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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER: 0-1100
HAWTHORNE FINANCIAL CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-2085671
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2381 ROSECRANS AVENUE, 2ND FLOOR 90245
EL SEGUNDO, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (310) 725-5000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.01 PER SHARE
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment to this
Form 10-K.
As of February 26, 1999, the aggregate market value of voting stock held by
nonaffiliates of the registrant was approximately $59,930,750.25 (based upon the
last reported sales price of the Common Stock as reported by the Nasdaq National
Market). Shares of Common Stock held by each executive officer, director, and
shareholders with beneficial ownership of greater than 10% of the outstanding
Common Stock of the registrant and persons or entities known to the registrant
to be affiliates of the foregoing have been excluded in that such persons may be
deemed to be affiliates. This assumption regarding affiliate status is not
necessarily a conclusive determination for other purposes.
The number of shares of Common Stock, par value $0.01 per share, of the
Registrant outstanding as of February 26, 1999 was 5,212,113 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Annual Report incorporates by reference portions of the
Proxy Statement to be filed with the Securities and Exchange Commission in
connection with the Registrant's 1999 Annual Meeting of Stockholders.
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HAWTHORNE FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10K
PAGE
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PART I.
ITEM 1. Business.................................................... 1
General..................................................... 1
Background.................................................. 2
New Business Generation..................................... 3
Interest Rate Risk Management............................... 24
Regulatory Matters.......................................... 25
Taxation.................................................... 32
Employees................................................... 33
Risk Factors................................................ 33
ITEM 2. Properties.................................................. 38
ITEM 3. Legal Proceedings........................................... 39
ITEM 4. Submission of Matters to a Vote of Security Holders......... 39
ITEM 4A. Executive Officers.......................................... 39
PART II.
ITEM 5. Market for Registrant's Common Stock and Related Stockholder
Matters..................................................... 40
ITEM 6. Selected Financial Data..................................... 41
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 43
Operating Results........................................... 43
Financial Condition, Capital Resources & Liquidity.......... 51
ITEM 7A. Quantitative and Qualitative Disclosure About Market
Risks....................................................... 54
ITEM 8. Financial Statements and Supplementary Data................. 55
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 55
PART III.
ITEM 10. Directors and Executive Officers of the Registrant.......... 56
ITEM 11. Executive Compensation...................................... 56
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 56
ITEM 13. Certain Relationships and Related Transactions.............. 56
PART IV.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 56
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FORWARD LOOKING STATEMENTS
When used in this Form 10-K or future filings by the Company with the
Securities and Exchange Commission, in the Company's press releases or other
public or stockholder communications, or in oral statements made with the
approval of an authorized executive officer, the words or phrases "will likely
result", "are expected to", "will continue", "is anticipated", "estimate",
"project", "believe" or similar expressions are intended to identify
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. The Company wishes to caution readers that all
forward-looking statements are necessarily speculative and not to place undue
reliance on any such forward-looking statements, which speak only as of the date
made, and to advise readers that various risks and uncertainties, including
regional and national economic conditions, changes in levels of market interest
rates, credit risks of lending activities, and competitive and regulatory
factors, could affect the Company's financial performance and could cause the
Company's actual results for future periods to differ materially from those
anticipated or projected. The risks highlighted herein should not be assumed to
be the only things that could affect future performance of the Company.
The Company does not undertake, and specifically disclaims any obligation,
to publicly release the result of any revisions which may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
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PART I.
ITEM 1. BUSINESS
GENERAL
HAWTHORNE FINANCIAL CORPORATION
Hawthorne Financial Corporation ("Hawthorne Financial" or "Company"), a
Delaware corporation organized in 1959, is a savings and loan holding company
that owns 100% of the stock of Hawthorne Savings, F.S.B. ("Hawthorne Savings" or
"Bank"). Hawthorne Savings was incorporated in 1950 and commenced operations on
May 11, 1951. The Bank's six full-service retail offices are located in Southern
California.
HAWTHORNE SAVINGS
Hawthorne Savings is a federally chartered stock savings bank (referred to
in applicable statutes and regulations as a "savings association") incorporated
and licensed under the laws of the United States. The Bank is a member of the
Federal Home Loan Bank of San Francisco ("FHLB"), which is a member bank of the
Federal Home Loan Bank System. The Bank's deposit accounts are insured up to the
$100,000 maximum amount currently allowable under federal laws by the Savings
Association Insurance Fund ("SAIF"), which is a separate insurance fund
administered by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is
subject to examination and regulation by the Office of Thrift Supervision
("OTS") and the FDIC. Hawthorne Savings is further subject to regulations of the
Board of Governors of the Federal Reserve System ("FRB") concerning reserves
required to be maintained against deposits and certain other matters.
The Company is a financial services company specializing in originating
real estate-secured loans in market niches which generally provide higher yields
of return and greater growth potential than the more traditional products
offered by most providers of mortgage loans. The Company generally seeks to
originate real estate-secured loans in which it can charge a premium price for
prompt, efficient execution and for tailoring the terms of its loans to meet the
objectives of both the Company and the borrower. Further the Company seeks to
originate a relatively limited number of high-balance loans in order to provide
reasonable leverage to its fixed loan origination cost structure. The Company
focuses primarily on originating (1) loans secured by fee interests in real
estate located throughout Southern California, including, (2) loans secured by
multi-family residential and commercial real estate, (3) loans for the
acquisition of land and construction or renovation of income-producing
improvements, and (4) loans for the construction of individual and tracts of
single-family residential homes and the acquisition and development of land for
the construction of such homes. The Company funds its lending activities
primarily with retail deposits obtained through the Bank's branch system. At
December 31, 1998, the Company had assets of $1.41 billion, deposits of $1.02
billion and stockholders' equity of $81.4 million.
In connection with its principal business activities, the Company generates
revenues from the interest and fees charged to borrowers and, to a much lesser
extent, the interest earned on its portfolio of liquid investments. The
Company's costs include primarily interest paid to depositors and to other
providers of borrowed funds, and general and administrative expenses.
The Company's operating results and its growth prospects are most directly
and materially influenced by (1) the health and vibrancy of the Southern
California real estate markets, and the underlying economic forces which affect
such markets, (2) the overall complexion of the interest rate environment,
including the absolute level of market interest rates and the volatility of such
interest rates, (3) the prominence of competitive forces which provide
customers, or potential customers, of the Company with alternative sources of
mortgage funds or investments which compete with the Company's deposit products
and services, and (4) regulations promulgated by regulatory authorities,
including those of the OTS, the FDIC and the FRB. The Company's success in
identifying trends in each of these factors, and implementing strategies to
exploit such trends, strongly influence the Company's long-term results and
growth prospects.
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The Company's operating results depend primarily on (1) the margin
("spread") between the yield earned on its loan portfolio (and to a much lesser
extent its portfolio of liquid investments) and the cost of borrowed funds, (2)
the size and relative amounts of its interest-earning assets and
interest-bearing liabilities, (3) the performance characteristics of its assets,
and (4) the extent to which the Company's business activities can be leveraged
from a largely fixed-cost infrastructure (people, technology and facilities).
At December 31, 1998, the Bank met and exceeded all three regulatory
capital requirements, with ratios of core capital to total assets of 7.65%, core
capital to risk-weighted assets of 10.10%, and total capital to risk-weighted
assets of 11.10%. Based on the foregoing, the Bank qualified as a "well
capitalized" institution under the prompt corrective action rules of the OTS.
BACKGROUND
Prior to 1993, the Company was primarily engaged in the origination of
loans for the construction of residential subdivisions and apartment buildings
and permanent loans secured by individual single-family residential homes and
apartment buildings. In addition, the Company utilized its construction
financing activities as its principal sources of permanent loans, by converting
its construction loans to permanent loans and by providing permanent financing
to purchasers of units within the residential subdivisions which were
constructed with financing from the Company. Due to the severe economic
recession in California during the early 1990s, and the resulting decline in
real estate values, the Company's nonperforming and classified assets increased
significantly and the Company incurred substantial losses and reduced levels of
capital.
In mid-1993, the Board of Directors hired a new President and Chief
Executive Officer, Mr. Scott Braly, who in turn hired a full complement of
professionals experienced in troubled asset resolution, retail banking, and the
core operations of a financial services company. The Company's new management
undertook and completed a comprehensive restructuring of all of the Company's
operations, including the following principal initiatives:
- The Bank's branch system was reduced through sales and consolidations
from 19 locations at December 31, 1993, with average deposits of $43.7
million per branch, to 6 locations, with average deposits of $169.9
million per branch, at December 31, 1998.
- Troubled and nonperforming assets were resolved, largely through
foreclosure of the Company's collateral and the subsequent construction
or renovation and retail disposition of foreclosed properties, which
reduced the Company's nonperforming assets to $17.1 million at December
31, 1998 from $151.2 million at December 31, 1993. During the six-year
period ending December 31, 1998, the Company acquired real-estate via
foreclosure with values at the time of each foreclosure totaling $272.2
million. Post-foreclosure investments for construction and renovation
totaled an additional $58.6 million.
- The Bank's regulatory core capital, which had declined to $23.6 million
by September 30, 1995 (or 3.28% of total assets), was supplemented by a
combination of (1) proceeds raised in December 1995 from the issuance of
$27.2 million of high-cost debt and preferred stock, (2) proceeds raised
in December 1997 from the issuance of $40.0 million of market-rate Senior
Notes (with $27.2 million of such proceeds applied to repay in full the
high-cost debt and preferred stock issued in December 1995), (3) net
proceeds of $27.6 million raised in July 1998 from the issuance of
approximately 2.0 million of the Company's common shares, and (4)
accumulated earnings since 1995, which together increased the Bank's
regulatory core capital to $108.7 million at December 31, 1998.
- Distinctive and tightly-focused long-term strategies designed to
re-establish the Company as a prominent provider of real estate-secured
credit throughout Southern California were developed and implemented,
which initiatives included the hiring of and support for a full
complement of lending professionals, which produced loan commitment
volumes of $964.6 million, $495.0 million and $332.3 million for 1998,
1997 and 1996, respectively.
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The successful implementation of these and related initiatives has produced
a return to, and consistent growth in, the Bank's and the Company's
profitability. See NEW BUSINESS GENERATION and ITEM 7. MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
NEW BUSINESS GENERATION
LENDING ACTIVITIES
General. The Company's principal asset-related business activity involves
the origination of loans secured by fee interests in real estate located
throughout Southern California. In each of its financing businesses, the Company
seeks to originate loans across the full spectrum of potential risk and reward.
Accordingly, the Company is often able to charge a premium price for highly
efficient and responsive transaction execution, for tailoring the terms and
conditions of such loans to meet the transaction-specific objectives of both the
Company and the borrower, and for accepting on occasion a relatively high
borrower risk profile. Since the beginning of 1995, the Company has emphasized
the origination of (1) permanent loans secured by single family residential
property, primarily very large, custom homes and unique estates ("Single
Family -- Estate Loans"), (2) loans for the construction of individual, custom
homes and the acquisition of land for the construction of such homes ("Single
Family Construction -- Single Residence Loans"), (3) term loans secured by
apartment buildings ("Income Property -- Multi-family loans") and commercial
real estate ("Income Property -- Commercial Loans"), (4) loans for the
construction of apartment buildings and commercial real estate ("Income Property
Development Loans"), and (5) loans for the construction of tracts of single
family residential homes and the acquisition and initial development of land for
the construction of such homes ("Single Family Construction -- Tract Loans").
The Company also originates a very modest volume of conventional single
family-secured loans ("Single Family -- Conventional Loans").
The Company's current loan origination activities are governed by
established policies and procedures appropriate to the risks inherent to the
types of collateral and borrowers financed by the Company. The Company's primary
competitive advantages, which include (1) a willingness and competence to tailor
the terms and conditions of individual transactions to accommodate both the
borrower's and the Company's transaction-specific objectives, (2) a strategy of
holding in portfolio virtually all new loan originations, and (3) highly
effective, efficient and responsive transaction execution, are consistent with
the Company's relatively flat organizational structure and its reliance upon
relatively few, highly-skilled lending professionals (including loan officers,
loan underwriters, processors and funders, in-house appraisers, and in-house
legal staff). Management believes that this combination of competitive,
organizational and strategic distinctions contribute to the Company's success in
attracting new business and in its ability to receive a return believed by
management to be commensurate with the inherent and transaction-specific risks
assumed and value added to customers.
The Company extends credit pursuant to a comprehensive lending policy
tailored to the specific attributes of the Company's lending activities. The
Company's lending policy establishes requirements and defines parameters
covering loan applications, borrower financial information and legal and
corollary agreements which support the vesting of title to the Company's
collateral, title policies, fire and extended liability coverage casualty
insurance, credit reports, and other necessary documents to support each
extension of credit. The real property collateral which secures the Company's
loans is appraised by either an independent fee appraiser or by one of the
Company's staff appraisers. All independent fee appraisals are reviewed by the
Company's staff appraisers and the Company's Chief Appraiser. With few
exceptions, the Company's in-house legal staff either prepares or reviews all of
the principal legal documents which support each extension of credit.
The Company seeks to originate relatively few in number, high-dollar
balance loans within each of its lending businesses, with the exception of
Single Family Conventional loans. This strategy affords the Company the
opportunity to leverage its fixed origination costs, which primarily consist of
a relatively few, highly-skilled professionals, to a greater extent than would
typically be possible in many mortgage lending operations. Accordingly, the
Company's "house limit", applicable to individual financing transactions or to
multiple loans with affiliated borrowers (as defined in applicable federal
regulations), is higher than for many other regulated financial institutions.
Since early 1998, the Company's "house limit" amounted to 70% of the
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Bank's legal lending limit (or $12.5 million at December 31, 1998), except for
special purpose commercial real estate loans, with respect to which the
Company's "house limit" is $5.0 million. Loan commitments below the Company's
"house limit" are approved by the Chief Executive Officer and reported to the
full Board of Directors subsequent to their funding. Loans in excess of the
Company's "house limit" and up to the Bank's legal lending limit ($17.9 million
at December 31, 1998) require submission to the Credit Committee of the Bank's
Board of Directors prior to their funding.
Each of the Company's principal financing activities is discussed in the
sections which follow. In this discussion, the Company's effective loan yield is
calculated by aggregating (1) the coupon interest rate, plus the annualized,
amortized effect of (2) loan origination modification and extension fees, (3)
fees paid to mortgage brokers, and (4) loan origination costs deferred under
generally accepted accounting principles. Such yields exclude the effect of exit
and release fees, and prepayment penalties (in each instance, these fees are
recognized as revenue only when received in cash and are included with
non-interest revenues in the Company's financial statements), and exclude the
effect of upward adjustments to low, introductory coupon interest rates offered
in connection with certain of the Company's Estate Loans.
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The following table sets forth information concerning the composition of
the Company's loan portfolio, and the percentage of the loan portfolio
represented by each type of loan, as of the dates indicated (dollars are in
thousands).
DECEMBER 31,
-------------------------------------------------------------------------------------------
1998 1997 1996 1995
--------------------- -------------------- ------------------- -------------------
BALANCE PERCENT BALANCE PERCENT BALANCE PERCENT BALANCE PERCENT
---------- ------- --------- ------- -------- ------- -------- -------
SINGLE FAMILY
Estate(1)...................... $ 368,911 23.0% $ 173,764 18.0% $107,891 14.6% $ 51,142 7.8%
Conventional................... 207,121 12.9 222,865 23.0 229,893 31.1 316,484 48.4
INCOME PROPERTY
Multi-family................... 250,876 15.6 225,738 23.2 220,707 29.8 219,015 33.5
Commercial..................... 222,558 13.9 111,893 11.6 60,388 8.2 31,258 4.8
Development.................... 78,425 4.8 7,310 0.8
LAND(2)............................ 69,581 4.3 39,475 4.1 14,513 2.0 5,579 0.9
SINGLE FAMILY CONSTRUCTION
Single residence............... 275,888 17.2 107,989 11.2 56,306 7.6 21,987 3.4
Tract.......................... 85,942 5.4 68,653 7.1 33,791 4.6 6,800 1.0
OTHER.............................. 46,615 2.9 9,698 1.0 15,684 2.1 1,459 0.2
---------- ----- --------- ----- -------- ----- -------- -----
GROSS LOANS RECEIVABLE(3).......... 1,605,917 100.0% 967,385 100.0% 739,173 100.0% 653,724 100.0%
===== ===== ===== =====
LESS
Undisbursed loan funds............. (256,096) (108,683) (46,646) (15,208)
Deferred loan fees and credits,
net.............................. (5,919) (7,177) (6,611) (5,996)
Allowance for credit losses........ (17,111) (13,274) (13,515) (15,192)
---------- --------- -------- --------
NET LOANS RECEIVABLE............... $1,326,791 $ 838,251 $672,401 $617,328
========== ========= ======== ========
DECEMBER 31,
-------------------
1994
-------------------
BALANCE PERCENT
-------- -------
SINGLE FAMILY
Estate(1)...................... $ -- --%
Conventional................... 372,248 65.6
INCOME PROPERTY
Multi-family................... 172,009 30.3
Commercial..................... 7,757 1.4
Development.................... 632 0.1
LAND(2)............................ 3,797 0.7
SINGLE FAMILY CONSTRUCTION
Single residence............... 3,270 0.6
Tract.......................... 6,000 1.0
OTHER.............................. 1,654 0.3
-------- -----
GROSS LOANS RECEIVABLE(3).......... 567,367 100.0%
=====
LESS
Undisbursed loan funds............. (2,795)
Deferred loan fees and credits,
net.............................. (6,091)
Allowance for credit losses........ (21,461)
--------
NET LOANS RECEIVABLE............... $537,020
========
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(1) Single family loans, generally in excess of $1.0 million, made subsequent to
1994. For loans originated prior to 1995, all loans secured by single family
homes are included with Single Family Conventional loans, irrespective of
their size.
(2) Includes predominantly loans secured by fully-entitled land, with respect to
which the Bank expects (though it is under no obligation) to provide
construction loans, the proceeds from which will fully repay these loans.
(3) Gross loans receivable includes the principal balance of loans outstanding,
plus outstanding but unfunded loan commitments, predominantly in connection
with construction loans.
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The table below summarizes the Company's loan origination activity,
measured by the dollar amount of loan commitments recorded by the Company, for
1998, 1997 and 1996. Such amounts generally exclude internal refinancings
(dollars are in thousands).
YEAR ENDED DECEMBER 31,
--------------------------------
TYPE OF LOANS 1998 1997 1996
------------- -------- -------- --------
SINGLE FAMILY
Estate(1)................................................. $274,600 $100,400 $ 72,500
Conventional.............................................. 28,000 25,700 27,400
INCOME PROPERTY
Multi-family(2)........................................... 64,800 51,700 70,700
Commercial(3)............................................. 125,900 105,100 46,000
Development(4)............................................ 81,200 -- --
LAND(5)..................................................... 98,500 35,700 12,500
SINGLE FAMILY CONSTRUCTION
Single residence(6)....................................... 220,400 104,900 53,200
Tract(7).................................................. 57,100 61,800 32,300
OTHER(8).................................................... 14,100 9,700 17,700
-------- -------- --------
$964,600 $495,000 $332,300
======== ======== ========
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(1) This amount includes unfunded commitments under lines of credit of $5.3
million, $7.4 million and $2.8 million at December 31, 1998, 1997 and 1996,
respectively.
(2) Includes $1.7 million, $5.0 million and $16.2 million of financings provided
in connection with sales of previously foreclosed properties for 1998, 1997,
and 1996, respectively.
(3) Includes unfunded commitments of $16.4 million, $15.9 million and $2.3
million at December 31, 1998, 1997 and 1996, respectively.
(4) Includes unfunded commitments of $17.5 at December 31, 1998. There were no
unfunded commitments at December 31, 1997 and 1996.
(5) Includes unfunded commitments of $12.9 million, $14.1 million and $3.4
million at December 31, 1998, 1997, and 1996, respectively.
(6) Includes unfunded commitments of $109.8 million, $50.8 million and $21.9
million at December 31, 1998, 1997 and 1996, respectively.
(7) Includes unfunded commitments of $34.7 million, $33.6 million and $18.7
million at December 31, 1998, 1997 and 1996, respectively.
(8) Includes unfunded commitments of $1.2 million, $4.0 million at December 31,
1998 and 1997, respectively.
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SINGLE FAMILY -- ESTATE LOANS. Since 1994, the Company has provided
financing to owners of large, custom homes and unique estates. Generally, Estate
Loans involve financings in excess of $1.0 million and are secured by properties
primarily located in the communities of Santa Barbara, Bel-Air, Beverly Hills,
Malibu, Newport Beach, Laguna Beach, Rancho Santa Fe and La Jolla, in
California.
During 1998, the market for loans individually in excess of $1.0 million
within the five-county area encompassed by Santa Barbara, Los Angeles, Orange,
Riverside and San Diego counties (e.g. the Company's principal market area),
approximated $4.0 billion of financings, an increase of nearly 50% from the $2.7
billion of such financings recorded during 1997. Based upon publicly-available
information, the Company was the fourth largest provider of term, home
financings of $1.0 million and more within this five-county area during 1998.
In a majority of instances, the Company originates Estate Loans to
refinance the borrower's existing loans, rather than to finance the borrower's
purchase of a home. This relationship of refinancings to purchases of Estate
Loans made by the Company approximates the mix in the estate financing market as
a whole, in which approximately 64.0% of such financings during 1998 were
originated in order to refinance the borrower's existing loan. The Company
generally provides financing to homeowners who have substantial equity in the
property or properties which secure the Estate Loans but who for a variety of
reasons, principally related to the purpose of the borrower's loan request, the
size of the loan request, the characteristics of the property or properties
which secure the Company's loan, the credit profile of the borrower (which
include such issues as the legal borrowing entity, citizenship, previous credit
history, loan purpose, or current employment income or assets), the terms and
conditions of the loan, or the execution time-frame required, are unacceptable
to or inconsistent with the guidelines of the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation or national conduits
which purchase conventional loans above the loan limits of such
government-sponsored enterprises.
Consistent with its principal competitors, the Company originates Estate
Loans principally through contact with, and submissions by, independent mortgage
brokers. As discussed below, the Company pays a fee, generally ranging from
0.50% to 2.00% of the loan amount, to mortgage brokers in connection with its
funding of certain Estate Loans, which practice and pricing are common for
single family-secured loans originated throughout the Company's market area.
The Company's Estate Loans are secured by homes with a wide range of
characteristics, from large, custom homes located within mature areas to very
large, multiple-acre, one-of-a-kind estates. The Company's Estate Loans also
encompass a wide range of borrower profiles, including borrowers with the
demonstrated capacity to service the loan to others with no verifiable source of
recurring cash flow. Estate Loans which meet the highest standards of collateral
quality, liquidity, borrower capacity and creditworthiness ("Tier 1 loans") are
similar to conventional loans except for their size, and generally possess
higher loan-to-value ratios and the most favorable pricing to the borrower.
Estate Loans with respect to which the borrower's resources are limited or
cannot be reliably measured, or with respect to which the Company's collateral
possesses such unique characteristics, including size, amenity or location, so
as to make its valuation difficult to reliably measure ("Tier 3 loans"), possess
the lowest loan-to-value ratios and the highest pricing to the borrower. Loans
which fall between these two sets of parameters ("Tier 2 loans") involve
advances and pricing which are tailored to the particular attributes of the
property, the borrower, the reason underlying the borrower's loan request and
other factors. Loan-to-value ratios generally range from 70% to 75% for Tier 1
loans, 60% to 70% for Tier 2 loans and 65% or less for Tier 3 loans.
The Company typically prices its Estate Loans to adjust monthly at a margin
over either the One-year Constant Maturity Treasury index (the "One-year CMT")
or the Monthly Treasury Average index (the "MTA"), which is a rolling
twelve-month average of the One-year CMT. On occasion, typically with respect to
Tier 3 loans, the Company prices its loans to float daily at a margin over the
Prime Rate. Generally, Tier 1 loans have an amortization period of 30 years and
a final maturity of 10 years from the date of origination, Tier 3 loans carry a
loan term of not more than 2 years and payments may be either amortizing or
interest-only, and Tier 2 loans have a variety of loan terms (though none
exceeding 10 years from the date of origination) and are typically amortizing
over 30 years. A majority of the Company's Tier 1 Estate Loans
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provide for a period, ranging from one-to-three years following origination,
during which the Company charges a fee (generally equal to six months' interest
at the fully-adjusted interest rate) for the prepayment of the loan by the
borrower. Prepayment penalty provisions are generally not included in Tier 2 and
Tier 3 loans because of the generally short-term nature of such loans.
Because the Company's Estate Loans entail certain risks not typically
associated with more conventional loans, including the size of many such loans,
the unique characteristics of certain of the properties securing such loans, and
the limited, demonstrated financial capacity of certain of the Company's
borrowers, the Company believes that the performance of its portfolio of Estate
Loans, as measured by the levels of nonperforming, nonaccrual and classified
Estate Loans, possesses a greater potential for volatility when compared with
originators of more conventional loans, which may adversely affect, even if
temporarily, the Company's interest income. In addition, because many of the
Company's Estate Loans have not been outstanding long enough to be considered
mature, seasoned loans, and because property values generally have been rising
during the four-year period during which the Company has been originating Estate
Loans, the Company cannot predict whether its experience to date in successfully
resolving performance-related problems with certain of its Estate Loans will
continue into the future.
At December 31, 1998, outstanding Estate Loans totaled $368.9 million, of
which approximately $233.9 million were Tier 1 loans, $63.1 million were Tier 2
loans and $71.9 million were Tier 3 loans.
SINGLE FAMILY CONSTRUCTION -- SINGLE RESIDENCE LOANS. The Company provides
individual home construction financing, primarily to local builders and, to a
much lesser extent, homeowners. Generally, the Company finances the construction
of luxury, custom homes throughout the coastal region of Southern California and
in other affluent areas within the Company's market area. A majority of the
Company's Single Family Construction -- Single Residence Loans are sourced
through standing relationships between the Company's loan officers and local
builders and, therefore, do not typically involve mortgage brokers.
The Company's Single Family Construction -- Single Residence Loans are
typically made in connection with the borrower's acquisition of
residentially-zoned and fully-entitled land located in mature, upscale areas,
with respect to which the borrower's intention is to construct new improvements
for resale (in the case of local builders) or occupancy (in the case of
homeowners). The Company's loan commitment generally includes provision for a
portion of the cost of the acquired land and all of the costs of construction
(including financing costs). Generally, the Company's loan commitment covers
between 70% and 75% of the total costs of construction (including the cost of
land acquisition, the cost to construct the planned improvements and financing
costs), with the borrower providing the remainder of the funds required at the
date the Company records its financing commitment.
Typically, the Company's Single Family Construction -- Single Residence
Loans have an initial term of 12 months, with an option for the borrower to
extend the loan for up to six months, subject to the Company's then current
evaluation of the status of construction, costs to and at completion, the
as-completed valuation of the property, and other factors. In certain instances,
typically involving the construction of very large estates, the initial loan
term can range up to 24 months. The Company prices its Single Family
Construction -- Single Residence Loans to float daily at a margin over the Prime
Rate and charges the borrower a loan fee at origination based upon the amount of
the Company's loan commitment. The Company's loan commitment typically provides
the funds necessary to carry interest on the Company's loan through the initial
loan term. Additional fees are charged to compensate the Company for its
periodic inspections and funds management during the course of construction, and
for any extensions to the original loan term which may be granted by the
Company.
Virtually none of the Company's Single Family Construction -- Single
Residence Loans carry a takeout loan commitment (in the case of Single Family
Construction -- Single Residence Loans made to homeowners) or a purchase
commitment for the completed home (in the case of Single Family
Construction -- Single Residence Loans made to builders).
Single Family Construction -- Single Residence Loans carry certain inherent
risks not typically associated with the financing of in-place, occupied
improvements, including (1) the accuracy of the initial estimate
8
12
of the property's valuation at completion of construction, (2) the estimated
cost (including financing costs) of construction, (3) the length of the
construction period, (4) the construction management capabilities of the
builder, and (5) the availability of permanent financing upon the completion of
construction.
The Company attempts to mitigate these inherent risks by (1) carefully
evaluating the line item costs of construction prior to recording the
construction loan commitment, (2) carefully evaluating the product type to be
built and the demand for the finished home (by reference to recent sales of
comparable homes) prior to recording the construction loan commitment, (3)
utilizing a voucher system in order to closely control disbursements during the
construction period, (4) performing frequent inspections (with Company-employed
inspectors) during the construction period, and (5) carefully evaluating the
development experience of the Company's borrower with similar projects.
At December 31, 1998, the Company had outstanding Single Family
Construction -- Single Residence Loan commitments of $275.9 million, covering
247 individual construction projects. Approximately $149.2 million of funds had
been disbursed against these outstanding commitments through December 31, 1998,
with $126.7 million of funds remaining to be disbursed. These unfunded amounts
are expected to be fully disbursed during 1999. At December 31, 1998, the
average Single Family Construction -- Single Residence Loan commitment was $1.0
million, and had a remaining contractual term to maturity of 6 months (excluding
extension option periods) Additionally the Company had 42 loans, with
outstanding principal of $18.6 million, secured by land parcels, with respect to
which the Company expects (though it is not committed) to provide Single Family
Construction -- Single Residence Loan financing in the future.
INCOME PROPERTY MULTI-FAMILY AND COMMERCIAL LOANS. Since 1994, the Company
has originated loans secured by multi-family properties and commercial
properties, such as office buildings, retail properties, industrial properties
and various special purpose properties. The Company generates a majority of its
new Income Property Loan opportunities through contact with, and submissions by,
independent mortgage loan brokers. However, a growing proportion of the
Company's new business is derived from existing customer relationships or
through referrals from existing customers. Management believes that the Company
is often able to obtain higher returns on its Income Property Loans, when
compared with the returns generally available in the marketplace for such
financings, because significant opportunities exist to provide financing which
requires highly responsive transaction execution, tailored loan terms and
conditions, and specialized market knowledge and expertise.
The Company typically prices its Income Property Loans to float monthly or
quarterly over a variety of market-sensitive indicies, including the six-month
London Inner-Bank Offer Rate ("LIBOR"), the Federal Home Loan Bank Eleventh
District Cost of Funds index (the "11th DCOFI"), and the Prime Rate. The Company
does not typically make fixed-rate Income Property Loans. Generally, Income
Property Loans carry maturities up to ten years from origination, and are
amortizing over 30 years. A majority of such loans provide for a period,
generally from one-to-three years, during which the Company charges a fee
(generally equal to one-to-three percent of the Company's commitment amount) for
the prepayment of the loan by the borrower.
Income Property Loans carry inherent risks not typically associated with
the single family residential lending traditionally emphasized by savings
institutions. This is because the payment experience of Income Property Loans is
generally dependent upon the successful operation of the income property, and
thus such loans may be affected to a greater extent by adverse conditions in the
real estate markets or in the economy in general, as well as the manner in which
the borrower manages the property. Moreover, Income Property Loans generally are
made with primary reliance upon the operation and/or sale of the Company's
collateral and without recourse to the borrower. The Company attempts to
mitigate these risks by (1) generally requiring borrowers to demonstrate their
commitment to the property through a significant cash equity investment, (2)
generally requiring minimum stabilized debt coverage ratios of 120% for
multi-familiy-secured loans and 130% for commercial real estate-secured loans
(with such ratios determined by reference to the Company's underwritten estimate
of the properties' stabilized operating cash flows), (3) carefully evaluating
the historical operations of the Company's collateral (for seasoned properties),
(4) investigating the rental markets for similar properties located within the
immediate market area of the Company's collateral, (5) validating the borrower's
operating expense assumptions (or the properties' reported operating expenses)
by reference to
9
13
industry benchmarks for similar properties, and (6) evaluating the operating
experience of the borrower with similar properties.
INCOME PROPERTY -- DEVELOPMENT LOANS. Commencing in 1998, the Company has
pursued financing opportunities involving (1) the acquisition of land and the
construction of income-producing improvements thereon, or (2) the acquisition
and substantial renovation of existing, income-producing improvements. To date,
these loans have been directed toward apartment building construction (primarily
located in the West Los Angeles area) and the renovation of existing commercial
real estate improvements located throughout Los Angeles County.
The Company typically prices its Income Property -- Development Loans to
float daily over the Prime Rate, with maturities of between 12 and 24 months.
Generally, these loans are made without recourse to the borrower.
Income Property -- Development Loans possess the inherent risks associated
with all real estate-secured construction lending as well as with financings
secured by existing income-producing real estate, each of which is described
elsewhere in this section. The Company attempts to mitigate these risks through
its extensive underwriting of the feasibility of the proposed project (including
its evaluation of the market demand for the completed property), the costs of
construction, the construction and operating experience of the borrower, and the
availability of permanent takeout financing (in those instances in which the
Company has not made such a commitment).
SINGLE FAMILY CONSTRUCTION -- TRACT LOANS. Since 1995, the Company has
provided financing to small-to-medium-sized developers of residential
subdivisions located throughout Southern California. Generally, the Company's
Tract Loans finance land acquisition, site development and home construction.
The Company prices its Tract Loans to float daily at a margin over the
Prime Rate and charges a loan fee at origination based upon the Company's loan
commitment. In certain instances, the Company also receives additional
compensation as completed homes are sold. Except for very small subdivisions
(i.e., generally developments involving 10 or fewer homes), the Company
generally structures its Tract Loans such that it will separately finance land
acquisition and site development, and the individual phased construction of
homes. In connection with these multi-phase developments, the Company does not
commit to finance more than one phase of the development at a time, and fully
underwrites future phases at such time as the borrower makes their financing
request. Generally, the Company's Tract Loans carry a loan term of 12 months,
with built-in options to extend the loan for up to an additional six months. As
finished homes are sold, the Company generally receives substantially all of the
proceeds from sales until its loan is fully repaid.
Tract Loans carry the inherent risks associated with construction financing
in general, which are discussed elsewhere in this section. Because Tract Loans
can involve the construction of several phases of homes, thereby often requiring
between 24 and 36 months from land acquisition to final sellout, there is the
additional risk that market conditions may become adverse during the course of
this extended construction period, which could result in lowered demand for
homes built in the final phase or phases of the development. Lastly, because a
majority of the Company's Tract Loan borrowers do not possess substantial
financial resources or capacity, most Tract Loans provide the borrower with
leverage well in excess of the leverage afforded the Company's Single Family
Construction -- Single Residence Loan and Income Property -- Development Loan
borrowers, which creates the risk that material cost overruns or delays, or
reduced prices for completed homes will quickly erode the borrower's or the
Company's equity in the development.
In addition to the mitigating factors discussed elsewhere in this section
for Single Family Construction -- Single Residence Loans, the Company attempts
to mitigate the additional risks associated with Tract Loans by (1) underwriting
the feasibility of the entire project at the inception of development, (2)
reevaluating revenues and costs to and at completion for the entire project in
connection with any subsequent phased loan request (by reference to both actual
sales activity and actual construction costs for completed phases and current
market sales data and the borrower's phase-specific estimate of construction
costs), (3) frequently inspecting the project (utilizing the Company's in-house
inspectors), and (4) ensuring that the disbursement
10
14
of funds during the course of construction is consistent with the stage of
completion and the actual work performed by the contractor and subcontractors.
In late 1998, the Company decided to suspend accepting requests for the
financing of any new developments. This decision was predicated upon
management's view that (1) the Company had not been particularly successful in
establishing a sustainable competitive advantage for its Tract Loans, resulting
in a consistently lower level of completed financings than targeted by
management, (2) the leverage generally afforded borrowers by the Company's Tract
Loans in order for the Company to acquire new business placed the Company at
increasing risk that cost overruns and/or lowered sales prices could not be
absorbed by either the borrower or the Company's equity position in the
development, and (3) because of competitive factors, the Company could no longer
receive an appropriate risk-adjusted rate of return on its Tract Loans.
Accordingly, the Company will actively manage its remaining portfolio of Tract
Loan commitments, which may include providing financing for future phases in
connection with developments with respect to which the Company has an existing
financing commitment.
At December 31, 1998, the Company's portfolio of Tract Loans consisted of
outstanding commitments totaling $94.7 million in connection with 29 separate
developments. At December 31, 1998, $47.8 million had been disbursed against
these commitments. The Company expects that the substantial majority of the
remaining funds associated with these commitments will be disbursed, and the
completed homes sold and the Company's Tract Loans repaid, by the end of 1999.
SINGLE FAMILY -- CONVENTIONAL LOANS. Although the Company does not
currently emphasize the origination of conventional, single-family-secured
loans, the Company does continue to make such loans, which are generally secured
by homes located in Los Angeles County. This business is the most competitive
and least profitable of all of the Company's lending businesses, and the Company
lacks the size and scale of operations to profitably penetrate this business,
especially in view of the significant capacity already in the marketplace in the
form of very large banking companies whose principal business is to originate
conventional single-family-secured loans, many for resale in the secondary
mortgage markets.
At December 31, 1998, the Company had outstanding Single
Family -- Conventional Loans totaling $74.7 million which had been originated
since 1994, with an effective yield of 7.49%.
PRE-1995 LOANS. At December 31, 1998, the Company had outstanding loan
principal of $235.1 million relating to loans originated prior to 1995 as
summarized below (dollars are in thousands).
PRINCIPAL
COLLATERAL TYPE BALANCE
--------------- ---------
Single family............................................. $132,457
Multi-family.............................................. 95,456
Commercial................................................ 6,852
Other..................................................... 334
--------
$235,099
========
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15
The table below sets forth, by contractual maturity, the Company's loan
portfolio at December 31, 1998 (dollars are in thousands). The table is based on
contractual loan maturities and does not consider amortization and prepayments
of loan principal.
MATURING IN
--------------------------------------------------------
OVER OVER
ONE YEAR FIVE YEARS TOTAL
LESS THAN THROUGH THROUGH OVER LOANS
ONE YEAR FIVE YEARS TEN YEARS TEN YEARS RECEIVABLE
--------- ---------- ---------- --------- ----------
SINGLE FAMILY
Estate................... $ 39,991 77,940 $219,630 $ 31,350 $ 368,911
Conventional............. 65 2,264 4,153 200,639 207,121
INCOME PROPERTY
Multi-family............. 8,236 51,315 101,300 90,024 250,875
Commercial............... 28,592 119,009 66,755 8,202 222,558
Development.............. 41,027 37,399 -- -- 78,426
LAND....................... 53,678 13,571 1,998 334 69,581
SINGLE FAMILY CONSTRUCTION
Single residence......... 254,216 21,672 -- -- 275,888
Tract.................... 62,369 23,573 -- -- 85,942
OTHER...................... 35,215 10,237 300 863 46,615
-------- -------- -------- -------- ----------
GROSS LOANS
RECEIVABLE(1)............ $523,389 356,980 $394,136 $331,412 1,605,917
======== ======== ======== ========
LESS
Undisbursed funds.......... (256,096)
Deferred loan fees and
credits, net............. (5,919)
Allowance for credit
losses................... (17,111)
----------
NET LOANS RECEIVABLE....... $1,326,791
==========
- ---------------
(1) Gross loans receivable includes the principal balance of loans outstanding
plus outstanding but unfunded loan commitments, predominantly in connection
with construction loans.
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16
The table below sets forth, by contractual maturity, the Company's fixed
rate and interest-rate sensitive loans at December 31, 1998 (dollars are in
thousands). The table is based on contractual loan maturities and does not
consider amortization and prepayments of loan principal.
MATURING IN
--------------------------------------------------
OVER OVER
ONE YEAR FIVE YEARS TOTAL
LESS THAN THROUGH THROUGH OVER LOANS
ONE YEAR FIVE YEARS TEN YEARS TEN YEARS RECEIVABLE
--------- ---------- ---------- --------- -----------
FIXED INTEREST RATES............... $ 32,628 $ 46,889 $ 8,814 $114,872 $ 203,203
ADJUSTABLE INTEREST RATES
11th DCOFI....................... 7,793 73,166 85,307 182,046 348,312
Prime rate....................... 470,572 152,895 48,693 -- 672,160
1 year CMT....................... -- 19,058 151,694 6,420 177,172
MTA.............................. -- -- 33,850 18,657 52,507
Other............................ 12,396 64,972 65,779 9,416 152,563
-------- -------- -------- -------- ----------
Total adjustable interest
rates......................... 490,761 310,091 385,323 216,539 1,402,714
-------- -------- -------- -------- ----------
GROSS LOANS RECEIVABLE(1).......... $523,389 $356,980 $394,137 $331,411 $1,605,917
======== ======== ======== ========
LESS
Undisbursed funds.................. (256,096)
Deferred loan fees and credits,
net.............................. (5,919)
Allowance for credit losses........ (17,111)
----------
NET LOANS RECEIVABLE............... $1,326,791
==========
- ---------------
(1) Gross loans receivable includes the principal balance of loans outstanding
plus outstanding but unfunded loan commitments predominantly in connection
with construction loans.
The foregoing table does not reflect the expected maturities of loans
because it does not take into account scheduled contractual amortization and
prepayments of loans. Moreover, because adjustable-rate loans are not shown in
the period in which they are first scheduled to adjust, such table also does not
reflect the sensitivity of the Company's loan portfolio to changes in interest
rates. See ITEM 1, BUSINESS -- INTEREST RATE RISK MANAGEMENT.
ASSET QUALITY
The Company is exposed to the inherent risks associated with financing real
estate on a secured basis, in which the Company's loans are secured by fee
interests in real property. The primary risks associated with the Company's
specific lending activities are described in the preceding section (see ITEM 1,
BUSINESS -- NEW BUSINESS GENERATION, LENDING ACTIVITIES). The Company seeks to
mitigate the inherent risks associated with its lending activities through (1)
its loan underwriting and appraisal practices (each of which is further
discussed in the preceding section), (2) its asset review and loan
classification practices, and (3) its practice of establishing loan-specific and
general valuation allowances for identified and potential loan losses.
The Company has an asset review and classification system to establish
specific and general reserves and to classify assets and groups of assets. The
Company's problem asset classifications are discussed below.
REAL ESTATE OWNED. Real estate acquired through foreclosure, or receipt of
a deed in lieu of foreclosure, is carried at the lower of the Company's basis in
the loan which was secured by the acquired property, or the fair value of the
acquired property. Subsequent declines in the fair value of the property, if
any, are accounted for by establishing a specific valuation allowance. The
determination of a property's fair value incorporates revenues projected to be
realized from sale of the property, less construction and renovation costs (if
any), marketing and transaction costs, and holding costs (e.g., property taxes,
insurance, homeowners' association dues).
13
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The table below details the Company's portfolio of real estate owned as of
the dates indicated (dollars are in thousands).
DECEMBER 31,
-------------------------------------------------
1998 1997 1996 1995 1994
------ ------- -------- -------- --------
SINGLE FAMILY
Conventional............................ $2,509 $ 7,695 $ 9,777 $ 15,234 $ 17,555
INCOME PROPERTY
Multi-family............................ 213 2,362 3,215 18,877 27,229
Commercial.............................. 1,393 -- 346 346 395
LAND...................................... -- 2,365 2,517 3,759 14,424
SINGLE FAMILY CONSTRUCTION
Tract................................... -- -- 16,156 15,414 39,516
------ ------- -------- -------- --------
GROSS INVESTMENT.......................... 4,115 12,422 32,011 53,630 99,119
RESERVES.................................. (45) (2,563) (11,871) (15,725) (36,506)
------ ------- -------- -------- --------
NET INVESTMENT............................ $4,070 $ 9,859 $ 20,140 $ 37,905 $ 62,613
====== ======= ======== ======== ========
In the preceding table, the Company's gross investment in real estate owned
equals loan principal at foreclosure, plus post-foreclosure capitalized costs,
less cumulative charge-offs. As of the years ended for the five years reported,
the Company did not carry any REOs relating to the Estate and Single Residence
construction loan portfolios.
NONACCRUAL LOANS. As a matter of policy, the Company generally ceases to
accrue interest on any loan with respect to which the loan's contractual
payments are more than 30 days past due. In addition, interest is not recognized
on any loan with respect to which management has determined that the probability
of collection of the Company's investment in the loan is less than certain.
The table below sets forth the balance of nonaccrual loans for each period
presented (dollars are in thousands).
DECEMBER 31,
------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------
LOANS PAST DUE 90 DAYS OR MORE.............. $13,042 $10,793 $16,643 $11,298 $18,103
LOANS PAST DUE 30 - 89 DAYS................. 20,002 4,435 10,082 8,811 17,747
OTHER NONACCRUAL LOANS...................... 14,644(1) 168 1,899 1,600 3,546
------- ------- ------- ------- -------
TOTAL NONACCRUAL LOANS............ $47,688(2) $15,396 $28,624 $21,709 $39,396
======= ======= ======= ======= =======
- ---------------
(1) Loans which have been modified and are paying as agreed with modified terms.
(2) Excludes $18.1 of loans at December 31, 1998 past due 30 days or more, of
which $13.1 million are past due for maturity but current with respect to
interest payments and, if applicable, principal payments. All $18.1 million
were renewed, paid current or paid off in the first quarter of 1999.
The annual dollar amount of interest revenue, based upon the contractual
interest rate, associated with nonaccrual loans at December 31, 1998, 1997,
1996, 1995 and 1994 was $4.9 million, $1.4 million, $2.8 million, $1.5 million
and $2.9 million, respectively. With respect to such loans, the Company recorded
interest revenue of $3.3 million, $0.9 million, $1.9 million, $1.0 million and
$1.5 million respectively, during 1998, 1997, 1996, 1995 and 1994. This revenue
predominantly represents cash payments made by borrowers prior to the date the
loan was placed on nonaccrual status.
TROUBLED DEBT RESTRUCTURINGS ("TDRS"). In the preceding table, total
nonaccrual loans include TDRs totaling $2.7 million (1998), $0.5 million (1997),
$5.6 million (1996), $0 (1995), and $0.1 million (1994). A TDR is a loan with
respect to which the terms have been modified in a manner which resulted in the
loan
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being classified as a TDR under generally accepted accounting principles. The
table below summarizes the Company's TDRs at each respective period-end (dollars
are in thousands).
DECEMBER 31,
-----------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------
PERFORMING TDRS.................................. $34,106 $29,460 $35,294 $24,029 $10,128
TDRS WHICH ARE 90 DAYS OR MORE DELINQUENT........ 170 102 3,790 -- 100
------- ------- ------- ------- -------
TOTAL TDRS............................. $34,276 $29,562 $39,084 $24,029 $10,228
======= ======= ======= ======= =======
INTEREST REVENUE
Recognized..................................... $ 2,484 $ 2,505 $ 3,106 $ 1,707 $ 690
Based upon original loan terms................. 2,873 2,908 3,759 1,929 1,046
Based upon modified loan terms................. 2,695 2,665 3,554 1,707 697
CLASSIFIED ASSETS. OTS regulations require insured institutions to classify
their assets in accordance with established policies and procedures. A
classified asset is an asset classified either Substandard, Doubtful or Loss.
Loans that are not classified are categorized as Pass or Special Mention. The
severity of an asset's classification is dependent upon, among other things, the
institution's risk of loss, the borrower's performance, the characteristics of
the institution's security, local market conditions, and other factors.
The Company automatically classifies as Substandard (1) real estate owned,
(2) loans delinquent 90 or more days, and (3) other nonaccrual loans. Performing
loans are classified consistent with the Company's classification policies.
The table below sets forth certain information regarding the Company's
classified assets as of the dates indicated (dollars are in thousands).
DECEMBER 31,
----------------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
REAL ESTATE OWNED, NET............. $ 4,070 $ 9,859 $ 20,140 $ 37,905 $ 62,613
TOTAL NONACCRUAL LOANS............. 47,688 15,396 28,624 21,709 39,396
---------- -------- -------- -------- --------
GROSS NONACCRUAL ASSETS............ 51,758 25,255 48,764 59,614 102,009
PERFORMING LOANS CLASSIFIED LOSS,
DOUBTFUL AND SUBSTANDARD(1)...... 45,397 35,845 45,088 57,049 63,763
---------- -------- -------- -------- --------
GROSS CLASSIFIED ASSETS............ $ 97,155 $ 61,100 $ 93,852 $116,663 $165,772
========== ======== ======== ======== ========
GROSS CLASSIFIED LOANS............. 93,085 51,241 73,712 78,758 103,159
========== ======== ======== ======== ========
GROSS LOANS RECEIVABLE............. $1,343,902 $851,525 $685,916 $632,520 $558,481
========== ======== ======== ======== ========
CORE CAPITAL....................... $ 108,673 $ 69,906 $ 52,803 $ 43,360 $ 38,438
========== ======== ======== ======== ========
RISK-BASED CAPITAL................. $ 119,400 $ 78,454 $ 59,560 $ 49,448 $ 43,937
========== ======== ======== ======== ========
RATIO OF CLASSIFIED ASSETS TO:
Loans receivable.............. 7.2% 7.2% 13.7% 18.4% 29.7%
========== ======== ======== ======== ========
Core capital.................. 89.4% 87.4% 177.7% 269.1% 431.3%
========== ======== ======== ======== ========
Risk-based capital............ 81.4% 77.9% 157.6% 235.9% 377.3%
========== ======== ======== ======== ========
- ---------------
(1) Includes $18.1 million in loans, at December 31, 1998, of which $13.1
million were past due for maturity but current with respect to interest and,
if applicable, principal payments. All $18.1 million were renewed, paid
current or paid off in the first quarter of 1999.
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19
The table below sets forth the Company's gross classified loans, by
principal loan portfolio segment, as of December 31, 1998 (dollars are in
thousands).
DELINQUENT LOANS(1) OTHER
---------------------- NONACCRUAL PERFORMING
90+ DAYS 30-89 DAYS LOANS(3) LOANS TOTAL
-------- ---------- ---------- ---------- -------
SINGLE FAMILY
Estate................................ $ 7,000(2) $22,086 $11,568 $ 3,042 $43,696
Conventional.......................... 2,561 2,778 -- 9,567 14,906
INCOME PROPERTY
Multi-family.......................... -- -- -- 1,633 1,633
Commercial............................ 3,480 130 -- 9,460 13,070
LAND.................................... 21 3,200 -- -- 3,221
SINGLE FAMILY CONSTRUCTION
Single residence...................... 770 2,055 -- 1,358 4,183
Tract................................. -- 7,058 3,076 -- 10,134
OTHER................................... -- -- -- 2,242 2,242
------- ------- ------- ------- -------
GROSS CLASSIFIED LOANS.................. $13,832 $37,307 $14,644 $27,302 $93,085
======= ======= ======= ======= =======
- ---------------
(1) Includes $18.1 million of loans at December 31, 1998 past due 30 days or
more, of which $13.1 million are past due for maturity but current with
respect to interest payments and if applicable principal payments. All $18.1
million were renewed, paid current or paid off in the first quarter of 1999.
(2) Represents a $7.0 million loan to a single borrower which was paid off in
full in the first quarter of 1999.
(3) Loans which have been modified and are paying as agreed with modified terms.
ALLOWANCE FOR ESTIMATED CREDIT LOSSES
GENERAL. The Company maintains an allowance for estimated credit losses
("the allowance") to absorb losses inherent in the loan portfolio. The allowance
is based upon an ongoing, quarterly assessment of the probable estimated losses
inherent in the loan portfolio and, to a lesser extent, unfunded commitments to
provide financing. Our methodology for assessing the appropriateness of the
allowance consists of two elements, which include:
- Specific allowances for identified problem loans
- The general allowance
In addition, the allowance incorporates the results of measuring impaired
loans as provided in:
- Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting
by Creditors for Impairment of a Loan," and
- SFAS No. 118, "Accounting by Creditors for Impairment of a Loan Income
Recognition and Disclosures."
These accounting standards prescribe the measurement methods, income
recognition and disclosures concerning impaired loans.
Virtually all of the Company's loans are secured by fee interests in real
property (at December 31, 1998, $5.5 million, or 0.4%, of net loans were
unsecured and $4.0 million, or 0.3%, of net loans were secured by the pledge of
ownership interests in real estate partnerships which, in turn, owned fee
interests in real property). Accordingly, the Company has the ability to, and
does, perform periodic reviews of each of its Single Family -- Estate, Income
Property -- Multi Family, Income Property -- Commercial, Income Property --
Development, Single Family Construction -- Single Residence and Single Family
Construction -- Tract Loans, generally no less frequently than annually (and in
the instance of nonaccrual loans or other loans classified Substandard, no less
frequently than semi-annually). These reviews include (1) assessing the
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20
borrower's performance with respect to loan payments, compliance with loan
covenants, etc., (2) determining whether the vesting of title to the Company's
loan has changed, and (3) for income-producing properties, reviewing the recent
operating performance of the property, and comparing such performance with
actual or forecasted operating data from the origination appraisal and the
Company's pre-funding underwriting analysis. With respect to construction loans,
the Company closely manages the disbursement of funds during the course of
construction by performing frequent inspections of the Company's collateral
(utilizing Company-employed inspectors) and by utilizing a voucher system for
disbursements. Together, these post-funding processes form the primary basis by
which the Company classifies its loans and identifies loan-specific and
portfolio-specific loss potential.
POST-1994 LOANS. At December 31, 1998, approximately $1.1 billion, or
82.6%, of the Company's net loans (and $1.4 billion, or 85.4%, of its gross loan
commitments) had been originated since 1994. As a consequence, these loans do
not possess extensive seasoning. Further, since 1994 the economic environment
within the Company's Southern California market area has steadily improved,
which has resulted in, among other things, rising property values and a
proliferation in the availability of mortgage credit for virtually all classes
of real property. These positive market conditions have permitted the Company to
successfully resolve virtually all of its loan performance-related problems with
respect to loans originated since 1994 with little loss of either principal or
interest (and, in many instances, with the receipt of substantial additional
compensation paid by the borrower to the Company upon resolution). Accordingly,
the Company does not possess portfolio-specific migration and loss experience
with respect to loans originated subsequent to 1994 which incorporates the
effects of an economic slowdown or downturn and a moderation or decline in
property values.
The Company has originated relatively few in number, high dollar balance
loans since 1994. At December 31, 1998, the Company had 1,376 loans originated
since 1994 in its loan portfolio (884 loans excluding Single
Family -- Conventional loans originated since 1994). This small number of loans
permits the Company to evaluate its Post-1994 loan portfolio on a loan-by-loan
basis for the purpose of assessing risk of loss, and quantifying the results
from such assessment.
As a matter of policy, management establishes a specific valuation
allowance, determined on a loan-by-loan basis, in connection with nonaccrual
loans and performing, classified loans where management believes that the
current or expected liquidation value of the Company's collateral is less than
the Company's cost basis in the loan. At December 31, 1998, the Company had
established aggregate specific valuation allowances totaling $4.2 million with
respect to Post-1994 Loans. Approximately $3.9 million of this total was
represented by six loans at December 31, 1998.
In measuring the adequacy of the Company's general valuation allowance for
Post-1994 Loans, management takes the results from its loan review and
classification processes and applies loss factors largely derived from
OTS-published guidelines for mortgage loans secured by various property types
(e.g., single family, multi-family properties, commercial real estate) for each
loan classification (e.g., Pass, Special Mention, Substandard, Doubtful).
Generally, the loss factors applied are the highest for loans adversely
classified and for loans secured by non-residential real estate and are the
lowest for the Single Family Conventional loans.
In addition to this formula approach to measuring the allowance, management
also performs a separate analysis, predominantly on a loan-by-loan basis, which
(1) identifies, assesses and quantifies specific, inherent risks embodied within
the Company's loans (e.g., borrower risk, property liquidity risk, property
operations risk (for income-producing real estate), construction risk,
refinancing risk, etc.), (2) measures the Company's portfolio-specific
performance experience (e.g., payment history, unscheduled repayments of
principal, the actual liquidation value of the Company's loan collateral, if
sold, in relation to the Company's pre-origination appraisal valuation,
resolution of borrower performance issues, etc.), (3) measures
portfolio-specific loan seasoning and duration, and (4) incorporates
management's assessment of recent trends and current and projected conditions
with respect to the property markets throughout Southern California. This
analysis, when completed, is designed to provide management with a "worst-case"
assessment of potential portfolio loss content for the Company's Post-1994 Loans
at each measurement date, which is then compared with the
17
21
results produced by the Company's formula approach to measuring the adequacy of
its general valuation allowance.
The tables below set forth certain information about the Company's general
valuation allowance for Post-1994 Loans as of the dates indicated (dollars are
in thousands).
DECEMBER 31,
------------------------------------
1998 1997 1996 1995
------ ------ ------ ------
DOLLARS
SINGLE FAMILY
Estate................................................ $1,835 $ 891 $ 279 $ 118
Conventional.......................................... 315 286 108 --
INCOME PROPERTY
Multi-family.......................................... 384 307 213 171
Commercial and Development............................ 3,886 2,149 1,038 91
LAND.................................................... 289 133 34 302
SINGLE FAMILY CONSTRUCTION
Single residence...................................... 778 364 168 69
Tract................................................. 205 210 338 --
OTHER................................................... 1,350 869 430 --
------ ------ ------ ------
$9,042 $5,209 $2,608 $ 751
====== ====== ====== ======
% OF YEAR END ALLOWANCE
SINGLE FAMILY
Estate................................................ 20.3% 17.1% 10.7% 15.7%
Conventional.......................................... 3.5 5.5 4.1 --
INCOME PROPERTY
Multi-family.......................................... 4.2 5.9 8.2 22.8
Commercial and Development............................ 43.0 41.3 39.8 12.1
LAND.................................................... 3.2 2.5 1.3 40.2
SINGLE FAMILY CONSTRUCTION
Single residence...................................... 8.6 7.0 6.4 9.2
Tract................................................. 2.3 4.0 13.0 --
OTHER................................................... 14.9 16.7 16.5 --
------ ------ ------ ------
100.0% 100.0% 100.0% 100.0%
====== ====== ====== ======
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22
The table below sets forth information concerning activity in the Company's
general and specific valuation allowances for Post-1994 Loans for the periods
indicated (dollars are in thousands).
YEAR ENDED DECEMBER 31,
----------------------------------------
1998 1997 1996 1995
-------- -------- -------- -------
LOANS
Average post-1994 loans outstanding.................... $824,087 $433,942 $284,886 $64,743
======== ======== ======== =======
Reserve balance at beginning of period................. $ 7,327 $ 2,726 $ 751 $ --
Provision for estimated losses......................... 7,357 4,807 1,975 751
Net Charge-offs:
Single Family
Estate............................................ (170) -- -- --
Conventional...................................... (181) (56) -- --
Income property
Commercial........................................ (815) -- -- --
Land................................................. -- (150) -- --
Single Family Construction
Single residence.................................. (267) -- -- --
Tract............................................. -- -- -- --
-------- -------- -------- -------
Net charge-offs........................................ (1,433) (206) -- --
-------- -------- -------- -------
Balance at end of period............................... $ 13,251 $ 7,327 $ 2,726 $ 751
======== ======== ======== =======
Ratio of net charge-offs to average loans outstanding
during the period.................................... .17% .05% N/A N/A
======== ======== ======== =======
PRE-1995 LOANS. At December 31, 1998, the Company's portfolio of loans
originated prior to 1995, predominantly under different management and directed
at segments of the real property financing markets which are substantially
different than the loans emphasized by the Company since 1994, totaled $235.1
million, or 17.4% of net loans. The significant majority of Pre-1995 Loans were
originated by the Company prior to 1992, since the Company was largely absent
from the new loan origination business during the period 1992 - 1994. The
Company's portfolio of Pre-1995 Loans has decreased from $537.0 million at
December 31, 1994 to $235.1 million at December 31, 1998, or by 56.2%. This
substantial decline in the portfolio of Pre-1995 Loans has been occasioned by
substantial foreclosures of the Company's loan collateral, predominantly during
the period 1993 - 1996, and by accelerated repayment of loan principal by
borrowers. Accordingly, management has accumulated substantial,
portfolio-specific migration and loss experience for the Company's Pre-1995
Loans, which management utilizes to measure the risk of loss inherent in this
portfolio of loans and the adequacy of the Company's allowance for estimated
credit losses ascribed to Pre-1995 Loans.
Consistent with the Company's practice for Post-1994 Loans, management
establishes a specific valuation allowance, determined on a loan-by-loan basis,
in connection with Pre-1995 Loans which are on nonaccrual status and which are
performing but adversely classified where management believes that the current
or expected liquidation value of the Company's collateral is less than the
Company's cost basis in the loan. At December 31, 1998, the Company had
established aggregate specific valuation allowances totaling $1.0 million with
respect to Pre-1995 Loans.
In measuring the Company's general valuation allowance ascribed to Pre-1995
Loans, management incorporates the Company's historical migration and loss
experience for each of the Company's principal Pre-
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1995 portfolios. The table below sets forth certain information concerning
activity in the Company's specific and general valuation allowances for Pre-1995
Loans (dollars are in thousands).
YEAR ENDED DECEMBER 31,
----------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
LOANS
Average pre -1995 loans outstanding..... $257,325 $311,255 $386,479 $514,023 $604,410
======== ======== ======== ======== ========
Reserve balance at beginning of year.... $ 5,947 $ 10,789 $ 14,441 $ 21,461 $ 46,629
Provision for estimated losses.......... (222) 330 4,092 (279) (24,449)
Charge-offs:
Single Family
Conventional....................... (827) (3,416) (3,103) (2,894) (380)
Income Property
Multi-family....................... (1,038) (1,745) (4,641) (3,595) (339)
Commercial......................... -- -- -- (70) --
Land.................................. -- -- -- (98) --
Single Family Construction
Tract.............................. -- -- -- (134) --
Other................................. -- (11) -- -- --
-------- -------- -------- -------- --------
Net charge-offs......................... (1,865) (5,172) (7,744) (6,741) (719)
-------- -------- -------- -------- --------
Balance at end of year.................. $ 3,860 $ 5,947 $ 10,789 $ 14,441 $ 21,461
======== ======== ======== ======== ========
Ratio of net charge-offs to average
loans outstanding during period....... .72% 1.66% 2.00% 1.31% .12%
======== ======== ======== ======== ========
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The table below sets forth information concerning activity in the Company's
general and specific valuation allowances for Post-1994 and Pre-1995 loans,
combined, for the periods indicated (dollars are in thousands).
YEAR ENDED DECEMBER 31,
------------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
LOANS
Average loans outstanding............ $1,081,382 $745,197 $671,365 $578,766 $604,410
========== ======== ======== ======== ========
Reserve balance at beginning of
period............................. $ 13,274 $ 13,515 $ 15,192 $ 21,461 $ 46,629
Provision for estimated losses....... 7,135 5,137 6,067 472 (24,449)
Net Charge-offs:
Single Family
Estate.......................... (170) -- -- -- --
Conventional.................... (1,008) (3,472) (3,103) (2,894) (380)
Income property
Multi-family.................... (1,038) (1,745) (4,641) (3,595) (339)
Commercial...................... (815) -- -- (70) --
Land............................... -- (150) -- (48) --
Single Family Construction
Single residence................ (267)
Tract........................... -- -- -- (134) --
Other.............................. -- (11) -- -- --
---------- -------- -------- -------- --------
Net charge-offs...................... (3,298) (5,378) (7,744) (6,741) (719)
---------- -------- -------- -------- --------
Balance at end of period............. $ 17,111 $ 13,274 $ 13,515 $ 15,192 $ 21,461
========== ======== ======== ======== ========
Ratio of net charge-offs to average
loans outstanding during the
period............................. .30% .72% 1.15% 1.16% .12%
REAL ESTATE OWNED
Reserve balance at beginning of
period............................. $ 2,563 $ 11,871 $ 15,725 $ 32,609 $ 39,457
Provision for estimated losses....... 60 913 4,933 18,973 29,747
Charge-offs.......................... (2,578) (10,221) (8,787) (35,857) (36,595)
Recoveries........................... -- -- -- -- --
---------- -------- -------- -------- --------
Balance at end of period............. $ 45 $ 2,563 $ 11,871 $ 15,725 $ 32,609
========== ======== ======== ======== ========
INVESTMENT SECURITIES
The Company has authority to invest in a variety of investment securities,
including United States Government and agency securities, mortgage-backed
securities and corporate securities. However, in recent years the Company's
strategy has been to grow through loan origination, rather than purchases of
investment securities. As a result, all of the Company's $57.4 million of
mortgage-backed securities at December 31, 1994 matured or were sold by the
Company during 1995 and the Company's investment securities decreased from $62.8
million at December 31, 1995 to $38.4 million at December 31, 1996. During the
first quarter of 1997, the Company purchased $40.0 million of U.S. Government
agency callable bonds, which was partially offset by sales of $12.5 million of
U.S. Government securities during the second and third quarters of 1997. These
bonds were ultimately called or sold during the fourth quarter of 1997.
Subsequent to the Company's stock offering in the third quarter of 1998, the
Company utilized the 27.6 million of proceeds to purchase $27.9 million in FNMA
discount notes, $5 million of which matured in September 1998 and $22.9 million
of which matured in December 1998. In addition, the Company sold $596 thousand
in mutual funds. The Company classifies all securities acquired as
available-for-sale under generally accepted accounting principles, and thus the
securities are carried at fair value, with unrealized gains and losses excluded
from earnings and reported as a separate component of stockholders' equity, net
of taxes.
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25
SOURCES OF FUNDS
GENERAL STRATEGY. The Company's principal sources of funds in recent years
have been deposits obtained on a retail basis through its branch offices and, to
a far lesser extent, advances from the FHLB and securities sold under agreements
to repurchase ("reverse repurchase agreements"). In addition, funds have been
obtained from maturities and repayments of loans and securities, and sales of
loans, securities and other assets, including real estate owned.
DEPOSITS. The Company operates six retail banking locations, a decrease
from the nineteen branch offices operated by the Company in mid-1993. Four of
these branches are located in the South Bay area of Los Angeles County, one is
located in the San Fernando Valley area of Los Angeles County and the other is
located near the border of Los Angeles and Ventura Counties. The Company's
retail branches carry average deposit balances of $169.9 million, which is
substantially higher than most local banking companies. The Company does not
operate a money desk or otherwise solicit brokered deposits.
The Company solicits deposits from the general public throughout its
service area. Generally, the Company competes for deposit funds with other
Southern California-based financial companies, including banks, savings
associations and thrift and loans. These companies generally compete with one
another based upon price, convenience and service.
Because the Company does not have a critical mass of retail banking
facilities, and because its smaller size does not afford it the economies of
scale to advertise its basic products to the extent of its principal
competitors, the Company generally competes on price and, to a lesser extent, on
service and convenience. Historically, these limitations have been moderated by
the loyalty afforded by, and the resistance to change of, the Company's primary
customer constituency, which includes individuals over 55 years of age.
The Company has several types of deposit accounts principally designed to
attract short-term deposits. The following table sets forth the distribution of
average deposits and the weighted average interest rates paid thereon during the
periods indicated (dollars are in thousands). See NOTE G of the NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------ ------------------------------ ------------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE PERCENT AVERAGE PERCENT AVERAGE PERCENT
AMOUNT INTEREST OF AMOUNT INTEREST OF AMOUNT INTEREST OF
(1) RATE TOTAL (2) RATE TOTAL (2) RATE TOTAL
--------- -------- ------- --------- -------- ------- --------- -------- -------
Checking/NOW.................. $ 45,904 1.7% 5.1% $ 30,786 1.2% 4.1% $ 28,032 0.8% 4.0%
Passbook...................... 17,003 3.7% 1.9 22,084 1.8% 3.0 26,500 1.9% 3.8
Money market.................. 73,190 4.0% 8.0 32,239 3.2% 4.3 26,254 1.4% 3.7
Certificates of deposit....... 771,618 5.6% 85.0 659,830 5.6% 88.6 621,050 5.6% 88.5
-------- ----- -------- ----- -------- -----
Total..................... $907,715 5.3% 100.0% $744,939 5.2% 100.0% $701,836 5.1% 100.0%
======== ===== ======== ===== ======== =====
- ---------------
(1) Amounts represent daily averages.
(2) Amounts represent monthly averages.
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26
The table below sets forth the remaining maturities of the Company's
certificates of deposit outstanding at the dates indicated (dollars are in
thousands).
DECEMBER 31, 1998 DECEMBER 31, 1997
---------------------------------------------------------- ------------------------------------
OVER OVER OVER OVER
THREE THREE MONTHS SIX MONTHS THREE THREE MONTHS SIX MONTHS
MONTHS THROUGH THROUGH OVER MONTHS THROUGH THROUGH
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL OR LESS SIX MONTHS ONE YEAR
-------- ------------ ---------- -------- -------- -------- ------------ ----------
BALANCES , $100,000
4.00% or less.............. $ 1,821 $ 632 $ 123 $ 17 $ 2,593 $ 1,660 $ 15 $ 26
4.01% - 5.00%.............. 30,923 33,075 27,410 9,141 100,549 38,460 1,650 1,571
5.01% - 6.00%.............. 147,740 132,013 196,001 35,206 510,960 119,283 111,758 176,146
6.01% - 7.00%.............. 694 343 523 -- 1,560 4,834 21,458 29,818
7.01% or more.............. -- -- 100 -- 100 -- -- --
-------- -------- -------- ------- -------- -------- -------- --------
181,178 166,063 224,157 44,364 615,762 164,237 134,881 207,561
-------- -------- -------- ------- -------- -------- -------- --------
BALANCES $ $100,000
4.00% or less.............. -- 100 101 -- 201 -- -- --
4.01% - 5.00%.............. 8,321 9,062 8,797 2,757 28,937 7,162 -- 548
5.01% - 6.00%.............. 61,020 47,719 68,115 8,504 185,358 38,734 30,306 57,313
6.01% - 7.00%.............. 910 1,930 442 178 3,460 2,663 9,933 10,926
7.01% or more.............. -- -- -- -- -- -- -- --
-------- -------- -------- ------- -------- -------- -------- --------
70,251 58,811 77,455 11,439 217,956 48,559 40,239 68,787
-------- -------- -------- ------- -------- -------- -------- --------
TOTAL.............. $251,429 $224,874 $301,612 $55,803 $833,718 $212,796 $175,120 $276,348
======== ======== ======== ======= ======== ======== ======== ========
DECEMBER 31, 1997
-------------------
OVER
ONE YEAR TOTAL
-------- --------
BALANCES , $100,000
4.00% or less.............. $ 88 $ 1,789
4.01% - 5.00%.............. 5,206 46,887
5.01% - 6.00%.............. 16,890 424,077
6.01% - 7.00%.............. 1,218 57,328
7.01% or more.............. 100 100
------- --------
23,502 530,181
------- --------
BALANCES $ $100,000
4.00% or less.............. -- --
4.01% - 5.00%.............. 1,271 8,981
5.01% - 6.00%.............. 4,129 130,482
6.01% - 7.00%.............. 523 24,045
7.01% or more.............. -- --
------- --------
5,923 163,508
------- --------
TOTAL.............. $29,425 $693,689
======= ========
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BORROWINGS. The twelve district banks which comprise the FHLB System
function as a source of credit to member associations. The Company may apply for
advances from the FHLB secured by the capital stock of the FHLB owned by the
Company and certain of the Company's loans and other assets. Advances can be
requested for any business purpose in which the Company is authorized to engage.
In granting advances, the FHLB considers a member's creditworthiness and other
relevant factors. At December 31, 1998, the Company had an approved line of
credit with the FHLB with a maximum advance of up to 35% of total assets (of
which 25% may be secured by mortgage collateral and 10% may be secured by
investment securities). At December 31, 1998, the Company had seven FHLB
advances outstanding, totaling $264.0 million which had a weighted average
interest rate of 5.18% and a weighted average remaining maturity of 5 years 3
months.
INTEREST RATE RISK MANAGEMENT
The objective of interest rate risk management is to stabilize the
Company's net interest income ("NII") while limiting the change in its market
value ("MV") from interest rate fluctuations. Generally, MV is the discounted
present value of the difference between incoming cash flows on interest-earning
assets and other assets and outgoing cash flows on interest-bearing liabilities
and other liabilities. The Company seeks to stabilize its NII and MV by matching
its interest sensitive assets and liabilities, and maintaining the maturity and
repricing of these assets and liabilities at appropriate levels given the
interest rate environment. When the amount of rate-sensitive liabilities exceeds
rate-sensitive assets within specified periods, the NII generally will be
negatively impacted by increasing interest rates and positively impacted by
decreasing interest rates during such periods. Conversely, when the amount of
rate-sensitive assets exceeds the amount of rate-sensitive liabilities within
specified periods, net interest income generally will be positively impacted by
increasing interest rates and negatively impacted by decreasing interest rates
during such periods. The speed and velocity of the repricing of assets and
liabilities will also contribute to the effects on the Company's MV and NII, as
will the presence or absence of periodic and lifetime interest rate caps and
floors.
The Company utilizes two methods for measuring interest rate risk, gap
analysis and interest rate simulations. Gap analysis focuses on measuring
absolute dollar amounts subject to repricing within certain periods of time,
particularly the one-year maturity horizon. SEE ITEM 7A, QUANTITATIVE AND
QUALITATIVE DISCLOSURE ABOUT MARKET RISKS.
Interest rate simulations provide the Company with an estimate of both the
dollar amount and percentage change in NII under various interest rate
scenarios. All assets and liabilities are subjected to tests of up to 400 basis
points in increases and decreases in interest rates. Under each interest rate
scenario, the Company projects its net interest income and the MV of its current
balance sheet. From these results, the Company can then develop alternatives to
dealing with the tolerance thresholds.
During 1995, the Company initiated certain measures to reduce interest rate
risk. These measures included the sale of approximately $110.0 million in fixed
rate assets and the purchase of a $450.0 million interest rate cap on the
liability base subject to reprice within a six-month period. During 1996, the
Company continued to reduce interest rate risk exposure by making additional
fixed rate loan sales of approximately $35.0 million and sales of single family
11th DCOFI-indexed loans of approximately $45.0 million. The Company also
extended the duration of its liability base from six to nine months during the
course of 1996. During 1997, the Company continued to reduce its interest risk
exposure by selling its fixed-rate investment securities and extending the
duration of its liability base through the use of advances from the FHLB. During
the last quarter of 1998, as interest rates dropped, the Company began using MTA
as an index for Estate Loans rather than CMT. The MTA index lags the CMT Index
when rates change.
Since 1995, the Company has been utilizing interest rate floors to mitigate
the risk of interest margin compression on its new loans in a decreasing
interest rate environment. Typically, these floors represent the rate at
underwriting. Additionally, on most new income property loans, the Company
utilizes interest rate caps. These caps are life caps and are usually five
points above the rate at underwriting or at an amount that would still allow for
one-to-one debt service coverage at the maximum rate, thereby reducing the
likelihood of borrower default in a rising interest rate environment. The risk
to the Company that is associated with the interest rate caps is that interest
rates will exceed the maximum loan rates on such loans, and while the
24
28
Company's cost of funds continues to rise, the interest income derived from
these loans will be fixed, resulting in an overall compression on net interest
income.
The table below sets forth information concerning sensitivity of the
Company's interest-earning assets and interest-bearing liabilities as of
December 31, 1998. The amounts of assets and liabilities shown within a
particular period were determined in accordance with their contractual
maturities, except that adjustable-rate loans are included in the period in
which they are first scheduled to adjust and not in the period in which they
mature. Such assets and liabilities are classified by the earlier of their
maturity or repricing date (dollars are in thousands).
OVER THREE OVER SIX OVER ONE
THREE THROUGH THROUGH YEAR OVER
MONTHS SIX TWELVE THROUGH FIVE
OR LESS MONTHS MONTHS FIVE YEARS YEARS TOTAL
-------- ---------- -------- ---------- -------- ----------
INTEREST-EARNING ASSETS
Investments and FHLB Stock.... $ 13,554 $ -- $ -- $ -- $ -- $ 13,554
Loans(1)...................... 642,721 242,226 299,142 42,046 123,686 1,349,821
-------- -------- -------- --------- -------- ----------
Total interest-earning
assets................ $656,275 $242,226 $299,142 $ 42,046 $123,686 $1,363,375
======== ======== ======== ========= ======== ==========
INTEREST-BEARING LIABILITIES
Deposits
Non-certificates of
deposit(2)............... $185,732 $ -- $ -- $ -- $ -- $ 185,732
Certificates of deposit.... 251,429 224,874 301,612 55,803 -- 833,718
FHLB advances................. -- -- -- 215,000 49,000 264,000
Senior Notes.................. -- -- -- -- 40,000 40,000
-------- -------- -------- --------- -------- ----------
Total interest-bearing
liabilities........... $437,161 $224,874 $301,612 $ 270,803 $ 89,000 $1,323,450
======== ======== ======== ========= ======== ==========
Interest Rate Sensitivity Gap... $219,114 $ 17,352 $ (2,470) $(228,757) $ 34,686 $ 39,925
Cumulative Interest Rate
Sensitivity Gap............... $219,114 $236,466 $233,996 $ 5,239 $ 39,925 $ 39,925
Cumulative Interest Rate
Sensitivity Gap as a
Percentage of Total
Interest-Earning Assets....... 16.1% 17.3% 17.2% 0.4% 2.9% 2.9%
- ---------------
(1) Balances include nonaccrual loans of $47.7 million at December 31, 1998.
(2) Includes checking/NOW, passbook and money market accounts.
REGULATORY MATTERS
GENERAL
The Company is registered with the OTS as a savings and loan holding
company and is subject to regulation and examination as such by the OTS. The
Bank is a member of the FHLB and its deposits are insured by the FDIC. The Bank
is subject to examination and regulation by the OTS under the Home Owners' Loan
Act ("HOLA") and the FDIC under the Federal Deposit Insurance Act ("FDIA") with
respect to most of its business activities, including, among others, lending
activities, capital standards, general investment authority, deposit-taking and
borrowing authority, mergers and other business combinations, establishment of
branch offices, and permitted subsidiary investment and activities. The effect
of the statutes, regulations and other pronouncements and policies which govern
the operations and activities of the Company and the Bank can be significant,
cannot be predicted with a high degree of certainty and can change over time.
Moreover, such statutes, regulations and other pronouncements and policies are
intended to protect depositors and the insurance funds administered by the FDIC,
and not stockholders or holders of indebtedness which are not insured by the
FDIC.
The following sections should be read in conjunction with ITEM 7,
MANAGEMENT'S DISCUSSION and NOTES L and M of the NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS. The description of the statutes and
25
29
regulations applicable to the Company and the Bank set forth below and elsewhere
herein do not purport to be complete descriptions of such statutes and
regulations and their effects on the Company and the Bank. Such descriptions
also do not purport to identify every statute and regulation that may apply to
the Company or the Bank.
SAVINGS AND LOAN HOLDING COMPANY REGULATION
ACTIVITIES RESTRICTIONS. The Company has only one savings association
subsidiary and is therefore a "unitary" savings and loan holding company. There
are generally no restrictions on the activities of a unitary savings and loan
holding company. However, if the savings association subsidiary of a unitary
holding company fails to meet the qualified thrift lender ("QTL") test (see
SAVINGS ASSOCIATION REGULATION -- Qualified Thrift Lender Test), then the
unitary holding company is subject to the activities restrictions applicable to
multiple savings and loan holding companies. Further, unless the savings
association subsidiary requalifies as a QTL within one year thereafter, the
unitary holding company must register as, and become subject to the restrictions
applicable to, a bank holding company.
Among other things, no multiple savings and loan holding company or
subsidiary thereof which is not a savings association may commence or continue
for a limited period of time after becoming a multiple savings and loan holding
company or subsidiary thereof any business activity, upon prior notice to, and
no objection by the OTS, other than: (I) furnishing or performing management
services for a subsidiary savings association; (II) conducting an insurance
agency or escrow business; (III) holding, managing or liquidating assets owned
by or acquired from a subsidiary savings association; (IV) holding or managing
properties used or occupied by a subsidiary savings association; (V) acting as
trustee under deeds of trust; (VI) those activities authorized by regulation as
of March 5, 1987 to be engaged in by multiple savings and loan holding
companies; or (VII) unless the OTS by regulation prohibits or limits such
activities for savings and loan holding companies, those activities authorized
by the Federal Reserve Board as permissible for bank holding companies. Those
activities described in (VII) above also must be approved by the OTS prior to
being engaged in by a multiple savings and loan holding company.
RESTRICTIONS ON ACQUISITIONS. Except under limited circumstances, savings
and loan holding companies are prohibited from acquiring, without prior approval
of the OTS, (I) control of any other savings association or savings and loan
holding company or substantially all the assets thereof or (II) more than 5% of
the voting shares of a savings association or holding company thereof which is
not a subsidiary. Except with the prior approval of the OTS, no director or
officer of a savings and loan holding company or person owning or controlling by
proxy or otherwise more than 25% of such company's stock, may acquire control of
any savings association, other than a subsidiary savings association, or of any
other savings and loan holding company.
SAVINGS ASSOCIATION REGULATION
QUALIFIED THRIFT LENDER TEST. Any savings association that does not meet
the QTL test set forth in the HOLA and complementary regulations must either
convert to a national bank charter or be subject to restrictions specified in
the OTS regulations. Any such savings association that does not become a bank
would be: (I) prohibited from making any new investment or engaging in
activities that would not be permissible for national banks; (II) prohibited
from establishing any new branch office in a location that would not be
permissible for a national bank in the association's home state; (III)
ineligible to obtain new advances from any FHLB; and (IV) subject to limitations
on the payment of dividends comparable to the statutory and regulatory dividend
restrictions applicable to national banks. Also, beginning three years after the
date on which the savings association ceases to be a QTL, the savings
association would be prohibited from retaining any investment or engaging in any
activity not permissible for a national bank and would be required to repay any
outstanding advances to any FHLB. A savings association may requalify as a QTL
if it thereafter complies with the QTL test.
Any savings association is a QTL if (I) it qualifies as a domestic building
and loan association under Section 7701(a)(19) of the Internal Revenue Code of
1986, as amended ("Code") (which generally requires that at least 60% of the
association's assets constitute housing-related and other qualifying assets), or
(II) at
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least 65% of the association's "portfolio assets" (as defined) consist of
certain housing and consumer-related assets on a monthly average basis in at
least nine out of every 12 months. At December 31, 1998, the Bank was in
compliance with the QTL test.
DEPOSIT INSURANCE. The FDIC administers two separate deposit insurance
funds. The Bank Insurance Fund ("BIF") generally insures the deposits of
commercial banks, and the SAIF generally insures the deposits of savings
associations.
Under FDIC regulations, associations are assigned to one of three capital
groups for insurance premium purposes -- "well capitalized," "adequately
capitalized" and "undercapitalized" -- which are defined in the same manner as
the regulations establishing the prompt corrective action system under Section
38 of the FDIA, as discussed under Prompt Corrective Action Rules below. These
three groups are then divided into subgroups which are based on supervisory
evaluations by the association's primary federal regulator, resulting in nine
assessment classifications. Effective January 1, 1997, assessment rates for
SAIF-insured associations range from 0% of insured deposits for well-capitalized
associations with minor supervisory concerns to .27% of insured deposits for
undercapitalized associations with substantial supervisory concerns. In
addition, an additional assessment of 6.4 basis points and 1.3 basis points will
be added to the regular SAIF-assessment and to the regular BIF-assessment,
respectively, until December 31, 1999 in order to cover Financing Corporation
debt service payments.
Both the SAIF and the BIF are required by law to attain and thereafter
maintain a reserve ratio of 1.25% of insured deposits. The BIF has achieved the
required reserve ratio, and as a result, the FDIC reduced the average deposit
insurance premium paid by BIF-insured banks to a level substantially below the
average premium previously paid by savings associations. Banking legislation was
enacted September 30, 1996 to eliminate the premium differential between
SAIF-insured associations and BIF-insured associations. The legislation provided
that all insured depository associations with SAIF-assessable deposits as of
March 31, 1995 pay a special one-time assessment to recapitalize the SAIF.
ENFORCEMENT AND TERMINATION OF DEPOSIT INSURANCE. The OTS' enforcement
authority over savings associations and their holding companies includes, among
other things, the ability to assess civil money penalties, to issue cease and
desist orders, to initiate removal and prohibition orders against officers,
directors and certain other association-affiliated persons, and to appoint a
conservator or receiver for savings associations under appropriate
circumstances. In general, these enforcement actions may be initiated for
violations of laws and regulations, violations of cease and desist orders and
"unsafe or unsound" conditions or practices, which are not limited to cases of
inadequate capital.
The FDIC has authority to recommend that the OTS take authorized
enforcement action with respect to any savings associations. If the OTS does not
take the recommended action or provide an acceptable plan for addressing the
FDIC's concerns within 60 days after the receipt of the recommendation from the
FDIC, the FDIC may take such action if the FDIC Board of Directors determines
that the association is in an unsafe or unsound condition or that failure to
take such action will result in the continuation of unsafe or unsound practices
in conducting the business of the association. The FDIC may also take action
prior to the expiration of the 60-day time period in exigent circumstances after
notifying the OTS.
The FDIC may terminate the deposit insurance of any insured depository
association if the FDIC determines, after a hearing, that the association has
engaged or is engaging in unsafe or unsound practices which, as with the OTS'
enforcement authority, are not limited to cases of capital inadequacy, is in an
unsafe or unsound condition to continue operations or has violated any
applicable law, regulation or order or any condition imposed in writing by the
FDIC. In addition, FDIC regulations provide that any insured association that
falls below a 2% minimum leverage ratio (see below) will be subject to FDIC
deposit insurance termination proceedings unless it has submitted, and is in
compliance with, a capital plan with its primary federal regulator and the FDIC.
The FDIC may also suspend deposit insurance temporarily during the hearing
process if the association has no tangible capital. The FDIC is additionally
authorized by statute to appoint itself as conservator or receiver of an insured
association (in addition to the powers of the association's primary federal
regulatory authority) in cases, among others and upon compliance with certain
procedures, of unsafe or unsound conditions or practices or willful violations
of cease and desist orders.
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BRANCHING. OTS regulations permit nationwide branching by federally
chartered savings institutions to the extent allowed by federal statute. This
permits federal savings institutions to establish interstate networks and to
geographically diversify their loan portfolios and lines of business. The OTS
authority preempts any state law purporting to regulate branching by federal
savings institutions. At this time, the Company's management (has no plans) to
establish physical branches outside of California, (although the Bank does serve
customers domiciled outside of California via alternative delivery channels such
as telephone, mail and ATM networks.)
TRANSACTIONS WITH AFFILIATES. Under HOLA, all transactions between and
among a savings association and its affiliates, which include holding companies,
are subject to Sections 23A and 23B of the Federal Reserve Act. Generally, these
requirements limit these transactions to a percentage of the savings
association's capital and require all of them to be on terms at least as
favorable to the association as transactions with non-affiliates. In addition, a
savings association may not lend to any affiliate engaged in non-banking
activities not permissible for a bank holding company or acquire shares of any
affiliate that is not a subsidiary. The OTS is authorized to impose additional
restrictions on transactions with affiliates if necessary to protect the safety
and soundness of a savings association. The OTS regulations also set forth
various reporting requirements relating to transactions with affiliates.
Extensions of credit by a savings association to executive officers,
directors and principal shareholders are subject to Section 22(h) of the Federal
Reserve Act, which, among other things, generally prohibits loans to any such
individual where the aggregate amount exceeds an amount equal to 15% of an
association's unimpaired capital and surplus, plus an additional 10% of
unimpaired capital and surplus in the case of loans that are fully secured by
readily marketable collateral.
FHLB SYSTEM. As a member of the FHLB system, the Bank is required to own
capital stock in its regional FHLB, the FHLB of San Francisco, in a minimum
amount determined at the end of each year based on the greater of (I) 1.0% of
the aggregate principal amount of its unpaid residential mortgage loans, home
purchase contracts and similar obligations, (II) 5.0% of its outstanding
borrowings from the FHLB of San Francisco, or (III) 0.3% of its total assets.
The Company was in compliance with this requirement, with an investment of $13.6
million in FHLB stock at December 31, 1998. The FHLB of San Francisco serves as
a reserve or central bank for the member institutions within its assigned
region, the Eleventh FHLB District. It makes advances to members in accordance
with policies and procedures established by the Federal Housing Finance Board
and the Board of Directors of the FHLB of San Francisco.
FEDERAL RESERVE SYSTEM. The Federal Reserve Board requires all depository
associations to maintain reserves against their transaction accounts (primarily
NOW and Super NOW checking accounts for savings associations) and non-personal
time deposits. At December 31, 1998, the Company was in compliance with its
reserve requirements.
LIQUIDITY. OTS regulations currently require a savings association to
maintain an average daily balance of liquid assets (including cash, certain time
deposits, bankers' acceptances and specified United States Government, state or
federal agency obligations) equal to at least 4% of either (i) the average daily
balance of its net withdrawable accounts and short-term borrowings during the
preceding calendar quarter, or (ii) the amount of its net withdrawable accounts
and short-term borrowings at the end of its preceding calendar quarter. This
liquidity requirement may be changed from time to time by the OTS to any amount
within the range of 4% to 10% of such accounts and borrowings depending upon
economic conditions and the deposit flows of member associations. Monetary
penalties may be imposed for failure to meet this liquidity ratio requirement.
The Company's average liquidity for the quarter ended December 31, 1998, was
12.6%, which exceeded the applicable requirements.
COMMUNITY REINVESTMENT ACT. Under the Community Reinvestment Act ("CRA") a
savings association has a continuing and affirmative obligation consistent with
its safe and sound operation to help meet the credit needs of its entire
community, including low and moderate income neighborhoods. The CRA also
requires the OTS to assess an association's performance in meeting the credit
needs of its delineated communities, as part of its examination of the
association, and to take such assessments into consideration in reviewing
applications with respect to branches, mergers and other business combinations,
and savings and
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loan holding company acquisitions. An unsatisfactory CRA rating may be the basis
for denying such an application and community groups have successfully protested
applications on CRA grounds. The OTS assigns CRA ratings of "outstanding",
"satisfactory", "needs to improve" or "substantial noncompliance". The Bank was
rated "satisfactory" in its most recent CRA examination (October 1998).
REGULATORY CAPITAL REQUIREMENTS. HOLA and the capital regulations of the
OTS promulgated thereunder ("Capital Regulations") impose three capital
requirements on savings associations, including a "core capital requirement", a
"tangible capital requirement" and a "risk-based capital requirement".
Under the core capital requirement, a savings association must maintain
"Core capital" of not less than 3.0% of adjusted total assets. "Core capital"
generally includes common stockholders' equity, noncumulative perpetual
preferred stock, including any related surplus, and minority interests in the
equity accounts of fully consolidated subsidiaries. The amount of an
association's core capital is, in general, calculated in accordance with
generally accepted accounting principles ("GAAP"), but with certain exceptions.
Among other exceptions, adjustments to an association's GAAP equity accounts
that are required pursuant to FASB 115 to reflect changes in market value of
certain securities held by the association that are categorized as "available-
for-sale" are not to be included in the calculation of core capital for
regulatory capital purposes. In computing core capital, intangible assets other
than certain servicing assets and purchased credit card relationships are
deducted from capital.
Under the tangible capital requirement, a savings association must maintain
"Tangible capital" in an amount not less than 1.5% of adjusted total assets.
"Tangible capital" means core capital less any intangible assets other than up
to 90% of the fair market value of mortgage servicing assets.
Under the risk-based capital requirement, a savings association must
maintain "Total capital" equal to 8.0% of risk-weighted assets. "Total capital"
consists of core capital and supplementary capital. Supplementary capital
includes, among other things, certain types of preferred stock and subordinated
debt and, subject to certain limitations, general reserves up to 1.25% of
risk-weighted assets. A savings association's supplementary capital may be used
to satisfy the risk-based capital requirements only to the extent of that
association's core capital. Risk-weighted assets are the assets of the
association (including certain off-balance sheet items, including letters of
credit, and loans or other assets sold with subordination or recourse
arrangements) adjusted to reflect the degree of credit risk deemed to be
associated with such assets, ranging from 0% for low-risk assets such as U.S.
Government securities and GNMA securities to 100% for various types of loans and
other assets deemed to be higher risk. Single family mortgage loans having
loan-to-value ratios not exceeding 80% and meeting certain additional criteria,
as well as certain multi-family residential mortgage loans, qualify for a 50%
risk-weighted treatment.
The risk-based capital rules of the OTS, FDIC and other federal banking
agencies provide that an association must hold capital in excess of regulatory
minimums to the extent that examiners find either (I) significant exposure to
concentration of credit risk such as risks from higher interest rates,
prepayments, significant off-balance sheet items (especially standby letters of
credit), or risks arising from nontraditional activities or (II) that the
association is not adequately managing these risks. For this purpose, however,
the agencies have stated that, in view of the statutory requirements relating to
permitted lending and investment activities of savings associations, the general
concentration by such associations in real estate lending activities would not,
by itself, be deemed to constitute an exposure to concentration of credit risk
that would require greater capital levels.
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The following table summarizes the regulatory capital requirements under
HOLA for the Bank at December 31, 1998. As indicated in the table, the Bank's
capital levels exceeded all three of the minimum HOLA capital requirements
(dollars are in thousands).
TANGIBLE CAPITAL CORE CAPITAL RISK-BASED CAPITAL
------------------ ------------------ -------------------
BALANCE % BALANCE % BALANCE %
---------- ---- ---------- ---- ---------- -----
Stockholders' equity........... $ 108,673 -- $ 108,673 -- $ 108,673 --
Adjustments....................
General reserves............. -- -- -- -- 11,932 --
Other(1)..................... -- -- -- -- (1,205) --
---------- ---- ---------- ---- ---------- -----
Regulatory capital............. 108,673 7.65% 108,673 7.65% 119,400 11.10%
Required minimum............... 21,302 1.50 56,804 4.00 86,090 8.00
---------- ---- ---------- ---- ---------- -----
EXCESS CAPITAL................. $ 87,371 6.15% $ 51,869 3.65% $ 33,310 3.10%
========== ==== ========== ==== ========== =====
ADJUSTED ASSETS(2)............. $1,420,100 $1,420,100 $1,076,122
========== ========== ==========
- ---------------
(1) Includes the portion of non-residential construction loans which exceed a
loan-to-value of 80%
(2) The term "adjusted assets" refers to (I) the term "adjusted total assets" as
defined in 12 C.F.R. Section 567.1 (a) for purposes of tangible and core
capital requirements, and (II) the term "risk-weighted assets" as defined in
12 C.F.R. Section 567.5 (d) for purposes of the risk-based capital
requirements.
PROMPT CORRECTIVE ACTION RULES. Under federal law, each federal banking
agency has implemented a system of prompt corrective action for institutions
which it regulates. Under OTS regulations for prompt corrective action ("PCA
Rules"), an association is deemed to be (I) "well capitalized" if it has total
risk-based capital ratio of 10.0% or more, has a Tier 1 risk-based capital ratio
of 6.0% or more, has a Tier 1 leverage capital ratio of 5.0% or more and is not
subject to any order or final capital directive to meet and maintain a specific
capital level for any capital measure; (II) "adequately capitalized" if it has a
total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital
ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0%
under certain circumstances) and does not meet the definition of "well
capitalized," (III) "undercapitalized" if it has a total risk-based capital
ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less
than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under
certain circumstances), (IV) "significantly undercapitalized" if it has a total
risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital
ratio that is less than 3.0% or a Tier 1 leverage capital ratio that is less
than 3.0%, and (V) "critically undercapitalized" if it has a ratio of tangible
equity to total assets that is equal to or less than 2.0%. Federal law
authorizes the OTS to reclassify a well capitalized association as adequately
capitalized and may require an adequately capitalized association or an
undercapitalized association to comply with supervisory actions as if it were in
the next lower category (except that the OTS may not reclassify a significantly
undercapitalized association as critically undercapitalized).
As of December 31, 1998, the most recent notification from the OTS
categorized the Bank as "well capitalized" under the regulatory framework for
prompt corrective action. The Bank's actual capital amounts and ratios and the
capital amounts and ratios required in order for an association to be well
capitalized and adequately capitalized are presented in the table below (dollars
are in thousands).
TO BE CATEGORIZED TO BE CATEGORIZED
AS ADEQUATELY AS
CAPITALIZED WELL CAPITALIZED
ACTUAL UNDER PCA RULES UNDER PCA RULES
----------------- ------------------ -----------------
AMOUNT RATIOS AMOUNT RATIOS AMOUNT RATIOS
-------- ------ -------- ------- -------- ------
AS OF DECEMBER 31, 1998
Total Capital (to Risk Weighted Assets).... $119,400 11.10% $86,090 8.00% $107,612 10.00%
Core Capital (to Adjusted Tangible
Assets)................................. 108,673 7.65% 56,804 4.00% 71,005 5.00%
Tangible Capital (to Adjusted Tangible
Assets)................................. 108,673 7.65% 21,302 1.50% N/A N/A
Tier 1 Capital (to Risk Weighted Assets)... 108,673 10.10% N/A N/A 64,567 6.00%
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Under the PCA Rules, an association that is deemed to be undercapitalized
must submit a capital restoration plan and is subject to mandatory restrictions
on capital distributions (including cash dividends) and management fees,
increased supervisory monitoring by the OTS, growth restrictions, restrictions
on certain expansion proposals and capital restoration plan submission
requirements. If an association is deemed to be significantly undercapitalized,
all of the foregoing mandatory restrictions apply, as well as a restriction on
compensation paid to senior executive officers. Furthermore, the OTS must take
one or more of the following actions: (I) require the association to sell shares
(including voting shares) or obligations; (II) require the association to be
acquired or merged (if one or more grounds for the appointment of a conservator
or receiver exists); (III) implement various restrictions on transactions with
affiliates; (IV) restrict interest rates on deposits; (V) impose further asset
growth restrictions or asset reductions; (VI) require the association or
subsidiary to alter, reduce, or terminate activities considered risky; (VII)
order a new election of directors; (VIII) dismiss directors and/or officers who
have held office more than 180 days before the association became
undercapitalized; (IX) require the hiring of qualified executives; (X) prohibit
correspondent bank deposits; (XI) require the association to divest or liquidate
a subsidiary in danger of insolvency or a controlling company to divest any
affiliate that poses a significant risk, or is likely to cause a significant
dissipation of assets or earnings; (XII) require a controlling company to divest
the association if it improves the association's financial prospects; or (XIII)
require any other action the OTS determines fulfills the purposes of the PCA
Rules.
The OTS may also impose on significantly undercapitalized associations one
or more of the mandatory restrictions applicable to critically undercapitalized
associations. The restrictions require prior regulatory approval for any
material transaction, to extend credit on a highly leveraged transaction, to
adopt charter or bylaws amendments, to make material accounting changes, to
engage in covered transactions with affiliates, to pay excessive compensation,
or to pay higher interest on new or renewing liabilities. A critically
undercapitalized association may not, beginning 60 days after becoming
critically undercapitalized, make any principal or interest payments on
subordinated debt not outstanding on July 15, 1991. The OTS is required, not
later than 90 days after a savings association becomes critically
undercapitalized to either (I) appoint a conservator or receiver or (II) take
such other actions it determines would better achieve the purpose of the PCA
Rules. In any event, the OTS is required to appoint a receiver within 270 days
after the association becomes critically undercapitalized unless (I) with the
concurrence of the FDIC, the OTS determines the association has a positive net
worth, has been in substantial compliance with an approved capital restoration
plan, is profitable or has an upward trend in earnings which the OTS finds is
substantial, and is reducing the ratio of nonperforming loans to total loans and
(II) the Director of the OTS and the Chairman of the FDIC both certify that the
association is viable and not expected to fail.
DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS. OTS regulations impose
limitations on "capital distributions" by savings associations. Distribution are
defined to include among other things, cash dividends and payments for the
repurchase or retirement of shares. Effective April 1, 1999, the OTS
significantly amended its capital distribution regulations. Under the new
regulations, the Bank, as a subsidiary of a savings and loan holding company,
may not make a capital distribution without filing a notice with the OTS. The
Bank would be required to file an application with the OTS (in lieu of a notice)
under the following circumstances: (I) it is not eligible for expedited
treatment by the OTS; (II) the total amount of its capital distributions during
the current year and the proposed capitals distribution would exceed its net
income for its current fiscal and its retained income for the preceding two
years; (III) it would not be adequately capitalized; or (IV) the capital
distribution would violate a prohibition contained in any applicable statute,
regulation or regulatory agreement. The OTS may deny any notice or application
if (I) the Bank would be undercapitalized following the capital distribution
(II) the OTS determines that the capital distribution would violate safety or
soundness concerns, or (III) the OTS determines that the capital distribution
would violate any applicable statute, regulation or regulatory agreement.
LOANS TO ONE BORROWER LIMITATION. With certain limited exceptions, the
maximum amount that a savings association may lend to one borrower (including
certain entities related to such borrower) is an amount equal to 15% of the
association's unimpaired capital and unimpaired surplus, plus an additional 10%
of capital and surplus for loans fully secured by readily marketable collateral.
Real estate is not included within the definition of readily marketable
collateral for this purpose. Pursuant to the current regulation, the
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maximum amount which the Bank could have loaned to any one borrower (and related
entities) under the general OTS loans to one borrower limit was $17.9 million as
of December 31, 1998.
OTHER REAL ESTATE LENDING STANDARDS. The OTS and the other federal banking
agencies have jointly adopted uniform rules on real estate lending and related
Interagency Guidelines for Real Estate Lending Policies. The uniform rules
require that associations adopt and maintain comprehensive written policies for
real estate lending. The policies must reflect consideration of the Interagency
Guidelines and must address relevant lending procedures, such as loan-to-value
limitations, loan administration procedures, portfolio diversification standards
and documentation, approval and reporting requirements. Although the final rule
did not impose specific maximum loan-to-value ratios, the related Interagency
Guidelines state that such ratio limits established by an individual
associations' board of directors should not exceed levels set forth in the
Guidelines, which range from a maximum of 65% for loans secured by raw land to
85% for improved property. No limit is set for single family residence loans,
but the Guidelines state that such loans exceeding a 95% loan-to-value ratio
should have private mortgage insurance or some other form of credit enhancement.
The Guidelines further permit a limited amount of loans that do not conform to
these criteria.
YEAR 2000 COMPLIANCE
In May 1997, the Federal Financial Institutions Examination Council
("FFIEC") issued an interagency statement to the chief executive officers of all
federally supervised financial institutions regarding Year 2000 project
management awareness. The FFIEC has highly prioritized Year 2000 compliance in
order to avoid major disruptions to the operations of financial institutions and
the country's financial systems when the new century results in two digit dates
for the year being below the prior year's value. The FFIEC statement provides
guidance to financial institutions, providers of data services and all examining
personnel of the federal banking agencies regarding Year 2000 Issue. The federal
banking agencies have been conducting Year 2000 compliance examinations, and the
failure to implement an adequate Year 2000 program can be identified as an
unsafe and unsound banking practice. The OTS has established an examination
procedure which contains three categories of ratings: "Satisfactory", "Needs
Improvement", and "Unsatisfactory". Institutions that receive a Year 2000 rating
of Unsatisfactory may be subject to formal enforcement action, supervisory
agreements, cease and desist orders, civil money penalties, or the appointment
of a conservator. In addition, federal banking agencies will be taking into
account Year 2000 compliance programs when reviewing applications and may deny
an application based on Year 2000 related issues.
TAXATION
FEDERAL
The Company and the Bank have historically filed a consolidated federal
income tax return based on a fiscal year ended September 30. The Company has
adopted a December 31 tax year for its consolidated federal income tax returns
beginning with a stub period ending December 31, 1998 and continuing each year
thereafter. Consolidated returns have the effect of eliminating inter-company
transactions, including dividends, from the computation of taxable income.
For taxable years beginning prior to January 1, 1996, a savings association
such as the Company that met certain definitional tests relating to the
composition of its assets and the sources of its income (a "qualifying savings
association") was permitted to establish reserves for bad debts and to claim
annual tax deductions for additions to such reserves. A qualifying savings
association was permitted to make annual additions to such reserves based on the
association's loss experience under the "experience method". Alternatively, a
qualifying savings association could elect, on an annual basis, to use the
"percentage of taxable income" method to compute its addition to its bad debt
reserve on qualifying real property loans (generally, loans secured by an
interest in improved real estate). The percentage of taxable income method
permitted the association to deduct a specified percentage (8%) of its taxable
income before such deduction, regardless of the association's actual bad debt
experience, subject to certain limitations. In fiscal years 1998, 1997 and 1996,
the Company utilized the experience method because that method produced a
greater deduction than the percentage method.
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On August 20, 1996, President Clinton signed the Small Business Job
Protection Act (the "Act") into law. One provision of the Act repealed the
reserve method of accounting for bad debts for savings associations effective
for taxable years beginning after 1995 and provided for recapture of a portion
of the reserves existing at the close of the last taxable year beginning before
January 1, 1996. For its tax years beginning on or after January 1, 1996, a
savings association will be required to account for its bad debts under the
specific charge-off method. Under this method, deductions may be claimed only as
and to the extent that loans become wholly or partially worthless. A savings
association will be required to recapture its "applicable excess reserves,"
which are its federal tax bad debt reserves in excess of the base year reserve
amount, which are generally the balance of reserves as of December 31, 1987. The
Company does not have applicable excess reserves and thus will not be subject to
the recapture provisions. The base year reserves will continue to be subject to
recapture if: (1) the Company fails to qualify as a "bank" for federal income
tax purposes, (2) certain distributions are made with respect to the stock of
the Company, (3) the bad debt reserves are used for any purpose other than to
absorb bad debt losses or (4) there is a change in federal tax law. The
enactment of this legislation is expected to have no material impact on the
Company's operations or financial position.
In accordance with Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes," a deferred tax liability has not been recognized
for the tax bad debt base year reserves of the Company. At December 31, 1998,
the amount of those reserves was approximately $21.3 million. This reserve could
be recognized in the future under the conditions described in the preceding
paragraph.
Corporations, including qualifying savings associations, are subject to an
alternative minimum tax in addition to the regular corporate income tax. This
20% tax is computed based on the Company's taxable income (with certain
adjustments), as increased by its tax preference items and applies only if this
tax is larger than its regular tax. The adjustments include an addition to
taxable income of an amount equal to 75% of the excess of the Company's
"adjusted current earnings" over its regular taxable income. The tax preference
items common to savings associations include the excess, if any, of its annual
tax bad debt deduction over the deduction that would have been available under
the experience method. The Company did not incur a minimum tax liability in 1996
(as computed for federal income tax purposes).
For additional information regarding taxation, see NOTE I of the NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
STATE
The California franchise tax applicable to the Company is a variable-rate
tax. This rate is computed under a formula that results in a rate higher than
the rate applicable to nonfinancial corporations because it includes an amount
"in lieu" of local personal property and business license taxes paid by such
corporations (but not paid by banks or financial institutions such as the
Company). For the taxable years 1998, 1997 and 1996, the maximum rate was set at
approximately 11%. Under California regulations, financial corporations are
permitted to claim bad debt deductions using a reserve method, with the reserve
level being determined by past experience or current facts and circumstances.
EMPLOYEES
The Company employed 272 full time equivalent persons at December 31, 1998.
Employees are not represented by a union or collective bargaining group and the
Company considers its employee relations to be satisfactory. Employees are
provided retirement, savings incentive and other benefits, including life,
health, accident and hospital insurance.
RISK FACTORS
RISKS ASSOCIATED WITH LENDING ACTIVITIES
Please refer to ITEM 1. BUSINESS. NEW BUSINESS GENERATION, LENDING
ACTIVITIES, for a thorough discussion of the Company's lending activities,
including our assessment of the risks associated with our real estate-secured
lending businesses, and the manner by which we mitigate these identified risks.
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RISKS ASSOCIATED WITH GROWTH IN LOAN ORIGINATION
We commenced each of our current lending businesses in 1995, following
several years during which we were not actively engaged in making new loans.
During the four-year period which ended December 31, 1998, the Company recorded
new loan commitments totaling $964.6 million (1998), $495.0 million (1997),
$332.3 million (1996), and $197.4 million (1995). This significant growth in
annual commitment volume has been driven by our increasingly successful
penetration of very tightly-defined segments within the Southern California real
property financing markets, with respect to which we employ the competitive
advantages possessed by the Company. Beyond the success of our strategic
initiatives, however, the growth in our financing businesses, especially since
the middle of 1997, has been substantially aided by (1) the generally low level
of interest rates prevailing in the market for some time (which increases the
availability of mortgage credit generally and which, in turn, enhances the
liquidity of real estate), (2) the recovery since 1994 in the Southern
California economy, and (3) the substantial rise in real property values since
1994 occasioned by the recovery (and now expansion) of the region's economic
base. These factors, taken together, have resulted in a substantial increase
since 1995 in the numbers of financial services companies who compete directly
with us for new financing opportunities centered in those markets targeted by
us. In addition, the volume of mergers of regulated financial companies within
the Company's market area, including most notably the amalgamation of Great
Western Bank, Home Savings and American Savings Bank into Washington Mutual, has
created a number of very large companies (measured by assets) who aggressively
deploy their capital and marketing resources, each of which substantially
exceeds our capital and marketing resources, to attract borrowers whom we also
pursue.
Because of these and related factors, we cannot be assured that we will be
able to access new financing opportunities, or record new loan commitments,
either in the volumes or with the effective yields, targeted by us.
RISKS ASSOCIATED WITH OUR LOAN PORTFOLIO
Through the end of 1998, we have devoted our energies, and the Company's
capital, to building each of our financing businesses. As a result, our assets
are represented almost entirely by real estate-secured loans, without any
substantial complement of more liquid, and less credit risk-sensitive assets
such as mortgage-backed securities, U.S. Treasury securities, and the like.
Though our loan portfolio routinely produces effective yields far in excess of
the yields which can be obtained from these less credit risk-sensitive assets,
we assume a much greater risk that our borrowers will cease to make their
payments to us, that our real estate collateral will decline in value over time,
or both. We seek to mitigate these risks throughout among other efforts (1) our
extensive pre-funding underwriting of each of our loans, (2) our post-funding
loan monitoring programs, and (3) providing reserves for the inherent or
loan-specific losses contained in our loan portfolio.
Though we believe that our risk management-related processes aid us in
significantly reducing and managing the credit risks we routinely assume, the
business of lending money possesses inherent risks, including the risk that our
judgment in extending credit in a particular instance may be proven fallible,
due to circumstances either within our control or otherwise. In addition, many
of our loans have terms which extend to ten years, which is clearly beyond the
boundaries of most economic cycles. As a result, it is probable that the current
vibrant regional economy, and its positive effect upon the region's real
property markets, cannot and will not be sustained for the entire duration of
many of our loans, which exposes us to the risk that the value of certain of the
real estate collateral which secures our loans may decline in value prior to or
at the loans' maturity. Should this occur, our risk of sustaining losses of
principal, interest, or both would increase, perhaps substantially. Should the
performance of our borrowers deteriorate because of these or other, more
loan-specific, factors, causing the level of our nonaccruing loans to increase
substantially, our operating results would deteriorate because of a loss of
interest revenue. Further, should economic factors become adverse, our allowance
for estimated credit losses may prove inadequate to absorb losses resulting from
foreclosure of our collateral, from the restructuring of loans, or other
resolution strategies.
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SOURCE OF REPAYMENT FOR OUR SENIOR NOTES
Hawthorne Financial Corporation is a holding company with no business
operations of its own. Hawthorne Financial's only significant asset is the
common stock of Hawthorne Savings Bank that it owns, and its only significant
liability is the $40.0 million of Senior Notes that it issued in December 1997.
The amount of cash we raised by issuing these Senior Notes was utilized to repay
existing obligations of Hawthorne Financial totaling $27.2 million (which arose
from our 1995 recapitalization), with the remainder contributed to Hawthorne
Savings to support its various business activities. The annual interest we pay
on the Senior Notes equals $5.0 million and we must repay the entire amount of
the Senior Notes in 2004, either from our own cash resources or from the
proceeds raised from a new issue of Senior Notes, the sale of common or
preferred stock, or other similar means. The only source of internal cash flow
to make our semi-annual interest payments on the Senior Notes comes from
dividends paid by Hawthorne Savings to Hawthorne Financial. In turn, the amount
of cash which can be dividended from Hawthorne Savings to Hawthorne Financial is
limited by regulation to a percentage of the earnings generated by Hawthorne
Savings, and is further limited by the dollar amount of capital (or net worth)
that Hawthorne Savings is required by regulation to retain. Hawthorne Savings
currently generates more than enough earnings, and maintains more than
sufficient capital, to comfortably dividend to Hawthorne Financial the amounts
necessary to make interest payments on the Senior Notes. However, should
Hawthorne Savings cease to generate substantial earnings, or should the amount
of capital required to be maintained by Hawthorne Savings increase, or both, it
is possible that Hawthorne Financial would not be able to make one or more
interest payments on its Senior Notes.
INTEREST RATE RISK
Our profitability is dependent upon the spread between the interest and fee
revenues we receive from lending money or investing it in securities, and the
interest we pay to our depositors and to other lenders. A substantial majority
of our assets are loans with interest rates which adjust periodically at a fixed
margin over various market-sensitive indicies (like the Prime Rate, 11th DCOFI,
CMT, MTA, etc). A majority of our liabilities are certificates of deposit, which
generally have terms of one year or less and which carry a fixed rate of
interest for their term, or borrowings from the FHLB, which carry a fixed rate
of interest for their terms, which range up to ten years, however, the majority
of which are five years or less.
Changes in the general level of interest rates directly and immediately
affect, either positively of negatively, our interest spread and therefore our
profitability. Sharp and significant changes to market interest rates, (similar
to what we observed during the last half of 1998) can cause our interest spread
to shrink or expand significantly in the near term, principally because the
periods during which our adjustable-rate loans reprice may be, and are,
different from the maturities (and, therefore, repricing) of our principal
liabilities (deposits and FHLB borrowings).
Increases to the general level of interest rates, especially if the
increases are abrupt and sustained, can also adversely affect our ability to
earn money by (1) causing an increasing number of borrowers to cease making
payments on their loans with us (because their required payments, which adjust
with changes to market interest rates, may have risen to a level which exceeds
their financial resources), (2) reducing the volume of financing opportunities
and recorded new loan commitments (because higher interest rates tend to make
the refinancing of real estate less attractive to owners, or because the
availability of mortgage credit and equity funds is reduced, thereby dampening
the liquidity of the region's property markets), and (3) extending the average
period of time each of our loans remains outstanding, which may result in our
need to raise additional capital to support our new loan origination activities.
To manage these potential risks, (1) we largely avoid making fixed-rate
loans, because the value of these loans, and the interest spread we can earn in
a rising interest rate environment, can decline substantially, (2) we include
interest rate floors and caps in the substantial majority of our loans, to
provide us and our borrowers with some certainty about the range of payments
required to be made over time, and (3) we seek to achieve reasonable equilibrium
between the periods over which our adjustable-rate loans reprice and the
maturity profile of our fixed-rate, fixed-term deposits and borrowings.
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RISK OF CHANGING ECONOMIC CONDITIONS
The vibrancy and sustainability of the region's economic activity is a
significant factor in determining our long-term success, as measured by the
volume of loans we originate, the yields we earn on our loans, the availability
and pricing of customer deposits, and our ability to collect on the loans we
make. Since the mid-1990's, California has experienced substantial economic
growth, which has directly translated into inflation in property values. During
this period, interest rates have dropped to near historical lows and substantial
wealth has been created by the gains in the U.S. and world stock markets. This
confluence of positive factors has resulted in a substantial increase in the
availability of funds for investment in new businesses, property acquisition,
and the like, which creates job growth, increases to individual wealth, and
growth in consumer confidence.
Taken together, these factors tend over time to cause financial services
companies to become ever more aggressive in extending credit to borrowers, and
to reduce the risk premiums they charge their customers (principally because of
competitive factors). Should economic conditions abruptly and adversely change,
there will almost certainly be a rise in the number of borrowers who cease
making payments on their loans (because of job loss or otherwise reduced
financial means) which, if significant and sustained, could cause property
values to decline (because of a reduced availability of mortgage credit and a
general imbalance between the supply and demand for real estate), which would
lead to lower interest spreads for, or higher credit losses by, lenders, and
lower earnings, or even losses.
We attempt to mitigate these risks by (1) generally advancing a relatively
low percentage against the value of our real property collateral, (2)
extensively underwriting the potential borrower, property and transactional
risks in each of our new loans, (3) pricing our loans to float over market
sensitive indicies, subject to established interest rate caps (and floors), (4)
providing careful and diligent oversight of our loan portfolio once loans are
funded and (5) establishing an allowance for estimated credit losses to absorb
the inherent losses, rather than just those near-term losses otherwise
identified, in our loan portfolio. SEE ITEM 1. BUSINESS, NEW BUSINESS
GENERATION.
RISK OF NATURAL DISASTER
The Southern California area is known for being subject to earthquakes,
sometimes with a severity that causes significant and costly property damage,
which can lead to borrower loan defaults and losses for lenders. Catastrophic
earthquakes are infrequent and tend to be somewhat localized in their geographic
reach. As a general matter, lenders with significant concentrations of loans
secured by properties located within a small geographic region are most at risk
of significant loss should a catastrophic earthquake hit.
As a general matter, we have mitigated our risks of being materially, and
adversely affected by a catastrophic earthquake by lending across a broad
geographic swath throughout Southern California, rather than localizing our
lending to properties concentrated within a small geographic area. This is less
true with our Estate Loans, which are secured by large homes concentrated along
the coastal region of Southern California and in inland pockets like Bel-Air and
Beverly Hills. Because the availability of earthquake insurance for borrowers is
generally limited and quite expensive to obtain, lenders (including Hawthorne)
do not require that such insurance coverage be obtained by homeowners as a
condition of a loan. We have addressed this risk by purchasing a $10 million
blanket insurance policy covering the collateral securing our Estate Loans in
the event of an earthquake. Under the terms of this insurance policy, the
insurance company will reimburse us for any losses we suffer (up to $10 million
in the aggregate) should the value of our collateral prove to be less than the
amount of a loan, upon the sale of the property following an earthquake. This
policy also provides for the payment to us by the insurance company for certain
lost interest on our Estate Loans in the event the borrower ceases making their
payments to us following an earthquake.
REGULATION
Both Hawthorne Financial, as a savings and loan holding company, and
Hawthorne Savings, as a federally-chartered savings institution, are subject to
significant governmental supervision and regulation, which is intended primarily
for the protection of depositors. Statutes and regulations affecting us may be
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changed at any time, and the interpretation of these statutes and regulations by
examining authorities also may change. We cannot assure you that future changes
in applicable statutes and regulations or in their interpretation will not
adversely affect our business. The OTS regulates and examines Hawthorne
Financial, while the OTS and the FDIC regulate and examine Hawthorne Savings. We
cannot assure you that the OTS or the FDIC will not, as a result of their
regulation or examination, impose various requirements or regulatory sanctions
upon us. In addition to governmental supervision and regulation, we are subject
to changes in federal and state laws, which could materially affect the real
estate industry.
YEAR 2000 COMPLIANCE
We have adopted, and are implementing, a plan to address Year 2000 data
processing issues. The plan includes the assessment of all internal systems,
programs and data processing applications, as well as those provided to us by
third-party vendors. The expense incurred and to be incurred to ensure year 2000
compliance is substantially integrated and included with the expense associated
with the conversion of our technology platform during 1998, to a
client-server-based platform from a host-based platform operated by a
third-party service bureau. Our management continues to evaluate third party
vendors' efforts with respect to compliance with Year 2000 issues. We cannot
assure you that the third party vendors' efforts will be successful or that our
costs will be consistent with internal projections. However, we do not believe
that any Year 2000 issues will materially affect our products, services or
competitive conditions. In addition, we do not believe that the cost of
addressing Year 2000 issues is a material event or uncertainty which would cause
reported financial information not to be necessarily indicative of future
operating results or financial condition, and the costs or the consequences of
incomplete or untimely resolution of our Year 2000 issues do not represent a
known material event or uncertainty that is reasonably likely to affect our
future financial results, or cause our reported financial information to not be
necessarily indicative of future operating results or future financial
conditions.
We anticipate incurring approximately $3.3 million in costs related to our
data processing conversion and the implementation of our Year 2000 plan.
Approximately $1.2 million of these costs were expensed during 1998. We expect
to capitalize and expense the remaining $2.1 million of these costs over a
three-year period.
DEPENDENCE ON CHIEF EXECUTIVE OFFICER
Scott A. Braly, our President and Chief Executive Officer, has had, and
will continue to have, a significant role in the development and management of
our business, including in particular our lending operations, where Mr. Braly
operates as our Chief Lending Officer. The loss of his services could have an
adverse effect on us. Mr. Braly does not have an employment agreement. During
the first quarter of 1999, the Company purchased a key man life insurance policy
relating to Mr. Braly.
NO INTENTION TO PAY DIVIDENDS; LIMITED SOURCES FOR DIVIDENDS ON THE COMMON STOCK
AND FUNDING OF ACTIVITIES
We do not pay cash dividends on our common stock and we have no plans to do
so in the future. As a holding company whose only significant asset is the
common stock of Hawthorne Savings, our ability to pay dividends on our common
stock and to conduct business activities directly or in non-banking subsidiaries
depends significantly on the receipt of dividends or other distributions from
Hawthorne Savings. Federal banking laws and regulations, including the
regulations of the OTS, limit Hawthorne Savings' ability to pay dividends to
Hawthorne Financial. Hawthorne Savings generally may not declare dividends or
make any other capital distribution to Hawthorne Financial if, after the payment
of such dividends or other distribution, Hawthorne Savings would fall within any
of the three undercapitalized categories under the prompt corrective action
standards established by the OTS and the other federal banking agencies. Another
regulation of the OTS also limits our ability to pay dividends and make other
capital distributions in a manner which depends upon the extent to which we meet
our regulatory capital requirements. In addition, HOLA requires every savings
association subsidiary of a savings and loan holding company to give the OTS at
least 30 days' advance notice of any proposed dividends to be made on its
guarantee, permanent or other non-withdrawable stock or else the dividend will
be invalid. Further, the OTS may prohibit any dividend or other capital
distribution that
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it determines would constitute an unsafe or unsound practice. In addition to the
regulation of dividends and other capital distributions, there are various
statutory and regulatory limitations on the extent to which Hawthorne Savings
can finance or otherwise transfer funds to Hawthorne Financial or any of our
non-banking subsidiaries, whether in the form of loans, extensions of credit,
investments or asset purchases. The director of the OTS may further restrict
these transactions in the interest of safety and soundness.
As of December 31, 1998, we met the capital and other requirements of a
"well capitalized" institution under the OTS' prompt corrective action
standards. We cannot assure you that we will remain "well capitalized" in the
future or that the OTS will not require us to maintain higher levels of capital
in light of the risk profile of our lending activities.
ITEM 2. PROPERTIES.
As of December 31, 1998, the Company had nine leased and two wholly owned
properties. The leased properties included its corporate headquarters, four
branch offices (two of which were ground leases for sites on which the Company
has built branch offices), two warehouses, and two office locations. All of the
properties owned or leased by the Company are in Southern California.
The following table summarizes the Company's owned and leased properties at
December 31, 1998 and, with respect to leased properties, highlights the
principal terms and net book values of the owned properties and leasehold
improvements. None of the leases contain any unusual terms and are all "net" or
"triple net" leases.
EXPIRATION RENEWAL MONTHLY SQUARE NET
FACILITY OF TERM OPTIONS RENTAL FEET BOOK VALUE
-------- ---------- ------------- -------- ------- ----------
LEASED El Segundo Corporate........... 11/30/05 One 5 - year $ 67,722 57,817 $ 800,635
Torrance Branch................ 12/31/01 One 5 - year 17,550 7,343 159,665
Irvine -- Offices Only......... 09/30/03 One 5 - year 13,500 8,000
Laguna Hills -- Offices Only... 07/31/01 Four 5 - year 13,273 4,125
Westlake Branch................ 03/31/00 None 11,828 7,600 14,949
Manhattan Beach Branch(1)...... 10/30/10 Four 5 - year 4,590 4,590
Warehouse...................... 06/30/01 Two 3 - year 3,900 10,000 74,426
Tarzana Branch(1).............. 01/31/00 Five 5 - year 3,283 3,352
Warehouse...................... 09/30/99 One 2 - year 2,916 6,480
-------- ------- ----------
$138,562 109,307 $1,049,675
======== ======= ==========
OWNED.. Hawthorne Branch............... 9,500 $ 210,698
Weschester Branch.............. 8,800 458,098
Manhattan Beach Branch
(building only)................ 4,590 41,315
Tarzana Branch
(building only)................ 3,352 59,821
------- ----------
26,242 $ 769,932
======= ==========
- ---------------
(1) Ground lease only; building and improvements are owned by Company but revert
to landlord upon termination of lease.
At December 31, 1998, the net book values of the Company's office real
property and improvements owned, and furniture, fixtures and equipment were $1.8
million and $4.7 million, respectively. See NOTE F of the NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS. The Company believes that all of the above facilities are
in good condition and are adequate for the Company's present operations.
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ITEM 3. LEGAL PROCEEDINGS.
The Bank is a defendant in an action entitled Takaki vs. Hawthorne Savings
and Loan Association, filed in the Superior Court of the State of California,
Los Angeles, as Case No. YC021815. The plaintiffs were owners of real property
which they sold in early 1992 to a third party. The Bank provided escrow
services in connection with the transaction. A substantial portion of the
consideration paid to the plaintiffs took the form of a deed of trust secured by
another property then owned by an affiliate of the purchaser. The value of the
collateral securing this deed of trust ultimately proved to be inadequate. The
plaintiffs alleged that the Bank knew, or should have known, that the security
that the plaintiffs received as sellers was inadequate and should have so
advised them. In late June 1997, a trial jury found for the plaintiffs and
awarded compensatory and punitive damages totaling $9.1 million. In late July
1997, the trial judge reduced the combined award to $3.3 million. The plaintiffs
accepted the reduced judgment. The Bank filed a Notice of Appeal from the
judgment and posted an Appeal Bond with the Court to stay plaintiffs'
enforcement of the judgment pending the Appellate Court's decision. After the
defendants and plaintiffs filed their respective appellate briefs and other
necessary pleadings and oral arguments were presented, in late July, 1998, the
Appellate Court remanded the case to the Superior Court with directions to
dismiss the fraudulent concealment, misrepresentation and punitive damages
claims and to conduct a new trial pertaining solely to damages arising from
negligence, in particular to determine whether any negligence of the Bank
contributed to the plaintiffs' injury and, if so, to apportion liability for
negligence between the Bank and the plaintiffs. On March 30, 1999, the jury
returned a verdict in favor of the plaintiffs in the amount of $1.8 million plus
pre-judgement interest. The Bank intends to file a notice of appeal from this
judgement. The Bank believes that there is a substantial likelihood that its
position will ultimately be upheld on appeal and, accordingly, that no amounts
having a materially adverse effect on the Bank's or the Company's financial
conditions or operations will be paid by the Bank to the plaintiffs in this
matter. There can be no assurances that this will be the case, however.
Subsequent to December 31, 1998, the Company settled two matters involving
real estate owned, sold by the Company to third parties. In each of these
matters, the Company was alleged to have sold the properties with known
construction defects which were not adequately disclosed to the purchasers. In
the aggregate, these settlements involved the payment by the Company of a total
of $0.6 million.
The Company is involved in a variety of other litigation matters. In the
opinion of management, none of these cases will have a materially adverse effect
on the Bank's or the Company's financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of stockholders during the 4th quarter
of 1998.
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ITEM 4A. EXECUTIVE OFFICERS.
The executive officers of the Company are as follows:
NAME AGE POSITION WITH THE COMPANY AND PRIOR BUSINESS EXPERIENCE
---- --- ----------------------------------------------------------
Scott A. Braly......... 44 President and Chief Executive Officer of Hawthorne
Financial and Hawthorne Savings since July 1993. Director
of Citadel Holding Corporation and Fidelity Federal Bank
from April 1992 to July 1993.
Simone Lagomarsino..... 37 Executive Vice President and Chief Financial Officer of
Hawthorne Financial and Hawthorne Savings since February
1999. Executive Vice President and Chief Financial Officer
of FirstPlus Bank from March 1998 to February 1999. Senior
Vice President -- Finance of Imperial Financial Group from
March 1997 to March 1998. Senior Vice President and Chief
Financial Officer Ventura County National Bank from March
1995 to March 1997. (Ventura County National Bank was sold
to City National Bank in January 1997.) Financial Advisor
Prudential Securities September 1993 to March 1995.
The above officers serve at the discretion of the Board of Directors.
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PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.
(a) MARKET PRICES OF COMMON STOCK
The common stock of the Company (the "Common Stock") is traded on the
Nasdaq National Market. The following table sets forth the high and low sales
prices as reported by the Nasdaq for the Common Stock for the periods indicated.
YEAR ENDED
DECEMBER 31, 1998 HIGH LOW
----------------- ---- ---
First quarter....................................... $21 1/2 $19 1/8
Second quarter...................................... 21 3/4 16 3/4
Third quarter....................................... 20 13 3/4
Fourth quarter...................................... 16 7/8 12
YEAR ENDED
DECEMBER 31, 1997 HIGH LOW
----------------- ---- ---
First quarter....................................... $11 3/4 $ 7 3/4
Second quarter...................................... 12 1/4 9 1/4
Third quarter....................................... 18 12 1/4
Fourth quarter...................................... 24 17 1/2
(b) STOCKHOLDERS
At the close of business on February 26, 1999, the Company had 5,212,113
shares of Common Stock outstanding and 453 holders of record of the Common
Stock.
(c) DIVIDENDS
It is the present policy of the Company to retain earnings to provide funds
for use in its business. The Company has not paid cash dividends on the Common
Stock during the past several years and does not anticipate doing so in the
foreseeable future.
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ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial data presented below at and for each of
the years in the five-year period ended December 31, 1998 are derived from the
audited consolidated financial statements of the Company (dollars are in
thousands).
AT OR FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
BALANCE SHEET DATA
Total assets........................ $1,412,434 $928,197 $847,195 $753,583 $743,793
Cash and cash equivalents........... 45,449 51,620 93,978 14,015 18,063
Investment securities............... -- 578 38,371 62,793 30,190
Mortgage-backed securities.......... -- -- -- -- 57,395
Loans receivable, net............... 1,326,791 838,251 672,401 617,328 537,020
Real estate owned, net.............. 4,070 9,859 20,140 37,905 62,613
Deposits............................ 1,019,450 799,501 717,809 698,008 649,382
Senior notes due 2004............... 40,000 40,000 -- -- --
Senior notes due 2000............... -- -- 12,307 12,006 --
Other borrowings.................... 264,000 40,000 50,000 -- 47,141
Stockholders' equity................ 81,424 42,319 43,922 38,966 40,827
Gross nonperforming assets (1)...... 17,112 20,652 36,783 49,203 80,716
Allowance for credit losses......... 17,111 13,274 13,515 15,192 21,461
STATEMENT OF OPERATIONS DATA
Interest revenues................... $ 106,992 $ 75,616 $ 65,354 $ 50,994 $ 49,571
Interest costs...................... (61,874) (43,825) (39,960) (34,486) (30,443)
---------- -------- -------- -------- --------
Net interest income................. 45,118 31,791 25,394 16,508 19,128
Provision for credit losses......... (7,135) (5,137) (6,067) (472) 24,449
---------- -------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR CREDIT LOSSES................. 37,983 26,654 19,327 16,036 43,577
NONINTEREST REVENUES, NET
Recurring items................ 4,646 3,599 1,927 1,311 1,973
Gains (losses) on sales of
securities................... 7 (11) 248 2,954 --
Net gain (loss) from
disposition of deposits and
premises..................... -- -- 6,413 (117) 2,835
Other, net..................... (31) 112 (3,366)(2) 864 --
GENERAL AND ADMINISTRATIVE COSTS.... (28,802) (22,009) (21,046) (20,339) (23,911)
INCOME (LOSS) FROM REAL ESTATE
OPERATIONS, NET................... 1,909 229 (2,378) (14,309) (27,314)
---------- -------- -------- -------- --------
TOTAL NONINTEREST EXPENSES.......... (26,893) (21,780) (23,424) (34,648) (51,225)
---------- -------- -------- -------- --------
EARNINGS (LOSS) BEFORE INCOME TAX
(EXPENSE) BENEFIT AND
EXTRAORDINARY ITEM................ 15,712 8,574 1,125 (13,600) (2,840)
INCOME TAX (EXPENSE) BENEFIT........ (4,674) 2,577 6,382 (617) (123)
---------- -------- -------- -------- --------
EARNINGS (LOSS) BEFORE EXTRAORDINARY
ITEM.............................. 11,038 11,151 7,507 (14,217) (2,963)
EXTRAORDINARY ITEM.................. -- (1,534)(3) -- -- --
---------- -------- -------- -------- --------
NET EARNINGS (LOSS)................. $ 11,038 $ 9,617 $ 7,507 $(14,217) $ (2,963)
========== ======== ======== ======== ========
NET EARNINGS (LOSS) AVAILABLE FOR
COMMON STOCK...................... $ 11,038 $ 5,254 $ 5,070 $(14,334) $ (2,963)
========== ======== ======== ======== ========
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AT OR FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
PER SHARE AMOUNTS
Basic earnings (loss) per share
before extraordinary item......... $ 2.64 $ 2.35 $ 1.95 $ (5.52) $ (1.14)
Basic earnings (loss) per share
after extraordinary item.......... 2.64 1.82 1.95 (5.52) (1.14)
Diluted earnings (loss) per share
before extraordinary item......... 1.65 1.30 1.17 (5.52) (1.14)
Diluted earnings (loss) per share
after extraordinary item.......... 1.65 1.00 1.17 (5.52) (1.14)
Dividends per share of Common
Stock............................. N/A N/A N/A N/A N/A
YIELDS AND COSTS (FOR THE PERIOD)
Interest-earning assets............. 9.06% 9.00% 8.43% 7.62% 6.63%
Interest-bearing liabilities........ 5.54% 5.44% 5.29% 5.01% 3.91%
Interest rate spread(4)............. 3.52% 3.56% 3.14% 2.61% 2.72%
Net interest margin(5).............. 3.82% 3.78% 3.28% 2.47% 2.56%
PERFORMANCE RATIOS(6)
Return on average assets............ 0.93% 1.11% 0.93% (1.96)% (0.36)%
Return on average common
stockholders' equity.............. 18.22% 19.83% 17.75% (47.57)% (6.99)%
Average stockholders' equity to
average assets.................... 5.09% 5.60% 5.24% 4.11% 5.12%
Efficiency ratio(7)................. 57.88% 62.19% 77.03% 114.14% 113.32%
BANK CAPITAL RATIOS (END OF PERIOD)
Tangible............................ 7.65% 7.55% 6.27% 5.80% 5.15%
Core................................ 7.65% 7.55% 6.27% 5.80% 5.15%
Tier I.............................. 10.10% 10.23% 9.85% 9.01% 8.19%
Risk-based.......................... 11.10% 11.48% 11.11% 10.27% 9.36%
ASSET QUALITY DATA(1)
Gross nonperforming assets.......... $ 17,112 $ 20,652 $ 36,783 $ 49,203 $ 80,716
Nonperforming assets to total assets
at end of period.................. 1.21% 2.22% 4.34% 6.53% 10.85%
Nonperforming loans to total loans
at end of period.................. .97% 1.27% 2.43% 1.79% 3.24%
Allowance for credit losses to loans
at end of period.................. 1.27% 1.56% 1.97% 2.40% 3.84%
Allowance for credit losses to
nonperforming loans at end of
period............................ 131.2% 122.99% 81.21% 134.47% 118.55%
- ---------------
(1) Nonperforming assets consist of loans delinquent 90 days or more and REO,
net of applicable write downs and reserves.
(2) Includes a one-time charge on all deposits insured by the SAIF as of March
31, 1996 to recapitalize the SAIF.
(3) Relates to the accelerated write off of unamortized issue costs and original
issue discount associated with Senior Notes due 2000, which were issued by
the Company in December 1995 and repaid in full in December 1997, with a
portion of the proceeds from the offering of Senior Notes due 2004.
(4) Interest rate spread represents the difference between the weighted average
yield on interest-earning assets and the weighted average cost of
interest-bearing liabilities.
(5) Net interest income divided by average interest-earning assets.
(6) With the exception of period-end ratios, all ratios are based on average
monthly balances.
(7) Represents general and administrative costs divided by net interest income
before provision for credit losses and noninterest revenues.
43
47
ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OPERATING RESULTS
GENERAL
For the year ended December 31, 1998, the Company earned $11.0 million, or
$1.65 per diluted share. By comparison, the Company earned $9.6 million, or
$1.00 per diluted share, for the year ended December 31, 1997, and earned $7.5
million, or $1.17 per diluted share, for the year ended December 31, 1996. The
results for 1997 included an extraordinary item of $1.5 million incurred in
connection with the early repayment, and the accelerated write-off of
unamortized issue costs and discounts, of the Senior Notes, due 2000, and Series
A Preferred Stock. The results for 1996 included (1) a pretax gain of $6.4
million in connection with the sale of certain of the Company's deposits and
retail banking offices, and (2) a pre-tax charge of $3.8 million in connection
with the one-time recapitalization of the SAIF. The results for 1996 and 1997
were substantially benefited by the recognition of income tax benefits which
totaled, respectively, $6.4 million and $2.6 million. The results for 1998
included an income tax provision of $4.7 million.
The table below identifies the principal components of the Bank's pre-tax
core earnings and the Company's net earnings for the three years ended December
31, 1998, 1997 and 1996, respectively (dollars are in thousands).
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
Net interest income........................................ $ 50,118 $ 33,770 $ 27,315
Provision for estimated credit losses...................... (7,135) (5,137) (6,067)
-------- -------- --------
Net interest income after provision........................ 42,983 28,633 21,248
Operating revenues......................................... 4,646 3,599 1,927
Non interest expense....................................... (28,802) (22,009) (21,046)
-------- -------- --------
PRE-TAX CORE EARNINGS...................................... 18,827 10,223 2,129
Nonrecurring gains (losses)
Sale of deposits and premises............................ -- -- 6,413
Sale of securities....................................... 7 (11) 248
Special SAIF assessment.................................. -- -- (3,813)
Real estate operations, net.............................. 1,909 229 (2,378)
Other, net............................................... (31) 112 447
Other items
Interest on Senior Notes................................. (5,000) (1,979) (1,921)
Income tax (provision) benefit........................... (4,674) 2,577 6,382
-------- -------- --------
(7,789) 928 5,378
-------- -------- --------
Net earnings before extraordinary item..................... 11,038 11,151 7,507
Extraordinary item......................................... -- (1,534) --
-------- -------- --------
NET EARNINGS............................................... $ 11,038 $ 9,617 $ 7,507
======== ======== ========
Because of the significant changes to the Company's capital structure and
taxable status since 1995, management believes that the Bank's pretax core
earnings ("Bank Core Earnings") are the most useful measure of the Company's
underlying operating performance. As illustrated in the preceding table, Bank
Core Earnings are earnings before interest on parent company debt (i.e., Senior
Notes), income taxes, real estate operations and non-operating items.
During the three-years ended December 31, 1998, Bank Core Earnings have
increased to $18.8 million from $2.1 million. This substantial growth in Bank
Core Earnings has resulted from the growth in the Bank's earning assets, a
widening of the Bank's effective interest margin, and a continuing reduction in
nonaccruing loans.
44
48
The growth in the Bank's earning assets has resulted directly from the
continuing successful development of the Company's real estate-secured financing
businesses. During 1998, the Company generated net new loan commitments of
$964.6 million which, net of repayments and disbursed loan funds, produced net
loan growth of $488.5 million for the year. By comparison, the Company recorded
net new loan commitments of $495.0 million and $332.3 million during 1997 and
1996, respectively, which, net of repayments and undisbursed loan funds,
produced net loan growth of $165.9 million in 1997 and $55.1 million in 1996.
In conjunction with the growth in the Bank's earning assets, the Bank's
effective interest margin has continued to widen, reaching 4.24% during 1998 as
compared with 4.02% during 1997 and 3.52% during 1996. The growth in the Bank's
effective interest margin (which excludes the impact of interest paid on the
Company's Senior Notes) has resulted primarily from the increasing share of the
Bank's loan portfolio represented by higher-yielding loans originated during the
period 1995 through 1998.
Nonperforming assets ("NPAs"), which consist of the carrying value of
properties acquired through foreclosure and loan principal delinquent three or
more payments, have declined from $49.2 million at December 31, 1995, to $17.1
million at December 31, 1998. Based upon the actual amount and duration of
nonaccruing loans outstanding during each of the three years ended December 31,
1998, which is a broader measure of the impact of troubled loans on the
Company's earnings performance, approximately $0.9 million (1998), $0.4 million
(1997) and $0.7 million (1996), of interest revenues otherwise contractually
payable to the Company and associated with nonaccruing loans were not recognized
as revenue.
In mid-1997, management commenced a series of initiatives designed to
enhance the Company's management depth, to expand its loan origination
capabilities, to convert its technology platform from an outsourced, host-based
system to an in-house, client server-based system, and to design and to
implement a plan to ensure Year 2000 compliance. These and related initiatives
served to increase the Company's non interest expense during 1998, as compared
with their level during 1997 and 1996. In 1998, non interest expense costs were
$28.8 million, an increase of $6.8 million, or 30.9%, over non interest expense
costs of $22.0 million incurred during 1997, and an increase of $7.8 million, or
36.9%, over non interest expense costs of $21.0 million incurred during 1996.
For 1998, the Company's effective tax rate was 29.7%, which reflected
utilization of substantially all of the Company's remaining Federal income tax
benefits during the year. By comparison, the Company recorded income tax
benefits of $2.6 million in 1997 and $6.4 million in 1996, which reflected the
Company's utilization of income tax benefits. These income tax benefits, which
consisted principally of tax loss carryforwards, accumulated during the early
1990's, a period during which the Company incurred substantial losses.
NET INTEREST INCOME
The Company recorded net interest income of $45.1 million, $31.8 million
and $25.4 million in 1998, 1997, and 1996 respectively, representing increases
of 41.8% and 25.2% in 1998 and 1997. The resulting net interest margin increased
during the three years from 3.28% in 1996 to 3.78% and 3.82% in 1997 and 1998.
There are two contributing factors to net interest income, namely interest
income, which increased in 1998 by $31.4 million as compared to 1997, and which
increased 10.3 million in 1997 compared to 1996. The other factor is interest
expense, which increased $18.0 million in 1998 compared to 1997 and $3.9 million
in 1997 compared to 1996.
The primary reason for the $31.4 million increase to interest income in
1998 compared to 1997, is that average loans, the highest yielding category of
interest-earning assets, increased by $336.2 million resulting in an increase in
interest income of $31.6 million. Loans averaged 91.5% of the Company's interest
earning assets during 1998 compared to 88.7% in 1997. Interest rate variances
had an insignificant impact on the increase in interest income during 1998.
This positive impact to net interest income was somewhat offset by the
increase in interest expense of $18.0 million. The increase was due primarily to
an increase in average interest-bearing liabilities of $312.5 million, which
resulted in an increase to interest expense of $20.2 million. This however was
partially mitigated by the reduction in rates paid on short-term borrowings and
on the Senior Notes which averaged
45
49
5.43% and 12.5% in 1998 compared to 6.02% and 15.87% in 1997, respectively.
These lower rates reduced the interest expense by $537 thousand and the
reduction resulting from the lower rate and volume together was $1.6 million
during 1998 as compared to 1997.
The resulting net interest margin was 3.82% during 1998 which is 4 basis
points more than in 1997 and 54 basis points more than in 1996. The average
yield on earning assets increased by 6 basis points during 1998 compared to
1997, while the average rate paid on interest-bearing liabilities increased 10
basis points. The ratio of interest earning assets to interest-bearing
liabilities was 105.7% in 1998 compared to 104.4% in 1997.
The Company's interest income increased by $10.3 million or 15.7% during
1997 compared to 1996. This increase was primarily attributable to increases in
the average balance of loans outstanding and to a lesser extent, increases in
the weighted average yield earned thereon,
The increase in the average balance of loans outstanding during 1997, along
with the reduction in real estate owned contributed to an improvement in the
ratio of interest-earning assets to interest bearing liabilities which was
104.4% in 1997 compared to 102.6% in 1996.
The increase in interest income during 1997 was partially offset by a $3.9
million, or 9.7% increase in interest expense. This was primarily due to an
increase in the average balance of the Company's deposit base and borrowings as
well as an increase in the average rates paid on deposits. Interest rates on
deposits increased an average of 16 basis points in 1997 compared to 1996, while
the rates paid on short term borrowings and Senior Notes remained relatively
constant.
The following table sets forth the Company's average interest-earning
assets and interest-bearing liabilities, and the related revenues and costs, and
effective weighted average yields and costs, for each of the three years in the
period ended December 31, 1998. The interest costs associated with the Company's
issues of Senior Notes are included in the table (dollars are in thousands).
46
50
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------- ----------------------------- -----------------------------
AVERAGE REVENUES/ YIELD/ AVERAGE REVENUES/ YIELD/ AVERAGE REVENUES/ YIELD/
BALANCE COSTS COST BALANCE COSTS COST BALANCE COSTS COST
---------- --------- ------ -------- --------- ------ -------- --------- ------
ASSETS
Interest-earning assets
Loans receivable.............. $1,081,382 $102,213 9.45% $745,197 $70,012 9.40% $671,365 $59,722 8.90%
Cash and cash equivalents..... 81,188 3,698 4.55% 33,747 1,776 5.26% 65,094 3,425 5.26%
Investment securities......... 8,801 510 5.79% 54,420 3,403 6.25% 32,014 1,814 5.67%
Investment in capital stock of
Federal Home Loan Bank...... 9,862 571 5.79% 6,980 425 6.09% 6,577 393 5.98%
---------- -------- -------- ------- -------- -------
Total interest-earning
assets................ 1,181,233 106,992 9.06% 840,344 75,616 9.00% 775,050 65,354 8.43%
-------- ------- -------
Noninterest-earning assets...... 8,839 25,403 31,675
---------- -------- --------
Total assets............ $1,190,072 $865,747 $806,725
========== ======== ========
LIABILITIES AND STOCKHOLDERS'
EQUITY
Interest-bearing liabilities
Deposits...................... $ 907,715 47,642 5.25% $744,165 38,920 5.23% $701,836 35,568 5.07%
Short-term borrowings......... 170,060 9,232 5.43% 48,621 2,926 6.02% 41,138 2,471 6.01%
Senior notes.................. 40,000 5,000 12.50% 12,473 1,979 15.87% 12,150 1,921 15.81%
---------- -------- -------- ------- -------- -------
Total interest-bearing
liabilities........... 1,117,775 61,874 5.54% 805,259 43,825 5.44% 755,124 39,960 5.29%
---------- -------- -------- ------- -------- -------
Other liabilities............... 11,703 11,997 9,310
Stockholders' equity............ 60,594 48,491 42,291
---------- -------- --------
Total liabilities &
stockholders'
equity................ $1,190,072 $865,747 $806,725
========== ======== ========
NET INTEREST INCOME............. $ 45,118 $31,791 $25,394
======== ======= =======
INTEREST RATE SPREAD............ 3.52% 3.56% 3.14%
===== ===== =====
NET INTEREST MARGIN............. 3.82% 3.78% 3.28%
===== ===== =====
NET INTEREST MARGIN OF BANK..... 4.24% 4.02% 3.52%
The table below shows the components of the changes in the Company's
interest revenues and costs for 1998 and 1997, as compared with the preceding
year (dollars are in thousands).
YEARS ENDED DECEMBER 31, YEARS ENDED DECEMBER 31,
1998 AND 1997 1997 AND 1996
------------------------------------- --------------------------------------
INCREASE (DECREASE) INCREASE (DECREASE)
DUE TO CHANGE IN DUE TO CHANGE IN
--------------------------- ----------------------------
RATE AND NET RATE AND NET
VOLUME RATE VOLUME(1) CHANGE VOLUME RATE VOLUME(1) CHANGE
------- ----- --------- ------- ------- ------ --------- -------
INTEREST REVENUES
Loans receivable(2).......................... $31,579 $ 428 $ 194 $32,201 $ 6,567 $3,354 $369 $10,290
Cash and cash equivalents.................... 2,482 (232) (324) 1,926 (1,649) -- -- (1,649)
Investment securities........................ (2,857) (245) 205 (2,897) 1,269 188 132 1,589
Investment in capital stock of Federal Home
Loan Bank.................................. 175 (21) (8) 146 25 7 -- 32
------- ----- ------- ------- ------- ------ ---- -------
31,379 (70) 67 31,376 6,212 3,549 501 10,262
------- ----- ------- ------- ------- ------ ---- -------
INTEREST COSTS
Deposits..................................... 8,510 173 38 8,721 2,042 1,235 75 3,352
Short term borrowings........................ 7,306 (286) (714) 6,306 442 11 2 455
Senior notes................................. 4,387 (424) (941) 3,022 46 12 -- 58
------- ----- ------- ------- ------- ------ ---- -------
20,203 (537) (1,617) 18,049 2,530 1,258 77 3,865
------- ----- ------- ------- ------- ------ ---- -------
NET INTEREST INCOME.......................... $11,176 $ 467 $ 1,684 $13,327 $ 3,682 $2,291 $424 $ 6,397
======= ===== ======= ======= ======= ====== ==== =======
- ---------------
(1) Calculated by multiplying change in rate by change in volume.
(2) Includes the interest on non-accrual and non-performing loans only to the
extent that it was paid and recognized as interest income.
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51
PROVISION FOR ESTIMATED CREDIT LOSSES
Provisions for estimated credit losses were $7.1 million, $5.1 million and
$6.1 million for 1998, 1997 and 1996, respectively. The company's ratio of
charge-offs to total loans has improved steadily in the past three years from
1.15% in 1996 to 0.72% in 1997 to 0.30% in 1998. Additionally, non-performing
loans to total loans have decreased from 2.43% in 1996 to 1.00% in 1998. Despite
this improvement in asset quality, the Company's provisions for 1998 reflected
an increase of $2.0 million, or 39%, over the provision for 1997. This increase
is primarily attributable to the substantial growth in the loan portfolio during
1998. Average loans outstanding during 1998 increased by $336.2 million, or 45%,
while loan provisions grew by $2.0 million, or 39% over 1997 provisions.
The Company routinely adds to its allowance for estimated credit losses
through provisions for credit losses. The Company makes recurring provisions at
a level deemed by management to be sufficient to absorb the inherent losses in
the Company's loan portfolio at each measurement date. Because of a continuing
decrease in the rate of loan charge-offs during 1998, and the very low rate of
loan charge-offs with respect to loans made by the Company since 1994, the rate
of growth in the Company's loan portfolio during 1998 exceeded the rate of
growth in its allowance for estimated credit losses. Due to the high volume of
loans originated in 1998 and the lack of seasoning of these loans and the fact
that the Company expanded into new loan products in 1998 including income
property development loans, the Company intends to increase provisioning during
1999. The Company intends to achieve a ratio of the general allowance for
estimated credit losses, net of specific reserves, to net loans of 1.50% by the
end of 1999. SEE ITEM 1. BUSINESS, NEW BUSINESS GENERATION, ASSET QUALITY for a
fuller discussion of the Company's allowances for estimated credit losses.
NONINTEREST REVENUES
The table below sets forth information concerning the Company's noninterest
revenues for the periods indicated (dollars are in thousands).
YEAR ENDED DECEMBER 31,
---------------------------
1998 1997 1996
------ ------ -------
OPERATING
Loan-related fees............................. $3,842 $2,718 $ 1,223
Other......................................... 804 881 704
------ ------ -------
$4,646 $3,599 $ 1,927
====== ====== =======
NON-OPERATING
Net gain (loss) on sale of securities......... 7 $ (11) $ 248
Disposition of deposits and premises.......... -- -- 6,413
Other......................................... (31) 112 (3,366)
------ ------ -------
$ (24) $ 101 $ 3,295
====== ====== =======
The growth in loan-related fees approximates the growth in the Company's
loan portfolio since 1995. These fees primarily consist of fees charged to
borrowers in connection with prepayments and modifications of loans and exit and
release fees collected upon the repayment of certain loans.
Other operating revenues are derived from the Company's retail banking
activities, and do not tend to fluctuate from year-to-year.
During 1996, the Company (1) sold certain of its branch deposits and sold
or closed the related offices at a net gain of $6.4 million, (2) sold $129.5
million of its loans for a gain of $0.4 million, and (3) made a one-time payment
of $3.8 million in connection with the recapitalization of the SAIF.
During 1998, 1997 and 1996, the Company sold marketable securities of $0.6
million, $37.6 million and $34.9 million, respectively. The Company realized
gains on the sale of securities in 1998 and 1996 of
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52
$7 thousand and $248 thousand, respectively and the Company realized a loss on
the sale of securities of $11 thousand in 1997.
NONINTEREST EXPENSES
The table below details the Company's noninterest expense for periods
indicated (dollars are in thousands).
YEAR ENDED DECEMBER 31,
---------------------------
1998 1997 1996
------- ------- -------
Employee.......................................... $14,414 $10,606 $ 9,507
Operating......................................... 6,177 4,470 4,337
Occupancy......................................... 3,404 2,921 2,689
Technology........................................ 2,117 816 722
Professional...................................... 1,738 1,907 1,615
SAIF insurance premium and OTS assessment(1)...... 952 1,289 2,152
Goodwill amortization............................. -- -- 24
------- ------- -------
TOTAL NONINTEREST EXPENSE(2)...................... $28,802 $22,009 $21,046
======= ======= =======
- ---------------
(1) Excludes the one time special SAIF assessment of $3.8 million which was paid
in 1996.
(2) Excludes: (i) non-recurring losses of $31 thousand in 1998, (ii)
non-recurring losses from the sale of securities in 1997 of $11 thousand and
(iii) non-recurring losses of $2.4 million related to real estate
operations.
Employee Costs
As the Company's business activities have grown and expanded, additional
personnel have been hired into the Company's various business and staff support
groups. During 1998, 1997 and 1996, the Company employed an average of 251, 206,
and 189 individuals, respectively, and the base salaries paid to these employees
grew to $8.1 million in 1998 from $7.8 million in 1997 and $8.8 million in 1996.
In addition to the increases in the number of individuals employed by the
Company and the base salaries paid to these employees, the Company has revised
its incentive compensation programs over the three-year period ended December
31, 1998, to more directly compensate individuals whose achievement of defined
financial and operational goals and objectives substantially exceeds targeted
thresholds. During 1998, the Company's financial performance substantially
exceeded targeted thresholds, resulting in the payment of cash bonuses of $2.5
million, as compared to $1.0 million in 1997 and $1.0 million in 1996.
Operating Costs
Operating costs principally include (1) the cost of advertising and
promotion, (2) the cost of corporate telecommunications, (3) premiums for
corporate liability insurance, (4) supplies, and (5) the amortization of prepaid
offering costs arising from the 1995 recapitalization of the Company (1996 and
1997). The 38.2% increase in operating expenses from 1997 to 1998 was due
primarily to increased advertising and marketing activities.
Occupancy Costs
Occupancy costs consist of the expenses related to the operation of the
Company's corporate facilities, and six branches. In 1998, the Company leased
additional space at the El Segundo Corporate office primarily due to the data
processing conversion from an outsourced third party vendor to an internal
computer system. Primarily as a result of the increase in facilities leased,
occupancy expense increased 16.5% in 1998 over the same period in 1997.
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53
Technology Costs
Technology costs in 1998 are principally costs associated with (1) systems
conversions from an outsourced third party vendor to an internal system, (2)
computer hardware and software maintenance costs, (3) depreciation for computer
hardware, (4) amortization of costs related to software, and (5) during the
first half of 1998, data processing charges from an outside vendor. In 1997 and
1996, technology costs are primarily related to maintenance and depreciation for
computer hardware and data processing service charges from an outside vendor.
Technology costs increased from $722 thousand in 1996 and $816 thousand in 1997
to $2.1 million in 1998, or an increase of 159.4% over 1997 costs.
Professional Fees
Professional fees are paid to outside lawyers, who represent the Company in
a variety of legal matters, the Company's independent accountants, and to
various other vendors that provide employee search and miscellaneous consulting
services to the Company. A significant portion of the professional fees paid in
1996 were legal costs due to the magnitude of the Company's foreclosures and
related actions against borrowers. Commencing in mid-1997, the Company
implemented a series of initiatives to increase the depth of its lending
management group and to hire programming and supplemental management talent in
anticipation of converting the Company's core technology to a client server
platform from an outsourced, mainframe provider. The platform conversion,
including Year 2000 compliance initiatives, were substantially completed in
1998. A majority of the new personnel hired by the company were sourced through
executive search firms.
SAIF Premiums
The Company pays premiums to the SAIF based upon the dollar amount of
deposits it holds and the assessment rate charged by the FDIC, which is based
upon the Company's financial condition, its capital ratios and the rating it
receives in connection with annual regulatory examinations by the OTS. Because
of the Company's improved financial condition, the assessment rate charged by
the FDIC has decreased during 1997 and 1998.
EXPENSES ASSOCIATED WITH REAL ESTATE OPERATIONS
The table below details the revenues and costs associated with the
Company's real estate owned for the periods indicated (dollars are in
thousands).
YEAR ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
EXPENSES ASSOCIATED WITH REAL ESTATE OWNED
Property taxes......................................... $ 7 $ 119 $ 135
Repairs, maintenance and renovation.................... 277 222 160
Insurance.............................................. 116 188 258
------- ------- -------
Total............................................. 400 529 553
NET RECOVERIES FROM SALE OF PROPERTIES...................... (2,278) (1,282) (1,769)
PROPERTY OPERATIONS, NET.................................... (91) (389) (1,339)
PROVISION FOR ESTIMATED LOSSES ON REAL ESTATE OWNED......... 60 913 4,933
------- ------- -------
(INCOME) LOSS FROM REAL ESTATE OPERATIONS,NET............... $(1,909) $ (229) $ 2,378
======= ======= =======
Net recoveries from REO sales represent the difference between the proceeds
received from the sales and the carrying value of the related REO. Improved
market conditions and the sale of large land parcels resulted in increased
recoveries in 1998.
During 1993, 1994 and 1995, the Company acquired via foreclosure over 100
multi-family properties. This accumulated portfolio of multi-family properties
was operated by the Company over an extended holding period, during which the
Company renovated the properties and operated the properties for their cash flow
return. Commencing in late 1995, and continuing throughout 1996 and into early
1997, the Company disposed
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54
of these properties through retail channels. Accordingly, the net revenues
received by the Company from this portfolio (reflected in the table as property
operations, net) has declined from 1996 to 1998.
During 1996 and 1997, the Company recorded additional provisions for
estimated losses on REO of $4.9 million and $0.9 million, respectively,
principally in connection with the completion and liquidation of certain tract
developments. At December 31, 1997, the Company had liquidated all of its
investments in these tract developments.
INCOME TAXES
The Company recorded an income tax provision of $4.7 million during 1998
compared to income tax benefits of $2.6 million and $6.4 million, during 1997
and 1996, respectively. The $2.6 million of income tax benefit recognized during
the year ended December 31, 1997, was due to a $5.9 million increase in the
Company's deferred tax asset as a result of the reduction in the valuation
allowance against deferred tax assets. Partially reducing this benefit was an
expected liability of $3.3 million attributable to the Company's profitable
operations.
At December 31, 1998, the Company had utilized substantially all income tax
benefits originated in prior years.
GROWTH IN 1999
The Company experienced substantial net growth in its assets during 1998,
primarily because the volume of new loan commitments recorded during the year
increased significantly from prior periods, the dollar amount of such
commitments was significant in relation to loans outstanding at the beginning of
the year, and the Company retained virtually all of these commitments for its
own account. This net growth in assets, which approximated 52.1% during 1998,
was supported by the successful issuance of 2,012,500 shares of the Common Stock
in July 1998, which raised net proceeds (after offering costs) of $27.6 million,
and by net earnings. At December 31, 1998, approximately $17.5 million of the
net proceeds raised in the 1998 offering had been contributed to the Bank, and
had been fully deployed. The significant part of the remainder of these net
proceeds (i.e., $10.0 million) is expected to be contributed to the Bank during
the first half of 1999.
Because the Company and the Bank will not have excess capital in 1999 to
the same extent excess capital was available during 1998, management does not
expect that growth in the Company's assets will approach the percentage growth
achieved during 1998, absent the issuance of additional debt or equity
securities by the Company or the Bank. The Company and Bank have no present
intention of issuing debt or equity securities in 1999.
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55
FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY
The table below sets forth the Company's consolidated assets, liabilities
and stockholders' equity and the percentage distribution of these items at the
dates indicated (dollars are in thousands).
DECEMBER 31,
------------------------------------------
1998 1997
-------------------- ------------------
BALANCE PERCENT BALANCE PERCENT
---------- ------- -------- -------
ASSETS
Cash and cash equivalents.............................. $ 45,449 3.2% $ 51,620 5.6%
Investment securities available-for-sale............... -- -- 578 0.1
Loans receivable, net(1)............................... 1,326,791 93.9 838,251 90.2
Real estate owned...................................... 4,070 0.3 9,859 1.1
Other assets(2)........................................ 36,124 2.6 27,889 3.0
---------- ----- -------- -----
Total assets........................................... $1,412,434 100.0% $928,197 100.0%
========== ===== ======== =====
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits............................................. $1,019,450 72.2% $799,501 86.1%
Short-term borrowings................................ 264,000 18.7 40,000 4.3
Accounts payable and other liabilities............... 7,560 0.5 6,377 0.7
Senior notes......................................... 40,000 2.8 40,000 4.3
---------- ----- -------- -----
1,331,010 94.2 885,878 95.4
Stockholders' equity................................... 81,424 5.8 42,319 4.6
---------- ----- -------- -----
Total liabilities and stockholders' equity............. $1,412,434 100.0% $928,197 100.0%
========== ===== ======== =====
- ---------------
(1) Includes nonaccrual loans of $47.7 million and $15.4 million for 1998 and
1997, respectively. SEE ITEM 1. BUSINESS, NEW BUSINESS GENERATION, ASSET
QUALITY.
(2) Includes fixed assets, accrued interest receivable, FHLB stock and other
assets.
ASSETS
Total assets increased by $484.2 million from year-end 1997 to year-end
1998. This increase was primarily due to a net increase in loans receivable of
$488.5 million.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, deposits at
correspondent banks and Federal funds sold. Cash and cash equivalents at
year-end 1998 were $45.4 million, a decrease of $6.2 million, from $51.6 million
at year-end 1997.
INVESTMENT SECURITIES
Investment securities consist of securities classified as
available-for-sale. Investment securities decreased by $0.6 million from
year-end 1997 resulting in the Company not holding any investment securities at
year end 1998. See NOTE C of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
LOANS RECEIVABLE
The Company's loan portfolio is almost exclusively secured by real estate
concentrated in Southern California. Net loans outstanding increased from $838.3
million to $1,326.8 million, or 58.3%, from year-end 1997 to year-end 1998. The
largest increases were centered in residential construction, single family
estate and income property lending. See ITEM 1. BUSINESS, NEW BUSINESS
GENERATION and NOTE D of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
52
56
REAL ESTATE OWNED
Real estate acquired in satisfaction of loans is transferred to REO at
estimated fair values, less any estimated disposal costs. The difference between
the fair value of the real estate collateral and the loan balance at the time of
transfer is recorded as a loan charge-off if fair value is lower. Any subsequent
declines in the fair value of the REO after the date of transfer are recorded
through the establishment of, or additions to specific reserves. The Company's
investment in REO decreased from $9.9 million to $4.1 million, or 58.7%, from
year-end 1997 to year-end 1998.
OTHER ASSETS
Other assets at year-end 1998 totaled $36.1 million, the principal
components of which are: (I) the Bank's investment in capital stock of the FHLB
($13.6 million), (II) a deferred tax asset ($2.8 million), (III) and accrued
interest receivable ($8.4 million). This compares to year-end 1997's amount of
$27.9 million, with allocations of $7.2 million, $6.8 million and $5.3 million,
respectively, for the same components.
LIABILITIES
GENERAL
The Company derives funds principally from deposits and, to a far lesser
extent, from borrowings from the FHLB. In addition, recurring cash flows are
generated from loan repayments and payoffs and, to a lesser extent, from sales
of foreclosed properties. In addition to the Company's recurring sources of
funds, the Company has generated funds by identifying certain of its securities
and seasoned real estate loans as available-for-sale, and selling such assets in
the open market.
DEPOSITS
The Company operates six retail branches, with an average of approximately
$169.9 million in deposits per location. Total deposits at December 31, 1998
were $1.02 billion, an increase of 27.5%, or $219.9 million, from $799.5 million
at December 31, 1997. See NOTE G of the NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS.
SHORT-TERM BORROWINGS
The Company considers advances from the FHLB system its primary source of
borrowings. The Company may apply for advances from the FHLB secured by the
capital stock of the FHLB owned by the Company and certain of the Company's real
estate secured loans and other assets (principally obligations issued or
guaranteed by the U.S. Government or agencies thereof). Advances can be
requested for any business purpose in which the Company is authorized to engage.
The Company had outstanding at year-end 1998 seven borrowings from the FHLB
totaling $264.0 million at a weighted average interest rate of 5.18% and a
weighted average remaining maturity of 5 years 3 months. During 1998 FHLB
advances averaged $170.1 million at an average rate of 5.43%. This compares to
average FHLB advances of $48.6 million during 1997. See NOTE H of the NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
SENIOR NOTES
On December 31, 1997, the Company sold $40.0 million of 12.5% Senior Notes
due 2004 ("1997 Senior Notes") in a private placement (the "1997 Offering").
Concurrent with the completion of the 1997 Offering, the Company prepaid all of
its 1995 Senior Notes and redeemed all of its Series A Preferred Stock. Interest
on the 1997 Senior Notes is payable semiannually. On or after December 31, 2002,
the 1997 Senior Notes will be redeemable at any time at the option of the
Company, in whole or in part, at the redemption price of 106.25% for the
twelve-month period beginning December 31, 2002, and 103.125% beginning December
31, 2003 and thereafter until maturity.
53
57
ACCOUNTS PAYABLE AND OTHER LIABILITIES
Accounts payable and other liabilities totaled $7.6 million and $6.4
million at December 31, 1998 and 1997, respectively.
STOCKHOLDERS' EQUITY
The Company's stockholders' equity was $81.4 million at December 31, 1998,
up 92.4% from $42.3 million at December 31, 1997. The increase in stockholders'
equity is composed of earnings retention and the issuance of 2,012,500 shares of
Common Stock in July 1998.
CAPITAL RESOURCES AND LIQUIDITY
Hawthorne Financial had $20.6 million of cash on hand at December 31, 1998.
Hawthorne Financial is a holding company with no significant business operations
outside of the Bank. Its requisite obligations which pertain to its debt and
operations are dependent upon its sole source of funds which are dividends from
the Bank.
The Company's liquidity position refers to the extent to which the
Company's funding sources are sufficient to meet its current and long-term cash
requirements. Federal regulations currently require savings associations to
maintain a monthly average daily balance of liquid assets equal to 4.0% of the
average daily balance of its net withdrawable accounts and short-term borrowings
during the preceding calendar quarter. The Bank had liquidity ratios of 12.6%
and 4.74% as of December 31, 1998 and 1997, respectively.
The Company's current primary funding resources are deposit accounts,
principal payments on loans, proceeds from sales of REO, advances from the FHLB
and cash flows from operations. Other possible sources of liquidity available to
the Company include whole loan sales, commercial bank lines of credit, and
direct access, under certain conditions, to borrowings from the Federal Reserve
System. The cash needs of the Company are principally for the payment of
interest on and withdrawals of deposit accounts, the funding of loans, operating
costs and expenses, and holding and refurbishment costs on REO.
YEAR 2000 COMPLIANCE
TECHNOLOGY
Data Processing Conversion. In July 1998, the Company completed a
conversion of substantially all of its computer-based systems and applications
to an in-house, client-server platform from an outsourced, host-based platform,
following over two years of planning, design, specification, hardware and
software acquisition and resource additions. The Company believes that the new
computer-based systems and applications will provide it with the information
processing, warehousing and reporting capabilities necessary to more efficiently
and reliably support its business activities in the future.
Year 2000 Compliance. The Year 2000 issue arises because many existing
computer programs use only two digits to identify a year in a date field. These
programs were designed and developed without considering the impact of the
upcoming change in the century. If a bank does not resolve problems related to
the Year 2000 issue, computer systems may incorrectly compute payment, interest,
or delinquency information. In addition, because payment and other important
data systems are linked by computer, if the banks or other third parties with
which the Company conducts ongoing operations do not resolve this potential
problem in time, the Company may experience significant data processing delays,
mistakes or failures. These delays, mistakes or failures may have a significant
adverse impact on the financial condition, results of operations, and cash flows
of the Company.
The Company, has adopted and is implementing a plan to address Year 2000
data processing issues. The plan includes the assessment of all internal
systems, programs and data processing applications (with respect to the Company,
including the new applications which are integral to the conversion of its
computer-based systems), as well as those provided to the Company by third-party
vendors. The Company has recently completed the process of converting from an
outsourced, host-based program to an in-house client-server
54
58
computer platform. The Company has completed its own Year 2000 testing by
creating a database that rolled forward systematically until the in-house
computer systems processed data into what it believed was early 2000.
Additionally, the Company is establishing contingency plans that will provide
for alternative methods of conducting business for critical functions. These
plans are substantially completed with the documentation being refined as a
result of the findings during the testing.
The Company has conducted an extensive review of all of its third party
service providers' Year 2000 compliance and identified ninety-nine providers
that require additional examination. In the process, the Company identified five
core data systems that are third party supported or developed. All providers
have asserted that their systems are compliant.
The Company has also identified twenty-nine critical service providers
(non-data service related) of which six have asserted that they are currently
Year 2000 compliant and five have asserted that will be so by mid-1999. The
Company is developing contingency plans for business continuity for all critical
functions. While the Company has received assurances from vendors as to
compliance, such assurances are not guarantees and may not be enforceable.
The Company, through the Bank, extends principally all of its credit on a
real estate-secured basis. The Company's primary source of repayment is by cash
flow of the borrower, although the underlying real estate collateral is the
ultimate security. The Company has approximately 2,400 loans within its
portfolio of assets. In September 1998, the Company initiated an internal scan
of its borrower relationships, beginning with an assessment of larger (greater
than $3.0 million) commercial property loans, whereby it attempted to identify
those loans having a business operations component. Within this first priority
group, the Company has identified at December 31, 1998, 29 loans that total
approximately $165.7 million and have a contractual maturity beyond December 31,
1999. Because these loans have business operations aspects, the Company believes
that they may be more susceptible to Year 2000 concerns. The Company is taking
steps to assess such borrowers' Year 2000 compliance. If the borrowers fail to
be Year 2000 compliant, the Company cannot at this time determine whether such
noncompliance would affect their ability to service their debt obligation. The
Company continues to assess its exposure related to high risk borrowers that may
be adversely impacted by Year 2000 issues and expects to complete its assessment
of such borrowers by June 1999.
The Company has installed Year 2000 compliant software and hardware as part
of a conversion completed in 1998. The expense incurred and to be incurred by
the Company to ensure Year 2000 compliance is substantially integrated and was
included with the expense associated with the planned conversion of its
computer-based systems. The Company does not anticipate any material additional
expenses in 1999 related to Year 2000 software or hardware. Year 2000 testing
occurs on a continual basis upon receipt of all new releases of Year 2000
compliant software and hardware.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
The Company's profitability is dependent to a large extent upon its net
interest income, which is the difference between its interest income on
interest-earning assets, such as loans and investment securities, and its
interest expense on interest-bearing liabilities, such as deposits and
borrowings. The Bank, like other financial institutions, is subject to interest
rate risk to the degree that its interest-earning assets reprice differently
than its interest-bearing liabilities. The Bank manages its mix of assets and
liabilities with the goals of limiting its exposure to interest rate risk,
ensuring adequate liquidity, and coordinating its sources and uses of funds.
Specific strategies have included shortening the amortized maturity of
fixed-rate loans and increasing the volume of adjustable-rate loans to reduce
the average maturity of the Bank's interest-earning assets. FHLB advances are
used in an effort to extend the effective duration of interest-bearing
liabilities to better match the repricing sensitivity of interest-earning
assets.
The Bank seeks to control its interest rate risk exposure in a manner that
will allow for adequate levels of earnings and capital over a range of possible
interest rate environments. The Bank has adopted formal policies and practices
to monitor and manage interest rate risk exposure. As part of this effort, the
Bank uses the market value ("MV") methodology, a type of sensitivity analysis,
to gauge interest rate risk exposure.
55
59
Generally, MV is the discounted present value of the difference between
incoming cash flows on interest-earning assets and other assets and outgoing
cash flows on interest-bearing liabilities and other liabilities. The
application of the methodology attempts to quantify interest rate risk as the
change in the MV which would result from changes in market interest rates in
theoretical increments of 100 basis points, up to 400 basis points in either
direction.
At December 31, 1998, according to the OTS Interest Rate Risk Exposure
Report, it was estimated that the Bank's MV would decrease 4% and 15% in the
event of 200 and 400 basis point increases in market interest rates,
respectively. The Bank's MV at the same date would increase 1% and 5% in the
event of 200 and 400 basis point decreases in market rates, respectively.
Presented below, as of December 31, 1998, is an analysis of the Bank's MV
interest rate risk as measured by changes in MV for instantaneous and sustained
parallel shifts of 200 and 400 basis point increments in market interest rates.
Such amounts reflect the results of the OTS Interest Rate model using
information obtained in the Bank's quarterly filing with the OTS.
(dollars are in thousands)
AS A % OF THE PRESENT
MARKET VALUE VALUE OF ASSETS
CHANGE ------------------------------ ---------------------
IN RATES $ AMOUNT % CHANGE % CHANGE RATIO CHANGE
- -------- -------- -------- -------- ------ -------
+400 bp $121,367 $(21,158) (14.85)% 8.64% -117bp
+200 bp 137,229 (5,296) (3.72)% 9.58% -23bp
0 bp 142,525 -- -- 9.81%
- -200 bp 144,614 2,089 1.47% 9.83% +2bp
- -400 bp 150,352 7,827 5.49% 10.07% +26bp
Management believes that the MV methodology overcomes three shortcomings of
the typical maturity gap methodology. First, it does not use arbitrary repricing
intervals and accounts for all expected future cash flows; weighting each by its
appropriate discount factor. Second, because the MV method projects cash flows
of each financial instrument under different interest-rate environments, it can
incorporate the effect of embedded options on an association's interest rate
risk exposure. Third, it allows interest rates on different instruments to
change by varying amounts in response to a change in market interest rates,
resulting in more accurate estimates of cash flows.
Although the Bank believes that the results of the OTS model presented
above do accurately depict the overall risk profile and sensitivity of the Bank
to changes in interest rates, the most significant limitations of the OTS model
are its lack of sufficient detailed information concerning repricing frequency
and velocity and its use of generic market information concerning discount rates
and prepayment speeds which may not precisely predict the behavior of the Bank's
unique lending portfolio under various interest rate scenarios, both of which
result in less precise estimates of MV and sensitivity. The Bank believes that
the inclusion of more Bank-specific information would result in less sensitivity
in MV particularly to upward parallel shifts in interest rates than the results
depicted in the table above.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
See Index included in Item 14 below and the Financial Statements which
begin on the first page following the Signature Page.
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
Not Applicable
56
60
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required in ITEM 10 is hereby incorporated by reference to
the Company's definitive Proxy Statement to be filed with the Securities and
Exchange Commission for the 1999 Annual Meeting of Stockholders ("Proxy
Statement") under the captions "ELECTION OF DIRECTORS" and "SECTION 16(a)
BENEFICIAL OWNERSHIP REPORTING."
ITEM 11. EXECUTIVE COMPENSATION.
The information required in ITEM 11 is hereby incorporated by reference to
the Proxy Statement under the captions "EXECUTIVE COMPENSATION."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required in ITEM 12 is hereby incorporated by reference to
the Proxy Statement under the caption "SECURITY OWNERSHIP OF PRINCIPAL
STOCKHOLDERS AND MANAGEMENT."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required in ITEM 13 is hereby incorporated by reference to
the Proxy Statement under the caption "CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS."
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(A) The following documents are filed as part of this report:
(1) Financial Statements.
INDEPENDENT AUDITORS' REPORT
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Financial Condition as of December 31,
1998 and 1997.
Consolidated Statements of Operations for the years ended December
31, 1998, 1997 and 1996.
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997 and 1996.
Consolidated Statements of Cash Flows for the years ended December
31, 1998, 1997 and 1996.
Notes to Consolidated Financial Statements for the years ended
December 31, 1998, 1997 and 1996.
(2) Financial Statement Schedules.
Schedules are omitted because the conditions requiring their filing are
not applicable or because the required information is provided in the
Consolidated Financial Statements, including the Notes thereto.
57
61
(3) Exhibits.
Exhibits are listed by number corresponding to the Exhibit Table of Item
601 of Regulation S-K.
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
3.1 Certificate of Incorporation of the Company(1)
3.2 Amendment of Certificate of Incorporation of the Company(2)
3.3 Bylaws of the Company(1)
4.1 Specimen certificate of the Company's Common Stock(3)
4.2 Indenture, dated as of December 31, 1997, between the
Company and United States Trust Company of New York, as
Trustee, relating to the Company's 12 1/2% Notes due 2004(4)
4.3 Form of the Company's 12 1/2% Notes due 2004 (included in
Section 2.02 of the Indenture included as Exhibit 4.2)(4)
4.4 Form of Warrants to purchase an aggregate of 2,512,188
shares of Common Stock(5)
4.5 Registration Rights Agreement among the Company and certain
investors(5)
4.6 Unit Purchase Agreement among the Company and the investors
named therein(5)
10.1 Hawthorne Financial Corporation 1994 Stock Option Plan(6)
10.2 Hawthorne Financial Corporation 1995 Stock Option Plan(7)
10.4 Lease of corporate headquarters(8)
11.1 Statement on computation of per share earnings(9)
21.1 Subsidiaries of the Registrant(10)
23.1 Consent of Deloitte & Touche LLP
27.1 Financial Data Schedule
- ---------------
(1) Incorporated by reference from the Company's Registration Statement on Form
S-8 (No. 33-74800) filed on February 3, 1994.
(2) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1995.
(3) Incorporated by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1985.
(4) Incorporated by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1997, as amended on May 11, 1998 and November
3, 1998.
(5) Incorporated by reference from the Company's Current Report on Form 8-k
filed on February 7, 1996.
(6) Incorporated by reference from the Company's Registration Statement on Form
S-8 (No. 333-59879) filed on July 24, 1998.
(7) Incorporated by reference from of the Company's Registration Statement on
Form S-8 (No. 33-59875) filed on July 24, 1998.
(8) Incorporated by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1996.
(9) See Note A to the Notes from Consolidated Financial Statements included in
Item 8 and listed in Item 14 (a) of this Annual Report on Form 10-K.
(10) Incorporated by reference from the Company's Annual Report on Form 10-K for
the year ended December 21, 1994.
58
62
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
DATED: March 31, 1999 Hawthorne Financial Corporation
By: /s/ SCOTT A. BRALY
------------------------------------
Scott A. Braly,
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.
SIGNATURE DATE
--------- --------------
/s/ SCOTT A. BRALY March 31, 1999
- -----------------------------------------------------
Scott A. Braly, President and
Chief Executive Officer
(Principal Executive Officer)
/s/ SIMONE LAGOMARSINO March 31, 1999
- -----------------------------------------------------
Simone Lagomarsino, Executive Vice
President and Chief Financial Officer (Principal
Financial and Accounting Officer)
/s/ MARILYN G. AMATO March 31, 1999
- -----------------------------------------------------
Marilyn G. Amato, Director
/s/ TIMOTHY R. CHRISMAN March 31, 1999
- -----------------------------------------------------
Timothy R. Chrisman, Chairman of the Board
/s/ ANTHONY W. LIBERATI March 31, 1999
- -----------------------------------------------------
Anthony W. Liberati, Director
/s/ HARRY F. RADCLIFFE March 31, 1999
- -----------------------------------------------------
Harry F. Radcliffe, Director
/s/ HOWARD E. RITT March 31, 1999
- -----------------------------------------------------
Howard E. Ritt, Director
/s/ DOUGLAS J. WALLIS March 31, 1999
- -----------------------------------------------------
Douglas J. Wallis, Director
59
63
CONSOLIDATED FINANCIAL STATEMENTS, INDEPENDENT AUDITORS' REPORT
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
CONTENTS
PAGE
----
Independent Auditors' Report................................ F-2
Consolidated Financial Statements
Consolidated Statements of Financial Condition............ F-3
Consolidated Statements of Operations..................... F-4
Consolidated Statements of Stockholders' Equity........... F-5
Consolidated Statements of Cash Flows..................... F-6
Notes to Consolidated Financial Statements................ F-8
F-1
64
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
Hawthorne Financial Corporation
El Segundo, California:
We have audited the accompanying consolidated statements of financial
condition of Hawthorne Financial Corporation and Subsidiary (the "Company") as
of December 31, 1998 and 1997 and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1998. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based upon 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 consolidated 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, such consolidated financial statements present fairly, in
all material respects, the financial condition of Hawthorne Financial
Corporation and Subsidiary as of December 31, 1998 and 1997, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
February 26, 1999
(March 30, 1999 as to Note N)
Los Angeles, California
F-2
65
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS ARE IN THOUSANDS)
DECEMBER 31,
----------------------
1998 1997
---------- --------
ASSETS
Cash and cash equivalents (NOTE B).......................... $ 45,449 $ 51,620
Investment securities available-for-sale, at fair value
(NOTE C).................................................. -- 578
Loans receivable (net of allowance for estimated credit
losses of $17,111 in 1998 and $13,274 in 1997) (NOTE D)... 1,326,791 838,251
Real estate owned (net of allowance for estimated credit
losses of $45 in 1998 and $2,563 in 1997) (NOTE E)........ 4,070 9,859
Accrued interest receivable................................. 8,424 5,298
Investment in capital stock of Federal Home Loan Bank -- at
cost...................................................... 13,554 7,213
Office property and equipment -- at cost, net (NOTE F)...... 6,513 4,200
Deferred tax asset, net (NOTE I)............................ 2,822 6,820
Other assets................................................ 4,811 4,358
---------- --------
Total Assets...................................... $1,412,434 $928,197
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits (NOTE G)......................................... $1,019,450 $799,501
Short-term borrowings (NOTE H)............................ 264,000 40,000
Accounts payable and other liabilities.................... 7,560 6,377
Senior notes (NOTE L)..................................... 40,000 40,000
---------- --------
Total Liabilities................................. 1,331,010 885,878
Commitments and contingencies (NOTE N)
Stockholders' equity (NOTES L and M)
Preferred Stock -- $.01 par value, authorized 10,000,000
shares;
no shares outstanding.................................. -- --
Common stock -- $0.01 par value; authorized, 20,000,000
shares; issued and outstanding, 5,194,996 shares (1998)
and 3,095,996 shares (1997)............................ 52 31
Capital in excess of par value -- common stock............ 40,349 12,310
Accumulated other comprehensive income -- unrealized gain
on available-for-sale securities, net.................. -- 6
Retained earnings......................................... 41,150 30,112
Less
Treasury stock, at cost -- 5,400 shares................... (48) (48)
Loan to Employee Stock Ownership Plan (NOTE K)............ (79) (92)
---------- --------
Total Stockholders' Equity........................ 81,424 42,319
---------- --------
Total Liabilities and Stockholders' Equity.................. $1,412,434 $928,197
========== ========
The accompanying notes are an integral part of these statements.
F-3
66
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
1998 1997 1996
-------- ------- -------
Interest revenues
Loans, net of nonaccrual income........................... $102,213 $70,012 $59,722
Investments............................................... 4,779 5,604 5,632
-------- ------- -------
Total interest revenues..................................... 106,992 75,616 65,354
-------- ------- -------
Interest costs
Deposits (NOTE G)......................................... 47,642 38,920 35,568
Short-term borrowings (NOTE H)............................ 9,232 2,926 2,471
Senior notes.............................................. 5,000 1,979 1,921
-------- ------- -------
Total interest costs........................................ 61,874 43,825 39,960
-------- ------- -------
Net interest income......................................... 45,118 31,791 25,394
Provision for credit losses (NOTE D)........................ 7,135 5,137 6,067
-------- ------- -------
Net interest income after provision for credit losses....... 37,983 26,654 19,327
Noninterest revenues, net Operating......................... 4,646 3,599 1,927
Gain (Loss) on sale of securities......................... 7 (11) 248
Gain on disposition of deposits and premises (NOTE J)..... -- -- 6,413
Other non-operating....................................... (31) 112 (3,366)
-------- ------- -------
Total noninterest revenues, net............................. 4,622 3,700 5,222
Noninterest expenses
Employee.................................................. 14,414 10,606 9,507
Operating................................................. 6,177 4,470 4,337
Occupancy................................................. 3,404 2,921 2,689
Technology................................................ 2,117 816 722
Professional.............................................. 1,738 1,907 1,615
SAIF premium and OTS assessment........................... 952 1,289 2,152
Goodwill.................................................. -- -- 24
-------- ------- -------
Total noninterest expenses.................................. 28,802 22,009 21,046
(Income) loss from real estate operations, net (NOTE E)..... (1,909) (229) 2,378
-------- ------- -------
Total noninterest expenses.................................. 26,893 21,780 23,424
-------- ------- -------
Earnings before income taxes and extraordinary item......... 15,712 8,574 1,125
Income tax (expense) benefit (NOTE I)....................... (4,674) 2,577 6,382
-------- ------- -------
Earnings before extraordinary item.......................... 11,038 11,151 7,507
Extraordinary item (NOTE L)................................. -- (1,534) --
-------- ------- -------
Net earnings................................................ $ 11,038 $ 9,617 $ 7,507
======== ======= =======
Net earnings available for Common........................... $ 11,038 $ 5,254 $ 5,070
======== ======= =======
Basic earnings per share before extraordinary item (NOTE
A)........................................................ $ 2.64 $ 2.35 $ 1.95
======== ======= =======
Basic earnings per share (NOTE A)........................... $ 2.64 $ 1.82 $ 1.95
======== ======= =======
Diluted earnings per share before extraordinary item (NOTE
A)........................................................ $ 1.65 $ 1.30 $ 1.17
======== ======= =======
Diluted earnings per share (NOTE A)......................... $ 1.65 $ 1.00 $ 1.17
======== ======= =======
Weighted average basic shares outstanding (NOTE A).......... 4,176 2,883 2,599
======== ======= =======
Weighted average diluted shares outstanding (NOTE A)........ 6,692 5,235 4,341
======== ======= =======
The accompanying notes are an integral part of these statements.
F-4
67
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS ARE IN THOUSANDS)
CAPITAL IN
EXCESS OF CAPITAL IN
PAR EXCESS OF ACCUMULATED LOAN TO
VALUE- PAR OTHER EMPLOYEE
NUMBER OF PREFERRED VALUE- COMPREHENSIVE STOCK
COMMON COMMON STOCK, COMMON INCOME RETAINED TREASURY OWNERSHIP
SHARES STOCK SERIES A STOCK (LOSS) EARNINGS STOCK PLAN
--------- ------ ---------- ---------- ------------- -------- -------- ---------
Balance at January 1, 1996......... 2,605 $26 $11,592 $ 7,745 $ 6 $19,788 $ (48) $(143)
Other comprehensive income, net of
tax, net change in unrealized
gains (losses) on securities, net
of tax........................... -- -- -- (138) -- -- --
Net earnings....................... -- -- -- -- 7,507 -- --
Accrued dividends on preferred
stock............................ -- -- -- -- (2,437) -- --
Repayments......................... -- -- -- -- -- -- 24
--- ------- ------- ----- ------- ------- -----
Comprehensive Income............... -- -- -- -- -- -- --
------ --- ------- ------- ----- ------- ------- -----
Balance at December 31, 1996....... 2,605 26 11,592 7,745 (132) 24,858 (48) (119)
Exercised stock options............ 60 1 -- 295 -- -- -- --
Other comprehensive income, net of
tax, net of change in unrealized
gains (losses) on securities, net
of tax........................... -- -- -- 138 -- -- --
Net earnings....................... -- -- -- -- 9,617 -- --
Dividends paid on preferred
stock............................ 431 4 -- 4,270 -- -- -- --
Accrued dividends on preferred
stock............................ -- -- -- -- (2,455) -- --
Redemption of preferred stock...... -- (11,592) -- -- (1,908) -- --
Repayments......................... -- -- -- -- -- -- 27
--- ------- ------- ----- ------- ------- -----
Comprehensive Income...............
------ --- ------- ------- ----- ------- ------- -----
Balance at December 31, 1997....... 3,096 31 -- 12,310 6 30,112 (48) (92)
------ --- ------- ------- ----- ------- ------- -----
Exercised stock options............ 86 1 -- 436 -- -- -- --
Stock offering proceeds, net....... 2,013 20 -- 27,603 -- -- -- --
Other comprehensive income, net of
tax, net change in unrealized
gains (losses) on securities, net
of tax........................... -- -- -- (6) -- -- --
Net earnings....................... -- -- -- -- 11,038 -- --
Repayments......................... -- -- -- -- -- -- 13
--- ------- ------- ----- ------- ------- -----
Comprehensive Income...............
------ --- ------- ------- ----- ------- ------- -----
Balance at December 31, 1998....... 5,195 $52 $ -- $40,349 $ -- $41,150 $ (48) $ (79)
------ --- ------- ------- ----- ------- ------- -----
TOTAL
STOCKHOLDERS' COMPREHENSIVE
EQUITY INCOME
------------- -------------
Balance at January 1, 1996......... $ 38,966
Other comprehensive income, net of
tax, net change in unrealized
gains (losses) on securities, net
of tax........................... (138) $ (138)
Net earnings....................... 7,507 7,507
Accrued dividends on preferred
stock............................ (2,437)
Repayments......................... 24
--------
Comprehensive Income............... $ 7,369
-------- -------
Balance at December 31, 1996....... 43,922
Exercised stock options............ 296
Other comprehensive income, net of
tax, net of change in unrealized
gains (losses) on securities, net
of tax........................... 138 $ 138
Net earnings....................... 9,617 9,617
Dividends paid on preferred
stock............................ 4,274
Accrued dividends on preferred
stock............................ (2,455)
Redemption of preferred stock...... (13,500)
Repayments......................... 27
-------- -------
Comprehensive Income............... $ 9,755
-------- -------
Balance at December 31, 1997....... 42,319
--------
Exercised stock options............ 437
Stock offering proceeds, net....... 27,623
Other comprehensive income, net of
tax, net change in unrealized
gains (losses) on securities, net
of tax........................... (6) $ (6)
Net earnings....................... 11,038 11,038
Repayments......................... 13
-------- -------
Comprehensive Income............... $11,032
-------- -------
Balance at December 31, 1998....... $ 81,424
-------- -------
The accompanying notes are an integral part of these statements.
F-5
68
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS ARE IN THOUSANDS)
YEARS ENDED DECEMBER 31,
-----------------------------------
1998 1997 1996
--------- --------- ---------
NET CASH FROM OPERATING ACTIVITIES
Net earnings.......................................... $ 11,038 $ 9,617 $ 7,507
Adjustments
Income tax provision (benefit)..................... -- (2,752) (4,257)
Provision for estimated credit losses on loans..... 7,135 5,137 6,067
Provision for estimated credit losses on real
estate owned..................................... 60 913 4,933
Net gain on disposition of deposits and premises... -- (6,413)
Net (gain) loss on sale of securities.............. (7) 11 (248)
Net recoveries from sale of real estate owned...... (2,278) (1,282) (1,769)
Net loss (gain) from disposal of other assets...... 34 7 (462)
Extraordinary item................................. -- 1,534 --
Loan fee and discount accretion.................... (6,396) (3,987) (3,537)
Depreciation and amortization...................... 1,913 1,819 1,654
FHLB dividends..................................... (571) (425) (393)
Goodwill amortization.............................. -- -- 24
(Decrease) increase in:
Accrued interest receivable...................... (3,126) (517) (1,275)
Deferred tax assets, net......................... 3,435 -- --
Decrease (increase) in accounts payable and
other liabilities................................ 1,183 (14,447) 14,616
Other assets....................................... (251) (3,215) (704)
--------- --------- ---------
Net cash provided (used) by operating activities... 12,169 (7,587) 15,743
--------- --------- ---------
NET CASH FLOWS FROM INVESTING ACTIVITIES
Investment securities
Purchases.......................................... (27,919) (40,571) (139,779)
Maturities......................................... 27,900 40,795 129,576
Sales proceeds..................................... 596 37,570 34,857
Mortgage-backed securities
Principal amortization............................. -- -- 33
Loans
New loans funded................................... (487,097) (229,433) (204,914)
Construction disbursements......................... (354,326) (140,783) (61,676)
Payoffs............................................ 345,044 202,999 72,897
Sales proceeds..................................... -- 1,370 130,413
Principal amortization............................. 121,940 30,134 21,056
Other, net......................................... (118,823) (44,523) (13,137)
Real estate owned, net
Sale proceeds...................................... 15,184 32,791 26,674
Capitalized costs.................................. (1,058) (8,842) (12,015)
Other, net......................................... (2,134) 166 (4)
Purchase of FHLB stock................................ (5,770) -- --
Office property and equipment
Sales proceeds..................................... 5 9 4,566
Additions.......................................... (3,904) (726) (441)
--------- --------- ---------
Net cash used by investing activities.............. (490,362) (119,044) (11,894)
--------- --------- ---------
The accompanying notes are an integral part of these statements.
F-6
69
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS -- CONTINUED
(DOLLARS ARE IN THOUSANDS)
YEARS ENDED DECEMBER 31,
-----------------------------------
1998 1997 1996
---------- -------- ---------
NET CASH FLOWS FROM FINANCING ACTIVITIES
Cash received from sale of deposits.................... -- -- (178,884)
Other deposit activity, net............................ 219,949 81,692 204,973
Net change in borrowings............................... 224,000 (10,000) 50,000
Net proceeds from exercise of options.................. 437 296 --
Collection of ESOP loan................................ 13 27 25
Net proceeds from issuance of senior notes............. -- 40,000 --
Redemption of senior notes............................. -- (13,500) --
Proceeds from stock offering........................... 27,623 -- --
Redemption of preferred stock.......................... (13,500) --
Cash dividends paid on preferred stock................. -- (742) --
---------- -------- ---------
Net cash provided by financing activities........... 472,022 84,273 76,114
---------- -------- ---------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS......... (6,171) (42,358) 79,963
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR........... 51,620 93,978 14,015
---------- -------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR................. $ 45,449 $ 51,620 $ 93,978
========== ======== =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for
Interest............................................ $ 61,272 $ 43,937 $ 39,672
Income taxes, net................................... 3,017 -- 175
Non-cash investing and financing activities
Real estate acquired in settlement of loans......... 6,387 21,360 21,486
Loans originated to finance sales of real estate
owned............................................. 2,402 5,157 18,141
Net change in unrealized gains/(losses) on
available-for-sale securities..................... (6) 138 (138)
Accrued dividends on preferred stock................ -- 2,455 2,437
Disposal of other assets............................ 39 -- --
Loan activity
Total commitments and permanent fundings............ $1,057,368 $494,931 $ 332,325
Less:
Change in undisbursed funds on construction
commitments.................................... (213,543) (62,846) (31,914)
Loans originated to finance property sales........ (2,402) (5,157) (18,141)
Non-cash portion of refinanced loans.............. -- (6,300) --
Undisbursed portion of new lines of credit........ -- (50,412) (15,680)
---------- -------- ---------
Net construction disbursements and loans funded..... $ 841,423 $370,216 $ 266,590
========== ======== =========
The accompanying notes are an integral part of these statements.
F-7
70
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A summary of the significant accounting policies applied in the preparation
of the accompanying consolidated financial statements are set forth in the
sections which follow.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include accounts of Hawthorne
Financial Corporation ("Company") and its wholly-owned subsidiary, Hawthorne
Savings, F.S.B. ("Bank"). All material intercompany transactions and accounts
have been eliminated.
NATURE OF OPERATIONS
The Company is principally engaged in the business of attracting deposits
from the general public and using those deposits, together with borrowings and
other funds, to originate residential and income property real estate loans. The
Company's principal sources of revenue are interest earned on mortgage loans,
and fees received in connection with various deposit account services and
miscellaneous loan processing activities. The Company's principal expenses are
interest paid on deposit accounts and the costs necessary to operate the
Company.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures 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. Significant
estimates include estimates of the allowance for loan losses, valuation of real
estate owned, fair value of stock options and fair values of financial
instruments.
CASH AND CASH EQUIVALENTS
The Bank, in accordance with regulations, must maintain qualifying liquid
assets at an average monthly balance of not less than 4% of the average of all
deposits and other borrowings due in less than one year. Liquid assets consists
primarily of cash, certificates of deposit and overnight investments. In
addition, bankers' acceptances, and certain U.S. Government securities,
corporate notes and mortgage-backed securities are liquid assets for regulatory
purposes.
In the consolidated statements of financial condition and cash flows, cash
and cash equivalents include cash, amounts due from banks and overnight
investments.
INVESTMENT SECURITIES
The Company classifies debt and equity securities upon acquisition as
available-for-sale. Debt and equity securities are classified as
available-for-sale securities and reported at fair value, with unrealized gains
and losses excluded from earnings and reported as a component of other
comprehensive income.
LOANS RECEIVABLE
The Company defers all loan fees, net of certain direct costs associated
with originating loans, and amortizes these net deferred fees into interest
revenue as a yield adjustment over the lives of the loans using the interest
method for permanent loans and the straight-line method for construction loans.
When a loan is paid off, any unamortized net deferred fees are recognized in
interest income.
F-8
71
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Interest on loans, including impaired loans, is recognized in revenue as
earned and is accrued only if deemed collectible. Loans with one or more
payments delinquent are generally placed on nonaccrual status, meaning that the
Company stops accruing interest on such loans and reverses any interest
previously accrued but not collected. A nonaccrual loan may be restored to
accrual status when delinquent principal and interest payments are brought
current and future monthly principal and interest payments are expected to be
collected.
All loans are classified as held-to-maturity as the Company has the current
intent and ability to hold these loans in portfolio until maturity.
REAL ESTATE OWNED
Properties acquired through foreclosure, or deed in lieu of foreclosure
("real estate owned"), are carried at the lower of cost or estimated fair value
of the property. Subsequent declines in fair value, if any, are accounted for
through the establishment of a specific reserve on the property. The
determination of a property's estimated fair value incorporates (1) revenues
projected to be realized from disposal of the property, (2) construction and
renovation costs, (3) marketing and transaction costs and (4) holding costs
(e.g., property taxes, insurance and homeowners' association dues). For
multiple-unit residential construction and land developments, these projected
cash flows are discounted utilizing a market rate of return to determine their
fair value. In many instances following foreclosure, these properties require
significant time for the completion of construction and their marketing and
eventual sale. During this period, estimates of future revenues and costs can,
and do, vary, requiring changes in the amount of specific reserves allocated to
individual properties.
For multiple-unit, for-sale housing developments, the actual loss incurred
from the sale of individual units is charged against previously established
specific reserves when all of the foreclosed units within the project have been
sold. For individual assets, the actual loss is charged against previously
established specific reserves when the property is sold.
Based upon periodic analysis of future recoverability, changes in specific
reserves established for the Company's real estate owned portfolio are charged
to real estate operations.
ALLOWANCE FOR ESTIMATED CREDIT LOSSES
The Company establishes specific reserves for losses on individual real
estate loans when it has determined that recovery of the Company's gross
investment is not probable and when the amount of loss can be reasonably
determined. In making this determination, the Company considers (1) the current
status of the asset, (2) the probable future status of the asset, (3) the value
of the asset or underlying collateral, and (4) the Company's intent with respect
to the asset. In quantifying the loss, if any, associated with individual loans,
the Company utilizes external sources of information (i.e., appraisals, price
opinions from real estate professionals, comparable sales data and internal
estimates). In establishing specific reserves, the Company estimates the
revenues expected to be generated from disposal of the Company's collateral,
less construction and renovation costs (if any), holding costs and transaction
costs. For multiple-unit residential construction and land developments, the
resulting projected net cash flows are discounted utilizing a market rate of
return to determine their fair value.
The Company establishes general reserves against the Company's portfolio of
loans. Generally, such reserves are established for each segment of the
Company's loan portfolio, including loans secured by single family residences,
multi-family residences, commercial properties, residential construction
developments and land parcels. In establishing general reserves, the Company
incorporates (1) the recovery rate for similar properties previously sold by the
Company, (2) valuations of groups of similar assets, (3) the probability of
F-9
72
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
future adverse events (i.e., performing loans which become nonperforming, loans
in default which proceed through to foreclosure) and (4) guidelines published by
the Office of Thrift Supervision ("OTS").
A loan is impaired when it is probable that the creditor will be unable to
collect all contractual principal and interest payments under the terms of the
loan agreement. The Company measures impaired loans based on the present value
of expected future cash flows discounted at the loan's effective interest rate
or, as an expedient, the fair value of the collateral (less estimated selling
costs if foreclosure is probable) if the loan is collateral-dependent.
DEPRECIATION AND AMORTIZATION
Depreciation is provided in amounts sufficient to relate the cost of
depreciable assets to operations over their estimated service lives, on a
straight-line basis. Buildings are depreciated over their estimated useful lives
ranging from twenty to thirty years on a straight-line basis. Leasehold
improvements are amortized over the lives of their respective leases or the
service lives of the improvements, whichever is shorter. In connection with the
issuance of its 1997 Senior Notes, the Company capitalized $2.5 million of
issuance costs. In 1998, the Company amortized $361,000 of its 1997 Senior Notes
issuance costs which are being amortized over the life of the debt, which is
seven years.
INCOME TAXES
The Company and its subsidiary have historically filed a consolidated
federal income tax return and a combined state franchise tax return on a fiscal
year ending September 30. The Company has adopted a December 31 tax year-end for
its consolidated federal income tax return and its combined state franchise tax
returns beginning with a stub period ending December 31, 1998 and continuing
each year thereafter.
Deferred tax assets and liabilities represent the tax effects, calculated
at currently effective tax rates, of future deductible or taxable amounts
attributable to events that have been recognized on a cumulative basis in the
financial statements. If it is more likely than not that any of a deferred tax
asset will not be realized, a valuation allowance is recorded.
STOCK BASED COMPENSATION PLANS
The Company applies APB Opinion No. 25 and related Interpretations in
accounting for its plans, which requires accounting for stock compensation
awards based on their intrinsic value as of the grant date. However, SFAS No.
123 requires pro forma disclosure of net income and, if presented, earnings per
share, as if the fair value based method of accounting defined in this statement
had been applied. See NOTE K.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets, certain identifiable intangibles, and goodwill related
to those assets to be held and used are reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount may not be
recoverable. Furthermore, this statement requires that certain long-lived assets
and identifiable intangibles to be disposed of be reported at the lower of
historical cost or fair value less cost to sell.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," effective for the fiscal years beginning after December 15, 1997. This
statement requires that all items that are required to be recognized under
accounting standards as components of comprehensive income be reported in a
financial
F-10
73
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
statement that is displayed with the same prominence as other financial
statements. This statement further requires that a company display an amount
representing total comprehensive income for the period in that financial
statement. This statement also requires that a company classify items of other
comprehensive income by their nature in a financial statement. Reclassification
of financial statements for earlier periods, provided for comparative purposes,
is required. The adoption of this standard did not have a material impact on the
Company's consolidated financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information," effective for financial statements for
periods beginning after December 15, 1997. This statement establishes standards
for reporting information about operating segments in annual financial
statements and requires that enterprises report selected information about
operating segments in interim financial reports issued to stockholders. It also
establishes standards for related disclosures about products and services,
geographic areas and major customers. The Company has determined that it
operates a single segment, retail banking.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," effective for financial statements for
periods beginning after June 15, 1999. This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts (collectively referred to as
derivatives), and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. Adoption of this statement
is not expected to have a material impact on the Bank's consolidated financial
statements.
RECLASSIFICATIONS
Certain amounts in the 1997 and 1996 consolidated financial statements have
been reclassified to conform to the 1998 presentation.
EARNINGS PER SHARE CALCULATION
The table below sets forth the Company's earnings per share calculations
for the years ended December 31, 1998, 1997 and 1996. In the table below, (1)
Warrants refers to the Warrants issued by the Company in December 1995, and
which expire December 11, 2005, (2) "Options" refers to the outstanding stock
options granted (See NOTE K) and (3) Preferred Stock refers to the Cumulative
Perpetual Preferred Stock issued by the Company in December 1995, and redeemed
in December 1997, which carried an annual dividend equal to 18% of the face
amount of the Preferred Stock, permitted dividends thereon to be paid, under
certain circumstances, in equivalent value of the Company's common stock.
In July 1998, the Company completed an offering of 2,012,500 of its Common
Stock (including 262,500 shares issued upon exercise by the underwriters of
their overallotment option) at a price of $15.00 per share, realizing net
proceeds (after offering costs) of approximately $27.6 million. As an additional
result of this offering, the exercise price of the Warrants was reduced to
$2.128 per share and the number of shares of Common Stock purchasable upon the
exercise of the Warrants was increased to 2,512,188.
F-11
74
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(AMOUNTS ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
YEARS ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
AVERAGE SHARES OUTSTANDING
Basic..................................................... 4,176 2,883 2,599
Warrants.................................................. 2,444 2,376 2,376
Options................................................... 587 657 686
Less Treasury shares(1)(2)................................ (515) (681) (1,320)
------- ------- -------
Diluted................................................... 6,692 5,235 4,341
======= ======= =======
NET EARNINGS
Earnings before extraordinary item........................ $11,038 $11,151 $ 7,507
Preferred stock dividends................................. -- (2,455) (2,437)
Premium on redemption of Preferred Stock.................. -- (1,908) --
------- ------- -------
Earnings available for Common Stock before extraordinary
item................................................... 11,038 6,788 5,070
Extraordinary item........................................ -- (1,534) --
------- ------- -------
Net earnings available for Common Stock................... $11,038 $ 5,254 $ 5,070
======= ======= =======
Basic earnings per share before extraordinary item (NOTE
A)........................................................ $ 2.64 $ 2.35 $ 1.95
======= ======= =======
Basic earnings per share (NOTE A)........................... $ 2.64 $ 1.82 $ 1.95
======= ======= =======
Diluted earnings per share before extraordinary item (NOTE
A)........................................................ $ 1.65 $ 1.30 $ 1.17
======= ======= =======
Diluted earnings per share (NOTE A)......................... $ 1.65 $ 1.00 $ 1.17
======= ======= =======
YEAR END SHARES OUTSTANDING
Basic..................................................... 5,190 3,091 2,599
Warrants.................................................. 2,512 2,376 2,376
Options................................................... 527 722 686
Less Treasury shares(1)(2)................................ (510) (490) (1,129)
------- ------- -------
Diluted................................................... 7,719 5,699 4,532
======= ======= =======
STOCKHOLDERS' EQUITY
Basic..................................................... $81,424 $42,319 $32,330
Warrants.................................................. 5,346 5,346 5,346
Options................................................... 2,792 5,073 3,482
Less Treasury shares(1)(2)................................ (9,088) (9,012) (8,790)
------- ------- -------
Diluted................................................... $80,474 $43,726 $32,368
======= ======= =======
BASIC BOOK VALUE PER SHARE.................................. $ 15.69 $ 13.69 $ 12.44
======= ======= =======
DILUTED BOOK VALUE PER SHARE................................ $ 10.43 $ 7.67 $ 7.14
======= ======= =======
- ---------------
(1) Under the Diluted Method, it is assumed that the Company will use proceeds
from the proforma exercise of the Warrants and Options to acquire the actual
shares currently outstanding (Treasury shares).
(2) Treasury shares were assumed to be repurchased at the average closing stock
price during the period.
F-12
75
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE B -- CASH AND CASH EQUIVALENTS
Cash and cash equivalents at December 31 consist of the following:
1998 1997
------- -------
Cash and due from banks.......................... $45,449 $ 9,520
Federal funds sold............................... -- 42,100
------- -------
$45,449 $51,620
======= =======
NOTE C -- INVESTMENT SECURITIES AVAILABLE-FOR-SALE
As of December 31, 1998, the Company did not have any investment securities
available-for-sale.
As of December 31, 1997, investment securities available-for-sale consisted
of mutual funds with amortized cost of $572,000, gross unrealized gains of
$6,000 and an estimated fair value of $578,000.
For the years ended December 31, 1998, 1997 and 1996, respectively, the
Company sold investment securities available-for-sale of $596,000, $37,570,000
and $34,857,000. The Company recognized gross gains from the sale of investment
securities of $7,000 in 1998 and $248,000 in 1996, and a gross loss of $11,000
from the sale of investment securities in 1997.
Comprehensive income, comprised of unrealized holding gains arising during
the period, net of tax, and reclassification adjustments for the three years
ended December 31, is as follows:
Disclosure of reclassification amount for December 31:
1998 1997 1996
---- ---- -----
Unrealized holding gains arising during period, net of tax
expense of $2 in 1998, $0 in 1997 and 1996(1)............. $ 1 $127 $ 110
Less: Reclassification adjustment for gains included in net
income, net of tax expense of $4 in 1998, $0 in 1997 and
1996(1)................................................... 7 (11) 248
---- ---- -----
Net change in unrealized loss on securities, net of tax
(expense) or benefit...................................... $ (6) 138 (138)
==== ==== =====
- ---------------
(1) Due to loss carry forward, there was no tax liability in 1997 and 1996.
F-13
76
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D -- LOANS RECEIVABLE
Loans receivable at December 31 are summarized as follows:
1998 1997
---------- ---------
SINGLE FAMILY
Estate(1)................................................. $ 368,911 $ 173,764
Conventional(2)........................................... 207,121 222,865
INCOME PROPERTY
Multi-family.............................................. 250,876 225,738
Commercial................................................ 222,558 111,893
Development............................................... 78,425 7,310
LAND........................................................ 69,581 39,475
SINGLE FAMILY CONSTRUCTION
Single residence(3)....................................... 275,888 107,989
Tract..................................................... 85,942 68,653
OTHER....................................................... 46,615 9,698
---------- ---------
GROSS LOANS RECEIVABLE(4)................................... 1,605,917 967,385
LESS
Undisbursed funds........................................... (256,096) (108,683)
Deferred fees and credits, net.............................. (5,919) (7,177)
Allowance for estimated losses.............................. (17,111) (13,274)
---------- ---------
NET LOANS RECEIVABLE........................................ $1,326,791 $ 838,251
========== =========
- ---------------
(1) Permanent loans generally in excess of $1.0 million secured by single family
residences, primarily large custom homes and unique estates.
(2) Permanent loans secured by single family residential properties other than
loans that qualify as Estate Loans.
(3) Loans for the construction of individual, custom homes and the acquisition
of land for the construction of such homes.
(4) Gross loans receivable includes outstanding balance plus undisbursed
commitments.
F-14
77
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D -- LOANS RECEIVABLE - CONTINUED
The table below summarizes the maturities for fixed-rate loans and the
repricing intervals for adjustable-rate loans as of December 31, 1998:
PRINCIPAL BALANCE
------------------------------------
FIXED ADJUSTABLE
INTERVAL RATE RATE TOTAL
-------- -------- ---------- ----------
1 to 3 months........................................... $ 28,325 $ 855,382 $ 883,707
>3 to 6 months.......................................... 1,696 240,574 242,270
>6 to 12 months......................................... 2,607 306,758 309,365
>1 to 2 years........................................... 4,679 -- 4,679
>2 to 5 years........................................... 42,210 -- 42,210
>5 to 10 years.......................................... 8,814 -- 8,814
>10 to 20 years......................................... 15,219 -- 15,219
More than 20 years...................................... 99,653 -- 99,653
-------- ---------- ----------
$203,203 $1,402,714 $1,605,917
======== ========== ==========
The contractual weighted average interest rates on loans at December 31,
1998 and 1997 were 8.84% and 8.96%, respectively.
The table below summarizes nonaccrual loans at December 31 by type of loan.
1998(1) 1997
------- -------
SINGLE FAMILY
Estate.................................................... $35,662 $ 7,885
Conventional.............................................. 5,339 7,348
INCOME PROPERTY
Commercial................................................ 3,611 --
LAND........................................................ -- 163
SINGLE FAMILY CONSTRUCTION
Tract..................................................... 3,076 --
------- -------
$47,688 $15,396
======= =======
- ---------------
(1) Excludes $790 in loans past due 90 days or more for maturity and still
accruing interest which were in process of renewal at December 31, 1998, and
$17,305 in loans 30-89 days past due and still accruing interest.
The interest income recognized on nonaccrual loans for 1998, 1997 and 1996
was $3.3 million, $0.9 million and $1.9 million, respectively. If these loans
had been performing for the entire year, the income recognized would have been
$4.9 million, $1.4 million and $2.8 million for 1998, 1997 and 1996,
respectively.
F-15
78
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D -- LOANS RECEIVABLE - CONTINUED
The table below summarizes the amounts of interest income that would have
been recognized on troubled debt restructurings ("TDR's") had borrowers paid at
the original loan interest rate throughout each of the years below, the interest
income that would have been recognized based upon the modified interest rate,
and the interest income that was included in the consolidated statements of
operations for the periods indicated. For this purpose, a TDR is a loan with
respect to which (1) the original interest rate was changed for a defined period
of time, (2) the loan's maturity was extended, and/or (3) the Company agreed to
suspend principal or interest payments for a defined period of time.
PRINCIPAL ORIGINAL MODIFIED RECOGNIZED
BALANCE INTEREST INTEREST INTEREST
--------- -------- -------- ----------
YEAR ENDED DECEMBER 31, 1998
Permanent loans..................................... $34,276 $2,873 $2,695 $2,484
------- ------ ------ ------
YEAR ENDED DECEMBER 31, 1997
Permanent loans..................................... $29,562 $2,908 $2,665 $2,505
------- ------ ------ ------
YEAR ENDED DECEMBER 31, 1996
Construction loans.................................. $ 389 $ 43 $ 43 $ 18
Permanent loans..................................... 38,695 3,716 3,511 3,088
------- ------ ------ ------
$39,084 $3,759 $3,554 $3,106
======= ====== ====== ======
The table below summarizes the activity within the allowance for estimated
credit losses on loans for the years ended December 31:
1998 1997 1996
------- ------- -------
Balance at beginning of year................................ $13,274 $13,515 $15,192
Provision for credit losses................................. 7,135 5,137 6,067
Charge-offs................................................. (3,298) (5,378) (7,744)
------- ------- -------
Balance at year end......................................... $17,111 $13,274 $13,515
======= ======= =======
Management believes the level of allowance for estimated credit losses on
loans is adequate to absorb losses inherent in the loan portfolio; however,
circumstances might change which could adversely affect the performance of the
loan portfolio resulting in increasing loan losses which cannot be reasonably
predicted at December 31, 1998.
The recorded investment in loans considered to be impaired under SFAS No.
114 at December 31 was as follows:
1998 1997 1996
------- ------- -------
Impaired loans without specific loss
reserves.................................... $28,770 $27,970 $43,209
Impaired loans with specific loss reserves.... 41,124 24,476 8,728
Specific loss reserves allocated to impaired
loans....................................... (5,177) (2,815) (2,185)
------- ------- -------
Total impaired loans, net of
specific loss reserves............ $64,717 $49,631 $49,752
======= ======= =======
Average investment in impaired loans.......... $60,000 $50,400 $57,100
Interest income recognized on impaired
loans....................................... $ 4,879 $ 4,202 $ 3,607
F-16
79
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D -- LOANS RECEIVABLE - CONTINUED
The table below reconciles the principal balance of impaired loans and TDRs
at December 31, as follows:
1998 1997
-------- --------
Total impaired loans................................... $ 69,894 $ 52,446
Impaired loans 90 days or more days delinquent......... (13,832) (10,793)
-------- --------
Performing impaired loans.............................. 56,062 41,653
Impaired loans which are not TDRs...................... (21,956) (12,193)
-------- --------
Performing TDRs........................................ 34,106 29,460
TDRs which are 90 days or more delinquent.............. 170 102
-------- --------
Total TDRs................................... $ 34,276 $ 29,562
======== ========
LOANS TO EXECUTIVE OFFICERS AND DIRECTORS
In the ordinary course of business, the Bank has granted loans to certain
executive officers and directors and the companies with which they are
associated. In management's opinion, such loans and commitments to lend were
made under terms that are consistent with the Bank's normal lending policies.
During the year ended December 31, 1998, the Bank granted $155,000 in loans
to executive officers and directors and received repayments of $1,000, resulting
in an ending balance of $154,000. During 1997 and 1996, there were no loans to
executive officers and directors.
NOTE E -- REAL ESTATE OWNED
Real estate owned at December 31 is summarized as follows:
1998 1997
------ -------
SINGLE FAMILY
Conventional............................................ $2,509 $ 7,695
INCOME PROPERTY
Multi-family............................................ 213 2,362
Commercial.............................................. 1,393 --
LAND...................................................... -- 2,365
------ -------
GROSS INVESTMENT.......................................... 4,115 12,422
Allowance for estimated losses............................ (45) (2,563)
------ -------
NET INVESTMENT............................................ $4,070 $ 9,859
====== =======
The table below summarizes the allowance for estimated losses on real
estate owned for the years ended December 31:
1998 1997 1996
------- -------- -------
Balance at beginning of year................. $ 2,563 $ 11,871 $15,725
Provision for estimated losses............... 60 913 4,933
Charge-offs.................................. (2,578) (10,221) (8,787)
------- -------- -------
Balance at end of year....................... $ 45 $ 2,563 $11,871
======= ======== =======
F-17
80
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE E -- REAL ESTATE OWNED - CONTINUED
Real estate operations for the years ended December 31 are summarized as
follows:
1998 1997 1996
------- ------- -------
EXPENSES ASSOCIATED WITH REAL ESTATE OWNED
Property taxes.............................. $ 7 $ 119 $ 135
Repairs, maintenance and renovation......... 277 222 160
Insurance................................... 116 188 258
------- ------- -------
400 529 553
Net recoveries from sales of properties....... (2,278) (1,282) (1,769)
Rental income, net............................ (91) (389) (1,339)
Provision for estimated losses on real estate
owned....................................... 60 913 4,933
------- ------- -------
(INCOME) LOSS FROM REAL ESTATE OPERATIONS,
NET......................................... $(1,909) $ (229) $ 2,378
======= ======= =======
NOTE F -- OFFICE PROPERTY AND EQUIPMENT -- AT COST
Office property and equipment at December 31 consists of the following:
1998 1997
------- -------
Office buildings............................................ $ 1,228 $ 1,140
Furniture and equipment..................................... 7,994 4,844
Leasehold improvements...................................... 2,700 2,305
------- -------
11,922 8,289
Less
Accumulated depreciation and amortization................. (5,599) (4,279)
------- -------
6,323 4,010
Land........................................................ 190 190
------- -------
$ 6,513 $ 4,200
======= =======
The Company recognized $1.6 million, $1.2 million and $1.1 million of
depreciation expense for the years 1998, 1997 and 1996, respectively.
F-18
81
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE G -- DEPOSITS
The table below summarizes the balances by original term, weighted average
interest rates ("WAIR") and weighted average remaining maturities in months
("WARM") for the Company's deposits at December 31:
1998 1997
------------------------ ----------------------
PRODUCT TYPE BALANCE WAIR WARM BALANCE WAIR WARM
------------ ---------- ---- ---- -------- ---- ----
Non-interest bearing checking............ $ 20,292 -- -- $ 6,571 -- --
Checking/NOW............................. 35,579 2.36% -- 30,184 1.49% --
Passbook................................. 17,587 3.72% -- 20,139 1.83% --
Money market............................. 112,274 4.04% -- 48,918 3.16% --
Certificates of deposit
7 day maturities....................... 36,091 4.08% -- 42,907 4.43% --
Less than 6 months..................... 5,688 4.60% 2 35,418 5.57% 2
6 months to 1 year..................... 207,964 5.25% 3 456,072 5.80% 8
1 year to 2 years...................... 537,815 5.51% 7 146,674 5.74% 7
Greater than 2 years................... 46,160 5.40% 16 12,618 5.45% 13
---------- --------
$1,019,450 5.25% 5 $799,501 5.28% 6
========== ========
Interest expense on deposits, by type of account, for the years ended
December 31 is summarized as follows:
1998 1997 1996
------- ------- -------
Checking/NOW.................................. $ 765 $ 381 $ 212
Passbook...................................... 632 403 508
Money market.................................. 2,957 1,018 365
Certificates of deposit....................... 43,288 37,118 34,483
------- ------- -------
$47,642 $38,920 $35,568
======= ======= =======
F-19
82
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE G -- DEPOSITS - CONTINUED
The table below sets forth the remaining maturities of the Company's
certificates of deposit outstanding at December 31:
1998 1997
-------------------------------------------------------------- ------------
OVER OVER
THREE MONTHS SIX MONTHS
THREE MONTHS THROUGH THROUGH OVER THREE MONTHS
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL OR LESS
------------ ------------ ---------- -------- -------- ------------
BALANCES < $100,000
4.00% or less......................... $ 1,821 $ 632 123 $ 17 $ 2,593 $ 1,660
4.01% - 5.00%......................... 30,923 33,075 27,410 9,141 100,549 38,460
5.01% - 6.00%......................... 147,740 132,013 196,001 35,206 510,960 119,283
6.01% - 7.00%......................... 694 343 523 -- 1,560 4,834
7.01% or more......................... -- -- 100 -- 100 --
-------- -------- -------- ------- -------- --------
181,178 166,063 224,157 44,364 615,762 164,237
BALANCES >|= $100,000
4.00% or less......................... -- 100 101 -- 201 --
4.01% - 5.00%......................... 8,321 9,062 8,797 2,757 28,937 7,162
5.01% - 6.00%......................... 61,020 47,719 68,115 8,504 185,358 38,734
6.01% - 7.00%......................... 910 1,930 442 178 3,460 2,663
7.01% or more......................... -- -- -- -- -- --
-------- -------- -------- ------- -------- --------
70,251 58,811 77,455 11,439 217,956 48,559
-------- -------- -------- ------- -------- --------
Total.......................... $251,429 $224,874 $301,612 $55,803 $833,718 $212,796
======== ======== ======== ======= ======== ========
1997
-----------------------------------------------
OVER OVER
THREE MONTHS SIX MONTHS
THROUGH THROUGH OVER
SIX MONTHS ONE YEAR ONE YEAR TOTAL
------------ ---------- -------- --------
BALANCES < $100,000
4.00% or less......................... $ 15 $ 26 $ 88 $ 1,789
4.01% - 5.00%......................... 1,650 1,571 5,206 46,887
5.01% - 6.00%......................... 111,758 176,146 16,890 424,077
6.01% - 7.00%......................... 21,458 29,818 1,218 57,328
7.01% or more......................... -- -- 100 100
-------- -------- ------- --------
134,881 207,561 23,502 530,181
BALANCES >|= $100,000
4.00% or less......................... -- -- -- --
4.01% - 5.00%......................... -- 548 1,271 8,981
5.01% - 6.00%......................... 30,306 57,313 4,129 130,482
6.01% - 7.00%......................... 9,933 10,926 523 24,045
7.01% or more......................... -- -- -- --
-------- -------- ------- --------
40,239 68,787 5,923 163,508
-------- -------- ------- --------
Total.......................... $175,120 $276,348 $29,425 $693,689
======== ======== ======= ========
F-20
83
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE H -- SHORT-TERM BORROWINGS
A primary alternate funding source for the Company is a credit line with
the FHLB of San Francisco of up to 35% of the Company's total assets. The FHLB
system functions as a source of credit to savings institutions which are members
of a Federal Home Loan Bank. Advances are typically secured by the Company's
real estate loans and the capital stock of the FHLB owned by the Company.
Subject to the FHLB of San Francisco's advance policies and requirements, these
advances can be requested for any business purpose in which the Company is
authorized to engage. In granting advances, the FHLB of San Francisco considers
a member's creditworthiness and other relevant factors.
The balance and rate of FHLB advances at December 31 are summarized as
follows:
1998 1997
--------------------- ---------------------
AVERAGE AVERAGE
RATE AT RATE AT
ORIGINAL TERM PRINCIPAL YEAR END PRINCIPAL YEAR END
------------- --------- -------- --------- --------
12 Months................................. $ -- --% $ 40,000 5.95%
60 Months................................. 215,000 5.36%
120 Months................................ 49,000 4.36%
-------- --------
$264,000 5.18% $ 40,000 5.95%
======== ========
The following schedule summarizes information relating to the Company's
FHLB advances for the periods presented:
1998 1997
-------- --------
Average balance during the year............................. $170,156 $ 48,600
Average interest rate during the year....................... 5.43% 6.00%
Maximum month-end balance during the year................... $264,000 $ 75,000
Loans underlying the agreements at year end................. $750,800 $446,204
NOTE I -- INCOME TAXES
(Provision) benefit for income taxes for the years ended December 31
consist of the following:
1998 1997 1996
------- ------ ------
Current
Federal....................................... $ (654) $ -- $2,139
State......................................... (21) -- --
------- ------ ------
(675) -- 2,139
------- ------ ------
Deferred
Federal....................................... (4,013) 2,346 3,087
State......................................... 14 231 1,156
------- ------ ------
(3,999) 2,577 4,243
------- ------ ------
$(4,674) $2,577 $6,382
======= ====== ======
F-21
84
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE I -- INCOME TAXES - CONTINUED
The components of the net deferred income tax assets at December 31 are
summarized as follows:
1998 1997
------- -------
DEFERRED INCOME TAX LIABILITIES
Loan fees.............................................. $(3,629) $(2,690)
FHLB stock............................................. (1,581) (1,380)
Depreciation........................................... (395) (444)
Other.................................................. (2,835) (1,249)
------- -------
(8,440) (5,763)
------- -------
DEFERRED INCOME TAX ASSETS
Bad debts.............................................. 5,844 6,974
State NOL carryforward................................. 1,306 1,301
Federal AMT credit carryforward........................ 1,303 1,041
Federal NOL carryforward............................... 447 4,240
Other.................................................. 2,362 1,841
------- -------
11,262 15,397
------- -------
Valuation allowance...................................... -- (2,814)
------- -------
NET DEFERRED TAX ASSETS................................ $ 2,822 $ 6,820
======= =======
At December 31, 1998, the Company had (1) a federal net operating loss
carryforward of $1.3 million expiring in 2005, (2) state net operating loss
carryforwards of $3.4 million and $7.0 million expiring in 1999 and 2000,
respectively and (3) a federal alternative minimum tax credit carryover of $1.3
million which can be carried forward indefinitely.
The income tax assets (liabilities) at December 31 consist of the
following:
1998 1997
------ -------
CURRENT
Federal................................................. $ 507 $ --
State................................................... 56 --
------ -------
$ 563 $ --
------ -------
DEFERRED
FEDERAL
Income tax asset..................................... $1,420 $ 6,517
Valuation allowance.................................. -- (1,084)
STATE
Income tax asset..................................... 1,402 3,117
Valuation allowance.................................. -- (1,730)
------ -------
DEFERRED TAX ASSET........................................ $2,822 $ 6,820
------ -------
TOTAL........................................... $3,385 $ 6,820
====== =======
F-22
85
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE I -- INCOME TAXES - CONTINUED
The table below summarizes the differences between the statutory income tax
and the Company's effective tax for the years ended December 31:
1998 1997 1996
------- ------- ------
Federal income (tax) benefit................... $(5,497) $(2,464) $ (393)
Reduction (addition) resulting from Change in
Federal valuation allowance.................. 1,084 4,826 6,090
Goodwill amortization and charge-off......... -- -- (13)
California franchise tax, net of federal
income taxes.............................. (5) 152 763
Other........................................ (256) 63 (65)
------- ------- ------
$(4,674) $ 2,577 $6,382
======= ======= ======
NOTE J -- DISPOSITION OF DEPOSITS AND PREMISES
During 1996, the Company sold certain of its branch deposits and sold or
closed the related branch facilities, consolidated deposits from certain
branches and sold the related facilities, and sold its two owned corporate
office buildings. The table below sets forth the composition of the net gain or
loss realized from these transactions for the year ended December 31, 1996:
Deposits sold............................................. $186,573
========
Net premium received from sales of deposits............... $ 6,305
Net gain on disposition of premises proceeds received..... 1,826
Net book value at disposition............................. (1,479)
--------
Net gain from disposition of premises..................... 347
Other sale-related expenses............................... (239)
--------
Net gain.................................................. $ 6,413
========
The Company did not sell or close branch facilities during 1998 or 1997.
NOTE K -- EMPLOYEE BENEFIT PLANS
The Company has an Employee Stock Ownership Plan ("ESOP") that previously
covered substantially all employees over 21 years of age who met minimum service
requirements. As of December 15, 1995, the Company froze the ESOP and all
accounts became fully vested and nonforfeitable. At December 31, 1998, the ESOP
owned 111,968 shares of the Company's common stock. As of December 31, 1998, the
Company had a loan receivable from the ESOP of $79,000 collateralized by 5,833
shares of common stock owned by the ESOP.
Effective April 1, 1996, the ESOP was amended to include a 401(k) plan. The
Company makes a matching contribution equal to 100% of the amount each
participant elects to defer up to a maximum of 3% of the participant's
compensation for the calendar quarter. Employees are eligible to participate if
they were employed by the Company on March 1, 1996 or have been employed for 6
months, worked at least 500 hours, and are over 21 years of age.
The Company had a retirement income plan ("Retirement Plan") that
previously covered substantially all employees over 21 years of age who met
minimum service requirements. The Company terminated the Retirement Plan as of
July 1997.
F-23
86
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE K -- EMPLOYEE BENEFIT PLANS - CONTINUED
The Company has two stock option plans ("Option Plans"), one of which
provides for the issuance of stock options to directors and employees of the
Company and the other of which provides for the issuance of stock options to
employees other than certain executive officers of the Company. At December 31,
1998, the Option Plans provide for the issuance of an aggregate of a maximum of
1,100,000 shares of common stock of the Company upon exercise of options. The
exercise price of any option may not be less than the fair market value of the
common stock on the date of grant and the term of any option may not exceed 10
years.
A summary of the status of the Option Plans as of December 31, and changes
during the years ended on those dates, is presented below:
1998 1997 1996
------------------ ------------------ ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------- -------- ------- -------- ------- --------
Outstanding at beginning of
year........................... 721,800 $ 7.03 686,000 $ 5.08 696,000 $4.95
Granted.......................... 255,000 17.23 120,000 16.77 36,000 7.81
Exercised........................ (86,500) 5.06 (60,200) 4.92 -- --
Terminated....................... (8,000) 5.26 (24,000) 5.26 (46,000) 5.26
------- ------- -------
Outstanding at year end.......... 882,300 10.19 721,800 7.03 686,000 5.08
======= ======= =======
Options exercisable at year
end............................ 580,400 372,934 226,050
======= ======= =======
The following table summarizes information about stock options outstanding
at December 31, 1998:
WEIGHTED AVERAGE
EXERCISE NUMBER REMAINING CONTRACTUAL LIFE NUMBER
PRICE OUTSTANDING (YEARS) EXERCISABLE
- -------- ----------- -------------------------- -----------
$ 4.65 293,000 4.92 293,000
5.26 178,300 7.00 165,400
7.81 36,000 7.92 24,000
10.50 20,000 6.42 6,667
16.31 145,000 8.00 --
18.02 100,000 6.92 41,333
18.44 110,000 6.58 50,000
------- -------
10.19(1) 882,300 6.44 580,400
======= =======
- ---------------
(1) Weighted average.
If compensation costs for the Option Plans had been determined based on the
fair value at the grant date for awards in 1998, 1997 and 1996 consistent with
the provisions of SFAS No. 123, the Company's net
F-24
87
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE K -- EMPLOYEE BENEFIT PLANS - CONTINUED
earnings and net earnings per share would have been reduced to the pro forma
amounts indicated below (dollar amounts in tables are in thousands, except per
share data):
1998 1997 1996
------- ------ ------
Net earnings -- as reported............................. $11,038 $9,617 $7,507
======= ====== ======
Net earnings -- pro forma............................... $ 9,371 $8,880 $6,646
======= ====== ======
Basic earnings per share -- as reported................. $ 2.64 $ 1.82 $ 1.95
======= ====== ======
Basic earnings per share -- pro forma................... $ 2.24 $ 1.57 $ 1.62
======= ====== ======
Diluted earnings per share -- as reported............... $ 1.65 $ 1.00 $ 1.17
======= ====== ======
Diluted earnings per share -- pro forma................. $ 1.40 $ 0.86 $ 0.97
======= ====== ======
Weighted average fair value at date of grant............ $ 8.33 $ 7.99 $ 3.81
======= ====== ======
The fair value of options granted under the Option Plans were estimated on
the date of grant using the Black-Scholes option-pricing model. In 1998, the
following weighted average assumptions were used: no dividend yield, expected
volatility of 33%, risk free interest rate of 5.25% and expected lives of 5 to 8
years. In 1997, no dividend yield, expected volatility of 123%, risk free
interest rate of 5.7% and expected lives of 3 to 5 years. In 1996, no dividend
yield, expected volatility of 124%, risk free interest rate of 5.6% and expected
lives of 3 to 5 years.
NOTE L -- CAPITAL AND DEBT OFFERINGS
In December 1995, the Company sold $27.0 million of "investment units" at a
price of $500,000 per unit in a private placement offering (the "1995
Offering"). Each investment unit consisted of $250,000 principal amount of the
Company's senior notes due 2000 ("1995 Senior Notes"), five shares of the
Company's cumulative preferred stock, series A ("Series A Preferred"), and one
warrant to purchase 44,000 shares of the Company's common stock ("Warrants").
The Company contributed $19.0 million of the net proceeds of the Offering as
qualifying Tier 1 capital to the Bank.
The Company recorded the 1995 Senior Notes, with a face amount of $13.5
million, at $12.0 million. Interest was payable semiannually at a rate of 12.0%
per annum on the face amount and had an effective annual cost of 15.87% during
1997 after recording the effect of the Original Issue Discount ("OID") of $1.5
million. The accretion of the OID was to be recognized using the constant yield
method over the five-year term of the Senior Notes. During 1997 and 1996, the
Company recorded $350,000 and $301,000, respectively, of OID as part of its
interest expense.
The Company also recorded the receipt of $12.8 million from the issuance of
270 shares of Series A Preferred with a par value of $.01 as Capital in Excess
of Par Value -- Cumulative Preferred Stock, Series A. The Series A Preferred
provided for cumulative dividends, payable quarterly commencing June 1997 at an
annual rate of 18% on the $13.5 million liquidation preference of the stock.
The Company recorded $2.2 million of the proceeds from the sale of the
units to the Warrants as additional paid in capital. The Warrants entitle the
holders to purchase up to an aggregate of 2.5 million shares of common stock for
$2.128 per share and expire in December 2005.
On December 31, 1997, the Company sold $40.0 million of 12.5% Senior Notes
due 2004 ("1997 Senior Notes") in a private placement (the "1997 Offering"),
which included registration rights. Concurrent with the completion of the 1997
Offering, the Company prepaid all of its 1995 Senior Notes and redeemed all of
its
F-25
88
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE L -- CAPITAL AND DEBT OFFERINGS - CONTINUED
Series A Preferred. The 1995 Senior Notes and Series A Preferred were retired at
par plus accrued interest and dividends, which approximated $27.2 million. This
repayment and redemption resulted in the write-off of the remaining OID ($0.8
million) and prepaid offering costs ($0.7 million) as an extraordinary item. Net
proceeds after the offering costs and the prepayment of the 1995 Senior Notes
and Series A Preferred amounted to approximately $10.4 million, funds which
became available to the Company for general corporate purposes, inclusive of
supporting the planned business activities of the Bank.
Interest on the 1997 Senior Notes is payable semiannually. On or after
December 31, 2002, the 1997 Senior Notes will be redeemable at any time at the
option of the Company, in whole or in part, at the redemption price of 106.25%
for the twelve-month period beginning December 31, 2002, and 103.125%
thereafter.
In July 1998, the Company sold 2,012,500 shares of its common stock
(including 262,500 shares, issued upon exercise by the underwriters of their
over allotment option) at a price of $15.00 per share, realizing net proceeds
(after offering costs) of approximately $27.6 million. As a result of this
offering, the exercise price of the Warrants was reduced to $2.128 and the
number of shares of common stock acquirable upon the exercise of the Warrants
was increased to 2,512,188.
NOTE M -- STOCKHOLDERS' EQUITY
Retained earnings, which includes bad debt deductions of approximately
$21.3 million for federal income tax purposes at December 31, 1998, are
restricted and may be used only for the absorption of losses on loans and real
estate acquired through foreclosure. Retained earnings are not subject to
federal income tax unless used for other purposes. The Company has not provided
for federal income tax on these amounts, since it is not contemplated that such
amounts will be used for purposes other than to absorb such losses.
The Bank is subject to various regulatory capital requirements administered
by the federal banking agencies. Failure to meet minimum capital requirements
can initiate certain mandatory and possible additional discretionary actions by
regulators that, if undertaken, could have a direct material effect on the
Bank's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
following table) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), to average assets (as defined). Management
believes, as of December 31, 1998, that the Bank meets all capital adequacy
requirements to which it is subject.
As of December 31, 1998 and 1997, the most recent notification from the OTS
categorized the Bank as well capitalized under the regulatory framework for
Prompt Corrective Action Rules. There are no conditions or events since that
notification that management believes have changed the Bank's category. The
following
F-26
89
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE M -- STOCKHOLDERS' EQUITY - CONTINUED
table sets forth as of December 31, 1998 and 1997, the Bank's actual regulatory
capital amounts and ratios and the regulatory capital amounts and ratios for the
Bank to be "adequately capitalized" and "well capitalized."
TO BE CATEGORIZED
AS ADEQUATELY TO BE CATEGORIZED
ACTUAL CAPITALIZED AS WELL CAPITALIZED
----------------- ------------------ -------------------
AMOUNT RATIOS AMOUNT RATIOS AMOUNT RATIOS
-------- ------ -------- ------- --------- -------
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
AS OF DECEMBER 31, 1998:
Total capital (to Risk weighted
assets)............................... $119,400 11.10% $86,090 8.00% $107,612 10.00%
Core capital (to Adjusted tangible
assets)(1)............................ 108,673 7,65% 56,804 4.00% 71,005 5.00%
Tangible capital (to Tangible assets).... 108,673 7.65% 21,302 1.50% N/A N/A
Tier 1 capital (to Risk weighted
assets)............................... 108,673 10.10% N/A N/A 64,567 6.00%
AS OF DECEMBER 31, 1997:
Total capital (to Risk weighted
assets)............................... $ 78,454 11.48% $54,679 8.00% $ 68,349 10.00%
Core capital (to Adjusted tangible
assets)(1)............................ 69,906 7.55% 37,031 4.00% 46,289 5.00%
Tangible capital (to Tangible assets).... 69,906 7.55% 13,887 1.50% N/A N/A
Tier 1 capital (to Risk weighted
assets)............................... 69,906 10.23% N/A N/A 41,009 6.00%
- ---------------
(1) The term "adjusted tangible assets" refers to the term "adjusted total
assets" as defined in 12 C.F.R. Section 567.1(a) for purposes of tangible
and core capital requirements, and refers to the term "risk-weighted assets"
as defined in 12 C.F.R. Section 567.1(b) for purposes of risk-based capital
requirements.
NOTE N -- COMMITMENTS AND CONTINGENCIES
LITIGATION
The Bank is a defendant in an action entitled Takaki vs. Hawthorne Savings
and Loan Association, filed in the Superior Court of the State of California,
Los Angeles, as Case No. YC021815. The plaintiffs were owners of real property
which they sold in early 1992 to a third party. The Bank provided escrow
services in connection with the transaction. A substantial portion of the
consideration paid to the plaintiffs took the form of a deed of trust secured by
another property then owned by an affiliate of the purchaser. The value of the
collateral securing this deed of trust ultimately proved to be inadequate. The
plaintiffs alleged that the Bank knew, or should have known, that the security
that the plaintiffs received as sellers was inadequate and should have so
advised them. In late June 1997, a trial jury found for the plaintiffs and
awarded compensatory and punitive damages totaling $9.1 million. In late July
1997, the trial judge reduced the combined award to $3.3 million. The plaintiffs
accepted the reduced judgment. The Bank filed a Notice of Appeal from the
judgment and posted an Appeal Bond with the Court to stay plaintiffs'
enforcement of the judgment pending the Appellate Court's decision. After the
defendants and plaintiffs filed their respective appellate briefs and other
necessary pleadings and oral arguments were presented, in late July, 1998, the
Appellate Court remanded the case to the Superior Court with directions to
dismiss the fraudulent concealment, misrepresentation and punitive damages
claims and to conduct a new trial pertaining solely to damages arising from
negligence, in particular to determine whether any negligence of the Bank
contributed to the plaintiffs' injury and, if so, to apportion liability for
negligence between the Bank and the plaintiffs. On March 30, 1999, the jury
returned a verdict in favor of the plaintiffs in the amount of $1.8 million plus
pre-judgement interest. The Bank intends to file a notice of appeal from this
judgement. The Bank believes that there is a substantial likelihood that its
position will ultimately be upheld on appeal and, accordingly, that no amounts
having a
F-27
90
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE N -- COMMITMENTS AND CONTINGENCIES - CONTINUED
materially adverse effect on the Bank's or the Company's financial conditions or
operations will be paid by the Bank to the plaintiffs in this matter. There can
be no assurances that this will be the case, however.
The Company is involved, in the normal course of business, in a variety of
other litigation matters. In the opinion of management, none of these cases will
have a material adverse effect on the Bank's or the Company's financial
condition or results of operations.
LENDING COMMITMENTS
At December 31, 1998, the Company had commitments to fund the undisbursed
portion of existing construction and land loans of $235.1 million and
commitments to fund the undisbursed portion of existing lines of credit of $20.9
million.
ERRORS AND OMISSIONS INSURANCE
The Company had a mortgagee's errors and omissions insurance policy as of
December 31, 1998. The Company did not have errors and omissions insurance on
other aspects of its operation.
LEASES
The Company has entered into agreements to lease certain office facilities
under operating leases which expire at various dates to the year 2010. The
leases generally provide that the Company pay property taxes, insurance and
other items. Current rental commitments for the remaining terms of these
noncancelable leases as of December 31, 1998 are as follows:
AMOUNT
-------
1999....................................... $ 1,662
2000....................................... 1,536
2001....................................... 1,754
2002....................................... 1,415
2003....................................... 1,376
Thereafter................................. 2,654
-------
$10,397
=======
Lease expense for office facilities was $1.4 million, $1.0 million and $1.0
million for the years ended December 31, 1998, 1997 and 1996, respectively.
NOTE O -- ESTIMATED FAIR VALUE INFORMATION
The following disclosure of the estimated fair value of financial
instruments is made in accordance with the requirements of SFAS No. 107,
"Disclosures about Fair Value of Financial Instruments." The estimated fair
value amounts have been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is required to interpret market data to develop the estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the
F-28
91
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE O -- ESTIMATED FAIR VALUE INFORMATION - CONTINUED
amounts the Company could realize in a current market exchange. The use of
different market assumptions and or estimation methodologies may have a material
effect on the estimated fair value amounts.
1998 1997
------------------------ ---------------------
ESTIMATED ESTIMATED
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
---------- ---------- -------- ---------
ASSETS
Cash and cash equivalents.................. $ 45,449 $ 45,449 $ 51,620 $ 51,620
Investment securities...................... -- -- 578 578
Loans receivable........................... 1,326,791 1,357,988 838,251 848,989
Investment in FHLB stock................... 13,554 13,554 7,213 7,213
LIABILITIES
DEPOSITS
Money market............................ 112,274 112,274 48,918 48,918
Passbook................................ 17,587 17,587 20,139 20,139
Checking/NOW............................ 35,579 35,579 30,177 30,177
Certificates of deposit................. 833,718 832,920 693,689 693,887
Noninterest bearing demand.............. 20,292 20,292 6,578 6,578
FHLB advances.............................. 264,000 268,570 40,000 40,106
Senior Notes............................... 40,000 39,200 40,000 40,000
The methods and assumptions used to estimate the fair value of each class
of financial instruments for which it is practicable to estimate that value are
explained below.
For cash and cash equivalents, the carrying amount is considered to be
their estimated fair value.
For investment securities, fair values are based on quoted market prices
obtained from an independent pricing service (NOTES A and C).
For FHLB stock, the carrying amount approximates fair value, as the stock
may be sold back to the FHLB at the carrying value.
The carrying amount of loans receivable is their contractual amounts
outstanding reduced by net deferred loan origination fees and the allowance for
loan losses (NOTE D). Adjustable rate loans consist primarily of loans whose
interest rates float with changes in either a specified bank's reference rate or
the FHLB eleventh district cost of funds index.
The fair value of both adjustable and fixed rate loans was estimated by
discounting the remaining contractual cash flows using the estimated current
rate at which similar loans would be made to borrowers with similar credit risk
characteristics over the same remaining maturities, reduced by net deferred loan
origination fees and the allocable portion of the allowance for the loan losses.
The estimated current rate for discounting purposes was not adjusted for any
change in borrowers' credit risks since the origination of such loans. Rather,
the allocable portion of the allowance for loan losses is considered to provide
for such changes in estimating fair value.
The fair value of nonaccrual loans (NOTE D) has been estimated at the
carrying amount of these loans, as it is not practicable to reasonably assess
the credit risk adjustment that would be applied in the market place for such
loans.
F-29
92
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE O -- ESTIMATED FAIR VALUE INFORMATION - CONTINUED
The withdrawable amounts for checking, money market, and non-interest
bearing demand accounts are considered to be stated at their estimated fair
value. The fair value of passbook accounts and fixed-maturity certificates of
deposit is estimated using the rates currently offered for deposits of similar
remaining maturities.
The fair value of FHLB advances is estimated using the rates currently
offered on similar instruments with similar terms.
The fair value of Senior Notes in 1998 is based on quoted market price. The
Senior Notes were issued December 31, 1997 and therefore the fair value at
December 31, 1997 is considered to be the carrying amount. The Senior Notes have
a stated coupon interest rate of 12.5% and mature December 31, 2004.
Additionally, optional commitments to originate mortgages are excluded from
this presentation because such commitments are typically at market terms, are
typically for adjustable rate loans, and are generally cancellable by borrower
without significant fees or costs upon cancellation.
The fair value estimates presented herein are based on pertinent
information available to management as of December 31, 1998 and 1997. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been comprehensively
revalued for purposes of these financial statements since that date and,
therefore, current estimates of fair value may differ significantly from the
amounts presented above.
F-30
93
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE P -- SEPARATE PARENT COMPANY FINANCIAL STATEMENTS
STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31,
-------------------
1998 1997
-------- -------
ASSETS
Cash at the Bank and cash equivalents....................... $ 20,637 $ 9,944
Loan receivable, net........................................ 150 --
Investment in subsidiary.................................... 108,673 69,906
Other assets................................................ 2,184 2,501
-------- -------
TOTAL ASSETS................................................ $131,644 $82,351
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and other liabilities...................... $ 10,220 $ 32
Senior notes................................................ 40,000 40,000
-------- -------
TOTAL LIABILITIES........................................... $ 50,220 $40,032
======== =======
STOCKHOLDERS' EQUITY
Preferred Stock -- $0.01 par value, authorized 10,000,000
shares no outstanding.................................. -- --
Common stock -- $0.01 par value; authorized 20,000,000
shares; issued and outstanding, 5,194,996 shares (1998)
and 3,095,996 shares (1997)............................ $ 52 $ 31
Capital in excess of par value -- common stock............ 40,349 12,310
Accumulated other comprehensive income.................... -- 6
Retained earnings......................................... 41,150 30,112
Less
Treasury stock, at cost -- 5,400 shares................... (48) (48)
Loan to Bank ESOP......................................... (79) (92)
-------- -------
TOTAL STOCKHOLDERS' EQUITY.................................. 81,424 42,319
-------- -------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $131,644 $82,351
======== =======
F-31
94
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(AMOUNTS IN TABLES ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE P -- SEPARATE PARENT COMPANY FINANCIAL STATEMENTS - CONTINUED
STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
INTEREST REVENUES
Investments............................................... $ 571 $ 95 $ 246
From subsidiary........................................... -- 10 16
------- ------- -------
Total interest revenues..................................... 571 105 262
Interest costs.............................................. 5,000 1,979 1,921
------- ------- -------
Net interest income......................................... (4,429) (1,874) (1,659)
NONINTEREST REVENUES, NET
Operating................................................. 1 21 13
Loss on sale of securities................................ -- (10) --
Other non-operating....................................... -- (1) (1)
Operating costs............................................. (1,307) (882) (910)
------- ------- -------
Loss before income taxes, equity in subsidiary, and
extraordinary item........................................ (5,735) (2,746) (2,557)
Income tax expense.......................................... -- -- --
------- ------- -------
Loss before equity in subsidiary and extraordinary item..... (5,735) (2,746) (2,557)
Equity in earnings of subsidiary............................ 16,773 13,897 10,064
------- ------- -------
Earnings before extraordinary item.......................... 11,038 11,151 7,507
Extraordinary item.......................................... -- (1,534) --
------- ------- -------
NET EARNINGS................................................ $11,038 $ 9,617 $ 7,507
======= ======= =======
Net earnings available for Common........................... $11,038 $ 5,254 $ 5,070
======= ======= =======
Basic earnings per share before extraordinary item.......... $ 2.64 $ 2.35 $ 1.95
======= ======= =======
Basic earnings per share.................................... $ 2.64 $ 1.82 $ 1.95
======= ======= =======
Diluted earnings per share before extraordinary item........ $ 1.65 $ 1.30 $ 1.17
======= ======= =======
Diluted earnings per share.................................. $ 1.65 $ 1.00 $ 1.17
======= ======= =======
Weighted average basic shares outstanding................... 4,176 2,883 2,599
======= ======= =======
Weighted average diluted shares outstanding................. 6,692 5,235 4,341
======= ======= =======
F-32
95
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE P -- SEPARATE PARENT COMPANY FINANCIAL STATEMENTS - CONTINUED
STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net earnings............................................. $ 11,038 $ 9,617 $ 7,507
Adjustments
Equity in undistributed earnings of subsidiary........ (16,773) (13,897) (10,064)
Depreciation and amortization......................... 361 582 479
Decrease (increase) in interest receivable............ -- 16 (2)
Loss on early extinguishment of debt.................. -- 1,534
Loss of sale of investments........................... -- 10 --
Increase in other assets.............................. (44) (2,451) --
Increase (decrease) in accounts payable and other
liabilities......................................... 10,188 (79) (228)
-------- -------- --------
NET CASH PROVIDED BY (USED IN) OPERATING
ACTIVITIES....................................... 4,770 (4,668) (2,308)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities.................................. (27,900) -- --
Maturities of securities................................. 27,900 795 1,677
Proceeds from sale of securities......................... -- 2,414 --
Net increase in loans receivable......................... (150) -- --
-------- -------- --------
Net cash provided by investing activities........... (150) 3,209 1,677
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from exercise of options.................... 437 296 --
Net collection of ESOP loan.............................. 13 27 24
Cash contribution to subsidiary.......................... (22,000) (3,400) --
Cash dividends received.................................. -- 1,000 --
Net proceeds from issuance of senior notes............... -- 40,000 --
Redemption of senior notes............................... -- (13,500) --
Redemption of preferred stock............................ -- (13,500) --
Stock offering proceeds, net............................. 27,623
Cash dividends paid on preferred stock................... -- (742) --
-------- -------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES........... 6,073 10,181 24
-------- -------- --------
Increase (decrease) in cash.............................. 10,693 8,722 (607)
Cash at beginning of year................................ 9,944 1,222 1,829
-------- -------- --------
CASH AT END OF YEAR...................................... $ 20,637 $ 9,944 $ 1,222
======== ======== ========
NON-CASH INVESTING AND FINANCING ITEMS
Net change in unrealized gain (loss) on
available-for-sale securities....................... $ (6) $ 19 $ (25)
Accrued dividends on preferred stock.................. -- 2,455 2,437
F-33
96
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(AMOUNTS IN TABLES ARE IN THOUSANDS EXCEPT PER SHARE DATA)
NOTE Q -- QUARTERLY INFORMATION (UNAUDITED)
THREE MONTHS ENDED
---------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
YEAR ENDED DECEMBER 31, 1998
Interest revenues.............................. $21,994 $25,097 $28,924 $30,977
Interest costs................................. 12,918 14,497 16,622 17,837
------- ------- ------- -------
Net interest income............................ 9,076 10,600 12,302 13,140
Provision for credit losses.................... 1,485 1,750 1,950 1,950
------- ------- ------- -------
Net interest income after provision for credit
losses....................................... 7,591 8,850 10,352 11,190
NONINTEREST REVENUES, NET
Operating.................................... 709 1,460 1,372 1,105
Gain/loss on sale of securities.............. -- -- 10 --
Other non-operating.......................... 4 (8) (20) (10)
------- ------- ------- -------
Total noninterest revenue, net................. 713 1,452 1,362 1,095
NONINTEREST EXPENSES
Operating costs.............................. 6,280 6,791 7,240 8,491
(Income) loss from real estate operations,
net....................................... (333) (1,031) (616) 71
------- ------- ------- -------
Total noninterest expenses..................... 5,947 5,760 6,624 8,562
Earnings before income taxes and extraordinary
item......................................... 2,357 4,542 5,090 3,723
Income tax expense............................. (524) (1,370) (1,632) (1,148)
------- ------- ------- -------
Earnings before extraordinary item............. 1,833 3,172 3,458 2,575
Extraordinary item............................. -- -- -- --
------- ------- ------- -------
NET EARNINGS................................... $ 1,833 $ 3,172 $ 3,458 $ 2,575
======= ======= ======= =======
Net earnings available for Common.............. $ 1,833 $ 3,172 $ 3,458 $ 2,575
======= ======= ======= =======
Basic earnings per share before extraordinary
item......................................... $ 0.58 $ 1.00 $ 0.67 $ 0.50
======= ======= ======= =======
Basic earnings per share....................... $ 0.58 $ 1.00 $ 0.67 $ 0.50
======= ======= ======= =======
Diluted earnings per share before extraordinary
item......................................... $ 0.32 $ 0.56 $ 0.45 $ 0.33
======= ======= ======= =======
Diluted earnings, per share.................... $ 0.32 $ 0.56 $ 0.45 $ 0.33
======= ======= ======= =======
Weighted average basic shares outstanding...... 3,157 3,168 5,189 5,190
======= ======= ======= =======
Weighted average diluted shares outstanding.... 5,681 5,663 7,732 7,692
======= ======= ======= =======
F-34
97
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(AMOUNTS IN TABLES ARE IN THOUSANDS EXCEPT PER SHARE DATA)
NOTE Q -- QUARTERLY INFORMATION (UNAUDITED) - CONTINUED
THREE MONTHS ENDED
---------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
YEAR ENDED DECEMBER 31, 1997
Interest revenues............................... $17,007 $18,748 $19,382 $20,479
Interest costs.................................. 10,155 10,826 11,275 11,569
------- ------- ------- -------
Net interest income............................. 6,852 7,922 8,107 8,910
Provision for credit losses..................... 1,220 1,019 1,500 1,398
------- ------- ------- -------
Net interest income after provision for credit
losses........................................ 5,632 6,903 6,607 7,512
NONINTEREST REVENUES, NET
Operating..................................... 732 832 1,126 909
Loss on sale of securities.................... -- (10) (1) --
Other non-operating........................... (13) 10 220 (105)
------- ------- ------- -------
Total noninterest revenues, net................. 719 832 1,345 804
NONINTEREST EXPENSES
Operating costs............................... 5,424 5,244 5,202 6,139
Loss (income) from real estate operations,
net........................................ 260 2 (489) (2)
------- ------- ------- -------
Total noninterest expenses...................... 5,684 5,246 4,713 6,137
Earnings before income taxes and extraordinary
item.......................................... 667 2,489 3,239 2,179
Income tax benefit (expense).................... 692 935 (25) 975
------- ------- ------- -------
Earnings before extraordinary item.............. 1,359 3,424 3,214 3,154
Extraordinary item.............................. -- -- -- (1,534)
------- ------- ------- -------
NET EARNINGS.................................... $ 1,359 $ 3,424 $ 3,214 $ 1,620
======= ======= ======= =======
Net earnings (loss) available for Common........ $ 750 $ 2,815 $ 2,606 $ (914)
======= ======= ======= =======
Basic earnings per share before extraordinary
item.......................................... $ 0.29 $ 1.02 $ 0.85 $ 0.20
======= ======= ======= =======
Basic earnings (loss) per share................. $ 0.29 $ 1.02 $ 0.85 $ (0.30)
======= ======= ======= =======
Diluted earnings per share before extraordinary
item.......................................... $ 0.16 $ 0.57 $ 0.47 $ 0.11
======= ======= ======= =======
Diluted earnings, (loss) per share.............. $ 0.16 $ 0.57 $ 0.47 $ (0.16)
======= ======= ======= =======
Weighted average shares outstanding............. 4,794 4,959 5,507 5,622
======= ======= ======= =======
F-35
98
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE R -- CONSOLIDATING SCHEDULES
HAWTHORNE HAWTHORNE
SAVINGS FINANCIAL ELIMINATIONS CONSOLIDATED
---------- --------- ------------ ------------
ASSETS
Cash and cash equivalents.................. $ 45,449 $ 20,637 $ (20,637) $ 45,449
Investment in subsidiary................... -- 108,673 (108,673) --
Loans receivable, net...................... 1,326,653 150 (12) 1,326,791
Real estate owned, net..................... 4,070 -- -- 4,070
Accrued interest receivable................ 8,424 -- -- 8,424
FHLB stock................................. 13,554 -- -- 13,554
Office property and equipment.............. 6,513 -- -- 6,513
Other assets............................... 15,437 2,184 (9,988) 7,633
---------- -------- --------- ----------
TOTAL ASSETS............................... $1,420,100 $131,644 $(139,310) $1,412,434
========== ======== ========= ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits................................. $1,040,087 $ -- $ (20,637) $1,019,450
Borrowings............................... 264,000 -- -- 264,000
Accounts payable and other liabilities... 7,340 10,220 (10,000) 7,560
Senior debt.............................. -- 40,000 -- 40,000
---------- -------- --------- ----------
TOTAL LIABILITIES.......................... 1,311,427 50,220 (30,637) 1,331,010
STOCKHOLDERS' EQUITY
Capital stock............................ 150 52 (150) 52
Capital in excess of par value -- common
stock................................. 46,165 40,349 (46,165) 40,349
Retained earnings........................ 62,358 41,150 (62,358) 41,150
Less
Treasury stock........................ -- (48) -- (48)
Loan to Bank ESOP..................... -- (79) -- (79)
---------- -------- --------- ----------
TOTAL STOCKHOLDERS' EQUITY................. 108,673 81,424 (108,673) 81,424
---------- -------- --------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY................................... $1,420,100 $131,644 $(139,310) $1,412,434
========== ======== ========= ==========
F-36
99
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE R -- CONSOLIDATING SCHEDULES - CONTINUED
HAWTHORNE HAWTHORNE
SAVINGS FINANCIAL ELIMINATIONS CONSOLIDATED
--------- --------- ------------ ------------
YEAR ENDED DECEMBER 31, 1998
INTEREST REVENUES
Loans...................................... $102,212 $ -- $ 1 $102,213
Investments................................ 4,293 571 (85) 4,779
-------- ------- -------- --------
106,505 571 (84) 106,992
INTEREST COSTS
Deposits................................... 47,727 -- (85) 47,642
Borrowings................................. 9,232 -- -- 9,232
Senior notes............................... -- 5,000 -- 5,000
-------- ------- -------- --------
56,959 5,000 (85) 61,874
-------- ------- -------- --------
NET INTEREST INCOME.......................... 49,546 (4,429) 1 45,118
Loan provision for credit losses............. 7,135 -- -- 7,135
-------- ------- -------- --------
Net interest income after provision for
credit losses.............................. 42,411 (4,429) 1 37,983
NONINTEREST REVENUES, NET
Operating.................................. 4,796 -- (150) 4,646
Other non-operating........................ (24) 1 (1) (24)
-------- ------- -------- --------
TOTAL NONINTEREST REVENUES, NET.............. 4,772 1 (151) 4,622
NONINTEREST EXPENSES
Employee................................... 14,414 -- -- 14,414
Operating.................................. 5,020 1,307 (150) 6,177
Occupancy.................................. 3,404 -- -- 3,404
Technology................................. 2,117 -- -- 2,117
Professional............................... 1,738 -- -- 1,738
SAIF Premium and OTS assessment............ 952 -- -- 952
-------- ------- -------- --------
TOTAL NONINTEREST EXPENSE.................... 27,645 1,307 (150) 28,802
Income from real estate operations, net...... (1,909) -- -- (1,909)
-------- ------- -------- --------
Total noninterest expenses................... 25,736 1,307 (150) 26,893
-------- ------- -------- --------
Earnings before income taxes, equity in
subsidiary, and extraordinary item......... 21,447 (5,735) -- 15,712
Income tax benefit........................... (4,674) -- -- (4,674)
-------- ------- -------- --------
Income before equity in subsidiary and
extraordinary item......................... 16,773 (5,735) -- 11,038
Equity in subsidiary......................... -- 16,773 (16,773) --
-------- ------- -------- --------
NET EARNINGS................................. $ 16,773 $11,038 $(16,773) $ 11,038
======== ======= ======== ========
F-37