(Mark one)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2003
[ ] Transitional Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to
Wilshire Financial Services Group Inc.
(Exact name of registrant as specified in its charter)
| Delaware | 93-1223879 |
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
| 14523 SW Millikan Way, Suite 200, Beaverton, OR | 97005 |
| (Address of principal executive offices) | (Zip Code) |
(503) 223-5600
(Registrant's telephone number, including area code)
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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [___] No [ X ]
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the
Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.
Yes [ X ] No [___]
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
| Class | Outstanding at October 31, 2003 |
| Common Stock, par value $0.01 per share | 18,635,491 shares |
Item 1. Interim Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Statements of Financial Condition...............3
Condensed Consolidated Statements of Operations........................4
Condensed Consolidated Statements of Stockholders' Equity..............5
Condensed Consolidated Statements of Cash Flows........................6
Notes to Interim Condensed Consolidated Financial Statements...........8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................................16
Item 3. Quantitative and Qualitative Disclosures About Market Risk............30
Item 4. Controls and Procedures...............................................32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.....................................................33
Item 2. Changes in Securities.................................................33
Item 3. Defaults Upon Senior Securities.......................................33
Item 4. Submission of Matters to a Vote of Security Holders...................33
Item 5. Other Information.....................................................33
Item 6. Exhibits and Reports on Form 8-K......................................33
Signature .....................................................................35
2
September 30, December 31,
2003 2002
------------ ------------
ASSETS
Cash and cash equivalents ...................................................... $ 23,716 $ 17,579
Government agency mortgage-backed securities available for sale, at fair value . 153,121 211,082
AAA mortgage-backed securities available for sale, at fair value ............... 48,524 48,320
Other mortgage-backed securities available for sale, at fair value ............. 1,236 2,133
Investment securities available for sale, at fair value ........................ 22,222 11,962
Investment securities held to maturity, at amortized cost ...................... 9,594 --
Loans, net of allowance for loan losses of $6,751 and $7,980 ................... 537,548 486,667
Discounted loans, net of allowance for loan losses of $33,945 and $40,920 ...... 5,061 6,630
Stock in Federal Home Loan Bank of San Francisco, at cost ...................... 11,786 10,808
Real estate owned, net ......................................................... 473 1,101
Leasehold improvements and equipment, net ...................................... 3,071 3,218
Accrued interest receivable .................................................... 3,879 4,043
Servicer advance receivables, net .............................................. 29,892 19,922
Service fees receivable ........................................................ 2,709 2,334
Purchased mortgage servicing rights, net ....................................... 10,163 5,405
Receivables from loan servicers ................................................ 1,719 462
Intangible assets, net ......................................................... 3,507 3,701
Prepaid expenses and other assets .............................................. 10,058 7,654
------------ ------------
TOTAL ................................................................ $ 878,279 $ 843,021
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Noninterest-bearing deposits .............................................. $ 3,688 $ 3,659
Interest-bearing deposits ................................................. 397,510 392,122
Short-term borrowings ..................................................... 96,000 91,870
Accounts payable and other liabilities .................................... 15,297 14,284
FHLB advances ............................................................. 233,337 216,000
Investment financing ...................................................... 5,358 4,284
Trust preferred subordinated debt ......................................... 20,000 20,000
Investor participation liability .......................................... 1,447 1,346
------------ ------------
Total liabilities .................................................... 772,637 743,565
============ ============
COMMITMENTS AND CONTINGENCIES (NOTE 3)
STOCKHOLDERS' EQUITY:
Preferred stock, $0.01 par value, 10,000,000 shares authorized, 0 shares
outstanding ............................................................ -- --
Common stock, $0.01 par value, 90,000,000 shares authorized, 24,261,703
and 23,820,874 shares issued (including treasury shares of 5,626,212) .. 117,666 114,357
Treasury stock, 5,626,212 shares, at cost ................................. (15,106) (15,106)
Retained earnings (accumulated deficit) ................................... 2,549 (3,096)
Accumulated other comprehensive income, net ............................... 533 3,301
------------ ------------
Total stockholders' equity ........................................... 105,642 99,456
------------ ------------
TOTAL ................................................................ $ 878,279 $ 843,021
============ ============
See notes to unaudited interim condensed consolidated financial statements
3
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
INTEREST INCOME:
Loans ......................................................... $ 8,523 $ 9,226 $ 25,419 $ 29,709
Mortgage-backed securities .................................... 1,993 4,256 8,007 9,661
Securities and federal funds sold ............................. 342 274 731 914
------------ ------------ ------------ ------------
Total interest income ....................................... 10,858 13,756 34,157 40,284
------------ ------------ ------------ ------------
INTEREST EXPENSE:
Deposits ...................................................... 2,575 3,810 8,564 12,160
Borrowings .................................................... 3,213 3,523 9,909 10,028
------------ ------------ ------------ ------------
Total interest expense ...................................... 5,788 7,333 18,473 22,188
------------ ------------ ------------ ------------
NET INTEREST INCOME .................................................... 5,070 6,423 15,684 18,096
PROVISION FOR (RECAPTURE OF) LOSSES ON LOANS ........................... 78 136 (592) 372
------------ ------------ ------------ ------------
NET INTEREST INCOME AFTER PROVISION FOR (RECAPTURE OF) LOSSES ON
LOANS .............................................................. 4,992 6,287 16,276 17,724
------------ ------------ ------------ ------------
OTHER INCOME:
Servicing income .............................................. 10,004 6,917 25,751 18,463
Loan fees and charges ......................................... 33 32 83 103
Real estate owned, net ........................................ (109) (45) (196) (156)
(Loss) gain on sale of loans .................................. (97) 25 (17) 2,505
Gain on sale of securities .................................... 249 1,490 249 1,428
Market valuation losses and impairments ....................... -- (2,238) -- (3,611)
Investor participation interest ............................... (32) (20) (161) (1,565)
Other, net .................................................... 99 155 830 1,361
------------ ------------ ------------ ------------
Total other income .......................................... 10,147 6,316 26,539 18,528
------------ ------------ ------------ ------------
OTHER EXPENSES:
Compensation and employee benefits ............................ 6,931 6,279 21,093 18,097
Professional services ......................................... 1,144 879 3,835 3,697
Occupancy ..................................................... 554 677 1,634 1,759
FDIC insurance premiums ....................................... 101 107 316 316
Data processing ............................................... 278 237 811 838
Communication ................................................. 182 276 631 878
Insurance ..................................................... 360 316 1,065 870
Corporate travel and development .............................. 75 74 201 243
Depreciation .................................................. 386 486 1,190 1,345
Amortization of intangibles ................................... 65 65 194 194
Postage and courier expense ................................... 240 247 814 767
Provision for litigation claims ............................... -- -- -- 3,600
Other general and administrative expenses ..................... 479 1,373 1,675 2,686
------------ ------------ ------------ ------------
Total other expenses ........................................ 10,795 11,016 33,459 35,290
------------ ------------ ------------ ------------
INCOME BEFORE MINORITY INTEREST AND INCOME TAXES ....................... 4,344 1,587 9,356 962
MINORITY INTEREST ...................................................... -- (561) -- (686)
------------ ------------ ------------ ------------
INCOME BEFORE INCOME TAXES ............................................. 4,344 1,026 9,356 276
INCOME TAX PROVISION (BENEFIT) ......................................... 1,669 159 3,711 (144)
------------ ------------ ------------ ------------
NET INCOME ............................................................. $ 2,675 $ 867 $ 5,645 $ 420
============ ============ ============ ============
Earnings per share - basic.............................................. $ 0.14 $ 0.05 $ 0.31 $ 0.02
Earnings per share - diluted............................................ $ 0.13 $ 0.04 $ 0.28 $ 0.02
Weighted average shares outstanding - basic............................. 18,633,781 18,000,489 18,432,450 16,799,210
Weighted average shares outstanding - diluted........................... 20,564,647 20,016,196 20,419,687 18,550,728
See notes to unaudited interim condensed consolidated financial statements
4
(Accumulated Accumulated
Preferred Stock Common Stock Treasury Stock (Deficit) Other
------------- --------------------- ----------------------- Retained Comprehensive
Shares Amount Shares Amount Shares Amount Earnings Income Total
------ ------ ----------- --------- ----------- ---------- --------- ------------- ---------
BALANCE, January 1, 2002...... -- $ -- 20,349,458 $ 105,530 (4,168,854) $ (10,005) $ (5,058) $ 953 $ 91,420
Comprehensive income:
Net income................ 1,962 1,962
Unrealized holding gains
on available for sale
securities - net of tax
expense of $1,851(1).... 2,490 2,490
Unrealized loss on
interest-rate swap - net (142) (142)
of tax benefit of $101.. --------
Total comprehensive income.... 4,310
Tax benefit from utilization
of pre-reorganizational Net
Operating Losses (Note 4). 815 815
Exercise of stock options..... 75,000 96 96
Conversion of subordinated
debentures................ 3,396,416 7,690 7,690
Receipt of income tax refund
related to pre-
reorganizational income... 226 226
Treasury stock acquired....... (1,457,358) (5,101) (5,101)
------ ------ ----------- --------- ----------- ---------- ---------- ------------- ---------
BALANCE, December 31, 2002.... -- -- 23,820,874 114,357 (5,626,212) (15,106) (3,096) 3,301 99,456
Comprehensive income:
Net income................ 5,645 5,645
Unrealized holding loss
on available for sale
securities - net of tax
benefit of $1,959....... (2,696) (2,696)
Unrealized loss on
interest-rate swap - net
of tax benefit of $51... (72) (72)
--------
Total comprehensive income.... 2,877
Tax benefit from utilization
of pre-reorganizational
Net Operating Losses
(Note 4).................. 1,965 1,965
Tax benefit from adjustment to
pre-reorganizational Net
Operating Losses (Note 4). 775 775
Exercise of stock options.... 440,829 569 569
------ ------ ----------- --------- ----------- ---------- ---------- ------------- ---------
BALANCE, September 30, 2003... -- $ -- 24,261,703 $ 117,666 (5,626,212) $ (15,106) $ 2,549 $ 533 $ 105,642
====== ====== =========== ========= =========== ========== ========== ============= =========
__________
(1) Includes reclassification adjustment for gain included in net income of $1,321, net of tax expense of $937.
(2) Includes reclassification adjustment for gain included in net income of $289, net of tax expense of $205.
See notes to unaudited interim condensed consolidated financial statements
5
Nine Months Ended
September 30,
---------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income .................................................................. $ 5,645 $ 420
Adjustments to reconcile net income to net cash provided by
operating activities:
(Recapture of) provision for losses on loans ........................... (592) 372
Provision for losses on real estate owned .............................. 159 33
Valuation adjustment for mortgage servicing rights ..................... (102) 577
Market valuation losses and impairments ................................ -- 3,611
Depreciation and amortization .......................................... 1,384 1,539
Tax effect from utilization of net operating loss carryforward ......... 1,965 --
(Gain) loss on sale of real estate owned ............................... (15) 102
Loss (gain) on sale of loans ........................................... 17 (2,505)
Gain on sale of securities ............................................. (249) (1,428)
(Gain) loss on disposal of equipment ................................... (10) 43
Amortization of discounts and deferred fees ............................ 2,587 2,556
Amortization of mortgage servicing rights .............................. 3,989 2,642
Federal Home Loan Bank stock dividends ................................. (391) (399)
Minority interest ...................................................... -- 686
Change in:
Servicer advance receivables ........................................... (9,970) 2,415
Service fees receivable ................................................ (375) 299
Accrued interest receivable ............................................ 164 (54)
Receivables from other loan servicers .................................. (1,257) 1,315
Prepaid expenses and other assets ...................................... (517) 907
Accounts payable and other liabilities ................................. 1,696 (2,303)
Investor participation liability ....................................... 101 641
------------ ------------
Net cash provided by operating activities ......................... 4,229 11,469
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of loans ...................................................... (67,571) (12,556)
Proceeds from sale of loans ............................................ 4,068 --
Loan repayments ........................................................ 122,001 146,433
Loan originations ...................................................... (108,515) (67,251)
Purchase of discounted loans ........................................... (30,093) (10)
Proceeds from sale of discounted loans ................................. 30,308 7,395
Purchase of mortgage-backed securities available for sale .............. (81,714) (254,233)
Proceeds from sale of mortgage-backed securities available for sale .... 9,436 71,462
Repayment of mortgage-backed securities available for sale ............. 125,034 31,703
Purchase of investment securities available for sale ................... (20,458) (13,731)
Proceeds from sale of investment securities available for sale ......... -- 10,599
Proceeds from sale of real estate owned ................................ 1,150 740
Purchase of FHLB stock ................................................. (587) (801)
Purchases of leasehold improvements and equipment ...................... (1,054) (1,585)
Proceeds from sale of leasehold improvements and equipment ............. 21 18
Purchase of mortgage servicing rights .................................. (8,647) (80)
Proceeds from sale of mortgage servicing rights ........................ 2 335
------------ ------------
Net cash used in investing activities ............................. (26,619) (81,562)
------------ ------------
See notes to unaudited interim condensed consolidated financial statements
6
Nine Months Ended
September 30,
---------------------------
2003 2002
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in deposits ........................................... $ 5,417 $ (21,203)
Proceeds from FHLB advances ................................................... 56,337 94,000
Repayments of FHLB advances ................................................... (39,000) (70,000)
Net increase in short-term borrowings ......................................... 4,130 56,569
Proceeds from servicing acquisition notes ..................................... 5,677 2,444
Repayment of servicing acquisition notes ...................................... (4,603) (11,239)
Issuance of convertible subordinated debentures ............................... -- 7,690
Issuance of trust preferred subordinated debt ................................. -- 20,000
Issuance of common stock pursuant to exercise of stock options ................ 569 40
Purchase of treasury stock .................................................... -- (5,101)
------------ ------------
Net cash provided by financing activities ................................ 28,527 73,200
------------ ------------
NET INCREASE IN CASH AND CASH EQUIVALENTS ............................................. 6,137 3,107
CASH AND CASH EQUIVALENTS:
Beginning of period ........................................................... 17,579 39,974
------------ ------------
End of period ................................................................. $ 23,716 $ 43,081
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION--Cash paid for:
Interest ...................................................................... $ 16,480 $ 20,780
Income taxes .................................................................. 374 473
NONCASH INVESTING ACTIVITIES:
Additions to real estate owned acquired in settlement of loans ................ 666 1,732
Transfer of securities classified as available for sale to held to maturity ... 9,594 --
NONCASH FINANCING ACTIVITIES:
Conversion of subordinated debentures into common stock ....................... -- 7,690
See notes to unaudited interim condensed consolidated financial statements
7
The accompanying interim condensed consolidated financial statements of Wilshire Financial Services Group Inc. and its subsidiaries (“WFSG” or the “Company”) are unaudited and should be read in conjunction with the 2002 Annual Report on Form 10-K. A summary of the Company’s significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements in the 2002 Annual Report on Form 10-K.
In the opinion of management, all adjustments, other than the adjustments described below, generally comprised of normal recurring accruals necessary for fair presentation of the interim condensed consolidated financial statements have been included and all intercompany accounts and transactions have been eliminated in consolidation. Operating results for the nine months ended September 30, 2003 are not indicative of the results that may be expected for the year ending December 31, 2003.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 amounts and results could differ from those estimates.
Certain reclassifications of 2002 amounts were made in order to conform to the 2003 presentation, none of which affect previously reported net income.
Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares and potentially dilutive stock options outstanding during the period. Following is a reconciliation of the number of shares used in the calculation of basic and diluted earnings per share for the quarters and nine-month periods ended September 30, 2003 and 2002.
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income ....................................... $ 2,675 $ 867 $ 5,645 $ 420
Weighted average number of common shares
outstanding - basic ........................... 18,633,781 18,000,489 18,432,450 16,799,210
Outstanding stock options ........................ 1,930,866 2,015,707 1,987,237 1,751,518
------------ ------------ ------------ ------------
Weighted average number of common shares
outstanding - diluted ......................... 20,564,647 20,016,196 20,419,687 18,550,728
------------ ------------ ------------ ------------
Net income per share - basic...................... $ 0.14 $ 0.05 $ 0.31 $ 0.02
============ ============ ============ ============
Net income per share - diluted.................... $ 0.13 $ 0.04 $ 0.28 $ 0.02
============ ============ ============ ============
The Company has two stock-based employee compensation plans, the 1999 Equity Participation Plan and the 2002 Equity Participation Plan, pursuant to which stock options have been granted to its directors and certain employees. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
8
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income, as reported ............................. $ 2,675 $ 867 $ 5,645 $ 420
Less: Total stock-based employee compensation
expense determined under fair value-based
method for all awards, net of related tax
effects .......................................... 129 175 375 508
------------ ------------ ------------ ------------
Pro forma net income (loss) ......................... $ 2,546 $ 692 $ 5,270 $ (88)
============ ============ ============ ============
Earnings (loss) per share:
Basic - as reported............................... $ 0.14 $ 0.05 $ 0.31 $ 0.02
============ ============ ============ ============
Basic - pro forma................................. $ 0.14 $ 0.04 $ 0.29 $ (0.01)
============ ============ ============ ============
Diluted - as reported............................. $ 0.13 $ 0.04 $ 0.28 $ 0.02
============ ============ ============ ============
Diluted - pro forma............................... $ 0.12 $ 0.03 $ 0.26 $ (0.01)
============ ============ ============ ============
At September 30, 2003, the Company’s banking subsidiary, First Bank of Beverly Hills, F.S.B. (“FBBH” or the “Bank”), had outstanding commitments to fund $41.1 million in mortgage loans and to purchase $1.5 million of new loans.
The Company expects to incur additional expenses in connection with legal costs for prior officers. These costs, which totaled approximately $0.5 million and $1.8 million, respectively, for the quarter and nine months ended September 30, 2003, relate to the events that gave rise to litigation arising from the financial collapse of Capital Consultants LLC (“CCL”). The Company on May 13, 2002 entered into a settlement agreement to resolve that litigation and has completed all of its obligations under the settlement agreement. The court has ordered that pursuant to the settlement the litigation should be dismissed. Management, after consultation with legal counsel, believes that this litigation will be dismissed in the next few months. However, this dismissal will not affect any continuing obligation of the Company for legal costs of officers arising from such events.
The Company files consolidated federal income tax returns with all of its subsidiaries. The operations of Wilshire Credit Corporation (“WCC”), the Company’s loan servicing subsidiary, are included in WFSG’s consolidated income tax returns for periods beginning October 11, 2002, the effective date of WFSG’s purchase of WCC’s 49.99% minority interest. For tax years through the year ended December 31, 2001 and for the 2002 year through October 10, 2002, WCC’s operations were excluded from WFSG’s consolidated federal income tax return because WCC did not meet the required ownership threshold of 80% (the Company’s economic interest was 50.01%).
The Company recorded a current income tax provision of approximately $1.7 million and $3.7 million, respectively, for the quarter and nine months ended September 30, 2003. The Company’s deferred tax provision (benefit) is determined on a quarterly basis pursuant to an evaluation of WFSG’s net deferred tax asset. These deferred tax assets and liabilities represent the tax effect of future deductible or taxable amounts. They are attributable to carryforwards, such as net operating losses and capital losses, and also to temporary differences between amounts that have been recognized in the financial statements and amounts that have been recognized in the income tax returns. An effective tax rate of approximately 41% is applied to each attribute in determining the amount of the related deferred tax asset or liability. Decreases (increases) in the net deferred tax asset are recorded as a deferred tax provision (benefit) in the consolidated statements of operations.
9
WFSG’s net deferred tax asset at September 30, 2003 and December 31, 2002 is included in prepaid expenses and other assets on the accompanying consolidated statements of financial condition. In accounting for the deferred tax asset, the Company applies Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires, among other things, that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. Management believes that it is more likely than not that the Company will realize a portion of the deferred tax asset and has recorded the valuation allowance accordingly. As benefits relating to the Company’s pre-reorganization (before June 10, 1999) period are realized and the valuation allowance is reduced, the tax effect is recorded as an increase to stockholders’ equity in accordance with the American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code (“SOP 90-7”), and not as a tax benefit in the statement of operations.
As of December 31, 2002, the Company had U.S. net operating loss carryforwards and capital loss carryforwards of approximately $109 million and $12 million, respectively. In addition, the Company has state net operating loss carryforwards. The federal carryforward period runs through 2021. However, in June 2002 the Company experienced a change in control as set forth by Section 382 of the Internal Revenue Code. In general, a change in control is defined as a greater than 50% ownership shift as measured over the prior three-year period. As a result of the change in control, the Company’s net operating loss carryforwards and capital loss carryforwards that were generated prior to the change in control are subject to a limitation on the amount that may be used annually to offset taxable income. The Company estimates that the limitation is approximately $6 million per year. The Company has adequately provided for this limitation with its valuation allowance against the deferred tax asset.
In the third quarter of 2003 the Company identified approximately $1.975 million in additional net operating losses at WCC which arose in the 1998 tax year. These losses have been applied to WCC’s year 2002 tax liability, resulting in a reduction of approximately $0.8 million in accrued income taxes payable. The Company has recorded the related tax benefit as a direct increase to stockholders’ equity in the accompanying financial statements.
The Company’s reportable operating segments, as defined by the Company’s management, consist of its Banking Operations, Loan Servicing Operations, and Mortgage Investment Operations. The operating segments differ in terms of regulatory environment, funding sources and asset acquisition strategies, as described below:
| o | Banking Operations—Through FBBH, the Company conducts a banking business focused primarily on specialty-niche products, including small-balance commercial and multi-family real estate lending, investments in residential whole loans, and investments in primarily AAA-rated and government agency mortgage-backed securities. The primary sources of liquidity for the Bank’s acquisitions and originations are wholesale certificates of deposit, retail deposits, FHLB advances and repurchase agreements. The Bank is a federally chartered savings bank and is regulated by the Office of Thrift Supervision (“OTS”). At September 30, 2003, FBBH had total assets of $819.8 million. |
| o | Loan Servicing Operations—Through its loan servicing subsidiary, WCC, the Company conducts a full-service mortgage and consumer loan servicing business, specializing in the servicing of labor-intensive mortgage pools requiring expertise in loss mitigation and/or investor reporting. As of September 30, 2003, WCC serviced approximately $5.9 billion principal balance of residential and commercial mortgage pools for more than 500 individual and institutional investors and government agencies. WCC’s funding sources consist primarily of internal liquidity and commercial bank financing. |
| o | Mortgage Investment Operations— The Company’s investment subsidiary, WFC, acquires mortgage-backed securities and pools of performing, sub-performing and non-performing residential and commercial loans. WFC conducts certain of these activities with an institutional investor where such investments align the Company’s interests with those of the institutional investor. WFC’s funding sources consist primarily of commercial bank financing and co-investors, with debt service repayment terms that generally parallel the cash flows of the underlying collateral. |
10
| o | Holding Company and Miscellaneous Operations—The Company’s Holding Company and Miscellaneous Operations consist of other operating revenues and expenses not directly attributable to the aforementioned business segments. In addition, this segment includes interest expense on the $20 million of junior subordinated debt issued in July 2002 and eliminations of intercompany accounts and transactions. Primary sources of liquidity include funds available from the Company’s non-bank subsidiaries, proceeds from the July 2002 issuance of junior subordinated debt and, to a limited extent, reimbursement payments received from FBBH pursuant to a tax allocation agreement between the Company and the Bank. However, OTS regulations limit the amount of these tax reimbursement payments to the lesser of (1) the Bank’s stand-alone tax liability and (2) the total tax payments made by the Company. |
The Company in the second quarter of 2003 revised the method by which it allocates certain operating expenses among its business entities. As a result, in current and future periods WCC will assume higher proportions of overall compensation and benefits, insurance, depreciation and various other categories of expenses. The additional expenses allocated to WCC from the other business segments totaled approximately $0.4 million and $0.6 million, respectively, for the quarter and nine-month period ended September 30, 2003. On an annual basis, the total additional expenses transferred to WCC is expected to approximate $1.5 million, with corresponding reductions at FBBH, WFC and the holding company of approximately $0.2 million, $1.0 million and $0.3 million, respectively. The Company believes that this new allocation methodology accurately reflects the costs to be incurred by each business entity, and more closely matches the operating segments’ expenses with their revenue-producing activities.
11
Segment data for the quarters ended September 30, 2003 and 2002 are as follows:
Three Months Ended September 30, 2003
------------------------------------------------------------------------
Holding
Company and
Loan Mortgage Miscellaneous
Banking Servicing Investments Operations Total
------------ ------------ ------------ ------------ ------------
Interest income ................................ $ 10,202 $ 17 $ 623 $ 16 $ 10,858
Interest expense ............................... 5,343 183 14 248 5,788
------------ ------------ ------------ ------------ ------------
Net interest income (expense) .................. 4,859 (166) 609 (232) 5,070
Provision for loan losses ...................... -- -- 78 -- 78
------------ ------------ ------------ ------------ ------------
Net interest income (expense) after
provision for loan losses ................... 4,859 (166) 531 (232) 4,992
Realized gains (losses) on asset sales ......... 249 -- (97) -- 152
Servicing income ............................... 419 9,889 6 (310) 10,004
Other (loss) income ............................ (214) 138 (254) 321 (9)
Compensation and benefits ...................... 1,058 5,665 106 102 6,931
Other expense .................................. 1,159 1,715 13 977 3,864
------------ ------------ ------------ ------------ ------------
Income (loss) before taxes ..................... 3,096 2,481 67 (1,300) 4,344
Income tax provision (benefit) ................. 1,300 -- 47 322 1,669
------------ ------------ ------------ ------------ ------------
Net income (loss) .............................. $ 1,796 $ 2,481 $ 20 $ (1,622) $ 2,675
============ ============ ============ ============ ============
Total assets ................................... $ 819,815 $ 50,460 $ 24,024 $ (16,020) $ 878,279
============ ============ ============ ============ ============
Three Months Ended September 30, 2002
------------------------------------------------------------------------
Holding
Company and
Loan Mortgage Miscellaneous
Banking Servicing Investments Operations Total
------------ ------------ ------------ ------------ ------------
Interest income ................................ $ 11,600 $ 32 $ 2,058 $ 66 $ 13,756
Interest expense ............................... 6,856 143 63 271 7,333
------------ ------------ ------------ ------------ ------------
Net interest income (expense) .................. 4,744 (111) 1,995 (205) 6,423
Provision for loan losses ...................... -- -- 136 -- 136
------------ ------------ ------------ ------------ ------------
Net interest income (expense) after
provision for loan losses ...................... 4,744 (111) 1,859 (205) 6,287
Realized and unrealized (losses) gains ......... (748) -- 25 -- (723)
Servicing income ............................... 130 7,208 (16) (405) 6,917
Other (loss) income ............................ (90) 42 (171) 341 122
Compensation and benefits ...................... 1,035 4,672 224 348 6,279
Other expense .................................. 1,304 1,345 221 1,867 4,737
------------ ------------ ------------ ------------ ------------
Income (loss) before minority interest
and taxes ...................................... 1,697 1,122 1,252 (2,484) 1,587
Minority interest .............................. -- -- -- (561) (561)
------------ ------------ ------------ ------------ ------------
Income (loss) before taxes ..................... 1,697 1,122 1,252 (3,045) 1,026
Income tax provision (benefit) ................. 717 -- -- (558) 159
------------ ------------ ------------ ------------ ------------
Net income (loss) .............................. $ 980 $ 1,122 $ 1,252 $ (2,487) 867
============ ============ ============ ============ ============
Total assets ................................... $ 789,674 $ 28,865 $ 26,167 $ 2,179 $ 846,885
============ ============ ============ ============ ============
12
Segment data for the nine months ended September 30, 2003 and 2002 are as follows:
Nine Months Ended September 30, 2003
------------------------------------------------------------------------
Holding
Company and
Loan Mortgage Miscellaneous
Banking Servicing Investments Operations Total
------------ ------------ ------------ ------------ ------------
Interest income ................................ $ 31,631 $ 79 $ 2,393 $ 54 $ 34,157
Interest expense ............................... 17,210 446 62 755 18,473
------------ ------------ ------------ ------------ ------------
Net interest income (expense) .................. 14,421 (367) 2,331 (701) 15,684
(Recapture of) provision for loan losses ....... (750) -- 158 -- (592)
------------ ------------ ------------ ------------ ------------
Net interest income (expense) after
(recapture of) provision for loan
losses ...................................... 15,171 (367) 2,173 (701) 16,276
Realized gains (losses) on asset sales ......... 249 75 (92) -- 232
Servicing income ............................... 922 25,700 87 (958) 25,751
Other (loss) income ............................ (452) 575 (568) 1,001 556
Compensation and benefits ...................... 3,333 16,231 462 1,067 21,093
Other expense .................................. 3,704 5,344 201 3,117 12,366
------------ ------------ ------------ ------------ ------------
Income (loss) before taxes ..................... 8,853 4,408 937 (4,842) 9,356
Income tax provision (benefit) ................. 3,718 -- 402 (409) 3,711
------------ ------------ ------------ ------------ ------------
Net income (loss) .............................. $ 5,135 $ 4,408 $ 535 $ (4,433) $ 5,645
============ ============ ============ ============ ============
Total assets ................................... $ 819,815 $ 50,460 $ 24,024 $ (16,020) $ 878,279
============ ============ ============ ============ ============
Nine Months Ended September 30, 2002
------------------------------------------------------------------------
Holding
Company and
Loan Mortgage Miscellaneous
Banking Servicing Investments Operations Total
------------ ------------ ------------ ------------ ------------
Interest income ................................ $ 34,686 $ 275 $ 4,936 $ 387 $ 40,284
Interest expense ............................... 20,852 480 401 455 22,188
------------ ------------ ------------ ------------ ------------
Net interest income (expense) .................. 13,834 (205) 4,535 (68) 18,096
Provision for loan losses ...................... -- 166 206 -- 372
------------ ------------ ------------ ------------ ------------
Net interest income (expense) after
provision for loan losses ................... 13,834 (371) 4,329 (68) 17,724
Realized and unrealized (losses) gains ......... (2,183) 1,904 601 -- 322
Servicing income ............................... 501 19,370 93 (1,501) 18,463
Other (loss) income ............................ (255) (456) (788) 1,242 (257)
Compensation and benefits ...................... 2,915 13,469 659 1,053 18,097
Other expense .................................. 4,004 5,606 641 6,943 17,193
------------ ------------ ------------ ------------ ------------
Income (loss) before minority interest
and taxes .................................... 4,978 1,372 2,935 (8,323) 962
Minority interest .............................. -- -- -- (686) (686)
------------ ------------ ------------ ------------ ------------
Income (loss) before taxes ..................... 4,978 1,372 2,935 (9,009) 276
Income tax provision (benefit) ................. 2,066 -- -- (2,210) (144)
------------ ------------ ------------ ------------ ------------
Net income (loss) .............................. $ 2,912 $ 1,372 $ 2,935 $ (6,799) $ 420
============ ============ ============ ============ ============
Total assets ................................... $ 789,674 $ 28,865 $ 26,167 $ 2,179 $ 846,885
============ ============ ============ ============ ============
13
In June 2000, FBBH acquired a branch location and recorded goodwill of $3,393 and a core deposit intangible of $1,294. Through December 31, 2001, the goodwill was amortized on a straight-line basis over an estimated useful life of 15 years. In January 2002 the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” and, as a result, no longer amortizes goodwill, but tests it at least annually for impairment. The Company will continue to amortize the core deposit intangible over an estimated useful life of 5 years.
Following is a summary of the Company’s intangible assets:
Intangible Assets
As of September 30, 2003
---------------------------------
Gross Carrying Accumulated
Amount Amortization
--------------- ---------------
Goodwill............................. $ 3,393 $ (339)
Core deposit intangible.............. 1,294 (841)
--------------- ---------------
Total............................. $ 4,687 $ (1,180)
=============== ===============
For the quarter and nine months ended September 30, 2003 the Company recorded amortization expense of $65 and $194, respectively, related to the core deposit intangible. The estimated amortization of the balance for the remainder of 2003 and the five succeeding fiscal years is $64 (2003), $259 (2004), $130 (2005), and none thereafter.
The Company tested goodwill for impairment as of March 31, 2003 and determined that no impairment charge was required. There were no conditions that indicated impairment as of September 30, 2003.
The Company’s purchased mortgage servicing rights (MSRs) totaled approximately $10.2 million at September 30, 2003, $5.4 million at December 31, 2002, and $5.0 million at September 30, 2002. Amortization expense for MSRs was $1.6 million and $4.0 million, respectively, for the quarter and nine months ended September 30, 2003, and $0.8 million and $2.6 million, respectively, for the quarter and nine months ended September 30, 2002. The estimated amortization expense of the September 30, 2003 balance of MSRs for the remainder of 2003 and the five succeeding fiscal years is $1.1 million (2003), $3.5 million (2004), $2.3 million (2005), $1.4 million (2006), $0.8 million (2007), and $0.5 million (2008). The estimated amortization expense is based only on currently held MSRs and on current information regarding loan payments and prepayments. Actual results may vary as a result of changes in the rate of prepayments and other market factors.
In June 2001, FBBH sold its Bankcard Division to iPayment Holdings, Inc. for a total purchase price of approximately $6.2 million, including approximately $0.4 million consisting of a contingency payment due the Bank upon one merchant customer’s attainment of certain processing volumes. In a lawsuit commenced by FBBH for payment of part of the purchase price, iPayment, in September 2002, filed a cross-complaint against the Bank for fraud, breach of contract and negligent misrepresentation. iPayment contends that the Bank knew, or should have known, that a merchant was concealing significant product returns by issuing checks as refunds, rather than issuing credit card refunds as required by MasterCard operating rules. iPayment claims damages for the decreased value to iPayment of the merchant’s account; chargebacks and credits that iPayment has paid and will not be able to recover from the merchant which may total $5-7 million; mitigation costs of approximately $2 million; and punitive damages. The Bank denies the claims, and the Bank also maintains that iPayment failed to mitigate any claimed damages. The Bank intends to defend the cross-complaint vigorously. The factual discovery process has not been completed. Although the Company expects to incur costs in defending these claims, based on the results of the discovery proceedings thus far and preliminary discussions with its lawyers, the Company currently does not believe the ultimate resolution of the claims will have a material impact on its financial condition or results of operations. The Company has not recognized, for accounting purposes, the contingency payment from iPayment which is the subject of this litigation.
14
WFSG on May 13, 2002 entered into a settlement agreement to resolve litigation which arose from the financial collapse of CCL, and the Company has completed all of its obligations under the settlement agreement. The court has ordered that pursuant to the settlement the litigation should be dismissed. Management, after consultation with legal counsel, believes that this litigation will be dismissed in the next few months.
The Company is a defendant in other legal actions arising from transactions conducted in the ordinary course of business. Some of these claims involve borrowers demanding amounts for alleged damages. Management, after consultation with legal counsel, and based on prior experience with consumer claims, believes the ultimate liability, if any, arising from such actions will not materially affect the Company’s financial position, consolidated results of operations or cash flows.
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51". FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 are effective with the first period ending after December 15, 2003. The Company is currently evaluating the impact that the adoption of FIN 46 may have on its financial position and results of operations.
15
The following discussion and analysis should be read in conjunction with the Interim Condensed Consolidated Financial Statements of Wilshire Financial Services Group Inc. and the notes thereto included elsewhere in this filing. References in this filing to “Wilshire Financial Services Group Inc.,” “WFSG,” the “Company,” “we,” “our,” and “us” refer to Wilshire Financial Services Group Inc. and our wholly owned subsidiaries, unless the context indicates otherwise.
Wilshire Financial Services Group Inc., a financial services company, conducts (1) community banking operations (referred to herein as our “Banking Operations”) through our wholly-owned subsidiary, First Bank of Beverly Hills, F.S.B. (“FBBH” or the “Bank”); (2) specialized mortgage loan servicing operations through Wilshire Credit Corporation (“WCC”) and (3) mortgage investment operations through Wilshire Funding Corporation (“WFC”). WFSG’s administrative, investment and loan servicing headquarters are located in Beaverton, Oregon. The Bank is headquartered in Calabasas, California and conducts its branch banking activities in Beverly Hills, California.
Our consolidated net income for the quarter ended September 30, 2003 was approximately $2.7 million, or $0.14 per basic share, compared with $0.9 million, or $0.05 per basic share, for the quarter ended September 30, 2002. WFSG’s pre-tax income was approximately $4.3 million for the third quarter of 2003, compared with $1.0 million for the third quarter of 2002.
The increase in income for the third quarter of 2003 over the third quarter of 2002 was due primarily to a $3.1 million increase in consolidated net servicing income. This increase primarily reflects the continued growth of our loan servicing operations. Additionally, servicing income for the third quarter of 2003 includes a $1.3 million increase which the Company recorded pursuant to the adjustment and retroactive application of the terms of certain servicing contracts. Also, the results for the third quarter of 2002 included $2.2 million in impairment write-downs related to two interest-only mortgage-backed securities (I/Os) at our banking subsidiary, with no such charges in the 2003 period. Partially offsetting these gains was a $1.4 million decrease in net interest income (primarily at Wilshire Funding Corporation, our mortgage investment subsidiary) and a $1.2 million decline in gains on sales of investment securities as compared with the third quarter of 2002. Our total consolidated operating expenses declined by approximately $0.2 million as the results for the third quarter of 2002 included $0.9 million of expenses and charges related to the relocation of our corporate headquarters and loan servicing operations to Beaverton, Oregon. However, we experienced a $0.7 million increase in compensation costs due to the growth of our loan servicing operations and a $0.3 million increase in legal expenses.
For the nine-month period ended September 30, 2003, our net income was approximately $5.6 million, or $0.31 per basic share, compared with $0.4 million, or $0.02 per basic share, for the nine months ended September 30, 2002. Our pre-tax income was approximately $9.4 million for the nine months ended September 30, 2003, compared with $0.3 million for the corresponding 2002 period.
Our results for the nine months ended September 30, 2003 versus the comparable 2002 period reflect a $7.3 million increase in net servicing income, which includes the $1.3 million additional servicing income recorded in the third quarter, as discussed above. In addition, we recaptured $0.6 million of loan loss reserves in the first three quarters of 2003, versus incurring a loan loss provision of $0.4 million for the comparable 2002 period, for a net improvement of $1.0 million. The results for the first three quarters of 2002 also were adversely impacted by $3.6 million of impairment charges related to the I/O securities cited above. These increases in income for 2003 were partially offset by a $2.4 million decline in net interest income (primarily at Wilshire Funding Corporation) and a $1.2 million decrease in gains on sales of investment securities as compared with the first three quarters of 2002. Our consolidated operating expenses for the nine months ended September 30, 2003 declined by $1.8 million compared with the corresponding 2002 period. The decrease in operating expenses resulted from approximately $4.75 million in legal fees and expenses which were accrued in the first quarter of 2002 and related to the May 13, 2002 settlement of litigation which arose from events prior to the Company’s 1999 restructuring. The absence of such expenses in the current year was partially offset by a $3.0 million increase in compensation expense, primarily at our loan servicing subsidiary.
16
We continue to incur legal expenses on behalf of some of our former officers in connection with the above-described litigation. Such costs totaled approximately $0.5 million and $1.8 million, respectively, for the quarter and nine months ended September 30, 2003, compared with $0.4 million and $1.3 million for the corresponding 2002 periods.
The following table compares income before taxes for FBBH for the quarters and nine-month periods ended September 30, 2003 and 2002 (dollars in thousands):
Quarter Ended September 30, Nine Months Ended September 30,
------------------------------------------ ------------------------------------------
Increase Increase
2003 2002 (Decrease) 2003 2002 (Decrease)
------------ ------------ ------------ ------------ ------------ ------------
Interest income ................... $ 10,202 $ 11,600 (1,398) $ 31,631 $ 34,686 $ (3,055)
Interest expense .................. 5,343 6,856 (1,513) 17,210 20,852 (3,642)
------------ ------------ ------------ ------------ ------------ ------------
Net interest income ............... 4,859 4,744 115 14,421 13,834 587
Recapture of loan losses .......... -- -- -- (750) -- (750)
------------ ------------ ------------ ------------ ------------ ------------
Net interest income after
recapture of loan losses ........ 4,859 4,744 115 15,171 13,834 1,337
Realized and unrealized gains
(losses) ........................ 249 (748) 997 249 (2,183) 2,432
Servicing income .................. 419 130 289 922 501 421
Other loss ........................ (214) (90) (124) (452) (255) (197)
Compensation and benefits ......... 1,058 1,035 23 3,333 2,915 418
Other expense ..................... 1,159 1,304 (145) 3,704 4,004 (300)
------------ ------------ ------------ ------------ ------------ ------------
Income before taxes ............... $ 3,096 $ 1,697 $ 1,399 $ 8,853 $ 4,978 $ 3,875
============ ============ ============ ============ ============ ============
Net Interest Income
The following table sets forth information regarding the Bank’s income from interest-earning assets and expenses from interest-bearing liabilities for the quarters ended September 30, 2003 and 2002.
Quarter Ended September 30, 2003 Quarter Ended September 30, 2002
--------------------------------- ---------------------------------
Average Annualized Average Annualized
Balance Interest Yield/Rate Balance Interest Yield/Rate
---------- --------- ---------- ---------- --------- ----------
Interest-Earning Assets:
Federal funds and short-term investments...... $ 24,421 $ 78 1.26% $ 16,134 $ 75 1.82%
Mortgage-backed and other securities.......... 235,204 1,932 3.29 258,742 3,201 4.95
Loans ........................................ 503,432 8,192 6.51 471,399 8,324 7.06
---------- --------- ---------- ---------- --------- ----------
Total interest-earning assets.............. $ 763,057 $ 10,202 5.23% $ 746,275 $ 11,600 6.08%
---------- --------- ---------- ---------- --------- ----------
Interest-Bearing Liabilities:
Interest-bearing deposits..................... $ 377,265 $ 2,574 2.71% $ 418,606 $ 3,810 3.61%
Borrowings.................................... 311,937 2,769 3.52 262,256 3,046 4.61
---------- --------- ---------- ---------- --------- ----------
Total interest-bearing liabilities......... $ 689,202 $ 5,343 3.07% $ 680,862 $ 6,856 3.99%
---------- --------- ---------- ---------- --------- ----------
Net interest income........................... $ 4,859 $ 4,744
========= =========
Net interest spread........................... 2.16% 2.09%
Net interest margin........................... 2.53% 2.52%
17
The following table sets forth information regarding the Bank’s income from interest-earning assets and expenses from interest-bearing liabilities for the nine-month periods ended September 30, 2003 and 2002.
Nine Months Ended September 30, 2003 Nine Months Ended September 30, 2002
------------------------------------ ------------------------------------
Average Annualized Average Annualized
Balance Interest Yield/Rate Balance Interest Yield/Rate
---------- --------- ---------- ---------- --------- ----------
Interest-Earning Assets:
Federal funds and short-term investments...... $ 17,824 $ 173 1.28% $ 23,782 $ 338 1.87%
Mortgage-backed and other securities.......... 249,241 7,076 3.79 217,380 8,117 4.98
Loans ........................................ 491,722 24,382 6.61 487,812 26,231 7.17
---------- --------- ---------- ---------- --------- ----------
Total interest-earning assets.............. $ 758,787 $ 31,631 5.50% $ 728,974 $ 34,686 6.28%
---------- --------- ---------- ---------- --------- ----------
Interest-Bearing Liabilities:
Interest-bearing deposits..................... $ 378,080 $ 8,563 3.03% $ 422,587 $ 12,160 3.85%
Borrowings.................................... 307,527 8,647 3.76 239,876 8,692 4.85
---------- --------- ---------- ---------- --------- ----------
Total interest-bearing liabilities......... $ 685,607 $ 17,210 3.36% $ 662,463 $ 20,852 4.21%
---------- --------- ---------- ---------- --------- ----------
Net interest income........................... $ 14,421 $ 13,834
========= =========
Net interest spread........................... 2.14% 2.07%
Net interest margin........................... 2.54% 2.54%
The Bank’s net interest income was approximately $4.9 million for the quarter ended September 30, 2003, compared with $4.7 million for the quarter ended September 30, 2002. For the nine months ended September 30, 2003, the Bank’s net interest income was approximately $14.4 million, compared with $13.8 million for the nine months ended September 30, 2002.
The continuing low interest-rate environment has impacted the Bank’s interest-bearing liabilities to a slightly greater extent than its interest-earning assets, resulting in a higher interest spread in the 2003 periods. The Bank’s net interest spread increased by 7 basis points, from 2.09% to 2.16%, from the third quarter of 2002 to the third quarter of 2003. The yield on the Bank’s average interest-earning assets declined by 85 basis points, from 6.08% to 5.23%, from the third quarter of 2002 to the third quarter of 2003. However, this drop in yield was exceeded by a 92-basis point decline, from 3.99% to 3.07%, in the Bank’s cost of interest-bearing liabilities for the same periods.
For the nine-month periods ended September 30, the interest spread increased by 7 basis points, from 2.07% for the 2002 period to 2.14% for the 2003 period. The Bank’s yield on interest-earning assets declined from 6.28% for the nine months ended September 30, 2002 to 5.50% for the nine months ended September 30, 2003, and the Bank’s average cost of funds reflected a slightly larger decrease, from 4.21% to 3.36%, for the same periods.
The Bank’s interest income on mortgage-backed and other investment securities decreased by approximately $1.3 million from the third quarter of 2002 to the third quarter of 2003, due to both a 166-basis point drop in yield, from 4.95% to 3.29%, and a $23.5 million decline in the average investment balance. For the nine months ended September 30, 2003, interest income on mortgage-backed and other investment securities was $7.1 million, a decrease of $1.0 million from the corresponding 2002 period. The slightly smaller decrease in income for the nine-month period was due to a 119-basis point drop in yield, from 4.98% to 3.79%, partially offset by a $31.9 million increase in the average asset balance for the current year to date. Utilizing new debt facilities, the Bank purchased approximately $295 million in AAA-rated mortgage-backed and other investment securities in 2002 and an additional $102 million in the first nine months of 2003.
The Bank’s interest income on loans was approximately $8.2 million for the quarter ended September 30, 2003, compared with $8.3 million for the quarter ended September 30, 2002. For the nine months ended September 30, 2003, interest on loans was approximately $24.4 million, compared with $26.2 million for the nine months ended September 30, 2002. These decreases were due to declines in the yield on loans of 55 and 56 basis points, respectively, from the quarter and nine months ended September 30, 2002 to the corresponding 2003 periods as a result of the continuing decline in interest rates. However, these declines in yield were partially offset by increases in average balances, particularly in the third quarter of 2003. The Bank originated and purchased a total of $176 million in new loans during the first three quarters of 2003, including $97 million in the third quarter, resulting in a higher earning volume despite continuing significant principal repayments.
18
FBBH’s interest expense on deposits decreased by approximately $1.2 million from the third quarter of 2002 to the third quarter of 2003 and by $3.6 million from the nine months ended September 30, 2002 to the nine months ended September 30, 2003. These decreases were the result of declines in both the average balance and average rates paid for the quarters and nine-month periods. The Bank raised significant amounts of wholesale certificates of deposit in prior years to fund certain loan acquisitions, but has since permitted the run-off of the higher-rate CDs and utilized lower-costing debt facilities as its primary funding source. As a result, the average balance of deposits decreased by $41.3 million and $44.5 million, respectively, for the quarter and nine months ended September 30, 2003 compared with the corresponding 2002 periods. The average rate paid on deposits decreased by 90 basis points and 82 basis points over the same periods.
The Bank’s interest expense on borrowings was approximately $2.8 million for the third quarter of 2003, compared with approximately $3.0 million for the third quarter of 2002. For the nine months ended September 30, 2003, interest expense on borrowings was $8.6 million, a slight decrease from the $8.7 million for the corresponding 2002 period. The decreases in 2003 were due to a 109-basis point decline in the average cost for both the three- and nine-month periods ended September 30, 2003 as compared with the corresponding 2002 periods. The decline in cost was partially offset by the higher borrowing balance in the 2003 periods, as the Bank obtained additional FHLB advances to finance its earning-asset acquisitions.
Recapture of Loan Losses
Provisions
for losses on loans are charged to operations to maintain an allowance for
losses on the loan portfolio at a level which the Bank believes is adequate
based on an evaluation of the inherent risks in the portfolio. The Bank’s
evaluation is based on an analysis of the loan portfolio, historical loss
experience, current economic conditions and trends, collateral values, and other
relevant factors.
Based on its quarterly evaluations of the adequacy of its loan loss reserves, the Bank did not record a provision for loan losses in 2002 or for the nine months ended September 30, 2003. In the second quarter of 2003, the Bank recaptured $0.75 million of loan loss reserves, primarily as a result of the sale of its performing mobile home loan portfolio.
Realized and Unrealized Losses
The
Bank’s realized and unrealized losses totaled approximately $0.2 million
for the quarter and nine months ended September 30, 2003, as a result of sales
of $9.2 million of government agency mortgage-backed securities.
For the quarter and nine months ended September 30, 2002, the Bank recorded net losses of $0.7 million and $2.2 million, respectively, on its portfolio mortgage-backed securities. These losses were due primarily to write-downs related to interest-only mortgage-backed securities (I/Os) totaling $2.2 million and $3.6 million for the respective 2002 periods, partially offset by realized gains on sales of securities. The I/Os were purchased in March and April 2002 as a hedge against possible increases in interest rates. However, as rates continued to fall, the market values of the I/Os decreased significantly. Since this decline in market value was deemed to be other than temporary, the write-downs were reflected as “Market valuation losses and impairments” in the accompanying statements of operations for the quarter and nine-month period ended September 30, 2002, and not as a direct reduction to stockholders’ equity. The Bank disposed of the I/Os in the third and fourth quarters of 2002.
Compensation and Benefits
The
Bank’s compensation and benefits totaled approximately $1.1 million for the
third quarter of 2003, compared with $1.0 million for the third quarter of 2002.
For the nine months ended September 30, 2003, compensation and benefits totaled
$3.3 million, compared with $2.9 million for the first nine months of 2002. The
increase was due to an increase in the Bank’s employee head count from 2002
to 2003, primarily as a result of the expansion of its commercial lending
operations.
Other Expenses
The
Bank’s other expenses were approximately $1.2 million for the quarter ended
September 30, 2003, compared with $1.3 million for the quarter ended September
30, 2002. For the nine months ended September 30, 2003, other expenses totaled
$3.7 million, compared with $4.0 million for the first nine months of 2002. The
Bank’s occupancy expenses have declined from the prior year due to the
sublease of excess office space after the sale of its Bankcard division, and
data processing expenses have dropped substantially through the Bank’s
efforts to control overhead. In addition, depreciation expense has declined as
certain equipment and leasehold improvements have become fully depreciated.
These decreases were partially offset by higher legal expenses associated with
pending litigation related to the Bank’s sale of its Bankcard operations in
2001 (see note 7 to the interim condensed consolidated financial statements).
19
Following are condensed statements of financial condition for FBBH as of September 30, 2003 and December 31, 2002:
September 30, December 31,
2003 2002
------------ ------------
(Dollars in thousands)
ASSETS:
Cash and cash equivalents ............................................ $ 20,989 $ 10,003
Mortgage-backed securities available for sale, at fair value ......... 201,862 259,707
Other investment securities available for sale, at fair value ........ 22,222 11,962
Investment securities held to maturity, at amortized cost ............ 9,594 --
Loans, net ........................................................... 537,643 486,821
Real estate owned, net ............................................... 473 1,040
Other assets ......................................................... 27,032 24,545
------------ ------------
Total assets ..................................................... $ 819,815 $ 794,078
============ ============
LIABILITIES:
Deposits ............................................................. $ 401,198 $ 395,781
Short-term borrowings ................................................ 88,000 91,870
FHLB advances ........................................................ 233,337 216,000
Other liabilities .................................................... 17,838 13,795
------------ ------------
Total liabilities ................................................ 740,373 717,446
NET WORTH ............................................................ 79,442 76,632
------------ ------------
Total liabilities and net worth .................................. $ 819,815 $ 794,078
============ ============
Mortgage-Backed and Other Securities Available for Sale. The Bank’s total portfolio of mortgage-backed securities (MBS) available for sale decreased by $57.8 million over the nine months ended September 30, 2003. This decrease was primarily due to $124.4 million in principal repayments and $3.9 million in unrealized losses, as the declining interest-rate environment continued to trigger significant paydowns on the loans underlying the securities in the portfolio. In addition, the Bank sold approximately $9.2 million of agency MBS in the third quarter. These portfolio decreases were partially offset by $81.7 million in purchases of AAA-rated and agency MBS during the first three quarters, including $53.9 million in the third quarter.
The Bank’s portfolio of treasury and other investment securities available for sale increased by approximately $10.3 million during the nine months ended September 30, 2003. The Bank purchased approximately $20.5 million of such securities in the first three quarters, and transferred $9.6 million from securities available for sale to its portfolio of investment securities held to maturity.
Loans, net. The Bank’s portfolio of loans, net of discounts and allowances, increased by approximately $50.8 million for the nine months ended September 30, 2003. In the current year to date, the Bank has originated $108.5 million of predominantly commercial mortgage loans and purchased an additional $67.6 million of multi-family and commercial loans. These additions to the portfolio were partially offset by $120.7 million of principal repayments and a sale of $4.1 million of loans secured by mobile homes.
Real Estate Owned, net. The Bank’s portfolio of real estate owned, net decreased by approximately $0.6 million in the first nine months of 2003, as a result of sales and write-downs of properties totaling $1.2 million, partially offset by $0.7 million in new acquisitions through foreclosures.
Deposits. The Bank's deposits increased by approximately $5.4 million during the nine months ended September 30, 2003. This increase was due to a $46 million increase in the third quarter, consisting primarily of new wholesale and brokered certificates of deposit. As part of an ongoing strategy to reduce its cost of funds, the Bank generally seeks to utilize lower-costing debt facilities as its primary funding source, and in recent periods has permitted the run-off of higher-rate certificates of deposit. However, due to authorized limits on its FHLB advance borrowings, the Bank from time to time must raise new CDs to finance its acquisitions of interest-earning assets.
20
Short-Term Borrowings. The Bank’s short-term borrowings decreased by approximately $3.9 million during the nine months ended September 30, 2003. This decrease was due to repayments of $131.9 million of repurchase agreements, partially offset by repurchase advances and renewals totaling $128 million. These borrowings are used primarily to finance the Bank’s purchases of mortgage-backed and other investment securities.
FHLB Advances. The Bank’s FHLB advances increased by $17.3 million for the first nine months of 2003, as a result of $56.3 million of new advances during the period, partially offset by maturities of $39.0 million of advances. The Bank’s FHLB advances are currently limited to 35% of its total assets as of the previous quarter-end.
Net Worth. The Bank’s total net worth increased by approximately $2.8 million during the nine months ended September 30, 2003. The Bank earned net income for the period of $5.1 million, which was partially offset by a decline in after-tax unrealized gains of approximately $2.3 million on its portfolio of available-for-sale securities and hedging instruments.
Federally insured savings associations such as FBBH are required to maintain minimum levels of regulatory capital. Those standards generally are as stringent as the comparable capital requirements imposed on national banks. The OTS has indicated that the capital level of FBBH exceeds the minimum requirement for “well capitalized” status under provisions of the Prompt Corrective Action Regulation.
The following table sets forth the Bank’s regulatory capital ratios at September 30, 2003.
Amount Required
For Capital To be Categorized
Adequacy as
Actual Purposes "Well Capitalized"
------------------- ------------------- -------------------
Amount Ratio Amount Ratio Amount Ratio
--------- -------- --------- -------- --------- --------
(Dollars in thousands)
Total Capital to Risk-Weighted Assets (Risk-Based
Capital)......................................... $ 82,457 13.8% $ 47,766 =>8.0% $ 59,708 =>10.0%
Tier 1 Capital to Risk-Weighted Assets............... 75,991 12.7% Not Applicable 35,825 => 6.0%
Core Capital to Tangible Assets...................... 75,991 9.3% 32,727 =>4.0% 40,908 => 5.0%
Tangible Capital to Tangible Assets.................. 75,991 9.3% 12,273 =>1.5% Not Applicable
Liquidity is the measurement of the Bank’s ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund investments, purchase pools of loans, and make payments for general business purposes. The Bank’s sources of liquidity include wholesale and retail deposits, FHLB advances, repurchase agreements, whole loan and mortgage-backed securities sales, and net interest income. In April 2003, the FHLB raised the Bank’s authorized borrowing limit from 30% to 35% of the Bank’s total assets as of the previous quarter-end. Liquidity in the Bank’s operations is actively managed on a daily basis and periodically reviewed by the Bank’s Board of Directors.
At September 30, 2003 the Bank’s cash balances totaled approximately $21.0 million, compared with $10.0 million at December 31, 2002. The increase in cash was due primarily to principal repayments of loans and mortgage-backed securities and proceeds from new deposits and borrowings, partially offset by originations and purchases of new loans, purchases of mortgage-backed and other investment securities, and repayments of debt facilities.
21
At September 30, 2003, the Bank had approximately $339.2 million of certificates of deposit. Scheduled maturities of certificates of deposit during the 12 months ending September 30, 2004 and thereafter amounted to approximately $294.0 million and $45.2 million, respectively. Wholesale deposits generally are more responsive to changes in interest rates than core deposits, and thus are more likely to be withdrawn by the investor upon maturity as changes in interest rates and other factors are perceived by investors to make other investments more attractive. Bank management continues its effort to reduce its exposure to interest rate changes by utilizing funding sources whose repricing characteristics more closely match those of the Bank’s interest-earning assets.
In 2001 the OTS rescinded the regulatory requirement that institutions maintain an average daily balance of liquid assets of at least 4% of its liquidity base. Even though the percentage requirement has been eliminated, each bank is still required by the OTS to maintain adequate liquidity to assure safe and sound operation. It is the Bank’s responsibility to determine the appropriate level of liquidity to be maintained.
WFSG conducts its Loan Servicing Operations through WCC, our servicing subsidiary which was formed pursuant to our June 10, 1999 reorganization. Some of WCC’s activities are conducted with a co-investor which has participation interests in the returns generated by the assets that serve as collateral for the related borrowings. The share of such activities held by this co-investor is reflected as “Investor participation interest” in the Company’s consolidated statements of operations.
The following table compares WCC’s operating income before taxes for the quarters and nine-month periods ended September 30, 2003 and 2002 (dollars in thousands).
Quarter Ended September 30, Nine Months Ended September 30,
------------------------------------------ ------------------------------------------
Increase Increase
2003 2002 (Decrease) 2003 2002 (Decrease)
------------ ------------ ------------ ------------ ------------ ------------
Servicing income ............. $ 9,889 $ 7,208 $ 2,681 $ 25,700 $ 19,370 $ 6,330
Interest income .............. 17 32 (15) 79 275 (196)
Realized gains on sales ...... -- -- -- 75 1,904 (1,829)
Other income (loss) .......... 138 42 96 575 (456) 1,031
------------ ------------ ------------ ------------ ------------ ------------
Total income .............. 10,044 7,282 2,762 26,429 21,093 5,336
------------ ------------ ------------ ------------ ------------ ------------
Interest expense ............. 183 143 40 446 480 (34)
Provision for loan losses .... -- -- -- -- 166 (166)
Compensation and benefits .... 5,665 4,672 993 16,231 13,469 2,762
Other expenses ............... 1,715 1,345 370 5,344 5,606 (262)
------------ ------------ ------------ ------------ ------------ ------------
Total expenses ............ 7,563 6,160 1,403 22,021 19,721 2,300
------------ ------------ ------------ ------------ ------------ ------------
Income before taxes .......... $ 2,481 $ 1,122 $ 1,359 $ 4,408 $ 1,372 $ 3,036
============ ============ ============ ============ ============ ============
Servicing Income
The
components of WCC’s servicing income are reflected in the following table:
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(Dollars in thousands)
Servicing revenue ..................................... $ 8,628 $ 6,931 $ 23,330 $ 18,982
Ancillary fees ........................................ 2,817 1,573 7,495 4,536
Amortization of mortgage servicing rights ............. (1,452) (562) (3,506) (1,934)
Valuation adjustment for mortgage servicing rights .... (79) (76) (2) (352)
Custodial float ....................................... 267 472 855 1,152
Unreimbursed servicing expenses ....................... (388) (228) (813) (488)
Prepayment interest shortfall expense ................. 96 (902) (1,659) (2,526)
------------ ------------ ------------ ------------
Total servicing income ................................ $ 9,889 $ 7,208 $ 25,700 $ 19,370
============ ============ ============ ============
22
WCC’s total servicing income for the quarter ended September 30, 2003 was approximately $9.9 million, compared with $7.2 million for the quarter ended September 30, 2002. For the nine months ended September 30, 2003, servicing income totaled $25.7 million, compared with $19.4 million for the nine months ended September 30, 2002. The increase over the prior periods was due primarily to the continuing growth in WCC’s servicing volume, as shown in the table below. Through new contractual agreements and servicing rights acquisitions, WCC increased its portfolio of serviced loans by approximately $0.8 billion in the third quarter of 2003 and by $1.9 billion since September 30, 2002. This growth was achieved despite significant repayments precipitated by the decline in interest rates. As a result of this growth, WCC’s total servicing revenues and ancillary fees (including late charges) increased by approximately 31% from the first nine months of 2002 to the first nine months of 2003. In October 2003 WCC contracted to service an additional $0.8 billion unpaid principal balance of loans and completed the transfer of this new servicing.
The increase in WCC’s servicing income for the 2003 periods also reflects an adjustment of $1.3 million which was recorded in September 2003. This adjustment represents the reimbursement of deposits of interest made by WCC for prepaid serviced loans in excess of the amount actually owed by WCC. WCC had previously deposited these funds into custodial accounts in compliance with the related servicing agreements. However, the terms of the servicing agreements were subsequently clarified and retroactively applied, resulting in WCC’s recovery of these excess funds. The adjustment is reflected as a reduction to “prepayment interest shortfall expense” in the above table for the quarter and nine months ended September 30, 2003.
Net servicing income has been negatively impacted due to the prevailing low interest-rate environment, which has triggered extremely rapid prepayments of loans comprising our serviced asset base. These accelerated prepayments have resulted in significant amortization expense on our mortgage servicing rights (MSRs) over the past three years (though the increases from 2002 to 2003 shown above are attributable also to the larger portfolio volume). In addition, as a result of the continuing low interest rates, float income earned on deposit balances has declined from the prior year to the current.
The following table sets forth the composition of loans serviced by WCC by type of loan at the dates indicated.
September 30, December 31, September 30,
2003 2002 2002
------------ ------------ ------------
(Dollars in thousands)
Single-family residential .............. $ 5,455,444 $ 3,668,401 $ 3,585,147
Multi-family residential ............... 110,120 121,908 119,269
Commercial real estate ................. 277,964 218,976 223,040
Consumer and other ..................... 69,991 78,880 77,264
------------ ------------ ------------
Total (1) ......................... $ 5,913,519 $ 4,088,165 $ 4,004,720
============ ============ ============
(1) WCC's servicing portfolio at September 30, 2003 and December 31, 2002 included approximately $0.3 billion unpaid principal balance of non-performing consumer loans in addition to those reflected in the above table.
Interest Income and Interest Expense
WCC’s
interest income decreased for the quarter and nine months ended September 30,
2003 compared with the corresponding 2002 periods. The decrease was due to a
drop in loan volume as a result of WCC’s sales of $7.3 million unpaid
principal balance of loans in 2002. Proceeds from these sales were used to pay
down certain debt facilities, resulting in a corresponding decrease in interest
expense for the current year to date. The slight increase in interest expense
from the third quarter of 2002 to the third quarter of 2003 was due primarily to
additional borrowings in the 2003 period to fund WCC’s advances on new
servicing arrangements.
Realized Gains on Sales
WCC’s
gains on sales totaled $75 thousand for the nine months ended September 30,
2003, compared with $1.9 million for the nine months ended September 30, 2002.
WCC sold $7.3 million unpaid principal balance of loans in the second quarter of
2002, resulting in the $1.9 million gain. However, one half of this gain was
shared with a co-investor and is included in other income (loss) as discussed
below.
23
Other Income (Loss)
The
components of WCC’s other income (loss) are reflected in the following
table:
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(Dollars in thousands)
Other income (loss):
Real estate owned, net ........................... $ -- $ -- $ -- $ (56)
Investor participation interest .................. (2) (6) (5) (897)
Other, net ....................................... 140 48 580 497
------------ ------------ ------------ ------------
Total other income (loss) .................... $ 138 $ 42 $ 575 $ (456)
============ ============ ============ ============
The increase in WCC’s total other income for 2003 was a result of the $0.9 million of “Investor participation interest” expense recorded for the nine months ended September 30, 2002. This charge primarily reflects the co-investor’s share of WCC’s gain on its sale of loans in June 2002. WCC’s other, net in the 2003 periods was due primarily to a gain from a litigation settlement and miscellaneous gains from recoveries of servicer advances, in excess of carrying value.
Compensation and Benefits
WCC’s
compensation and employee benefits totaled approximately $5.7 million for the
quarter ended September 30, 2003, compared with $4.7 million for the quarter
ended September 30, 2002. For the nine months ended September 30, 2003,
compensation expense was $16.2 million, compared with $13.5 million for the nine
months ended September 30, 2002. The increase in the 2003 periods was due
primarily to a continuing increase in WCC’s employee head count as a result
of the growth of our loan servicing operations. Additionally, in the second
quarter of 2003 some existing employees were transferred to WCC’s payroll
as part of the Company’s reallocation of certain operating expenses among
its business segments (see Note 5 to the interim condensed consolidated
financial statements).
Other Expenses
WCC’s
other expenses for the third quarter of 2003 totaled approximately $1.7 million,
compared with $1.3 million for the third quarter of 2002. The increase was due
primarily to a reversal of $0.5 million of legal expenses in the third quarter
of 2002, pursuant to an analysis of the legal accrual and estimated future
expenses.
For the nine months ended September 30, 2003, WCC’s other expenses decreased by approximately $0.3 million compared with the nine months ended September 30, 2002. The decrease was due primarily to a $0.2 million decline in legal expenses for the year to date as a result of a significant accrual in March 2002 in connection with the settlement of litigation arising from events prior to our June 1999 restructuring. The high legal expenses in early 2002 were partially offset by the $0.5 million reduction in the legal accrual in the third quarter of 2002 as discussed above.
Following are condensed statements of financial condition for WCC as of September 30, 2003 and December 31, 2002:
September 30, December 31,
2003 2002
------------ ------------
(Dollars in thousands)
ASSETS:
Cash and cash equivalents .................................. $ 27 $ 1,598
Discounted loans, net ...................................... 543 801
Servicer advance receivables, net .......................... 29,892 19,922
Purchased mortgage servicing rights, net ................... 9,830 4,692
Other assets ............................................... 10,168 5,807
------------ ------------
Total assets ........................................... $ 50,460 $ 32,820
============ ============
LIABILITIES:
Short-term borrowings ...................................... $ 8,000 $ --
Investment financing ....................................... 4,609 2,151
Other liabilities .......................................... 9,662 8,147
------------ ------------
Total liabilities ..................................... 22,271 10,298
NET WORTH .................................................. 28,189 22,522
------------ ------------
Total liabilities and net worth ........................ $ 50,460 $ 32,820
============ ============
24
Discounted Loans, net. WCC’s discounted loans, net decreased by approximately $0.3 million from December 31, 2002 to September 30, 2003 primarily as a result of principal payments received during the current year.
Servicer Advance Receivables, net. Servicer advance receivables, net increased by approximately $10.0 million during the nine months ended September 30, 2003. This increase resulted primarily from new senior lien advances made by WCC during the period, partially offset by recoveries of advances on loans previously made.
Purchased Mortgage Servicing Rights, net. Purchased mortgage servicing rights, net (MSRs) increased by approximately $5.1 million for the nine months ended September 30, 2003. WCC purchased approximately $8.6 million of MSRs associated with new servicing portfolio acquisitions in the first nine months of 2003. These purchases were partially offset by $3.5 million of amortization of MSRs for the year to date.
Short-Term Borrowings and Investment Financing. WCC’s short-term borrowings and investment financing increased by an aggregate of $10.5 million for the nine months ended September 30, 2003. WCC utilized its commercial bank lines of credit to fund new servicer advances and its acquisitions of servicing rights during the first three quarters.
WCC’s sources of cash flow include primarily servicing revenue and lines of credit from commercial banks. The availability of liquidity from our line of credit facilities is subject to the Company’s maintenance of sufficient available collateral to pledge against such borrowings. We are currently maintaining sufficient collateral under the credit agreements. WCC’s liquidity is actively managed on a daily basis and is periodically reviewed by our Board of Directors. This process is intended to ensure the maintenance of sufficient funds to meet WCC’s operating needs.
At September 30, 2003, WCC’s liquidity (including cash and unused borrowings under our credit facilities) totaled $9.4 million, compared with approximately $21.1 million at December 31, 2002. Based on our current and expected asset size, capital levels, and organizational infrastructure, we believe there will be sufficient available liquidity to meet our needs for the near future. We will attempt to increase our line of credit if it appears that additional liquidity is needed.
Adequate credit facilities and other sources of funding are essential to the continuation of WCC’s ability to purchase servicing assets, secure new contractual servicing agreements, and to meet our advancing obligations under the servicing agreements. Our growth strategy is dependent in part on its ability to find credit facilities and equity partners to provide funding for such business opportunities. Otherwise, such growth could be significantly curtailed or delayed.
WFSG conducts its Mortgage Investment Operations through WFC, our wholly-owned investment subsidiary. Some of WFC’s activities are conducted with a co-investor which has participation interests in the returns generated by the assets that serve as collateral for the loans. The share of such activities held by this co-investor is reflected as “Investor participation interest” in the Company’s consolidated statements of operations.
25
The following table compares WFC’s operating income before taxes for the quarters and nine-month periods ended September 30, 2003 and 2002 (dollars in thousands).
Quarter Ended September 30, Nine Months Ended September 30,
------------------------------------------ ------------------------------------------
Increase Increase
2003 2002 (Decrease) 2003 2002 (Decrease)
------------ ------------ ------------ ------------ ------------ ------------
Interest income ........................ $ 623 $ 2,058 $ (1,435) $ 2,393 $ 4,936 $ (2,543)
Realized (losses) gains on sales ....... (97) 25 (122) (92) 601 (693)
Other loss ............................. (248) (187) (61) (481) (695) 214
------------ ------------ ------------ ------------ ------------ ------------
Total income ........................ 278 1,896 (1,618) 1,820 4,842 (3,022)
------------ ------------ ------------ ------------ ------------ ------------
Interest expense ....................... 14 63 (49) 62 401 (339)
Provision for loan losses .............. 78 136 (58) 158 206 (48)
Compensation expense ................... 106 224 (118) 462 659 (197)
Other expenses ......................... 13 221 (208) 201 641 (440)
------------ ------------ ------------ ------------ ------------ ------------
Total expenses ...................... 211 644 (433) 883 1,907 (1,024)
------------ ------------ ------------ ------------ ------------ ------------
Income before taxes .................... $ 67 $ 1,252 $ (1,185) $ 937 $ 2,935 $ (1,998)
============ ============ ============ ============ ============ ============
Interest Income and Interest Expense
WFC’s
interest income was approximately $0.6 million for the quarter ended September
30, 2003, compared with $2.1 million for the quarter ended September 30, 2002.
WFC’s interest on mortgage-backed securities declined by approximately $0.9
million from the third quarter of 2002 to the third quarter of 2003, due to the
runoff of WFC’s MBS portfolio as a result of prepayments on the loans
underlying the securities. WFC records the receipt of such payments directly to
interest income since its portfolio of securities has been written down to an
amortized cost of zero. In addition, interest on loans decreased by
approximately $0.5 million from the third quarter of 2002 to the third quarter
of 2003, as a result of a decline in WFC’s portfolio of discounted loans
due to principal repayments.
For the nine months ended September 30, 2003, WFC’s interest income was approximately $2.4 million, compared with $4.9 million for the nine months ended September 30, 2002. The decrease in 2003 was due to a decline in loan volume as a result of WFC’s sale of approximately $3.3 million unpaid principal balance of loans in June 2002 and also due to principal repayments. In addition, in the first quarter of 2002 WFC recorded approximately $0.3 million in loan interest income on the recovery of discounts and reserves on loans which terminated during that period. WFC’s interest on mortgage-backed securities declined by approximately $0.4 million from the first nine months of 2002 to the corresponding 2003 period, due to the runoff of WFC’s MBS portfolio precipitated by underlying loan prepayments.
WFC’s interest expense decreased slightly from the third quarter of 2002 to the third quarter of 2003 and by $0.3 million from the nine months ended September 30, 2002 to the nine months ended September 30, 2003. These decreases resulted from WFC’s repayments of debt facilities in June 2002 with the proceeds from the loan sale described above and also from the continuing decline in interest rates.
Realized Gains on Sales
WFC’s
gains on sales decreased by approximately $0.1 million and $0.7 million,
respectively, from the quarter and nine-month periods ended September 30, 2002
to the corresponding 2003 periods. The larger gains in 2002 reflect WFC’s
gain from the sale of approximately $3.3 million unpaid principal balance of
loans in June 2002. Since the loans sold were originally acquired with a
co-investor, one half of the gain on sale was shared with the co-investor and
included in “Investor participation interest” as discussed below.
26
Other Loss
The components of WFC’s other loss are reflected in the following table:
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(Dollars in thousands)
Other loss:
Real estate owned, net ........................... $ (43) $ (33) $ (57) $ (82)
Investor participation interest .................. (29) (14) (154) (668)
Other, net ....................................... (176) (140) (270) 55
------------ ------------ ------------ ------------
Total other loss ............................. $ (248) $ (187) $ (481) $ (695)
============ ============ ============ ============
Other loss includes the co-investor’s share of certain investment activities conducted with WFC, which is reported as “Investor participation interest” expense. The larger expense amounts in the 2002 periods reflect the co-investor’s 50% share of the gain on WFC’s loan sale in June 2002.
Compensation Expense
WFC’s
compensation and employee benefits decreased by approximately $0.1 million from
the third quarter of 2002 to the third quarter of 2003 and by $0.2 million from
the nine months ended September 30, 2002 to the nine months ended September 30,
2003. As part of the Company’s reallocation of operating expenses among its
business segments (see Note 5 to the interim condensed financial statements),
certain employees’ compensation has been transferred to WCC from WFC,
commencing in the second quarter of 2003.
Other Expenses
WFC’s
other operating expenses decreased by approximately $0.2 million from the third
quarter of 2002 to the third quarter of 2003 and by $0.4 million from the nine
months ended September 30, 2002 to the nine months ended September 30, 2003.
These decreases were primarily due to a decline in depreciation expense from the
prior year to the current year, as a result of the transfer of certain fixed
assets from WFC to WFSG’s other business segments.
Following are WFC’s condensed statements of financial condition as of September 30, 2003 and December 31, 2002:
September 30, December 31,
2003 2002
------------ ------------
(Dollars in thousands)
ASSETS:
Cash and cash equivalents ............................................ $ 8 $ 1,172
Mortgage-backed securities available for sale, at fair value ......... 1,019 1,828
Discounted loans, net ................................................ 4,518 5,829
Real estate owned, net ............................................... 0 61
Intercompany receivables ............................................. 17,120 16,354
Other assets ......................................................... 1,359 1,851
------------ ------------
Total assets ..................................................... $ 24,024 $ 27,095
============ ============
LIABILITIES:
Investment financing ................................................. $ 749 $ 2,133
Other liabilities .................................................... 2,203 4,150
------------ ------------
Total liabilities ............................................... 2,952 6,283
NET WORTH ............................................................ 21,072 20,812
------------ ------------
Total liabilities and net worth .................................. $ 24,024 $ 27,095
============ ============
Mortgage-Backed Securities Available for Sale. WFC’s portfolio of mortgage-backed securities available for sale decreased by approximately $0.8 million during the nine months ended September 30, 2003 as a result of continuing paydowns on the underlying loan portfolio. WFC received $1.5 million in principal and interest repayments in the current year to date on its mortgage-backed securities, which have been written down to an amortized cost of zero. Consequently, any payments received on these securities are recorded directly to interest income.
Discounted Loans, net. WFC’s discounted loans, net decreased by approximately $1.3 million from December 31, 2002 to September 30, 2003, primarily as a result of $1.2 million of principal repayments and a loan loss provision of approximately $0.2 million.
27
Intercompany Receivables. Intercompany receivables increased by approximately $0.8 million from year-end 2002 to September 30, 2003. This increase was primarily due to the ongoing transfer of funds from WFC to WFSG to meet the holding company’s operating costs, partially offset by WFC’s settlement of its tax obligation to WFSG for prior tax years.
Investment Financing. WFC’s investment financing decreased by approximately $1.4 million during the nine months ended September 30, 2003, as a result of repayments of debt facilities which financed previous asset acquisitions.
WFC’s sources of cash flow include whole loan and mortgage-backed securities sales, net interest income, and borrowings from co-investors. WFC’s liquidity is actively managed on a daily basis and is periodically reviewed by our Board of Directors. This process is intended to ensure the maintenance of sufficient funds to meet WFC’s operating needs. Based on our current and expected asset size, capital levels, and organizational infrastructure, we believe there will be sufficient available liquidity to meet WFC’s needs.
We no longer own subordinated mortgage-backed securities backed by loan pools serviced by unaffiliated third parties, and currently hold subordinated mortgage-backed securities only where we act as servicer of the loan pools backing these securities. At September 30, 2003 WFC held $1.0 million of such mortgage-backed securities.
Our Holding Company and Miscellaneous Operations consist of other operating revenues and expenses not directly attributable to our Banking, Loan Servicing or Mortgage Investment Operations, and also includes eliminations of intercompany accounts and transactions. Primary sources of liquidity include funds available from the Company’s wholly-owned non-bank subsidiaries, proceeds from the July 2002 issuance of junior subordinated debt, and payments received from FBBH pursuant to a tax allocation agreement between the Company and the Bank. However, the OTS has limited the amount of these payments to the lesser of (1) the Bank’s stand-alone tax liability and (2) the total tax payments made by the Company. In January 2003 the Bank remitted $0.4 million to the Company for a portion of its 2001 liability, and in October 2003 the Bank remitted $0.8 million for its 2002 liability under the foregoing formula. WFSG will continue to depend on its non-Bank subsidiaries to meet its liquidity needs.
The “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures included elsewhere in this Form 10-Q, are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingencies. On an ongoing basis, we evaluate the estimates used, including those related to allowances for loan losses, other than temporary impairment in the market values of investment securities and other assets, assumptions used to estimate fair values of certain financial instruments for which there is not an active market, the allocation of basis between assets sold and retained, the selection of yields utilized to recognize interest income on certain mortgage-backed securities, and contingencies and litigation. We base our estimates on historical experience, current conditions and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identifying and assessing our accounting treatment with respect to commitments and contingencies. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of the consolidated financial statements:
28
• Mortgage-Backed and Other Investment Securities Available for Sale. The Company’s mortgage-backed and other investment securities available for sale are reported at their current fair market value. In determining current fair value when quotes from third parties are not available, we estimate the present value of the anticipated cash flows of the securities based on certain assumptions, including the amount and timing of future repayments, the discount rate to be used, and default rates and expected losses (if any) on the loans underlying the securities. If the change in market value is considered temporary, the unrealized holding gains and losses are reported net of tax, when applicable, as a separate component of accumulated other comprehensive income in stockholders’ equity. In the event of a decline in market value, management must evaluate whether the decline is temporary in nature or other than temporary. Declines that are considered other than temporary are reflected as “Market valuation losses and impairments” in the consolidated statements of operations and not as a direct reduction to stockholders’ equity. The Company’s portfolio of mortgage-backed and other investment securities available for sale has increased significantly over the past two years and, as of September 30, 2003, represented more than 25% of consolidated total assets. Consequently, fluctuations in the securities’ values can have a significant impact on our financial condition and results of operations.
• Allowance for Loan Losses. In estimating the allowance for loan losses, management utilizes historical experience as well as other factors, including the effect of changes in the real estate market on collateral values, the effect on the loan portfolio of current economic indicators and their probable impact on borrowers, and increases or decreases in nonperforming and impaired loans. Changes in these factors may cause management’s estimate of the allowance to increase or decrease and result in adjustments to the Company’s provision for loan losses in its consolidated statements of operations and the carrying value of the Company’s loans on its consolidated statement of financial condition.
• Mortgage Servicing Rights. Our loan servicing business represents an increasingly significant proportion of our core operations. In determining the fair value of our mortgage servicing rights (MSRs), we make assumptions of market discount rates, prepayment speeds, default rates and related servicing costs which affect the estimated present value of future cash flows. Changes in these assumptions and economic factors may result in increases or decreases in the carrying value of our MSRs and increases or decreases in the amortization of MSRs and valuation allowances related to MSRs, which may be temporary or other than temporary.
• Income Taxes. At September 30, 2003 we had a total deferred tax asset of approximately $53.8 million. This asset represents the tax effect of future deductible or taxable amounts and is attributable to carryforwards, such as net operating losses and capital losses, and also to temporary differences between amounts that have been recognized in the financial statements and amounts that have been recognized in the Company’s income tax returns. In accounting for the deferred tax asset, we apply Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” which requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the deferred tax asset quarterly and, as of September 30, 2003, have recorded a valuation allowance of approximately $47.8 million. The net deferred tax asset, $6.0 million, is included in prepaid expenses and other assets in our consolidated statement of financial condition as of September 30, 2003. We currently believe that it is more likely than not that this portion of the deferred tax asset will be realized. However, there can be no assurance that the amount, if any, that we ultimately realize will not differ materially from our assessment. As portions of the deferred tax asset are realized and the valuation allowance is reduced, the related benefits, to the extent they relate to our post-reorganizational period, are recorded as a deferred tax benefit in our consolidated statements of operations. As benefits relating to our pre-reorganizational period are realized, they are recorded as a direct increase to stockholders’ equity.
• Contingencies. We are party to various legal proceedings, as discussed above and in the notes to the consolidated financial statements. These matters have a degree of uncertainty associated with them. We continually assess the likely outcomes of these proceedings, the amounts of any related ongoing costs, and the adequacy of amounts provided for these matters. There also can be no assurance that all matters that may be brought against us or that we may bring against other parties are known to us at any point in time.
29
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in such statements. All of the statements contained in this Quarterly Report on Form 10-Q which are not identified as historical should be considered forward-looking. In connection with certain forward-looking statements contained in this Quarterly Report on Form 10-Q and those that may be made in the future by or on behalf of the Company which are identified as forward-looking, the Company notes that there are various factors that could cause actual results to differ materially from those set forth in any such forward-looking statements. Such factors include, but are not limited to, the condition of the real estate market, interest rates, regulatory matters, the availability of pools of servicing rights and loans at acceptable prices, and the availability and conditions of financing for loan pool acquisitions, mortgage loan servicing rights and other financial assets. Accordingly, there can be no assurance that the forward-looking statements contained in this Quarterly Report on Form 10-Q will be realized or that actual results will not be significantly higher or lower. The forward-looking statements have not been audited by, examined by or subjected to agreed-upon procedures by independent accountants, and no third party has independently verified or reviewed such statements. Readers of this Quarterly Report on Form 10-Q should consider these facts in evaluating the information contained herein. The inclusion of the forward-looking statements contained in this Quarterly Report on Form 10-Q should not be regarded as a representation by the Company or any other person that the forward-looking statements contained in this Quarterly Report on Form 10-Q will be achieved. In light of the foregoing, readers of this Quarterly Report on Form 10-Q are cautioned not to place undue reliance on the forward-looking statements contained herein.
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It is our objective to attempt to control risks associated with interest rate movements. In general, management’s strategy is to limit our exposure to earnings volatility and variations in the value of assets and liabilities as interest rates change over time. Our asset and liability management strategy is formulated and monitored by the investment committee of the Company and the asset and liability committee of the Bank (the “Committees”) which meet to review, among other things, the sensitivity of our assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses (including those attributable to hedging transactions), purchase activity, and maturities of investments and borrowings. FBBH’s Asset and Liability Committee establishes rate sensitivity tolerances (within regulatory guidelines) which are approved by the Bank’s Board of Directors, and coordinates with the Bank’s Board with respect to overall asset and liability composition.
The Committees are authorized to utilize off-balance sheet financial techniques to assist them in the management of interest rate risk. These techniques include interest rate swap agreements, pursuant to which the parties exchange the difference between fixed-rate and floating-rate interest payments on a specified principal amount (referred to as the “notional amount”) for a specified period without the exchange of the underlying principal amount. The Bank has entered into a $35 million notional principal amount interest rate swap agreement, which became effective in December 2002 and matures in December 2004. Pursuant to the agreement, the Bank will pay interest at a fixed rate of 2.22% and receive quarterly interest payments at the three-month LIBOR rate.
We continually monitor the interest rate sensitivity of our portfolios of interest-earning assets and interest-bearing liabilities in conjunction with the current interest rate environment. When a new pool of loans, securities or mortgage servicing rights is acquired, we will assess the incremental change in our sensitivity to interest rates, and determine accordingly whether or not to hedge.
In addition, as required by OTS regulations, the Bank’s Asset and Liability Committee also regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on the interest rate sensitivity of Net Portfolio Value (“NPV”), which is defined as the net present value of an institution’s existing assets, liabilities and off-balance sheet instruments. The Committee further evaluates such impacts against the maximum tolerable change in interest income that is authorized by the Board of Directors of the Bank.
The following table quantifies the potential changes in the Company’s net portfolio value at September 30, 2003, should interest rates increase or decrease by 100 to 300 basis points, assuming the yield curves of the rate shocks will be parallel to each other.
Net Portfolio Value NPV as % of Assets
---------------------------------- ---------------------
$ Amount $ Change % Change NPV Ratio Change
---------- --------- -------- --------- ---------
Change in Rates (Dollars in thousands)
+300bp............................. $ 103,239 $ (16,366) (14)% 12.07% (126)bp
+200bp............................. 110,131 (9,474) (8) 12.65 (68)bp
+100bp............................. 116,853 (2,752) (2) 13.19 (14)bp
0bp............................. 119,605 -- -- 13.33 --
-100bp............................. 114,744 (4,861) (4) 12.73 (60)bp
-200bp............................. 110,250 (9,355) (8) 12.19 (114)bp
-300bp............................. 109,159 (10,446) (9) 12.03 (130)bp
In determining net portfolio value, Management relies upon various assumptions, including, but not limited to, prepayment speeds on the Company’s assets and the discount rates to be used. We review our assumptions regularly and adjust them when it is deemed appropriate based on current and future expected market conditions.
Management believes that the assumptions (including prepayment assumptions) it uses to evaluate the vulnerability of our operations to changes in interest rates approximate actual experience and considers them reasonable. However, the interest rate sensitivity of our assets and liabilities and the estimated effects of changes in interest rates on NPV could vary substantially if different assumptions were used or actual experience differs from the historical experience on which they are based.
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Evaluation of
Controls and Procedures
We
maintain a set of disclosure controls and procedures that are designed to ensure
that information required to be disclosed in our reports filed under the
Securities Exchange Act of 1934, as amended (“Exchange Act”) is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms. As of the end of the period covered by this
report, we carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer (CEO) and
Chief Financial Officer (CFO), of the effectiveness of the design and operation
of our disclosure controls and procedures pursuant to Rule 13a-14 of the
Exchange Act. Based on that evaluation, our CEO and CFO concluded that the
Company’s disclosure controls and procedures are effective in timely
alerting him to material information relating to the Company (including its
consolidated subsidiaries) required to be included in the Company’s
Exchange Act filings.
Changes in
internal controls
There
have been no significant changes in the Company’s internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of that evaluation.
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| Item 1. | Legal Proceedings. |
The Company is a defendant in other legal actions arising from transactions conducted in the ordinary course of business. Some of these claims involve borrowers demanding material amounts for alleged damages. Management, after consultation with legal counsel, and based on prior experience with consumer claims, believes the ultimate liability, if any, arising from such actions will not materially affect the Company’s financial position, consolidated results of operations or cash flows.
| Item 2. | Changes in Securities. |
| Not applicable. |
| Item 3. | Defaults Upon Senior Securities. |
| Not applicable. |
| Item 4. | Submission of Matters to a Vote of Security Holders. |
| Not applicable. |
| Item 5. | Other Information. |
| Not applicable. |
| Item 6. | Exhibits and Reports on Form 8-K. |
| (a) | Exhibits. |
| 31 | Certification by the Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32 | Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.§1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| (b) | The following reports on Form 8-K were filed during the quarter covered by this report, and subsequently through the date of issuance: |
| Current Report on Form 8-K dated August 11, 2003, reporting the Company’s operating results for the quarter ended June 30, 2003. |
| Current Report on Form 8-K dated August 11, 2003, reporting that the Company’s application for listing of its common stock on the Nasdaq SmallCap Market had been approved and that trading would commence on August 13, 2003. |
| Current Report on Form 8-K dated August 12, 2003, containing the amended certification by the Company’s Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 with respect to the Company’s Report on Form 10-Q for the quarter ended June 30, 2003. |
33
| Current Report on Form 8-K dated November 12, 2003, reporting the Company’s operating results for the quarter ended September 30, 2003. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| WILSHIRE FINANCIAL SERVICES GROUP INC. |
| Date: November 14, 2003 | By: | /s/ STEPHEN P. GLENNON |
| Stephen P. Glennon | ||
| Chief Executive Officer and | ||
| Chief Financial Officer |
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