accompanying financial statements.
22
24
Securities
The Company classifies all securities as held-to-maturity or as
available-for-sale. Available-for-sale securities are reported at fair value
with unrealized gains and losses included as a separate component of
stockholders' equity. There were no held-to-maturity securities at December 31,
1998.
Interest income on securities, including amortization of discount or
premium, is included in earnings. Realized gains and losses, as a result of
securities sales, are included in securities gains, with the cost of securities
sold determined on the specific identification basis.
The Company purchases U.S. Treasury and Federal agency securities from the
Bank under agreements to resell identical securities. The amounts advanced under
these agreements represent short-term loans and are reflected as receivables in
the Balance Sheet. Securities purchased under agreement to resell totaled $17
million at December 31, 1998. The securities underlying the agreements are
book-entry securities. Securities are transferred by appropriate entry into the
Company's account with the Bank under a written custodial agreement with the
Bank that explicitly recognizes the Company's interest in these securities.
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about
Segments of an Enterprise and Related Information". SFAS No. 131 is effective
for fiscal years beginning after December 31, 1997. The Company adopted SFAS No.
131, as required, without material impact of the Company's financial statements
(see Note 7 to these financial statements).
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits". Because the Company has no
employees, reporting under SFAS No. 132 is not applicable.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". The Statement establishes accounting and
reporting standards for derivative instruments and for hedging activities. It
requires all derivatives to be recognized as either assets or liabilities in the
statement of financial position and to be measured at fair value. The Statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. The Company will adopt this Statement in 2000 and does not expect its
adoption to have a material effect on its financial position or results of
operations.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". As the company does not engage
in mortgage banking activities nor has securitized mortgage loans that are held
for sale, reporting under SFAS No. 134 is not applicable.
Management's Estimates
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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
3. NOTES RECEIVABLE FROM THE BANK
On February 11, 1998, proceeds received from the Offering were used in part
to purchase $356 million of Notes at a rate of 6.4%. The Notes are secured by
mortgage loans originated by the Bank. The principal amount of the Notes equals
approximately 80% of the aggregate outstanding principal amount of the
collateralizing mortgage loans.
The Notes are recourse only to the securing mortgage loans that are secured
by real property. The Notes mature on October 1, 2027. Payments of principal and
interest on the notes are recorded monthly from
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payments received on the securing mortgage loans. The Company has a security
interest in the real property securing the underlying mortgage loans and is
entitled to enforce payment on the securing mortgage loans in its own name if a
mortgagor should default. In the event of default, the Company has the same
rights as the original mortgagee to foreclose the mortgaged property and satisfy
the obligations of the Bank out of the proceeds. The securing mortgage loans are
serviced by the Bank, as agent of the Company.
The Company intends that each mortgage loan securing the Notes will
represent a first lien position and will be originated in the ordinary course of
the Bank's real estate lending activities based on the underwriting standards
generally applied (at the time of origination) for the Bank's own account. The
Company also intends that all Mortgage Assets held by the Company will meet
market standards, and servicing guidelines promulgated by the Company, and
Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan
Mortgage Corporation ("FHLMC") guidelines and procedures.
The balance of securing mortgage loans at December 31, 1998 was $260
million. The weighted average interest rate on those loans was 7.408% at
December 31, 1998.
None of the mortgage loans collateralizing the Notes were on nonaccrual
status at December 31, 1998.
A majority of the collateral securing the underlying mortgage loans is
located in Illinois and Arizona. The financial viability of customers in these
states is, in part, dependent on those states' economies. The Company's maximum
risk of accounting loss, should all customers in Illinois and Arizona fail to
perform according to contract terms and all collateral prove to be worthless,
was approximately $161 million and $34 million, respectively, as of December 31,
1998.
4. SECURITIES
DECEMBER 31, 1998
-------------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- -----
(IN THOUSANDS)
AVAILABLE-FOR-SALE SECURITIES
Mortgage-backed..................................... $258,992 $2,502 $-- $261,494
-------- ------ --- --------
Total Securities.................................... $258,992 $2,502 $-- $261,494
======== ====== === ========
Mortgage-backed securities represent Government National Mortgage
Association 6 1/2% Platinum Certificates. The contractual maturities are shown
below. Expected maturities can differ from contractual maturities since
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.
DECEMBER 31, 1998
---------------------
AMORTIZED FAIR
COST VALUE
--------- -----
(IN THOUSANDS)
Maturities:
Over 10 years............................................. $258,992 $261,494
-------- --------
Total Securities............................................ $258,992 $261,494
======== ========
5. COMMON AND PREFERRED STOCK
On February 11, 1998, the Company issued 10,000,000 Preferred Shares,
Series A, at a price of $25 per share pursuant to its Registration Statement on
Form S-11. Proceeds from this issuance, net of underwriting fees, totaled
$242,125,000. The liquidation value of each Preferred Share is $25 plus any
authorized, declared and unpaid dividends. Except upon the occurrence of certain
events, the Preferred Shares are not redeemable by the Company prior to March
30, 2003. On or after such date, the Preferred Shares will be redeemable at the
option of the Company, in whole or in part, at the liquidation preference
thereof, plus the quarterly accrued and unpaid dividends, if any, to the date of
redemption. Except under certain limited circumstances,
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as defined, the holders of the Preferred Shares have no voting rights. The
Preferred Shares are automatically exchangeable for a new series of preferred
stock of the Bank upon the occurrence of certain events.
Holders of Preferred Shares are entitled to receive, if declared by the
Board of Directors of the Company, noncumulative dividends at a rate of 7 3/8%
per annum of the $25 per share liquidation preference (an amount equivalent to
$1.84375 per share per annum). Dividends on the Preferred Shares, if authorized
and declared, are payable quarterly in arrears on March 30, June 30, September
30, and December 30 of each year. Dividends paid to the holders of the Preferred
Shares during the quarter ended December 31, 1998 and the period from inception
(January 2, 1998) through December 31, 1998 were $4,609,400 and $16,389,001,
respectively. The allocations of the distributions declared and paid for income
tax purposes were 100% of ordinary income and 0% of capital gain.
On December 30, 1998, the Bank contributed the common stock of the Company
to HCH. The Bank is required to maintain direct or indirect ownership of at
least 80% of the outstanding Common Stock of the Company for as long as any
Preferred Shares are outstanding. Dividends on Common Stock are paid if and when
authorized and declared by the Board of Directors out of funds legally available
after all preferred dividends have been paid. A Common Stock dividend of
$9,700.00 per common share was declared on December 10, 1998, to stockholders of
record on December 30, 1998, paid on January 28, 1999.
6. TRANSACTIONS WITH AFFILIATES
The Company entered into an advisory agreement (the "Advisory Agreement")
with the Bank pursuant to which the Bank administers the day-to-day operations
of the Company. The Bank is responsible for (i) monitoring the credit quality of
Mortgage Assets held by the Company, (ii) advising the Company with respect to
the reinvestment of income from and payments on, and with respect to the
acquisition, management, financing, and disposition of the Mortgage Assets held
by the Company, and (iii) monitoring the Company's compliance with the
requirements necessary to qualify as a REIT.
The Advisory Agreement has an initial term of one year and may be renewed
for additional one-year periods. The Bank is entitled to receive an advisory fee
equal to $50,000 per year, payable in equal quarterly installments.
The securing mortgage loans are serviced by the Bank pursuant to the terms
of a servicing agreement (the "Servicing Agreement"). The Bank receives a fee
equal to 0.25% per annum on the principal balances of the loans serviced. The
Servicing Agreement requires the Bank to service the mortgage loans in a manner
generally consistent with accepted secondary market practices, and servicing
guidelines promulgated by the Company and with Fannie Mae and FHLMC guidelines
and procedures.
7. OPERATING SEGMENT
The Company's operations consist of monitoring and evaluating the
investments in Mortgage Assets. Accordingly, the Company operates in only one
segment. The Company has no external customers and transacts most of its
business with the Bank. See Note 3 for further information.
8. COMMITMENTS AND CONTINGENCIES
Legal proceedings in which the Company is a defendant may arise in the
normal course of business. At December 31, 1998, there is no pending litigation
against the Company.
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9. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The following table sets forth selected quarterly financial data for the
Company:
PERIOD FROM INCEPTION (JANUARY 2, 1998)
THROUGH DECEMBER 31, 1998
------------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------
(IN THOUSANDS EXCEPT PER SHARE DATA)
Total interest income............................. $ 4,365 $ 7,680 $ 7,715 $ 7,707
Total operating expenses.......................... 172 294 343 177
--------- --------- --------- ---------
Net income........................................ 4,193 7,386 7,372 7,530
Preferred dividends............................... 2,561 4,609 4,609 4,610
--------- --------- --------- ---------
Net income available to common stockholder........ $ 1,632 $ 2,777 $ 2,763 $ 2,920
========= ========= ========= =========
Basic and diluted income per common share......... $1,632.00 $2,777.00 $2,763.00 $2,920.00
========= ========= ========= =========
FINANCIAL STATEMENTS OF HARRIS TRUST AND SAVINGS BANK
The following unaudited financial information and audited financial
statements for Harris Trust and Savings Bank are included because the Preferred
Shares are automatically exchangeable for a new series of preferred stock of the
Bank upon the occurrence of certain events.
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HARRIS TRUST AND SAVINGS BANK
CERTAIN INFORMATION REGARDING HARRIS TRUST AND SAVINGS BANK
Harris Trust and Savings Bank ("the Bank") is an Illinois Banking operation
located at 111 West Monroe Street, Chicago, Illinois 60603. The Bank is a
wholly-owned subsidiary of Harris Bankcorp, Inc., a multibank holding company
incorporated under the laws of the State of Delaware and headquartered in
Chicago and registered under the Bank Holding Company Act of 1956, as amended.
Harris Bankcorp, Inc. also owns 13 other banks, 12 in the counties surrounding
Chicago and one in Arizona. Another Chicago metropolitan area multibank holding
company, Harris Bankmont, Inc. was purchased in 1994 by Bankmont Financial Corp.
("Bankmont"), which is also the parent company of Harris Bankcorp, Inc. Harris
Bankmont, Inc. owns 13 banks and, together with Harris Bankcorp, is collectively
referred to as "Harris Bank." Bankmont is a wholly-owned subsidiary of Bank of
Montreal. At December 31, 1998, Harris Bank's assets amounted to $25.1 billion,
with the Bank representing approximately 72 percent of that total.
The Bank, an Illinois state-chartered bank, has its principal office, 53
domestic branch offices and 94 automated teller machines ("ATMs") located in the
Chicago area. The Bank also has representative offices in Los Angeles, New York,
Houston, Dallas, San Francisco and Tokyo; a foreign branch office in Nassau; and
an Edge Act subsidiary, Harris Bank International Corporation ("HBIC"), engaged
in international banking and finance in New York. At December 31, 1998, the Bank
had total assets of $18.0 billion, total deposits of $11.2 billion, total loans
of $9.3 billion and equity capital of $1.3 billion.
The bank provides a broad range of banking and financial services to
individuals and corporations domestically and abroad, including corporate
banking, personal financial services, corporate and personal trust services,
charge cards and investment services. The Bank also offers (i) demand and time
deposit accounts; (ii) various types of loans (including term, real estate,
revolving credit facilities and lines of credit); (iii) sales and purchases of
foreign currencies; (iv) interest rate management products (including swaps,
forward rate agreements and interest rate guarantees); (v) cash management
services; (vi) underwriting of municipal bonds; (vii) financial consulting; and
(viii) a wide variety of trust and trust-related services.
Competitors of the Bank include commercial banks, savings and loan
associations, consumer and commercial finance companies, credit unions and other
financial services companies. Based on legislation passed in 1986 that allows
Illinois banks to be acquired by banks or holding companies in states with a
reciprocal law in effect together with Federal Interstate Banking Efficiency Act
of 1994, that allows for both interstate banking and interstate branching in
certain circumstances, the Bank believes that the level of competition will
increase in the future.
The Bank is subject to regulation by the Board of Governors and the Federal
Deposit Insurance Corporation. As a state-chartered bank, it is also regulated
by the Illinois Office of Banks and Real Estate. These regulatory bodies examine
the Bank and supervise numerous aspects of its business. The Federal Reserve
System regulates money and credit conditions and interest rates in order to
influence general economic conditions, primarily through open market operations
in U.S. Government securities, varying the discount rate on bank borrowings,
setting reserve requirements against financial institution deposits and
prescribing minimum capital requirements for member banks. These policies have a
significant influence on overall growth and distribution of bank loans,
investments and deposits, and affect interest rates charged on loans and earned
on investments or paid for time, savings and other deposits. Board of Governors
monetary policies have had a significant effect on the operating results of
commercial banks in the past and this is expected to continue.
Although primarily focusing on U.S. domestic customers, identifiable
foreign assets accounted for 1 percent of the Bank's total consolidated assets
at December 31, 1998, foreign net income was approximately 20 percent of the
Bank's consolidated net income. Foreign net income is generated from three
primary sources: (i) lending to foreign banks and other financial institutions;
(ii) time deposits held in foreign banks; and (iii) foreign exchange trading
profits of approximately $7.0 million.
Credit Card Portfolio Sale. On January 29, 1998, the Bank sold its credit
card portfolio to a company owned by BankBoston Corporation, First Annapolis
Consulting, Inc. and Bankmont. The assets sold had a
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carrying value of $693.0 million, representing less than 5 percent of the Bank's
total consolidated assets. Upon completion of the transfer, the Bank received
cash and an equity interest in the newly formed company, which it immediately
sold for cash to Bankmont.
Household Branch Acquisition. On June 28, 1996 the Bank completed the
acquisition of 54 Chicago-area branches previously owned by Household Bank,
f.s.b. ("Household"), a wholly-owned subsidiary of Household International, Inc.
In addition to acquiring real and personal property, the Bank has assumed
certain deposit liabilities and purchased other assets, primarily consumer
loans. In anticipation of this transaction, on June 27, 1996 the Bank increased
its capital base by $340 million, in part through a direct cash infusion of $325
million of common equity by Harris Bankcorp, Inc. and the issuance of $15
million of long term subordinated debt.
At the closing, the Bank assumed deposits totaling $2.9 billion. In
addition, the Bank acquired loans amounting to $340 million along with real
property and certain other miscellaneous assets. After paying a purchase price
of $277 million, the Bank received approximately $2.24 billion in cash from
Household as consideration for the deposit liabilities assumed, net of assets
purchased. The purchase price of $277 million was recorded as an intangible
asset, along with certain fair value adjustments and deferred acquisition costs,
resulting in goodwill and other intangibles recognized of $284 million.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
1998 COMPARED TO 1997
SUMMARY
Harris Trust and Savings Bank's 1998 net income was $129.6 million, up
$25.3 million, or 24% from 1997. Return on average common equity ("ROE") for
1998 was 10.02 percent and return on average assets ("ROA") was 0.78 percent.
For 1997, ROE was 8.47 percent and ROA was 0.69 percent.
Earnings before amortization of goodwill and other valuation intangibles
("cash earnings") was $142.5 million in 1998, a 19 percent increase compared to
1997. With the Bank's June 1996 acquisition of Household Bank's Chicagoland
network, earnings on a cash basis is the most relevant measure of performance.
Cash flow return on average common stockholder's equity ("Cash flow ROE") is
calculated as net income applicable to common stock plus after-tax amortization
expenses of goodwill and other valuation intangibles, divided by average common
stockholder's equity less gross average intangible assets. For the year ended
December 31, 1998, cash flow ROE was 13.87 percent compared to cash flow ROE of
12.67 percent in 1997. Cash flow return on average assets ("Cash flow ROA") is
calculated as net income plus after-tax amortization expenses of goodwill and
other valuation intangibles, divided by average assets less average intangible
assets. Cash flow ROA was 0.87 percent in 1998 compared to 0.81 percent a year
ago.
For 1998, net interest income on a fully taxable equivalent basis of $372.0
million was down 15 percent from 1997. Net interest margin fell from 3.40
percent to 2.66 percent in 1998, reflecting the impact of the credit card sale
portfolio sale in January 1998 (see Note 19 to Financial Statements). Average
earning assets rose $1.17 billion or 9 percent to $14.01 billion. Average loans
increased 7 percent or $573 million. Excluding the credit card portfolio,
average loans rose $1.37 billion or 18 percent. Commercial and residential real
estate lending were strong contributors to this growth.
Noninterest income increased 21 percent to $375.9 million for 1998. The
primary contributors to this revenue growth were trust and investment management
fees, service charges on deposits, gains on debt portfolio securities,
syndication fees, gains on mortgage loan sales and income from bank-owned
insurance investments.
Total noninterest expenses were $530.6 million up $8.1 million or 2 percent
from 1997. Employment-related expenses totaled $313.6 million up $14.9 million
or 5 percent. Net occupancy expenses totaled $40.1 million, down $4.7 million or
10 percent. Equipment expenses totaled $45.4 million, up $5.0 million or 12
percent from 1997. Contract programming and expert service expenses were up $9.6
million and $2.4 million respectively, primarily due to Year 2000 compliance
activities. Other expenses including marketing, communication and delivery
expense totaled $54.6 million down $15.9 million due primarily from the
reduction of cost from the sale of the credit card portfolio. Amortization of
goodwill and other valuation intangibles decreased $3.1 million or 13 percent
from 1997, due to the credit card sale in January 1998. Excluding the cost
associated with the credit card portfolio, expenses increased 7 percent.
Income taxes were $45.3 million down $2.0 million from 1997. The 1998 and
1997 effective tax rates are 25.9 percent and 31.2 percent respectively. The
reduction in rate is primarily from the increase revenue in bank owned life
insurance investments from 1997 (see Note 14 to Financial Statements).
The 1998 provision for loan losses of $25.4 million was down $33.0 million
from $58.4 million in 1997. Net loan charge-offs during the current year were
$16.8 million compared to $67.1 million in 1997, primarily reflecting lower
writeoffs in the charge card portfolio.
Nonperforming assets at December 31, 1998 totaled $16 million, or 0.2
percent of total loans compared to $8 million or 0.1 percent a year ago. At
December 31, 1998, the allowance for possible loan losses was $108 million or
1.2 percent of total loans outstanding compared to $100 million or 1.2 percent
of loans at the
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end of 1997. As a result, the ratio of the allowance for possible loan losses to
nonperforming assets declined from a multiple of 12.6 at December 31, 1997 to
6.9 at December 31, 1998.
At December 31, 1998, the Bank's equity capital amounted to $1.33 billion,
up from $1.28 billion at December 31, 1997. The Bank's regulatory capital
leverage ratio was 7.50 percent compared to 6.54 percent one year earlier. In
February 1998, Harris Preferred Capital Corporation, a subsidiary of the Bank,
issued $250 million of noncumulative preferred stock in a public offering (see
Note 15 to Financial Statements). The preferred stock qualifies as Tier 1
capital for U.S. banking regulatory purposes.
Regulators require most banking institutions to maintain capital leverage
ratios of not less than 4.0 percent. At December 31, 1998, the Bank's Tier 1 and
Total risk-based capital ratios were 8.57 percent and 10.77 percent,
respectively, compared to respective ratios of 7.29 percent and 10.36 percent at
December 31, 1997. The 1998 year-end ratios substantially exceeded minimum
required regulatory ratios of 4.0 percent and 8.0 percent, respectively.
1997 COMPARED TO 1996
The Bank's 1997 net income was $104.3 million, up $1.2 million, or 1% from
1996. Earnings comparability between years was affected by the June 1996
purchase of Household's Chicagoland retail banking business (see Note 19 to
Financial Statements). As part of the Household transaction in 1996, the Bank
was assessed a one-time $10 million after-tax charge resulting from third
quarter 1996 legislation to recapitalize the Savings Association Insurance Fund
("SAIF"). In addition to the impact of the Household transaction, during the
first quarter of 1996 the Bank realized a $2.4 million after-tax gain from the
sale of its securities custody and related trustee services business for large
institutions. Excluding the effect of the Household transaction, (which included
the $10 million after-tax SAIF charge) and the gain from the sale of the custody
business for large institutions, 1997 core earnings decreased 3% from 1996.
ROE for 1997 was 8.47 percent and return on average assets ("ROA") was 0.69
percent. For 1996, ROE was 10.20 percent and ROA was 0.77 percent. Cash flow ROE
and cash flow ROA were 12.67 percent and 0.81 percent, respectively, in 1997
compared to cash flow ROE of 13.26 percent and cash flow ROA of 0.85 percent in
1996.
For 1997, net interest income on a fully taxable equivalent basis of $437.0
million was up 8 percent from 1996. Net interest margin fell from 3.53 percent
to 3.40 percent in 1997, while average earning assets rose $1.4 billion or 12
percent to $12.8 billion. Average loans increased 7 percent or $563 million.
Excluding the contribution of the Household transaction, net interest income
would have increased $6.9 million or 2 percent from 1996 to 1997.
The Bank's net interest margin declined to 3.40 percent from 3.53 percent
in the prior year. This decrease reflects the relative decrease in
noninterest-bearing funds and spread compression within certain categories of
assets and related funding. This was somewhat offset by the lower interest cost
of the assumed deposits from Household compared to interest costs on wholesale
funds displaced.
Noninterest income increased 17 percent to $311.8 million for 1997. The
primary contributors to this revenue growth were trust and investment management
fees, service charges on deposits, syndication fees, gains on mortgage loan
sales and income from bank-owned insurance investments.
Total noninterest expenses were $522.5 million in 1997 up $76.0 million or
17 percent primarily due to the acquisition of Household. Excluding the effect
of charges related to the acquisition and ongoing operations of the Household
retail banking business acquired at the end of second quarter 1996 (including a
one-time special SAIF assessment), expenses increased by 13 percent compared to
1996.
Income taxes remained virtually unchanged from 1996. The effective tax
rates were 31.2 percent in 1997 compared to 31.9 percent in 1996.
The 1997 provision for loan losses of $58.4 million was up $1.0 million
from $57.4 million in 1996. Net loan charge-offs during 1997 were $67.1 million
compared to $47.9 million in 1996, primarily reflecting higher writeoffs in the
charge card portfolio.
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Nonperforming assets at December 31, 1997 totaled $8 million, or 0.1
percent of total loans compared to $19 million or 0.2 percent in 1996. At
December 31, 1997, the allowance for possible loan losses was $100 million or
1.2 percent of total loans outstanding compared to $108 million or 1.3 percent
of loans at the end of 1996. As a result, the ratio of the allowance for
possible loan losses to nonperforming assets rose from a multiple of 5.9 at
December 31, 1996 to 12.6 at December 31, 1997.
At December 31, 1997, the Bank's equity capital amounted to $1.28 billion,
up from $1.19 billion at December 31, 1996. The Bank's regulatory capital
leverage ratio was 6.54 percent in 1997 compared to 6.65 percent in 1996.
Regulators require most banking institutions to maintain capital leverage ratios
of not less than 4.0 percent. At December 31, 1997, the Bank's Tier 1 and Total
risk-based capital ratios were 7.29 percent and 10.36 percent, respectively,
compared to respective ratios of 7.44 percent and 10.74 percent at December 31,
1996. The 1997 year-end ratios substantially exceeded minimum required
regulatory ratios of 4.0 percent and 8.0 percent, respectively.
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JOINT INDEPENDENT AUDITORS
The Board of Directors of Harris Trust and Savings Bank engaged the firms
of KPMG LLP and PricewaterhouseCoopers LLP to serve as joint auditors for each
of the years in the three year period ended December 31, 1998.
The Bank's ultimate parent company, Bank of Montreal ("BMO"), has elected
to appoint two firms of independent public accountants to be auditors of BMO and
all significant subsidiaries. The Bank's independent public accountants reflect
the appointments made by BMO.
INDEPENDENT AUDITORS' REPORT
To the Stockholder and Board
of Directors of Harris Trust and Savings Bank:
We have audited the accompanying consolidated statements of condition of
Harris Trust and Savings Bank and Subsidiaries as of December 31, 1998 and 1997,
and the related consolidated statements of income, comprehensive income, changes
in stockholder's equity and cash flows for each of the years in the three year
period ended December 31, 1998. These consolidated financial statements are the
responsibility of Harris Trust and Savings Bank's management. Our responsibility
is to express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Harris Trust
and Savings Bank and Subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three year period ended December 31, 1998 in conformity with generally accepted
accounting principles.
KPMG LLP PricewaterhouseCoopers LLP
Chicago, Illinois
January 29, 1999
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF CONDITION
DECEMBER 31
--------------------------------
1998 1997
------------- -------------
(IN THOUSANDS EXCEPT SHARE DATA)
ASSETS
Cash and demand balances due from banks..................... $ 1,434,619 $ 1,251,609
Money market assets:
Interest-bearing deposits at banks........................ 98,929 598,062
Federal funds sold and securities purchased under
agreement to resell.................................... 151,575 71,725
Securities available-for-sale............................... 5,295,498 3,879,399
Trading account assets...................................... 120,668 53,209
Loans....................................................... 9,306,607 8,088,060
Allowance for possible loan losses.......................... (108,280) (99,678)
----------- -----------
Net loans................................................. 9,198,327 7,988,382
Premises and equipment...................................... 284,962 231,594
Customers' liability on acceptances......................... 30,829 46,480
Assets held for sale........................................ -- 725,760
Bank-owned insurance investments............................ 725,302 267,463
Goodwill and other valuation intangibles.................... 257,627 279,897
Other assets................................................ 399,126 406,347
----------- -----------
TOTAL ASSETS......................................... $17,997,462 $15,799,927
=========== ===========
LIABILITIES
Deposits in domestic offices -- noninterest-bearing......... $ 3,382,309 $ 3,665,951
-- interest-bearing........... 6,859,778 5,233,744
Deposits in foreign offices -- noninterest-bearing.......... 69,215 18,431
-- interest-bearing.............. 866,394 1,741,459
----------- -----------
Total deposits....................................... 11,177,696 10,659,585
Federal funds purchased and securities sold under agreement
to repurchase............................................. 3,642,049 2,693,600
Short-term borrowings....................................... 166,510 501,027
Senior notes................................................ 940,000 100,000
Acceptances outstanding..................................... 30,829 46,480
Accrued interest, taxes and other expenses.................. 141,431 118,257
Other liabilities........................................... 90,550 76,547
Minority interest -- preferred stock of subsidiary.......... 250,000 --
Long-term notes............................................. 225,000 325,000
----------- -----------
TOTAL LIABILITIES.................................... 16,664,065 14,520,496
----------- -----------
STOCKHOLDER'S EQUITY
Common stock ($10 par value); 10,000,000 shares authorized,
issued and outstanding.................................... 100,000 100,000
Surplus..................................................... 608,116 601,027
Retained earnings........................................... 593,973 573,416
Accumulated other comprehensive income...................... 31,308 4,988
----------- -----------
TOTAL STOCKHOLDER'S EQUITY........................... 1,333,397 1,279,431
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY........... $17,997,462 $15,799,927
=========== ===========
The accompanying notes to financial statements are an integral part of
these statements.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31
------------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS EXCEPT PER SHARE DATA)
INTEREST INCOME
Loans, including fees....................................... $672,648 $699,160 $645,319
Money market assets:
Deposits at banks......................................... 10,816 31,431 30,480
Federal funds sold and securities purchased under
agreement to resell..................................... 8,338 12,977 11,000
Trading account............................................. 3,775 3,752 3,960
Securities available-for-sale:
U.S. Treasury and federal agency.......................... 266,979 219,027 168,665
State and municipal....................................... 3,286 4,630 5,550
Other..................................................... 1,386 1,322 1,873
-------- -------- --------
Total interest income..................................... 967,228 972,299 866,847
-------- -------- --------
INTEREST EXPENSE
Deposits.................................................... 360,762 344,274 282,730
Short-term borrowings....................................... 170,082 147,207 152,360
Senior notes................................................ 47,689 39,883 22,425
Minority interest -- dividends on preferred stock of
subsidiary................................................ 16,389 -- --
Long-term notes............................................. 17,425 20,171 19,744
-------- -------- --------
Total interest expense.................................... 612,347 551,535 477,259
-------- -------- --------
NET INTEREST INCOME......................................... 354,881 420,764 389,588
Provision for loan losses................................... 25,358 58,415 57,382
-------- -------- --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES......... 329,523 362,349 332,206
-------- -------- --------
NONINTEREST INCOME
Trust and investment management fees........................ 111,130 102,718 83,195
Money market and bond trading............................... 10,370 7,011 7,725
Foreign exchange............................................ 6,772 5,364 9,978
Merchant and charge card fees............................... 26,519 49,800 46,830
Service fees and charges.................................... 97,033 84,262 71,440
Portfolio securities gains.................................. 26,514 12,799 8,531
Gain on sale of charge card portfolio....................... 12,000 -- --
Bank-owned insurance investments............................ 32,339 12,917 8,484
Foreign fees................................................ 19,373 18,022 15,953
Syndication fees............................................ 15,167 9,222 5,220
Other....................................................... 18,719 9,641 8,144
-------- -------- --------
Total noninterest income.................................. 375,936 311,756 265,500
-------- -------- --------
NONINTEREST EXPENSES
Salaries and other compensation............................. 264,503 252,104 211,083
Pension, profit sharing and other employee benefits......... 49,108 46,651 40,384
Net occupancy............................................... 40,139 44,793 36,530
Equipment................................................... 45,434 40,480 34,208
Marketing................................................... 23,279 21,935 24,973
Communication and delivery.................................. 20,792 21,688 19,252
Deposit insurance........................................... 2,602 2,537 18,155
Expert services............................................. 31,660 29,219 17,696
Contract programming........................................ 23,633 14,047 7,069
Other....................................................... 7,972 24,381 22,166
-------- -------- --------
509,122 497,835 431,516
Goodwill and other valuation intangibles.................... 21,494 24,636 14,930
-------- -------- --------
Total noninterest expenses................................ 530,616 522,471 446,446
-------- -------- --------
Income before income taxes.................................. 174,843 151,634 151,260
Applicable income taxes..................................... 45,286 47,319 48,179
-------- -------- --------
NET INCOME.................................................. $129,557 $104,315 $103,081
======== ======== ========
BASIC EARNINGS PER COMMON SHARE (based on 10,000,000 average
shares outstanding)
Net income.................................................. $ 12.96 $ 10.43 $ 10.31
The accompanying notes to financial statements are an integral part of
these statements.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31
--------------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
NET INCOME............................................... $129,557 $104,315 $103,081
Other comprehensive income:
Unrealized gains on available-for-sale securities:
Unrealized holding gains/(losses) arising during
period, net of tax expense (benefit) of $27,668 in
1998, $13,838 in 1997 and ($11,668) in 1996....... 42,520 26,919 (26,020)
Less reclassification adjustment for gains included
in net income, net of tax expense of $10,314 in
1998, $4,979 in 1997 and $3,318 in 1996........... (16,200) (7,820) (5,213)
-------- -------- --------
Other comprehensive income............................. 26,320 19,099 (31,233)
-------- -------- --------
Comprehensive income..................................... $155,877 $123,414 $ 71,848
======== ======== ========
The accompanying notes to financial statements are an integral part of
these statements.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY
ACCUMULATED
OTHER
COMPREHENSIVE TOTAL
COMMON RETAINED INCOME STOCKHOLDER'S
STOCK SURPLUS EARNINGS (LOSSES) EQUITY
-------- -------- -------- ------------- -------------
(IN THOUSANDS EXCEPT SHARE DATA)
BALANCE AT DECEMBER 31, 1995..................... $100,000 $275,000 $445,119 $17,122 $ 837,241
Contribution to capital surplus................ -- 325,377 -- -- 325,377
Net income..................................... -- -- 103,081 -- 103,081
Dividends -- ($4.19 per common share).......... -- -- (41,900) -- (41,900)
Other comprehensive income..................... -- -- -- (31,233) (31,233)
-------- -------- -------- ------- ----------
BALANCE AT DECEMBER 31, 1996..................... 100,000 600,377 506,300 (14,111) 1,192,566
Contribution to capital surplus................ -- 650 -- -- 650
Net income..................................... -- -- 104,315 -- 104,315
Dividends -- ($3.72 per common share).......... -- -- (37,199) -- (37,199)
Other comprehensive income..................... -- -- -- 19,099 19,099
-------- -------- -------- ------- ----------
BALANCE AT DECEMBER 31, 1997..................... 100,000 601,027 573,416 4,988 1,279,431
Contribution to capital surplus................ -- 7,089 -- -- 7,089
Net income..................................... -- -- 129,557 -- 129,557
Dividends -- ($10.90 per common share)......... -- -- (109,000) -- (109,000)
Other comprehensive income..................... -- -- -- 26,320 26,320
-------- -------- -------- ------- ----------
BALANCE AT DECEMBER 31, 1998..................... $100,000 $608,116 $593,973 $31,308 $1,333,397
======== ======== ======== ======= ==========
The accompanying notes to financial statements are an integral part of
these statements.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
---------------------------------------
1998 1997 1996
----------- ----------- -----------
(IN THOUSANDS EXCEPT SHARE DATA)
OPERATING ACTIVITIES:
Net Income.................................................. $ 129,557 $ 104,315 $ 103,081
Adjustments to reconcile net income to net cash (used)
provided by operating activities:
Provision for loan losses................................. 25,358 58,415 57,382
Depreciation and amortization, including intangibles...... 59,496 57,948 44,704
Deferred tax expense (benefit)............................ 5,352 2,705 (3,319)
Gain on sales of portfolio securities..................... (26,514) (12,799) (8,531)
Gain on sale of credit card portfolio..................... (12,000) -- --
Trading account net cash (purchases) sales................ (67,459) 57,146 (11,717)
Decrease (increase) in interest receivable................ 20,588 (29,296) (14,989)
Increase (decrease) in interest payable................... 18,341 (8,729) (445)
Increase in loans held for sale........................... (167,317) (2,822) (87,707)
Other, net................................................ (58,921) (26,505) 12,286
----------- ----------- -----------
Net cash (used) provided by operating activities........ (73,519) 200,378 90,745
----------- ----------- -----------
INVESTING ACTIVITIES:
Net decrease (increase) in interest-bearing deposits at
banks................................................... 499,133 60,125 (200,487)
Net (increase) decrease in Federal funds sold and
securities purchased under agreement to resell.......... (79,850) 244,550 (152,331)
Proceeds from sales of securities available-for-sale...... 2,307,598 1,234,860 1,269,870
Proceeds from maturities of securities
available-for-sale...................................... 10,499,960 9,897,550 4,868,823
Purchases of securities available-for-sale................ (14,147,509) (12,208,001) (6,905,006)
Net increase in loans and assets held for sale............ (1,035,388) (730,964) (306,628)
Net cash received upon assumption of certain assets and
liabilities of Household Bank f.s.b..................... -- -- 2,244,009
Proceeds from sales of premises and equipment............. 22,780 24,521 10,270
Purchases of premises and equipment....................... (116,437) (99,273) (59,739)
Net increase in bank-owned insurance investments.......... (457,839) (36,947) (102,484)
Other, net................................................ 28,290 (9,173) 54,141
----------- ----------- -----------
Net cash (used) provided by investing activities........ (2,479,262) (1,622,752) 720,438
----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in deposits....................... 518,111 933,380 (195,549)
Net increase (decrease) in Federal funds purchased and
securities sold under agreement to repurchase........... 948,449 701,534 (112,071)
Net (decrease) increase in other short-term borrowings.... (334,517) 156,655 (495,690)
Proceeds from issuance of senior notes.................... 8,347,080 6,710,000 1,239,436
Repayment of senior notes................................. (7,507,080) (6,960,000) (1,367,436)
Proceeds from issuance of long-term notes................. -- 15,000 15,000
Repayment of long-term notes.............................. (100,000) -- --
Proceeds from the sale of the credit card portfolio....... 722,748 -- --
Proceeds from the issuance of preferred stock of
subsidiary.............................................. 250,000 -- --
Proceeds from contribution to capital surplus............. -- -- 325,377
Cash dividends paid on common stock....................... (109,000) (37,199) (41,900)
Other, net................................................ -- -- (433,497)
----------- ----------- -----------
Net cash provided (used) by financing activities........ 2,735,791 1,519,370 (1,066,330)
----------- ----------- -----------
Net increase (decrease) in cash and demand balances due
from banks............................................ 183,010 96,996 (255,147)
Cash and demand balances due from banks at January 1.... 1,251,609 1,154,613 1,409,760
----------- ----------- -----------
Cash and demand balances due from banks at December
31.................................................... $ 1,434,619 $ 1,251,609 $ 1,154,613
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest (net of amount capitalized).................... $ 594,006 $ 560,264 $ 467,006
Income taxes............................................ $ 31,991 $ 51,219 $ 54,288
The accompanying notes to financial statements are an integral part of
these statements.
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HARRIS TRUST AND SAVINGS BANK AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND NATURE OF OPERATIONS
Harris Trust and Savings Bank ("the Bank"), is a wholly-owned subsidiary of
Harris Bankcorp, Inc. ("Bankcorp"), a Delaware corporation which is a
wholly-owned subsidiary of Bankmont Financial Corp. ("Bankmont"), a Delaware
corporation which is a wholly-owned subsidiary of Bank of Montreal ("BMO").
Throughout these Notes to Financial Statements, the term "Bank" refers to Harris
Trust and Savings Bank and subsidiaries.
The consolidated financial statements include the accounts of the Bank and
its wholly-owned subsidiaries. Significant intercompany accounts and
transactions have been eliminated. Certain reclassifications were made to
conform prior years' financial statements to the current year's presentation.
See Note 19 for additional information on business combinations and Note 20 for
additional information on related party transactions.
The Bank provides banking, trust and other services domestically and
internationally through the main banking facility, 10 active nonbank
subsidiaries and an Edge Act subsidiary, Harris Bank International Corporation
("HBIC"), in New York. The Bank and its subsidiaries provide a variety of
financial services to commercial and industrial companies, financial
institutions, governmental units, not-for-profit organizations and individuals
throughout the U.S., primarily the Midwest and abroad. Services rendered and
products sold to customers include demand and time deposit accounts and
certificates; various types of loans; sales and purchases of foreign currencies;
interest rate management products; cash management services; underwriting of
municipal bonds; and financial consulting.
BASIS OF ACCOUNTING
The accompanying financial statements are prepared in accordance with
generally accepted accounting principles and conform to practices within the
banking industry.
FOREIGN CURRENCY AND FOREIGN EXCHANGE CONTRACTS
Assets and liabilities denominated in foreign currencies have been
translated into United States dollars at respective year-end rates of exchange.
Monthly translation gains or losses are computed at rates prevailing at
month-end. There were no material translation gains or losses during any of the
years presented. Foreign exchange trading positions including spot, forward,
futures and options contracts are revalued monthly using prevailing market
rates. Exchange adjustments are included with foreign exchange income in the
Consolidated Statement of Income.
DERIVATIVE FINANCIAL INSTRUMENTS
The Bank uses various interest rate and foreign exchange derivative
contracts in the management of its risk strategy or as part of its dealer and
trading activities. Interest rate contracts may include futures, forward rate
agreements, option contracts, guarantees (caps, floors and collars) and swaps.
Foreign exchange contracts may include spot, future, forward and option
contracts.
Derivative financial instruments which are used as part of the Bank's
dealer and trading activities are marked to market and the resulting unrealized
gains and losses are recognized in noninterest income in the period of change.
Realized and unrealized gains and losses on interest rate contracts and foreign
exchange contracts are recorded in trading account income and foreign exchange
income, respectively.
Derivative financial instruments which are used in the management of the
Bank's risk strategy may qualify for hedge accounting. A derivative financial
instrument may be a hedge of an existing asset, liability, firm commitment or
anticipated transaction. Hedge accounting is used when the following criteria
are met: the
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hedged item exposes the Bank to price, currency or interest rate risk; the
hedging instrument reduces the exposure to risk and the hedging instrument is
designated as a hedge. At the inception of the hedge and throughout the hedge
period, a high correlation of changes in both the market value of the hedging
instrument and the fair value of the hedged item should be probable. Additional
criteria for using hedge accounting for anticipated transactions are: the
significant characteristics and expected terms of the anticipated transaction
are identified and it is probable that the anticipated transaction will occur.
If hedge criteria are met, then unrealized gains and losses on derivative
financial instruments other than interest rate swaps are generally recognized in
the same period and in the same manner in which gains and losses from the hedged
item are recognized. Unrealized gains and losses on a hedging instrument are
deferred when the hedged item is accounted for on an historical cost basis. The
hedging instrument is marked to market when the hedged item is accounted for on
a mark to market basis.
Deferred gains and losses on interest rate futures contracts used to hedge
existing assets and liabilities are included in the basis of the item being
hedged. For hedges of anticipated transactions, the Bank recognizes deferred
gains or losses on futures transactions as adjustments to the cash position
eventually taken. Gains or losses on termination of an interest rate futures
contract designated as a hedge are deferred and recognized when the offsetting
gain or loss is recognized on the hedged item. When the hedged item is sold,
existing unrealized gains or losses on the interest rate futures contract are
recognized as part of net income at the time of the sale. Thereafter, unrealized
gains and losses on the hedge contract are recognized in income immediately.
The Bank engages in interest rate swaps in order to manage its interest
rate risk exposure. Contractual payments under interest rate swaps designated as
hedges are accrued in the Statement of Income as a component of interest income
or expense. There is no recognition of unrealized gains and losses on the
balance sheet. Gains or losses on termination of an interest rate swap contract
designated as a hedge are deferred and amortized as an adjustment of the yield
on the underlying balance sheet position over the remainder of the original
contractual life of the terminated swap. When the hedged item is sold, existing
unrealized gains or losses on the swap contract are recognized in income at the
time of the sale. Thereafter, unrealized gains and losses on the hedge contract
are recognized as part of net income when they occur.
Interest rate options are used to manage the Bank's interest rate risk
exposure from rate lock commitments and fixed rate mortgage loans intended to be
sold in the secondary market. Changes in the market value of options designated
as hedges are deferred from income recognition and effectively recognized as
other noninterest income when the loans are sold and the hedge position is
closed. Loans intended to be sold in the secondary market are carried at the
lower of amortized cost or current market value. When a hedge contract with an
embedded gain is terminated early, the deferred gain is recorded as an
adjustment to the carrying value of the loans. When a hedge contract with an
embedded loss is terminated early, the deferred loss is charged to other
noninterest income. When the hedged item is sold before the hedge contract is
terminated and the hedge contract has an embedded gain or loss, the deferred
gain or loss is recorded as other noninterest income in the same period as part
of the gain or loss on the sale of the loans. Thereafter, unrealized gains and
losses on the hedge contract are recognized as part of net income when they
occur.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." The Statement establishes accounting and
reporting standards for derivative instruments and for hedging activities. It
requires all derivatives to be recognized as either assets or liabilities in the
statement of financial position and to be measured at fair value. The Statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. The Bank is in the process of assessing the impact of adopting this
Statement on its financial position and results of operations.
SECURITIES
The Bank classifies securities as either trading account assets or
available-for-sale. Trading account assets include securities acquired as part
of trading activities and are typically purchased with the expectation of
near-term profit. These assets consist primarily of municipal bonds and U.S.
government securities. All other securities are classified as
available-for-sale, even if the Bank has no current plans to divest. Trading
account
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41
assets are reported at fair value with unrealized gains and losses included in
trading account income, which also includes realized gains and losses from
closing such positions. Available-for-sale securities are reported at fair value
with unrealized gains and losses included, on an after-tax basis, in a separate
component of stockholder's equity.
Interest income on securities, including amortization of discount or
premium, is included in earnings. Realized gains and losses, as a result of
securities sales, are included in securities gains, with the cost of securities
sold determined on the specific identification basis.
LOANS, LOAN FEES AND COMMITMENT FEES
Loans not held for sale are recorded at the principal amount outstanding,
net of unearned income, deferred fees and origination costs. Origination fees
collected on commercial loans, loan commitments, mortgage loans and standby
letters of credit, which are not held for sale, are generally deferred and
amortized over the life of the related facility. Other loan-related fees that
are not the equivalent of yield adjustments are recognized as income when
received or earned. At December 31, 1998 and 1997, the Bank's Consolidated
Statement of Condition included approximately $5.2 million and $7.1 million,
respectively, of deferred loan-related fees net of deferred origination costs.
In conjunction with its mortgage and commercial banking activities, the
Bank will originate loans with the intention of selling them in the secondary
market. These loans are carried at the lower of allocated cost or current market
value, on a portfolio basis. Deferred origination fees and costs associated with
these loans are not amortized, and are included as part of the basis of the loan
at time of sale. Realized gains and unrealized losses are included with other
noninterest income.
The Bank engages in the servicing of mortgage loans and acquires mortgage
servicing rights by purchasing or originating mortgage loans and then selling
those loans with servicing rights retained. As required by the Statement, the
rights to service mortgage loans for others are recognized as separate assets by
allocating the total cost of the mortgage loans to the mortgage servicing rights
and the loans (without the mortgage servicing rights) based on their relative
fair values. The capitalized mortgage servicing rights are amortized in
proportion to, and over the period of, estimated net servicing income. The
capitalized mortgage servicing rights are periodically evaluated for impairment
based on the fair value of those rights. Fair values are estimated using
discounted cash flow analyses. The risk characteristics of the underlying loans
used to stratify capitalized mortgage servicing rights for purposes of measuring
impairment are current market interest rates, loan type and repricing interval.
Commercial and real estate loans are placed on nonaccrual status when the
collection of interest is doubtful or when principal or interest is 90 days past
due, unless the credit is adequately collateralized and the past due amount is
in process of collection. When a loan is placed on nonaccrual status, all
interest accrued but not yet collected which is deemed uncollectible is charged
against interest income in the current year. Interest on nonaccrual loans is
recognized as income only when cash is received and the Bank expects to collect
the entire principal balance of the loan. Interest income on restructured loans
is accrued according to the most recently agreed upon contractual terms.
Commercial and real estate loans are charged off when, in management's
opinion, the loan is deemed uncollectible. Charge card and consumer installment
loans are charged off when 180 days past due. Accrued interest on these loans is
charged to interest income. Such loans are not normally placed on nonaccrual
status.
Loan commitments and letters of credit are executory contracts and are not
reflected on the Bank's Consolidated Statement of Condition. Fees collected are
generally deferred and recognized over the life of the facility.
Impaired loans (primarily commercial credits) are measured based on the
present value of expected future cash flows (discounted at the loan's effective
interest rate) or, alternatively, at the loan's observable market price or the
fair value of supporting collateral. Impaired loans are defined as those where
it is probable that amounts due according to contractual terms, including
principal and interest, will not be collected. Both nonaccrual and certain
restructured loans meet this definition. Large groups of smaller-balance,
homogeneous
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loans, primarily charge card, residential real estate and consumer installment
loans, are excluded from this definition of impairment. The Bank determines loan
impairment when assessing the adequacy of the allowance for possible loan
losses.
ALLOWANCE FOR POSSIBLE LOAN LOSSES
The allowance for possible loan losses is maintained at a level considered
adequate to provide for estimated loan losses. The allowance is increased by
provisions charged to operating expense and reduced by net charge-offs. Known
losses of principal on impaired loans are charged off. The provision for loan
losses is based on past loss experience, management's evaluation of the loan
portfolio under current economic conditions and management's estimate of losses
inherent in the portfolio. Such estimates are reviewed periodically and
adjustments, if necessary, are recorded during the periods in which they become
known.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. In March 1998, the AICPA (American Institute of Certified Public
Accountants) issued Statement of Position (SOP) 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use." SOP 98-1 provides
guidance on accounting for the costs of computer software developed or obtained
for internal use. The Bank adopted this statement in January 1998 and it did not
have a material effect on the Bank's financial position or results of
operations. Interest costs associated with long-term construction projects are
capitalized and then amortized over the life of the related asset after the
project is completed. For financial reporting purposes, the provision for
depreciation and amortization is computed on the straight-line basis over the
estimated useful lives of the assets.
ASSETS HELD FOR SALE
The Bank's credit card portfolio was sold on January 29, 1998. Credit card
loan balances were reclassified as of December 31, 1997 to assets held for sale
with the anticipation of this sale. See Note 19 to Financial Statements on page
65 of this Report. These assets are carried at the lower of original cost or
current market value, on a portfolio basis.
OTHER ASSETS
The Bank records specifically identifiable and unidentifiable (goodwill)
intangibles in connection with the acquisition of assets from unrelated parties
or the acquisition of new subsidiaries. Original lives range from 3 to 15 years.
Goodwill is amortized on the straight-line basis. Identifiable intangibles are
amortized on either an accelerated or straight-line basis depending on the
character of the acquired asset. Goodwill and other valuation intangibles are
reviewed for impairment when events or future assessments of profitability
indicate that the carrying value may not be recoverable. When assessing
recoverability, goodwill and other valuation intangibles are included as part of
the group of assets which were acquired in the transaction that gave rise to the
intangibles.
Property or other assets received in satisfaction of debt are included in
"Other Assets" on the Bank's Consolidated Statement of Condition and are
recorded at the lower of remaining cost or fair value. Fair values for other
real estate owned generally are reduced by estimated costs to sell. Losses
arising from subsequent write-downs to fair value are charged directly to
expense.
RETIREMENT AND OTHER POSTEMPLOYMENT BENEFITS
The Bank has noncontributory defined benefit pension plans covering
virtually all its employees. For its primary plan, the policy of the Bank is to,
at a minimum, fund annually an amount necessary to satisfy the requirements
under the Employee Retirement Income Security Act ("ERISA"), without regard to
prior years' contributions in excess of the minimum.
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43
Postemployment benefits provided to former or inactive employees after
employment but before retirement are accrued, if they meet the conditions for
accrual of compensated absences. Otherwise, postemployment benefits are recorded
when expenses are incurred.
CASH FLOWS
As of December 31, 1997, credit card loan balances were reported as assets
held for sale in anticipation of their sale in January 1998. See Note 19 on page
65 of this Report for further information. This transfer was a noncash
transaction and was excluded from the Consolidated Statement of Cash Flows.
INCOME TAXES
Bankmont, Bankcorp and their wholly-owned subsidiaries including the Bank
file a consolidated Federal income tax return. Income tax return liabilities for
the Bank are not materially different than they would have been if computed on a
separate return basis.
MANAGEMENT'S ESTIMATES
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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. The areas
requiring significant management judgment include provision and allowance for
possible loan losses, income taxes, pension cost, postemployment benefits,
valuation of intangible assets, fair values and temporary vs.
other-than-temporary impairment.
2. PORTFOLIO SECURITIES
The amortized cost and estimated fair value of securities
available-for-sale were as follows:
DECEMBER 31, 1998 DECEMBER 31, 1997
------------------------------------------------- -------------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
$39,885 $196 $ 3,032 $ 18
U.S. Treasury............. $1,243,878 $1,283,567 $1,286,036 $1,289,050
10,833 140 3,968 1,757
Federal agency............ 3,938,538 3,949,231 2,510,621 2,512,832
1,599 -- 2,975 --
State and municipal....... 33,812 35,411 51,038 54,013
4 52 59 --
Other..................... 27,337 27,289 23,445 23,504
---------- ------- ---- ---------- ---------- ------- ------ ----------
Total securities.......... $5,243,565 $52,321 $388 $5,295,498 $3,871,140 $10,034 $1,775 $3,879,399
========== ======= ==== ========== ========== ======= ====== ==========
At December 31, 1998 and 1997, portfolio and trading account securities
having a par value of $2.6 billion and $3.2 billion, respectively, were pledged
as collateral for certain liabilities, securities sold under agreement to
repurchase, public and trust deposits, trading account activities and for other
purposes where permitted or required by law. Securities carried at approximately
$2.5 billion and $1.9 billion were sold under agreement to repurchase at
December 31, 1998 and 1997, respectively.
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44
The amortized cost and estimated fair value of available-for-sale
securities at December 31, 1998, by contractual maturity, are shown below.
Expected maturities can differ from contractual maturities since borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties.
DECEMBER 31, 1998
------------------------
AMORTIZED FAIR
COST VALUE
---------- ----------
(IN THOUSANDS)
Maturities:
Within 1 year.......................................... $1,672,653 $1,673,919
1 to 5 years........................................... 965,158 982,292
5 to 10 years.......................................... 628,738 654,275
Over 10 years.......................................... 1,949,679 1,957,723
Other securities without stated maturity.................... 27,337 27,289
---------- ----------
Total securities............................................ $5,243,565 $5,295,498
========== ==========
In 1998, 1997 and 1996, proceeds from the sale of securities
available-for-sale amounted to $2.3 billion, $1.2 billion and $1.3 billion,
respectively. Gross gains of $27.9 million and gross losses of $1.4 million were
realized on these sales in 1998, while gross gains of $12.8 million and no gross
losses were realized on these sales in 1997, and gross gains of $8.6 million and
gross losses of $0.1 million were realized in 1996. Net unrealized holding gains
on trading securities included in earnings during 1998 declined by $1.0 million
from an unrealized gain of $1.8 million at December 31, 1997 to an unrealized
gain of $0.8 million at December 31, 1998.
3. LOANS
The following table summarizes loan balances by category:
DECEMBER 31
------------------------
1998 1997
---------- ----------
(IN THOUSANDS)
Domestic loans:
Commercial, financial, agricultural, brokers and dealers.... $7,625,927 $6,726,221
Real estate construction.................................. 53,059 55,627
Real estate mortgages..................................... 1,474,893 1,123,631
Installment............................................... 70,861 93,605
Foreign loans:
Governments and official institutions..................... 812 937
Banks and other financial institutions.................... 52,855 50,960
Other, primarily commercial and industrial................ 28,200 37,079
---------- ----------
Total loans............................................ 9,306,607 8,088,060
Less allowance for possible loan losses..................... 108,280 99,678
---------- ----------
Loans, net of allowance for possible loan losses....... $9,198,327 $7,988,382
========== ==========
43
45
Nonaccrual loans, restructured loans and other nonperforming assets are
summarized below:
DECEMBER 31
----------------------------
1998 1997 1996
------- ------ -------
(IN THOUSANDS)
Nonaccrual loans............................................ $14,507 $7,253 $17,879
Restructured loans.......................................... 924 -- 40
------- ------ -------
Total nonperforming loans................................... 15,431 7,253 17,919
Other assets received in satisfaction of debt............... 366 642 582
------- ------ -------
Total nonperforming assets................................ $15,797 $7,895 $18,501
======= ====== =======
Gross amount of interest income that would have been
recorded if year-end nonperforming loans had been accruing
interest at their original terms.......................... $ 1,225 $ 667 $ 2,267
Interest income actually recognized......................... 75 51 67
------- ------ -------
Interest shortfall, before consideration of any income tax
effect................................................. $ 1,150 $ 616 $ 2,200
======= ====== =======
At December 31, 1998 and 1997, the Corporation had no aggregate public and
private sector outstandings to any single country experiencing a liquidity
problem which exceeded one percent of the Corporation's consolidated assets.
MORTGAGE SERVICING RIGHTS
Mortgage servicing rights, included in other assets, of $11.1 million and
$4.1 million were capitalized in 1998 and 1997, respectively. Amortization
expense associated with these mortgage servicing rights was $1.6 million and
$0.7 million in 1998 and 1997, respectively. The net remaining capitalized
servicing rights of $16.4 million and $6.8 million at December 31, 1998 and
1997, respectively, had a corresponding valuation allowance of $4.1 million and
$1.2 million at December 31, 1998 and 1997, respectively. Accordingly, the
valuation allowance was increased by $2.9 million in 1998; there were no
reductions or direct write-downs in 1998. There were no reductions or direct
write-downs in 1997. The net capitalized assets of $12.3 million and $5.6
million at December 31, 1998 and 1997, respectively, are reflective of the fair
value of those rights.
4. ALLOWANCE FOR POSSIBLE LOAN LOSSES
The changes in the allowance for possible loan losses are as follows:
YEAR ENDED DECEMBER 31
--------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
Balance, beginning of year............................... $ 99,678 $108,408 $ 94,153
-------- -------- --------
Charge-offs.............................................. (25,680) (76,142) (57,935)
Recoveries............................................... 8,924 8,997 10,008
-------- -------- --------
Net charge-offs........................................ (16,756) (67,145) (47,927)
Provisions charged to operations......................... 25,358 58,415 57,382
Allowance related to acquired loans...................... -- -- 4,800
-------- -------- --------
Balance, end of year..................................... $108,280 $ 99,678 $108,408
======== ======== ========
44
46
Details on impaired loans and related allowance are as follows:
IMPAIRED LOANS IMPAIRED LOANS
FOR WHICH THERE IS FOR WHICH THERE IS TOTAL
A RELATED ALLOWANCE NO RELATED ALLOWANCE IMPAIRED LOANS
------------------- -------------------- --------------
(IN THOUSANDS)
December 31, 1998
Balance...................................... $13,403 $1,104 $14,507
Related allowance............................ 2,596 -- 2,596
------- ------ -------
Balance, net of allowance.................... $10,807 $1,104 $11,911
======= ====== =======
December 31, 1997
Balance...................................... $ 1,148 $6,105 $ 7,253
Related allowance............................ 749 -- 749
------- ------ -------
Balance, net of allowance.................... $ 399 $6,105 $ 6,504
======= ====== =======
YEAR ENDED DECEMBER 31
-----------------------------
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
Average impaired loans...................................... $23,629 $21,149 $29,018
======= ======= =======
Total interest income on impaired loans..................... $ 88 $ 91 $ 67
======= ======= =======
Interest income on impaired loans recorded on a cash
basis..................................................... $ 88 $ 91 $ 67
======= ======= =======
5. PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. A summary of these accounts is set forth below:
DECEMBER 31
--------------------
1998 1997
-------- --------
(IN THOUSANDS)
Land........................................................ $ 24,484 $ 24,451
Premises.................................................... 249,116 249,797
Equipment................................................... 265,903 270,223
Leasehold improvements...................................... 21,060 20,368
-------- --------
Total..................................................... 560,563 564,839
Accumulated depreciation and amortization................... 275,601 333,245
-------- --------
Premises and equipment.................................... $284,962 $231,594
======== ========
The provision for depreciation and amortization was $37.1 million in 1998,
$32.3 million in 1997, and $28.8 million in 1996.
6. SECURITIES PURCHASED UNDER AGREEMENT TO RESELL AND SECURITIES SOLD UNDER
AGREEMENT TO REPURCHASE
The Bank enters into purchases of U.S. Treasury and Federal agency
securities under agreements to resell identical securities. The amounts advanced
under these agreements represent short-term loans and are reflected as
receivables in the Consolidated Statements of Condition. There were no
securities purchased under agreement to resell outstanding at December 31, 1998
and December 31, 1997. The securities underlying the agreements are book-entry
securities. Securities are transferred by appropriate entry into the Bank's
account with Bank of New York at the Federal Reserve Bank of New York under a
written custodial agreement with Bank of New York that explicitly recognizes the
Bank's interest in these securities.
45
47
The Bank also enters into sales of U.S. Treasury and Federal agency
securities under agreements to repurchase identical securities. The amounts
received under these agreements represent short-term borrowings and are
reflected as liabilities in the Consolidated Statements of Condition. Securities
sold under agreement to repurchase totaled $2.55 billion and $1.96 billion at
December 31, 1998 and 1997, respectively. Securities sold under agreement to
repurchase are transferred via book-entry to the counterparty, if transacted
with a financial institution or a broker-dealer, or are delivered to customer
safekeeping accounts.
SECURITIES PURCHASED UNDER AGREEMENT TO RESELL
1998 1997
---------- ----------
(DOLLARS IN THOUSANDS)
Amount outstanding at end of year........................... $ -- $ --
Highest amount outstanding as of any month-end during the $ 159,000 $ 856,000
year......................................................
Daily average amount outstanding during the year............ $ 30,954 $ 17,540
SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE
1998 1997
---------- ----------
Amount outstanding at end of year........................... $2,552,261 $1,964,316
Highest amount outstanding as of any month-end during the $2,552,261 $2,871,374
year......................................................
Daily average amount outstanding during the year............ $2,081,408 $1,934,243
7. SENIOR NOTES AND LONG-TERM NOTES
The following table summarizes the Bank's long-term notes:
DECEMBER 31
------------------------
1998 1997
---------- ----------
(IN THOUSANDS)
Floating rate subordinated note to Bankcorp due December 1, $ -- $ 100,000
2004......................................................
Floating rate subordinated note to Bankcorp due March 31, 50,000 50,000
2005......................................................
Floating rate subordinated note to Bankcorp due December 1, 50,000 50,000
2006......................................................
Fixed rate 6 1/2% subordinated note to Bankcorp due December 60,000 60,000
27, 2007..................................................
Fixed rate 7 5/8% subordinated note to Bankcorp due June 27, 15,000 15,000
2008......................................................
Fixed rate 7 1/8% subordinated note to Bankcorp due June 30, 50,000 50,000
2009......................................................
---------- ----------
Total..................................................... $ 225,000 $ 325,000
========== ==========
All of the Bank notes are unsecured obligations, ranking on a parity with
all unsecured and subordinated indebtedness of the Bank and are not subject to
redemption prior to maturity at the election of the debtholders. The interest
rate on the floating rate notes reprices semiannually and floats at 50 basis
points above 180 day LIBOR. At year-end 1998, 180 day LIBOR was 5.07 percent.
The Bank offers to institutional investors from time to time, unsecured
short-term and medium-term bank notes in an aggregate principal amount of up to
$1.5 billion outstanding at any time. The term of each note could range from
fourteen days to fifteen years. The notes are subordinated to deposits and rank
pari passu with all other unsecured senior indebtedness of the Bank. As of
December 31, 1998, $940 million of short-term notes were outstanding with
original maturities ranging from 31 to 182 days (remaining maturities ranging
from 22 to 130 days) and stated interest rates ranging from 5.00 percent to 5.50
percent. As of December 31, 1997, $100 million of short-term notes were
outstanding with original maturities of 14 days (remaining maturities of 4 days)
and stated interest rate of 5.90 percent.
46
48
8. FAIR VALUE OF FINANCIAL INSTRUMENTS
Generally accepted accounting principles require the disclosure of
estimated fair values for both on- and off-balance-sheet financial instruments.
The Bank's fair values are based on quoted market prices when available. For
financial instruments not actively traded, such as certain loans, deposits,
off-balance-sheet transactions and long term borrowings, fair values have been
estimated using various valuation methods and assumptions. Although management
used its best judgment in estimating these values, there are inherent
limitations in any estimation methodology. In addition, accounting
pronouncements require that fair values be estimated on an item-by-item basis,
thereby ignoring the impact a large sale would have on a thin market and
intangible values imbedded in established lines of business. Therefore, the fair
value estimates presented herein are not necessarily indicative of the amounts
the Bank could realize in an actual transaction. The fair value estimation
methodologies employed by the Bank were as follows:
The carrying amounts for cash and demand balances due from banks along with
short-term money market assets and liabilities reported on the Bank's
Consolidated Statement of Condition were considered to be the best estimates of
fair value for these financial instruments. Fair values of trading account
assets and portfolio securities were based on quoted market prices.
A variety of methods were used to estimate the fair value of loans. Changes
in estimated fair value of loans reflect changes in credit risk and general
interest rates which have occurred since the loans were originated. Fair values
of floating rate loans, including commercial, broker dealer, financial
institution, construction, charge card, consumer and home equity, were assumed
to be the same as carrying value since the loans' interest rates automatically
reprice to market. Fair values of residential mortgages were based on current
prices for securities backed by similar loans. For long-term fixed rate loans,
including consumer installment and commercial mortgage loans, fair values were
estimated based on the present value of future cash flows with current market
rates as discount rates. A fair-value discount related to nonperforming loans
included in the above categories, along with a discount for future credit risk
throughout the portfolio, was based on an analysis of expected and unidentified
future losses. Accordingly, the fair value estimate for total loans was reduced
by these discounts, which in total approximated the allowance for possible loan
losses on the Bank's Consolidated Statements of Condition. Additionally,
management considered appraisal values of collateral when nonperforming loans
were secured by real estate.
The fair values of accrued interest receivable and payable approximate
carrying values due to the short-term nature of these assets and liabilities.
The fair values of bank-owned insurance investments approximate carrying
value, because upon liquidation of these investments the Corporation would
receive the cash surrender value which equals carrying value.
The fair values of demand deposits, savings accounts, interest checking
deposits, and money market accounts were the amounts payable on demand at the
reporting date, or the carrying amounts. The fair value of time deposits was
estimated using a discounted cash flow calculation with current market rates
offered by the Bank as discount rates.
The fair value of senior notes approximates carrying value because the
average maturity is less than one year.
The fair value of minority interest-preferred stock of subsidiary ("Harris
Preferred Capital Corporation") approximates carrying value as the preferred
stock has a liquidation preference that equals book value.
The fair value of long-term notes was determined using a discounted cash
flow calculation with current rates available to the Bank for similar debt as
discount rates.
The fair value of credit facilities are presented as an obligation in order
to represent the approximate cost the Bank would incur to induce third parties
to assume these commitments.
47
49
The estimated fair values of the Bank's financial instruments at December
31, 1998 and 1997 are presented in the following table. See Note 9 for
additional information regarding fair values of off-balance-sheet financial
instruments.
DECEMBER 31
-----------------------------------------------------------
1998 1997
---------------------------- ----------------------------
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
-------------- ----------- -------------- -----------
(DOLLARS IN THOUSANDS)
ASSETS
Cash and demand balances due from
banks.................................. $ 1,434,619 $ 1,434,619 $ 1,251,609 $ 1,251,609
Money market assets:
Interest-bearing deposits at banks..... 98,929 98,929 598,062 598,062
Federal funds sold and securities
purchased under agreement to
resell.............................. 151,575 151,575 71,725 71,725
Securities available-for-sale............ 5,295,498 5,295,498 3,879,399 3,879,399
Trading account assets................... 120,668 120,668 53,209 53,209
Loans, net of unearned income and
allowance for possible loan losses*.... 9,198,327 9,204,638 7,988,382 8,002,371
Customers' liability on acceptances...... 30,829 30,829 46,480 46,480
Accrued interest receivable.............. 110,530 110,530 131,118 131,118
Assets held for sale*.................... -- -- 725,760 745,760
Bank-owned insurance investments......... 725,302 725,302 267,463 267,463
----------- ----------- ----------- -----------
Total on-balance-sheet financial
assets............................ $17,166,277 $17,172,588 $15,013,207 $15,047,196
=========== =========== =========== ===========
LIABILITIES
Deposits:
Demand deposits........................ $ 6,401,678 $ 6,401,678 $ 6,264,132 $ 6,264,132
Time deposits.......................... 4,776,018 4,805,625 4,395,453 4,398,644
Federal funds purchased and securities
sold under agreement to repurchase..... 3,642,049 3,642,049 2,693,600 2,693,600
Other short-term borrowings.............. 166,510 166,510 501,027 501,027
Acceptances outstanding.................. 30,829 30,829 46,480 46,480
Accrued interest payable................. 41,955 41,955 23,614 23,614
Senior notes............................. 940,000 940,000 100,000 100,000
Minority interest -- preferred stock of
subsidiary............................. 250,000 250,000 -- --
Long-term notes.......................... 225,000 233,628 325,000 327,829
----------- ----------- ----------- -----------
Total on-balance-sheet financial
liabilities....................... $16,474,039 $16,512,274 $14,349,306 $14,355,326
=========== =========== =========== ===========
Off-Balance-Sheet Financial Instruments
(positive positions/(obligations))
Credit facilities........................ $ (5,160) $ (5,160) $ (7,083) $ (7,083)
Interest rate contracts:
Dealer and trading contracts........... (351) (351) 525 525
Risk management contracts.............. (297) (4,701) 13,076 10,300
----------- ----------- ----------- -----------
Total off-balance-sheet financial
instruments....................... $ (5,808) $ (10,212) $ 6,518 $ 3,742
=========== =========== =========== ===========
- ---------------
* In anticipation of the Bank's sale of its credit card portfolio in January
1998, credit card loan balances were reclassified as of December 31, 1997 to
assets held for sale.
See Note 19 to Financial Statements on page 65 of this Report.
48
50
9. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Bank utilizes various financial instruments with off-balance-sheet risk
in the normal course of business to a) meet its customers' financing and risk
management needs, b) reduce its own risk exposure, and c) produce fee income and
trading profits. The Bank's major categories of financial instruments with off-
balance-sheet risk include credit facilities, interest rate, foreign exchange,
equity and commodities contracts, and various securities-related activities.
Fair values of off-balance-sheet instruments are based on fees currently charged
to enter into similar agreements, market prices of comparable instruments,
pricing models using year-end rates and counterparty credit ratings.
CREDIT FACILITIES
Credit facilities with off-balance-sheet risk include commitments to extend
credit, standby letters of credit and commercial letters of credit.
Commitments to extend credit are contractual agreements to lend to a
customer as long as contract terms have been met. They generally require payment
of a fee and have fixed expiration dates. The Bank's commitments serve both
business and individual customer needs, and include commercial loan commitments,
credit card lines, home equity lines, commercial real estate loan commitments
and mortgage loan commitments. The Bank's maximum risk of accounting loss is
represented by the total contractual amount of commitments which was $7.3
billion and $9.7 billion at December 31, 1998 and 1997, respectively. Since only
a portion of commitments will ultimately be drawn down, the Bank does not expect
to provide funds for the total contractual amount. Risks associated with certain
commitments are reduced by participations to third parties, which at December
31, 1998, totaled $408 million and at December 31, 1997, totaled $299 million.
Standby letters of credit are unconditional commitments which guarantee the
obligation of a customer to a third party should that customer default. They are
issued to support financial and performance-related obligations including
brokers' margin maintenance, industrial revenue bond repayment, debt repayment,
construction contract performance and trade agreement performance. The Bank's
maximum risk of accounting loss for these items is represented by the total
commitments outstanding of $1.64 billion at December 31, 1998 and $1.70 billion
at December 31, 1997. Risks associated with standby letters of credit are
reduced by participations to third parties which totaled $490 million at
December 31, 1998 and $437 million at December 31, 1997.
Commercial letters of credit are commitments to make payments on behalf of
customers when letter of credit terms have been met. Maximum risk of accounting
loss is represented by total commercial letters of credit outstanding of $100
million at December 31, 1998 and $86 million at December 31, 1997.
Credit risks associated with all of these facilities are mitigated by
reviewing customers' creditworthiness on a case-by-case basis, obtaining
collateral, limiting loans to individual borrowers, setting restrictions on
long-duration maturities and establishing stringent covenant terms outlining
performance expectations which, if not met, may cause the Bank to terminate the
contract. Credit risks are further mitigated by monitoring and maintaining
portfolios that are well-diversified.
Collateral is required to support certain of these credit facilities when
they are drawn down and may include equity and debt securities, commodities,
inventories, receivables, certificates of deposit, savings instruments, fixed
assets, real estate, life insurance policies and seats on national or regional
exchanges. Requirements are based upon the risk inherent in the credit and are
more stringent for firms and individuals with greater default risks. The Bank
monitors collateral values and appropriately perfects its security interest.
Periodic evaluations of collateral adequacy are performed by Bank personnel.
The fair value of credit facilities (i.e. deferred income) is approximately
equal to their carrying value of $5.2 million at December 31, 1998 and $7.1
million at December 31, 1997.
49
51
INTEREST RATE CONTRACTS
Interest rate contracts include futures, forward rate agreements, option
contracts, guarantees (caps, floors and collars) and swaps. The Bank enters into
these contracts for dealer, trading and risk management purposes.
DEALER AND TRADING ACTIVITY
As dealer, the Bank serves customers seeking to manage interest rate risk
by entering into contracts as a counterparty to their (customer) transactions.
In its trading activities, the Bank uses interest rate contracts to profit from
expected future market movements.
These contracts may create exposure to both credit and market risk.
Replacement risk, the primary component of credit risk, is the risk of loss
should a counterparty default following unfavorable market movements and is
measured as the Bank's cost of replacing contracts at current market rates. The
Bank manages credit risk by establishing credit limits for customers and
products through an independent corporate-wide credit review process and
continually monitoring exposure against those limits to ensure they are not
exceeded. Credit risk is, in many cases, further mitigated by the existence of
netting agreements which provide for netting of contractual receivables and
payables in the event of default or bankruptcy.
Market risk is the risk of loss as a result of changes in interest rates.
The Bank manages market risk by establishing limits which are based on dollars
at risk given a parallel shift in the yield curve. Limits are established by
product, maturity and volatility. Limits are approved by management and
monitored independently of the traders on a regular basis. Market risk is
further diminished by entering into offsetting positions. Senior management
oversees all dealer risk-related activities.
Futures and forward contracts are agreements in which the Bank is obligated
to make or take delivery, at a specified future date, of a specified instrument,
at a specified price or yield. Futures contracts are exchange traded and,
because of exchange requirements that gains and losses be settled daily, create
negligible exposure to credit risk.
Forward rate agreements are arrangements between two parties to exchange
amounts, at a specified future date, based on the difference between an agreed
upon interest rate and reference rate applied to a notional principal amount.
These agreements enable purchasers and sellers to fix interest costs and
returns.
Options are contracts that provide the buyer the right (but not the
obligation) to purchase or sell a financial instrument, at a specified price,
either within a specified period of time or on a certain date. Interest rate
guarantees (caps, floors and collars) are agreements between two parties that,
in general, establish for the purchaser a maximum level of interest expense or a
minimum level of interest revenue based on a notional principal amount for a
specified term. Options and guarantees written create exposure to market risk.
As a writer of interest rate options and guarantees, the Bank receives a premium
at the outset of the agreement and bears the risk of an unfavorable change in
the price of the financial instrument underlying the option or guarantee.
Options and guarantees purchased create exposure to credit risk and, to the
extent of the premium paid or unrealized gain recognized, market risk.
Interest rate swaps are contracts involving the exchange of interest
payments based on a notional amount for a specified period. Most of the Bank's
activity in swaps is as intermediary in the exchange of interest payments
between customers, although the Bank also uses swaps to manage its own interest
rate exposure (see discussion of risk management activity below).
50
52
The following table summarizes the Bank's dealer/trading interest rate
contracts and their related contractual or notional amounts and maximum
replacement costs. Contractual or notional amount gives an indication of the
volume of activity in the contract. Maximum replacement cost reflects the
potential loss resulting from customer defaults and is computed as the cost of
replacing, at current market rates, all outstanding contracts with unrealized
gains.
DECEMBER 31
-------------------------------------------------
CONTRACTUAL OR MAXIMUM
NOTIONAL AMOUNT REPLACEMENT COST
------------------------ ---------------------
1998 1997 1998 1997
---------- ----------- ------- -----------
(IN THOUSANDS)
Interest Rate Contracts:
Futures and forwards.......................... $ 272,658 $ 210,266 $ 123 $ 81
Forward rate agreements....................... 146,800 272,120 558 438
Options written............................... -- -- -- --
Options purchased............................. -- -- -- --
Guarantees written............................ 735,221 594,760 91 118
Guarantees purchased.......................... 735,221 594,760 2,647 1,368
Swaps......................................... 2,727,942 1,817,508 33,909 8,432
The following table summarizes average and end of period fair values of
dealer/trading interest rate contracts for the years ended December 31, 1998 and
1997:
1998 1998 1997 1997
------------- ------------- ------------- -------------
END OF END OF
PERIOD AVERAGE PERIOD AVERAGE
ASSETS ASSETS ASSETS ASSETS
(LIABILITIES) (LIABILITIES) (LIABILITIES) (LIABILITIES)
------------- ------------- ------------- -------------
(IN THOUSANDS)
Interest Rate Contracts:
Futures and forwards
Unrealized gains............................. $ 123 $ -- $ 81 $ --
Unrealized losses............................ -- -- (24) --
Forward rate agreements
Unrealized gains............................. 558 192 438 19
Unrealized losses............................ (558) (192) (438) (26)
Options
Purchased.................................... -- -- -- --
Written...................................... -- -- -- --
Guarantees
Purchased.................................... 2,556 2,087 1,250 1,802
Written...................................... (2,556) (2,087) (1,249) (1,778)
Swaps
Unrealized gains............................. 33,909 43,790 8,432 13,827
Unrealized losses............................ (34,384) (42,672) (7,965) (12,388)
-------- -------- ------- --------
Total Interest Rate Contracts................ $ (352) $ 1,118 $ 525 $ 1,456
======== ======== ======= ========
51
53
Net gains (losses) from dealer/trading activity in interest rate contracts
and nonderivative trading account assets for the years ended December 31, 1998,
1997 and 1996 are summarized below:
YEARS ENDED DECEMBER 31
--------------------------------
GAINS GAINS GAINS
(LOSSES) (LOSSES) (LOSSES)
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
Interest Rate Contracts:
Futures and forwards...................................... $ 788 $ (649) $ 926
Forward rate agreements................................... -- -- --
Options................................................... (16) 54 (66)
Guarantees................................................ -- (6) (1,215)
Swaps..................................................... 210 42 69
Debt Instruments............................................ 9,388 7,570 8,011
------- ------ -------
Total Trading Revenue.................................. $10,370 $7,011 $ 7,725
======= ====== =======
The following table summarizes the maturities and weighted average interest
rates paid and received on dealer/trading interest rate swaps:
DECEMBER 31, 1998
-------------------------------------------------------------------
GREATER
WITHIN 1 TO 3 3 TO 5 5 TO 10 THAN 10
1 YEAR YEARS YEARS YEARS YEARS TOTAL
-------- -------- ---------- -------- -------- ----------
(IN THOUSANDS)
Pay Fixed Swaps:
Notional amount........... $140,102 $380,438 $ 821,319 $ 58,408 $ 64,000 $1,464,267
Average pay rate.......... 5.91% 5.92% 6.10% 6.33% 5.94% 6.04%
Average receive rate...... 4.70% 4.87% 5.16% 5.19% 5.00% 5.03%
Receive Fixed Swaps:
Notional amount........... $140,102 $380,298 $ 613,755 $ 65,520 $ 64,000 $1,263,675
Average pay rate.......... 4.70% 4.87% 5.20% 5.18% 5.00% 5.03%
Average receive rate...... 5.98% 5.93% 6.00% 6.24% 5.94% 5.99%
Total notional
amount............... $280,204 $760,736 $1,435,074 $123,928 $128,000 $2,727,942
The following table summarizes the bank's dealer/trading equities and
commodities contracts and their related contractual or notional amounts and
maximum replacement costs.
CONTRACTUAL OR MAXIMUM
NOTIONAL AMOUNT REPLACEMENT COST
---------------- ----------------
DECEMBER 31 DECEMBER 31
---------------- ----------------
1998 1997 1998 1997
------ ------ ------ ------
(IN THOUSANDS)
Equities Contracts:
Options written....................................... $3,702 $ -- $ -- $ --
Options purchased..................................... 3,702 -- 1,032 --
Commodities Contracts................................... 1,596 -- 193 --
52
54
The following table summarizes average and end of period fair values of
dealer/trading equities contracts and commodities contracts for the years ended
December 31, 1998 and 1997:
1998 1998 1997 1997
------------- ------------- ------------- -------------
END OF END OF
PERIOD AVERAGE PERIOD AVERAGE
ASSETS ASSETS ASSETS ASSETS
(LIABILITIES) (LIABILITIES) (LIABILITIES) (LIABILITIES)
------------- ------------- ------------- -------------
(IN THOUSANDS)
Equities Contracts:
Options
Purchased.............................. $ 1,032 $ 179 $ -- $ --
Written................................ (1,032) (179) -- --
------- ----- ------- -----
Total Equities Contracts............. $ -- $ -- $ -- $ --
======= ===== ======= =====
Commodities Contracts:
Unrealized Gains.......................... $ 193 $ 8 $ -- $ --
Unrealized Losses......................... (193) (8) -- --
------- ----- ------- -----
$ -- $ -- $ -- $ --
======= ===== ======= =====
There were no net gains (losses) from dealer/trading activity in equities
or commodities contracts for the years ended December 31, 1998 and 1997.
RISK MANAGEMENT ACTIVITY
In addition to its dealer activities, the Bank uses interest rate
contracts, primarily swaps, to reduce the level of financial risk inherent in
mismatches between the interest rate sensitivities of certain assets and
liabilities. During 1998 and 1997, interest rate swaps were primarily used to
alter the character of funds supporting certain fixed rate loans, the senior
note program and the municipal bond portfolio. The Bank had $152 million
notional amount of swap contracts, used for risk management purposes,
outstanding at December 31, 1998 with a fair value of $4.7 million and a zero
replacement cost. At December 31, 1997, the Bank had $483 million notional
amount of swap contracts outstanding with a fair value of $10.3 million and a
replacement cost of $13.0 million. Gross unrealized gains and losses,
representing the difference between fair value and carrying value (i.e. accrued
interest payable or receivable) on these contracts, totaled $0.1 million and
$4.5 million, respectively, at December 31, 1998 and $0.2 and $2.9 million,
respectively, at December 31, 1997. Risk management activity, including the
related cash positions, had no material effect on the Bank's net income for the
year ended December 31, 1998 or 1997. There were no deferred gains or losses on
terminated contracts at December 31, 1998 or 1997.
The following table summarizes swap activity for risk management purposes:
NOTIONAL
AMOUNT
---------
Amount, December 31, 1996................................... $ 584,081
Additions................................................... 802,440
Maturities.................................................. (903,489)
Terminations................................................ --
---------
Amount, December 31, 1997................................... $ 483,032
Additions................................................... 57,517
Maturities.................................................. (388,915)
Terminations................................................ --
---------
Amount, December 31, 1998................................... $ 151,634
=========
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The following table summarizes the maturities and weighted average interest
rates paid and received on interest rate swaps used for risk management:
DECEMBER 31, 1998
---------------------------------------------------
WITHIN 1 TO 3 3 TO 5 5 TO 10
1 YEAR YEARS YEARS YEARS TOTAL
------ ------- ------- ------- --------
(IN THOUSANDS)
Pay Fixed Swaps:
Notional amount...................... $6,902 $40,905 $74,694 $26,060 $148,561
Average pay rate..................... 6.78% 6.23% 6.00% 6.69% 6.22%
Average receive rate................. 5.30% 5.32% 5.33% 5.29% 5.32%
Receive Fixed Swaps:
Notional amount...................... $ -- $ -- $ 3,073 $ -- $ 3,073
Average pay rate..................... -- -- -- -- --
Average receive rate................. -- -- 5.10% -- 5.10%
Total notional amount........... $6,902 $40,905 $77,767 $26,060 $151,634
FOREIGN EXCHANGE CONTRACTS
DEALER ACTIVITY
The Bank is a dealer in foreign exchange. Foreign exchange contracts may
create exposure to market and credit risk, including replacement risk and
settlement risk. Credit risk is managed by establishing limits for customers
through an independent corporate-wide credit approval process and continually
monitoring exposure against those limits. In addition, both settlement and
replacement risk are reduced through netting by novation, agreements with
counterparties to offset certain related obligations. Market risk is managed
through establishing exposure limits by currency and monitoring actual exposure
against those limits, entering into offsetting positions, and closely monitoring
price behavior. Effective April 3, 1995, the Bank and BMO agreed to combine
their U.S. FX. Under this arrangement, FX net profit is shared by the Bank and
BMO in accordance with a specific formula set forth in the agreement. This
agreement expires in April 2002 but may be extended at that time. Either party
may terminate the arrangement at its option. FX revenues are reported net of
expenses.
At December 31, 1998, approximately 87 percent of the Bank's gross notional
positions in foreign currency contracts are represented by seven currencies:
English pounds, German deutsche marks, Japanese yen, French francs, Swiss
francs, Canadian dollars and Italian lira.
Foreign exchange contracts include spot, future, forward and option
contracts that enable customers to manage their foreign exchange risk. Spot,
future and forward contracts are agreements to exchange currencies at a future
date, at a specified rate of exchange. Foreign exchange option contracts give
the buyer the right and the seller an obligation (if the buyer asserts his
right) to exchange currencies during a specified period (or on a certain date in
the case of "European" options) at a specified exchange rate.
The following table summarizes the Bank's dealer/trading foreign exchange
contracts and their related contractual or notional amount and maximum
replacement cost:
CONTRACTUAL OR NOTIONAL AMOUNT MAXIMUM REPLACEMENT COST
DECEMBER 31 DECEMBER 31
------------------------------ ------------------------
1998 1997 1998 1997
----------- ----------- -------- --------
(IN THOUSANDS)
Foreign Exchange Contracts:
Spot, futures and forwards....... $1,734,546 $1,820,769 $12,370 $13,772
Options written.................. 184,615 88,440 -- --
Options purchased................ 184,615 88,440 3,885 3,772
Cross currency swaps............. 123,906 -- 2,996 --
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The following table summarizes average and end of period fair values of
dealer/trading foreign exchange contracts for the years ended December 31, 1998
and 1997:
1998 1998 1997 1997
------------- ------------- ------------- -------------
END OF PERIOD AVERAGE END OF PERIOD AVERAGE
ASSETS ASSETS ASSETS ASSETS
(LIABILITIES) (LIABILITIES) (LIABILITIES) (LIABILITIES)
------------- ------------- ------------- -------------
(IN THOUSANDS)
Foreign Exchange Contracts:
Spot, futures and forwards
Unrealized gains....................... $ 19,991 $ 35,056 $ 37,394 $ 34,076
Unrealized losses...................... (19,991) (35,056) (37,394) (34,076)
Options
Purchased.............................. 3,885 3,304 3,772 2,783
Written................................ (3,885) (3,304) (3,772) (2,783)
Cross currency swaps
Unrealized gains....................... 2,996 2,913 -- --
Unrealized losses...................... (2,996) (2,913) -- --
-------- -------- -------- --------
Total Foreign Exchange................... $ -- $ -- $ -- $ --
======== ======== ======== ========
At December 31, 1998, spot, futures and forward contracts with BMO
represent $8,738 and ($11,507) of unrealized gains and unrealized losses,
respectively. Options contracts with BMO represent $3,883 and zero of options
purchased and options written, respectively. Cross currency swaps with BMO
represent $2.8 million and $0.2 million of unrealized gains and unrealized
losses, respectively.
Net gains (losses) from dealer/trading foreign exchange contracts, for the
years ended December 31, 1998, 1997 and 1996 totaled $6.8 million, $5.4 million
and $10.0 million, respectively, of net profit under the aforementioned
agreement with BMO. All profits related to spot, futures and forward contracts.
SECURITIES ACTIVITIES
The Bank's securities activities that have off-balance-sheet risk include
municipal bond underwriting and short selling of securities.
Through its municipal bond underwriting activities, the Bank commits to buy
and offer for resale newly issued bonds. The Bank is exposed to market risk
because it may be unable to resell its inventory of bonds profitably as a result
of unfavorable market conditions. In syndicate arrangements, the Bank is
obligated to fulfill syndicate members' commitments should they default. The
syndicates of which the Bank was a member had underwriting commitments totaling
$83.2 million at December 31, 1998 and $29.6 million at December 31, 1997.
Security short selling, defined as selling of securities not yet owned,
exposes the Bank to off-balance-sheet market risk because the Bank may be
required to buy securities at higher prevailing market prices to cover its short
positions. The Bank had no short position at December 31, 1998 or 1997.
10. CONCENTRATIONS OF CREDIT RISK IN FINANCIAL INSTRUMENTS
The Bank had one major concentration of credit risk arising from financial
instruments at December 31, 1998 and 1997. This concentration was the Midwest
geographic area. This concentration exceeded 10 percent of the Bank's total
credit exposure, which is the total potential accounting loss should all
customers fail to perform according to contract terms and all collateral prove
to be worthless.
MIDWESTERN GEOGRAPHIC AREA
A majority of the Bank's customers are located in the Midwestern region of
the United States, defined here to include Illinois, Indiana, Iowa, Michigan,
Minnesota, Missouri, Ohio and Wisconsin. The Bank provides credit to these
customers through a broad array of banking and trade financing products
including
55
57
commercial loans, commercial loan commitments, commercial real estate loans,
consumer installment loans, charge card loans and lines, mortgage loans, home
equity loans and lines, standby and commercial letters of credit and banker's
acceptances. The financial viability of customers in the Midwest is, in part,
dependent on the region's economy. Corporate customers headquartered in the
region and serving a national or international market are not included in this
concentration because their business is broad-based and not dependent on the
region's economy. The Bank's maximum risk of accounting loss, should all
customers making up the Midwestern concentration fail to perform according to
contract terms and all collateral prove to be worthless, was approximately $11.4
billion or 44 percent of the Bank's total credit exposure at December 31, 1998
and $11.9 billion or 46 percent of the Bank's total credit exposure at December
31, 1997.
The Corporation manages this exposure by continually reviewing local market
conditions and customers, adjusting individual and industry exposure limits
within the region and by obtaining or closely monitoring collateral values. See
Note 9 for information on collateral supporting credit facilities.
11. EMPLOYEE BENEFIT PLANS
The Bank had noncontributory defined benefit pension plans covering
virtually all its employees as of December 31, 1998. Most of the employees
participating in retirement plans were included in one primary plan ("primary
plan") during the three-year period ended December 31, 1998. The benefit formula
for this plan is based upon length of service and an employee's highest
qualifying compensation during five consecutive years of active employment. The
plan is a multiple-employer plan covering the Bank's employees as well as
persons employed by certain affiliated entities.
The policy for this plan is to have the participating entities, at a
minimum, fund annually an amount necessary to satisfy the requirements under
ERISA, without regard to prior years' contributions in excess of the minimum.
For 1998 and 1997, cumulative contributions were greater than the amount
recorded as pension expense for financial reporting purposes. For 1996,
cumulative contributions were less than the amount recorded as pension expense
for financial reporting purposes.
The total consolidated pension expense of the Bank, including the
supplemental plan, for 1998, 1997 and 1996 was $8.2 million, $7.5 million and
$9.4 million, respectively.
In addition to pension benefits, the Bank provides medical care benefits
for retirees (and their dependents) who have attained age 55 and have at least
10 years of service. The Bank also provides medical care benefits for disabled
employees and widows of former employees (and their dependents). The Bank
provides these medical care benefits through a self-insured plan. Under the
terms of the plan, the Bank contributes to the cost of coverage based on
employees length of service. Cost sharing with plan participants is accomplished
through deductibles, coinsurance and out-of-pocket limits. Funding for the plan
largely comes from the general assets of the Bank, supplemented by contributions
to a trust fund created under Internal Revenue Code Section 401(h).
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58
The following tables set forth the change in benefit obligation and plan
assets for the pension and postretirement medical care benefit plans for the
Bank:
PENSION BENEFITS POSTRETIREMENT MEDICAL BENEFITS
------------------------------ ---------------------------------
1998*** 1997*** 1996*** 1998*** 1997*** 1996***
-------- -------- -------- --------- --------- ---------
(IN THOUSANDS)
CHANGE IN BENEFIT OBLIGATION*
Benefit obligation at beginning
of year...................... $221,496 $205,663 $207,944 $ 33,687 $ 32,957 $ 32,291
Service cost................... 8,781 7,928 7,676 1,363 939 1,034
Interest cost.................. 13,772 12,145 11,583 2,374 1,600 1,576
Benefits Paid (net of
participant contributions)... (20,899) (12,816) (14,515) (2,859) (1,031) (1,243)
Actuarial (gain) or loss....... 19,511 8,576 (7,025) 264 (778) (701)
-------- -------- -------- -------- -------- --------
Benefit obligation at end of
year......................... $242,661 $221,496 $205,663 $ 34,829 $ 33,687 $ 32,957
======== ======== ======== ======== ======== ========
CHANGE IN PLAN ASSETS
Fair value of plan assets at
beginning of year............ $237,072 $197,350 $189,248 $ 15,278 $ 11,710 $ 9,508
Actual return on plan assets... (7,903) 47,121 16,655 (864) 2,216 636
Employer contribution.......... 7,451 5,417 5,962 2,318 1,352 2,127
Benefits paid.................. (20,899) (12,816) (14,515) -- -- (561)
-------- -------- -------- -------- -------- --------
Fair value of plan assets at
end of year**................ $215,721 $237,072 $197,350 $ 16,732 $ 15,278 $ 11,710
======== ======== ======== ======== ======== ========
Funded Status.................. $(26,940) $ 15,576 $ (8,313) $(18,097) $(18,409) $(21,247)
Contributions made between
measurement date (September
30) and end of year.......... 8,040 7,451 5,417 -- -- --
Unrecognized actuarial (gain)
or loss...................... 36,764 (7,673) 16,085 (11,402) (13,886) (12,383)
Unrecognized transition (asset)
or obligation................ (1,022) (1,216) (1,423) 24,917 26,842 28,632
Unrecognized prior service
cost......................... (5,551) (5,729) (6,066) 2,030 1,569 1,662
-------- -------- -------- -------- -------- --------
Prepaid (accrued) benefit
cost......................... $ 11,291 $ 8,409 $ 5,700 $ (2,552) $ (3,884) $ (3,336)
======== ======== ======== ======== ======== ========
PENSION BENEFITS POSTRETIREMENT MEDICAL BENEFITS
--------------------------- ---------------------------------
1998 1997 1996 1998 1997 1996
------- ------- ------- --------- --------- ---------
WEIGHTED-AVERAGE ASSUMPTIONS AS OF
DECEMBER 31
Discount rate...................... 7.00% 7.25% 7.50% 7.00% 7.25% 7.50%
Expected return on plan assets..... 9.00% 9.00% 8.00% 8.00% 8.00% 8.00%
Rate of compensation increase...... 5.50% 5.70% 5.70% N/A N/A N/A
For measurement purposes, a 8.0 percent annual rate of increase in the per
capita cost of covered health care benefits was assumed for 1999.
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59
The rate was assumed to decrease gradually to 6.0 percent in 2001 and
remain level thereafter. For 1997 and 1996, the weighted average annual rate of
increase in the per capita cost of covered benefits was assumed to be 8.0
percent and 8.5 percent, respectively.
PENSION BENEFITS POSTRETIREMENT MEDICAL BENEFITS
------------------------------ -------------------------------
1998 1997 1996 1998 1997 1996
-------- -------- -------- --------- -------- --------
COMPONENTS OF NET PERIODIC BENEFIT
COST
Service cost...................... $ 8,781 $ 7,928 $ 7,676 $ 1,363 $1,203 $1,248
Interest cost..................... 13,772 12,145 11,583 2,374 2,248 2,228
Expected return on plan assets.... (16,499) (14,293) (11,976) (1,262) (891) (638)
Amortization of prior service
cost............................ (664) (671) (636) 176 176 176
Amortization of transition (asset)
or obligation................... (282) (285) (270) 1,780 1,780 1,774
Recognized actuarial (gain) or
loss............................ 50 -- 479 (497) (465) (358)
-------- -------- -------- ------- ------ ------
Net periodic benefit cost......... $ 5,158 $ 4,824 $ 6,856 $ 3,934 $4,051 $4,430
======== ======== ======== ======= ====== ======
- ---------------
* Benefit obligation is projected for Pension Benefits and accumulated for
Post-Retirement Medical Benefits.
** Plan assets consist primarily of participation units in collective trust
funds or mutual funds administered by the Bank.
*** Plan assets and obligation measured as of September 30.
For the postretirement medical care benefit plan, assumed health care cost
trend rates have a significant effect on the amounts reported for the health
care plans.
A one-percentage-point change in assumed health care cost trend rates would
have the following effects:
1-PERCENTAGE 1-PERCENTAGE
POINT INCREASE POINT DECREASE
-------------- --------------
Effect on total of service and interest cost components..... $ 830 $ (584)
Effect on postretirement benefit obligation................. $5,483 $(4,312)
Certain employees participating in the primary plan are also covered by a
supplemental unfunded retirement plan. The purpose of this plan is to extend
full retirement benefits to individuals without regard to statutory limitations
for qualified funded plans. The following table sets forth the status of this
supplemental plan:
YEARS ENDED DECEMBER 31
----------------------------
1998 1997 1996
-------- ------- -------
(IN THOUSANDS)
Accumulated benefit obligation.............................. $ 8,311 $ 5,732 $ 7,241
Projected benefit obligation for service rendered to date... 21,752 12,976 15,486
Accrued pension liability................................... (11,005) 9,452 8,827
Net periodic pension expense................................ 3,062 2,682 2,435
Assumptions used:
Discount rate............................................... 6.00% 6.00% 5.25%
Rate of increase in compensation............................ 5.70% 5.70% 5.70%
The Corporation has a defined contribution profit sharing plan covering
virtually all its employees. The plan includes a matching contribution and a
profit sharing contribution. The matching contribution is based on the amount of
eligible employee contributions. The profit sharing contribution is based on the
annual financial performance of the Corporation relative to predefined targets.
The Corporation's total expense for this plan was $8.8 million, $8.5 million and
$7.7 million in 1998, 1997 and 1996, respectively.
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12. STOCK OPTIONS
The Bank has two stock-based compensation plans, which are accounted for
under the fair value based method of accounting for stock based compensation
plans and are described below.
HARRIS BANK STOCK OPTION PROGRAM
The Harris Bank Stock Option Program was established under the Bank of
Montreal Stock Option Plan for certain designated executives and other employees
of the Bank and affiliated companies in order to provide incentive to attain
long-term strategic goals and to attract and retain services of key employees.
On February 26, 1996, the Bank granted 451,800 stock options with a ten-year
term which are exercisable only during the second five years of their term,
assuming cumulative performance goals are met. The stock options are exercisable
for Bank of Montreal common stock at a price of Canadian $31.00 per share, equal
to the market price on the date of grant (equivalent to U.S. $22.55). The
estimated grant date fair value of the options granted on February 26, 1996 was
Canadian $5.79, equivalent to U.S. $4.26. The fair value of the option grant was
estimated using the Bloomberg model with the following assumptions: risk-free
interest rate of 7.57%, expected life of 7.5 years, expected volatility of
16.97% and compound annual dividend growth of 5.24%.
On December 17, 1996, the Bank granted 341,850 stock options with a
ten-year term which are exercisable only during the second five years of their
term, assuming cumulative performance goals are met. The stock options are
exercisable for Bank of Montreal common stock at a price of Canadian $39.85 per
share, equal to the market price on the date of grant (equivalent to U.S.
$29.15). The estimated grant date fair value of the options granted on December
17, 1996 was Canadian $7.76, equivalent to U.S. $5.68. The fair value of the
option grant was estimated using the Bloomberg model with the following
assumptions: risk-free interest rate of 6.71%, expected life of 7.5 years,
expected volatility of 17.20% and compound annual dividend growth of 6.12%.
On December 15, 1997, the Bank granted 224,750 stock options with a
ten-year term which are exercisable only during the second five years of their
term, assuming cumulative performance goals are met. The stock options are
exercisable for Bank of Montreal common stock at a price of Canadian $65.80 per
share, equal to the market price on the date of grant (equivalent to U.S.
$46.33). The estimated grant date fair value of the options granted on December
15, 1997 was Canadian $13.53, equivalent to U.S. $9.53. The fair value of the
option grant was estimated using the Bloomberg model with the following
assumptions: risk-free interest rate of 5.81%, expected life of 7.5 years,
expected volatility of 15.96% and compound annual dividend growth of 8.82%.
On December 18, 1998, the Bank granted 814,000 stock options with a
ten-year term which are exercisable only during the second five years of their
term, assuming cumulative performance goals are met. The stock options are
exercisable for Bank of Montreal common stock at a price of Canadian $60.35 per
share, equal to the market price on the date of grant (equivalent to U.S.
$39.06). The estimated grant date fair value of the options granted on December
18, 1998 was Canadian $12.33, equivalent to U.S. $7.98. The fair value of the
option grant was estimated using the Bloomberg model with the following
assumptions: risk-free interest rate of 4.87%, expected life of 7.5 years,
expected volatility of 19.82% and compound annual dividend growth of 8.82%.
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The following table summarizes the stock option activity for 1998, 1997 and
1996 and provides details of stock options outstanding at December 31, 1998,
1997 and 1996.
1998 1997 1996
--------------------- ------------------- -------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS SHARES PRICE SHARES PRICE SHARES PRICE
- ------- --------- --------- ------- --------- ------- ---------
Outstanding at beginning of year............. 932,000 $30.51 784,850 $25.42 --
Granted...................................... 814,000 39.06 224,750 46.33 793,650 $25.39
Exercised.................................... -- -- -- -- -- --
Forfeited, cancelled......................... -- -- (77,600) 24.87 (8,800) 22.55
Transferred.................................. 5,600 22.55 -- -- -- --
Expired...................................... -- -- -- -- -- --
--------- ------- -------
Outstanding at end of year................... 1,751,600 34.46 932,000 30.51 784,850 25.42
========= ======= =======
Options exercisable at year-end.............. None None None
Weighted-average fair value of options
granted during the year.................... $7.98 $9.53 $4.87
NUMBER WEIGHTED AVERAGE
RANGE OF OUTSTANDING REMAINING WEIGHTED AVERAGE
EXERCISE PRICES DECEMBER 31, 1998 CONTRACTUAL LIFE EXERCISE PRICE
--------------- ----------------- ---------------- ----------------
$22 - 30 712,850 7.51 years $25.46
35 - 42 814,000 9.96 39.06
46 - 50 224,750 8.95 46.33
---------
22 - 50 1,751,600 8.83 34.46
=========
Compensation expense related to the Harris Bank Stock Option Program
totaled $1.1 million, $0.6 million and $0.4 million in 1998, 1997 and 1996
respectively.
STOCK APPRECIATION RIGHTS
The Bank maintains the Harris Bank Stock Appreciation Rights Plan which was
established in January 1995. The rights granted under this plan have either a
three-year or five-year term and are exercisable after the expiration of the
respective term, assuming cumulative performance goals are met. Compensation
expense for the Harris Bank Stock Appreciation Rights Plan totaled $0.5 million,
$5.1 million and $3.5 million in 1998, 1997 and 1996 respectively.
The following table details the rights outstanding at December 31, 1998,
1997 and 1996.
1998 1997 1996
------- -------- -------
Outstanding beginning of the year........................... 341,000 528,000 528,000
Granted..................................................... -- -- --
Exercised................................................... (13,500) (124,000) --
Cancelled................................................... -- (63,000) --
Transferred................................................. 4,200 -- --
------- -------- -------
Outstanding end of the year................................. 331,700 341,000 528,000
======= ======== =======
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13. LEASE EXPENSE AND OBLIGATIONS
Rental expense for all operating leases was $13.7 million in 1998, $16.7
million in 1997 and $15.5 million in 1996. These amounts include real estate
taxes, maintenance and other rental-related operating costs of $3.0 million,
$4.0 million and $4.4 million for 1998, 1997 and 1996, respectively, paid under
net lease arrangements. Lease commitments are primarily for office space.
Minimum rental commitments as of December 31, 1998 for all noncancelable
operating leases are as follows:
(IN THOUSANDS)
--------------
1999........................................................ $ 9,152
2000........................................................ 8,664
2001........................................................ 7,207
2002........................................................ 5,285
2003........................................................ 3,446
2004 and thereafter......................................... 24,220
-------
Total minimum future rentals.............................. $57,974
=======
Occupancy expenses for 1998, 1997 and 1996 have been reduced by $13.5
million, $13.7 million and $13.8 million, respectively, for rental income from
leased premises.
14. INCOME TAXES
The 1998, 1997, and 1996 applicable income tax expense (benefit) was as
follows:
FEDERAL STATE FOREIGN TOTAL
------- ------- ------- -------
(IN THOUSANDS)
1998: Current............................................ $41,356 $(1,445) $ 23 $39,934
Deferred........................................... 4,474 878 -- $ 5,352
------- ------- ------ -------
Total............................................ $45,830 $ (567) $ 23 $45,286
======= ======= ====== =======
1997: Current............................................ $44,602 $ (16) $ 28 $44,614
Deferred........................................... 1,986 719 -- $ 2,705
------- ------- ------ -------
Total............................................ $46,588 $ 703 $ 28 $47,319
======= ======= ====== =======
1996: Current............................................ $45,637 $ 4,648 $1,213 $51,498
Deferred........................................... (2,164) (1,155) -- (3,319)
------- ------- ------ -------
Total............................................ $43,473 $ 3,493 $1,213 $48,179
======= ======= ====== =======
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Deferred tax assets (liabilities) are comprised of the following at
December 31, 1998, 1997 and 1996:
DECEMBER 31
------------------------------
1998 1997 1996
-------- ------- -------
(IN THOUSANDS)
Gross deferred tax assets:
Allowance for possible loan losses........................ $ 43,551 $38,319 $41,038
Intangible assets......................................... 8,310 7,574 7,122
Deferred expense and prepaid income....................... -- 6,759 4,196
Deferred employee compensation............................ 6,208 5,175 3,848
Pension and medical trust................................. 4,321 2,984 3,438
Other assets.............................................. 42 1,793 3,359
-------- ------- -------
Deferred tax assets.................................... 62,432 62,604 63,001
-------- ------- -------
Gross deferred tax liabilities:
Other liabilities......................................... (8,365) (3,185) (876)
-------- ------- -------
Deferred tax liabilities............................... (8,365) (3,185) (876)
Valuation allowance......................................... -- -- --
-------- ------- -------
Net deferred tax assets................................... 54,067 59,419 62,125
-------- ------- -------
Tax effect of adjustment related to available-for-sale
securities................................................ (20,625) (3,271) 9,308
-------- ------- -------
Net deferred tax assets including adjustment related to
available-for-sale securities............................. $ 33,442 $56,148 $71,433
======== ======= =======
At December 31, 1998 and 1997, the respective net deferred tax assets of
$54.1 million and $59.4 million included $45.1 million and $49.5 million for
Federal tax and $9.0 million and $9.9 million for Illinois tax, respectively.
The Bank has fully recognized both its Federal and Illinois deferred tax assets.
Current taxable income and taxable income generated in the statutory carryback
period is sufficient to support the entire deferred tax asset. The deferred
taxes reported on the Bank's Consolidated Statements of Condition at December
31, 1998 and 1997 also include a $20.6 million deferred tax liability and a $3.3
million deferred tax liability, respectively, for the tax effect of the net
unrealized gains associated with marking to market certain securities designated
as available-for-sale.
Total income tax expense of $45.3 million for 1998, $47.3 million for 1997,
and $48.2 million for 1996 reflects effective tax rates of 25.9 percent, 31.2
percent, and 31.9 percent, respectively. The reasons for the differences between
actual tax expense and the amount determined by applying the U.S. Federal income
tax rate of 35 percent to income before income taxes were as follows:
YEARS ENDED DECEMBER 31
------------------------------------------------------------------
1998 1997 1996
-------------------- -------------------- --------------------
PERCENT OF PERCENT OF PERCENT OF
PRETAX PRETAX PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
------- ---------- ------- ---------- ------- ----------
(DOLLARS IN THOUSANDS)
Computed tax expense.................. $61,195 35.0% $53,072 35.0% $52,940 35.0%
Increase (reduction) in income tax
expense due to:
Tax-exempt income from loans and
investments net of municipal
interest expense disallowance.... (2,030) (1.1) (2,559) (1.7) (3,254) (2.1)
Bank owned life insurance........... (11,319) (6.5) (4,518) (3.0) (2,969) (2.0)
Other, net.......................... (2,560) (1.5) 1,324 0.9 1,462 1.0
------- ----- ------- ----- ------- -----
Actual tax expense.................... $45,286 25.9% $47,319 31.2% $48,179 31.9%
======= ===== ======= ===== ======= =====
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The tax expense from net gains on security sales amounted to $10.3 million,
$5.0 million, and $3.3 million in 1998, 1997, and 1996, respectively.
15. REGULATORY CAPITAL
The Bank, as a state-member bank, must adhere to the capital adequacy
guidelines of the Federal Reserve Board (the "Board"), which are not
significantly different than those published by other U.S. banking regulators.
The guidelines specify minimum ratios for Tier 1 capital to risk-weighted assets
of 4 percent and total regulatory capital to risk-weighted assets of 8 percent.
Risk-based capital guidelines define total capital to consist of Tier 1
(core) and Tier 2 (supplementary) capital. In general, Tier 1 capital is
comprised of stockholder's equity, including certain types of preferred stock,
less goodwill and certain other intangibles. Core capital must comprise at least
50 percent of total capital. Tier 2 capital basically includes subordinated debt
(less a discount factor during the five years prior to maturity), other types of
preferred stock and the allowance for possible loan losses. At year-end 1998,
the portion of the allowance for possible loan losses includable in Tier 2
capital is limited to 1.25 percent of risk-weighted assets.
The Board also requires an additional measure of capital adequacy, the Tier
1 leverage ratio, which is evaluated in conjunction with risk-based capital
ratios. The Tier 1 leverage ratio is computed by dividing period-end Tier 1
capital by adjusted quarterly average assets. The Board established a minimum
ratio of 3 percent applicable only to the strongest banking organizations
having, among other things, excellent asset quality, high liquidity, good
earnings and no undue interest rate risk exposure. Other institutions, including
those experiencing or anticipating significant growth, are expected to maintain
a ratio which exceeds the 3 percent minimum by at least 100 to 200 basis points.
The Federal Deposit Insurance Corporation Improvement Act of 1991 contains
prompt corrective action provisions that established five capital categories for
all Federal Deposit Insurance Corporation ("FDIC")-insured institutions ranging
from "well capitalized" to "critically undercapitalized." Classification within
a category is based primarily on the three capital adequacy measures. An
institution is considered "well capitalized" if its capital level significantly
exceeds the required minimum levels, "adequately capitalized" if it meets the
minimum levels, "undercapitalized" if it fails to meet the minimum levels,
"significantly undercapitalized" if it is significantly below the minimum levels
and "critically undercapitalized" if it has a ratio of tangible equity to total
assets of 2 percent or less.
Noncompliance with minimum capital requirements may result in regulatory
corrective actions which could have a material effect on the Bank. Depending on
the level of noncompliance, regulatory corrective actions may include the
following: requiring a plan for restoring the institution to an acceptable
capital category, restricting or prohibiting certain activities and appointing a
receiver or conservator for the institution.
As of December 31, 1998, the most recent notification from the FDIC
categorized the Bank as "well capitalized" under the regulatory framework for
prompt corrective action. Management is not aware of any conditions or events
since December 31, 1998 that have changed the capital category of the Bank.
Effective February 11, 1998, Harris Preferred Capital Corporation ("HPCC"),
a subsidiary of the Bank, issued $250 million of 7 3/8% noncumulative,
exchangeable Series A preferred stock. The preferred stock, which is listed and
traded on the New York Stock Exchange, is nonvoting except in certain
circumstances as outlined in HPCC's Form S-11 Registration Statement ("S-11").
Dividends on the preferred stock are noncumulative and are payable at the rate
of 7 3/8% per annum of the $25 per share liquidation preference. The preferred
shares can be redeemed in whole or in part at HPCC's option on or after March
30, 2003 or upon the occurrence of a tax event as defined in the S-11. Upon the
occurrence of specific events described in the S-11, including the Bank becoming
less than "adequately capitalized", the Bank being placed into conservatorship
or receivership or the Board of Governors of the Federal Reserve Bank directing
such an exchange, each preferred share would be exchanged automatically for one
newly issued Bank preferred share.
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The following table summarizes the Bank's risk-based capital ratios and
Tier 1 leverage ratio for the past two years as well as the minimum amounts and
ratios as per capital adequacy guidelines and FDIC prompt corrective action
provisions.
TO BE WELL CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
-------------------- ------------------------------ ------------------------------
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
---------- ------- ---------- ------- ---------- -------
(DOLLARS IN THOUSANDS)
As of December 31, 1998:
Total Capital to Risk-Weighted Assets.... $1,626,429 10.77% * $1,208,118 * 8.00% * $1,510,148 * 10.00%
Tier 1 Capital to Risk-Weighted Assets... $1,293,206 8.57% * $ 603,597 * 4.00% * $ 905,395 * 6.00%
Tier 1 Capital to Average Assets......... $1,293,206 7.50% * $ 689,710 * 4.00% * $ 862,137 * 5.00%
As of December 31, 1997:
Total Capital to Risk-Weighted Assets.... $1,431,338 10.36% * $1,105,280 * 8.00% * $1,381,600 * 10.00%
Tier 1 Capital to Risk-Weighted Assets... $1,006,763 7.29% * $ 552,408 * 4.00% * $ 828,612 * 6.00%
Tier 1 Capital to Average Assets......... $1,006,763 6.54% * $ 615,757 * 4.00% * $ 769,696 * 5.00%
*Represents "Greater Than or Equal To", which cannot be reproduced in EDGAR
character set.
16. INVESTMENTS IN SUBSIDIARIES AND STATUTORY RESTRICTIONS
The Bank's investment in the combined net assets of its wholly-owned
subsidiaries was $526.0 million and $20.4 million at December 31, 1998 and 1997,
respectively.
Provisions of both Illinois and Federal banking laws place restrictions
upon the amount of dividends that can be paid to Bankcorp by its bank
subsidiaries. Illinois law requires that no dividends may be paid in an amount
greater than the net profits then on hand, reduced by certain loan losses (as
defined). In addition to these restrictions, Federal Reserve member banking
subsidiaries require prior approval of Federal banking authorities if dividends
declared by a subsidiary bank, in any calendar year, will exceed its net profits
(as defined in the applicable statute) for that year, combined with its retained
net profits, as so defined, for the preceding two years. Based on these and
certain other prescribed regulatory limitations, the Bank could have declared,
without regulatory approval, $150.5 million of dividends at December 31, 1998.
Actual dividends paid, however, would be subject to prudent capital maintenance.
Cash dividends paid to Bankcorp by the Bank amounted to $109.0 million and $37.2
million in 1998 and 1997, respectively.
The Bank is required by the Federal Reserve Act to maintain reserves
against certain of their deposits. Reserves are held either in the form of vault
cash or balances maintained with the Federal Reserve Bank. Required reserves are
essentially a function of daily average deposit balances and statutory reserve
ratios prescribed by type of deposit. During 1998 and 1997, daily average
reserve balances of $193 million and $200 million, respectively, were required
for the Bank. At year-end 1998 and 1997, balances on deposit at the Federal
Reserve Bank totaled $184 million and $224 million, respectively.
17. CONTINGENT LIABILITIES
The Bank and certain subsidiaries are defendants in various legal
proceedings arising in the normal course of business. In the opinion of
management, based on the advice of legal counsel, the ultimate resolution of
these matters will not have a material adverse effect on the Bank's financial
position or results of operations.
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18. FOREIGN ACTIVITIES (BY DOMICILE OF CUSTOMER)
Income and expenses identifiable with foreign and domestic operations are
summarized in the table below:
FOREIGN DOMESTIC CONSOLIDATED
-------- ----------- ------------
(IN THOUSANDS)
1998
Total operating income................................... $ 53,747 $ 1,289,417 $ 1,343,164
Total expenses........................................... 11,627 1,156,694 1,168,321
-------- ----------- -----------
Income before taxes...................................... 42,120 132,723 174,843
Applicable income taxes.................................. 16,741 28,545 45,286
-------- ----------- -----------
Net income............................................... $ 25,379 $ 104,178 $ 129,557
======== =========== ===========
Identifiable assets at year-end.......................... $219,883 $17,777,579 $17,997,462
======== =========== ===========
1997
Total operating income................................... $ 60,823 $ 1,223,232 $ 1,284,055
Total expenses........................................... 12,884 1,119,537 1,132,421
-------- ----------- -----------
Income before taxes...................................... 47,939 103,695 151,634
Applicable income taxes.................................. 19,053 28,266 47,319
-------- ----------- -----------
Net income............................................... $ 28,886 $ 75,429 $ 104,315
======== =========== ===========
Identifiable assets at year-end.......................... $716,548 $15,083,379 $15,799,927
======== =========== ===========
1996
Total operating income................................... $ 40,067 $ 1,092,280 $ 1,132,347
Total expenses........................................... 13,399 967,688 981,087
-------- ----------- -----------
Income before taxes...................................... 26,668 124,592 151,260
Applicable income taxes.................................. 10,599 37,580 48,179
-------- ----------- -----------
Net income............................................... $ 16,069 $ 87,012 $ 103,081
======== =========== ===========
Identifiable assets at year-end.......................... $835,657 $13,371,009 $14,206,666
======== =========== ===========
Determination of rates for foreign funds generated or used are based on the
actual external costs of specific interest-bearing sources or uses of funds for
the periods. Internal allocations for certain unidentifiable income and expenses
were distributed to foreign operations based on the percentage of identifiable
foreign income to total income. As of December 31, 1998, 1997 and 1996,
identifiable foreign assets accounted for 1 percent, 5 percent and 6 percent,
respectively, of total consolidated assets.
19. BUSINESS COMBINATIONS AND DISPOSITIONS/INTANGIBLES
At December 31, 1998 and 1997, intangible assets, including goodwill
resulting from business combinations, amounted to $258 million and $280 million
respectively. Amortization of these intangibles amounted to $21.5 million in
1998, $24.6 million in 1997, and $14.9 million in 1996. The impact of purchase
accounting adjustments, other than amortization of intangibles, was not material
to the Bank's reported results.
On January 29, 1998, the Bank sold its credit card portfolio to Partners
First Holdings, LLC ("PFH") a corporation owned by BankBoston Corporation, First
Annapolis Consulting, Inc. and Bankmont. At the time of the sale, the credit
card portfolio had a carrying value of $693 million, representing less than 5
percent of the Bank's total consolidated assets. Upon completion of the sale,
the Bank received cash and an equity interest in PFH, which it immediately sold
for cash to Bankmont. The Bank recorded a pretax gain of $12.0 million on this
transaction.
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On June 28, 1996, the Bank completed the acquisition of 54 branches
previously owned by Household Bank, f.s.b. ("Household"), a wholly-owned
subsidiary of Household International, Inc. The 54 branches are located
throughout the metropolitan Chicago area. In addition to acquiring real and
personal property, the Bank assumed certain deposit liabilities and purchased
other assets, primarily consumer loans. The transaction was accounted for as a
purchase and the Bank's consolidated financial statements include the results of
the acquired branches from the date of acquisition. In anticipation of this
transaction, on June 27, 1996 the Bank increased its capital base by $340
million, in part through the issuance of $45 million of Series B non-voting,
callable perpetual preferred stock and an additional $15 million of long term
subordinated debt. Both issues were purchased by Bankmont. The balance of the
capital, $280 million, was provided through a direct infusion of common equity
by Bankmont.
At the closing, the Bank assumed deposits totaling $2.9 billion. In
addition, the Bank acquired loans amounting to $340 million along with real
property and certain other miscellaneous assets. After paying a purchase price
of $277 million, the Bank received approximately $2.24 billion in cash from
Household as consideration for the deposit liabilities assumed, net of assets
purchased.
The purchase price of $277 million was recorded as an intangible asset,
along with certain fair value adjustments and deferred acquisition costs,
resulting in goodwill and other intangibles recognized of $284 million.
In January 1996, the Bank announced the sale of its securities custody and
related trustee services business for large institutions to Citibank. After
restructuring charges, the Bank recognized a $4.0 million gain on the sale. The
gain was recorded net of certain anticipated costs to exit this activity,
including employee termination benefits, amounting to approximately $13.0
million. Computation of the gain also included the Bank's estimated obligation
to service affected customers on an interim basis. The Bank is entitled to
contingent revenue in the event certain levels of customer retention were
achieved by the purchaser of the business. The right to receive such revenue was
included as consideration in an arrangement consummated with Bankmont during
1996 (see Note 20 to Financial Statements below).
20. RELATED PARTY TRANSACTIONS
During 1998, 1997 and 1996, the Bank engaged in various transactions with
BMO and its subsidiaries. These transactions included the payment and receipt of
service fees and occupancy expenses, and purchasing and selling Federal funds,
repurchase and reverse repurchase agreements, long-term borrowings and interest
rate and foreign exchange contracts. The purpose of these transactions was to
facilitate a more efficient use of combined resources and to better serve
customers. Fees for these services were determined in accordance with applicable
banking regulations. During 1998, 1997 and 1996, the Bank received from BMO
approximately $17.1 million, $20.9 million and $14.3 million respectively,
primarily for trust services, data processing and other operations support
provided by the Bank.
In order to facilitate the Bank's exit from the securities custody and
related trustee services business for large institutions, the Bank and Bankmont
entered into an agreement effective December 31, 1996 whereby Bankmont assumed
responsibility for potential costs (subject to limits) related to certain
litigation matters involving the Bank. As part of this agreement, Bankmont
incurred $1.3 million of costs in 1997 and $2.7 million of costs through the
date of the agreement. Any costs incurred subsequent to December 31, 1997,
exceeded the limits specified in the agreement, thus the Bank incurred these
costs. In return for assuming this obligation, Bankmont received funds from a
contingent revenue arrangement between the Bank and Citibank. Bankmont paid the
Bank $0.5 million as consideration for accepting this arrangement in 1997, which
was recorded as income.
Effective April 3, 1995, the Bank and BMO agreed to combine their U.S.
foreign exchange activities. Under this arrangement, the Bank and BMO share FX
net profit in accordance with a specific formula set forth in the agreement.
This agreement expires in April 2002 but may be extended at that time. Either
party may terminate the arrangement at its option. FX revenues are reported net
of expenses. 1998, 1997 and 1996 foreign exchange revenues included $6.8
million, $5.4 million and $10.0 million of net profit, respectively, under this
agreement.
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