Item 1.A “Risk Factors” in this Annual Report on Form 10-K.
PART I
Item 1.
Business
GENERAL
Overview
Doral Financial Corporation (“Doral Financial” or the “Company”) was organized in 1972 under the laws of the Commonwealth of Puerto Rico and operates as a bank holding company. Doral Financial’s principal operations are conducted in Puerto Rico, with growing operations in the United States, specifically in the New York City metropolitan area and in northwest Florida. Doral Financial’s principal executive offices are located at 1451 F.D. Roosevelt Avenue, San Juan, Puerto Rico 00920-2717, and its telephone number is (787) 474-6700.
Doral Financial manages its business through three operating segments that are organized by legal entity and aggregated by line of business: banking (including thrift operations), mortgage banking and insurance agency. In the past, the Company operated a fourth operating segment: institutional securities. For additional information regarding the Company’s segments please refer to “Operating Segments” under Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, and to Note 41 of the accompanying Consolidated Financial Statements.
Banking. Through its principal banking subsidiary, Doral Bank, a Puerto Rico commercial bank (“Doral Bank PR”), Doral Financial accepts deposits from the general public and institutions, obtains borrowings, originates and invests in loans (primarily residential real estate mortgage loans), invests in mortgage-backed securities as well as in other investment securities, and offers traditional banking services. Approximately 88% of Doral Bank PR’s loan portfolio is secured by real estate. Doral Bank PR operates 34 branch offices in Puerto Rico. Mortgage loans are originated through the Company’s mortgage banking entity, Doral Mortgage, LLC (“Doral Mortgage”), which is a subsidiary of Doral Bank PR and is primarily engaged in the origination of mortgage loans on behalf of Doral Bank PR. Loan origination activities are conducted through the branch office network and centralized loan departments. Internal mortgage loan originations are also supplemented by wholesale loan purchases from third parties. As of December 31, 2010, Doral Bank PR had total assets and total deposits of $7.7 billion and $4.5 billion, respectively, including Doral Mortgage, which is part of the mortgage banking segment.
This segment also includes the operations conducted through Doral Bank PR’s subsidiaries, Doral Money, Inc. (“Doral Money”), which engages in commercial and construction lending in the New York City metropolitan area, and CB, LLC, a Puerto Rico limited liability company organized in connection with the receipt, in lieu of foreclosure, of real property securing an interim construction loan. During the third quarter of 2009, Doral Money started a middle market syndicated lending unit that is engaged in purchasing participations in senior credit facilities in the U.S. syndicated leverage loan market.
On July 8, 2010, the Company entered into a collateralized loan obligation (“CLO”) arrangement with a third party in which up to $450.0 million of largely U.S. mainland based commercial loans are pledged to collateralize AAA rated debt of $250.0 million paying three month LIBOR plus 1.85 percent issued by Doral CLO I, Ltd. Doral CLO I, Ltd. is a variable interest entity created to hold the commercial loans and issue the previously noted debt and $200.0 million of subordinated notes to the Company whereby the Company receives any excess proceeds after the payment of the senior debt interest and other fees and charges specified in the indenture agreement. The Company also serves as collateral manager of the assets of Doral CLO I, Ltd. The Company has concluded that it is the primary beneficiary of the CLO, and consolidates Doral CLO I, Ltd., as a subsidiary of Doral Bank PR.
On July 1, 2008, Doral International, Inc., which was a subsidiary of Doral Bank PR licensed as an international banking entity under the International Banking Center Regulatory Act of Puerto Rico (the “IBC Act”), was merged with and into Doral Bank PR in a transaction structured as a tax-free reorganization. On December 16, 2008, Doral Investment International LLC (“Doral Investment”) was organized to become a new subsidiary of Doral Bank PR under the IBC Act, but is not operational.
Doral Financial also operates a federal savings bank in New York and since 2010 in northwest Florida, under the name of Doral Bank, FSB (“Doral Bank US”). Doral Bank US gathers deposits and originates and invests in loans, consisting primarily of interim loans secured by multifamily apartment buildings and other commercial properties, and also invests in investment securities. During 2010, deposits were gathered primarily through an internet-based platform and during the second half of 2010, Doral Bank US started to expand its operations by opening new branches in the New York metropolitan area and in Florida. As of December 31, 2010, Doral Bank US had total assets and total deposits of $219.7 million and $194.5 million, respectively.
Mortgage Banking. Prior to 2007, Doral Financial and various of its subsidiaries were engaged in mortgage originations, securitization, servicing and related activities. As part of its business transformation effort, Doral Financial transferred its mortgage origination and servicing platforms, subject to certain exclusions, to Doral Bank PR (including its wholly-owned subsidiary, Doral Mortgage). The Company’s mortgage origination business is conducted by Doral Mortgage, and the Company’s mortgage servicing business is operated by Doral Bank PR. Substantially all new loan origination and investment activities at the holding company level were terminated.
Insurance Agency. Doral Financial through its wholly-owned subsidiary, Doral Insurance Agency, Inc. (“Doral Insurance Agency”), offers property, casualty, life and title insurance as an insurance agency, primarily to its mortgage loan customers.
Institutional Securities. Doral Financial operated an institutional securities business until 2008 through Doral Securities, Inc. (“Doral Securities”), a wholly-owned subsidiary. Doral Securities’ operations during 2008 were limited to acting as a co-investment manager to a local fixed-income investment company. Doral Securities provided notice to the investment company in December 2008 of its intent to assign its rights and obligations under the investment advisory agreement to Doral Bank PR. The assignment was completed in January 2009 and Doral Securities did not conduct any other operations in 2009. During the third quarter of 2009, this investment advisory agreement was terminated by the investment company. Effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial Corporation.
Availability of Information on Website
Doral Financial’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are available free of charge, through its website, http://www.doralfinancial.com, as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. In addition, Doral Financial makes available on its website under the heading “Corporate Governance” its: (i) Code of Business Conduct and Ethics; (ii) Corporate Governance Guidelines; (iii) Information Disclosure Policy; and (iv) the charters of the Audit, Compensation, Corporate Governance and Nominating, and Risk Policy committees, and also intends to disclose on its website any amendments to its Code of Business Conduct and Ethics, or waivers of the Code of Business Conduct and Ethics on behalf of its Chief Executive Officer, Chief Financial Officer, and Controller. The aforementioned reports and materials can also be obtained free of charge upon written request to the Secretary of the Company at 1451 F.D. Roosevelt Avenue, San Juan, Puerto Rico 00920-2717.
The public may read and copy any materials Doral Financial files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. In addition, the public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including Doral Financial, at its website (http://www.sec.gov).
Holding Company Structure
Doral Financial conducts its activities primarily through its wholly-owned subsidiaries, Doral Bank PR, Doral Bank US, Doral Insurance Agency, and Doral Properties, Inc. (“Doral Properties”). Doral Bank PR operates four wholly-owned subsidiaries: Doral Mortgage, Doral Money, Doral Investment and CB, LLC.
On July 19, 2007, Doral Holdings Delaware, LLC (“Doral Holdings”), a newly formed bank holding company in which Irving Place Capital (formerly known as Bear Stearns Merchant Banking) and other investors, including funds managed by Marathon Asset Management, Perry Capital, the DE Shaw Group and Tennenbaum Capital, purchased 48,412,698 shares of Doral Financial common stock for an aggregate purchase price of $610.0 million. As a result of this transaction, Doral Holdings initially owned approximately 90% of the then outstanding common stock of Doral Financial.
On April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers of the Company’s common stock, including certain direct and indirect investors in Doral Holdings, which was the Company’s parent company, to raise up to $600.0 million of new equity capital for the Company through a private placement. Shares were sold in two tranches: (i) a $180.0 million non-contingent tranche consisting of approximately 180,000 shares of the Company’s Mandatorily Convertible Non-Cumulative Non-Voting Preferred Stock (the “Mandatorily Convertible Preferred Stock”), $1.00 par value and $1,000 liquidation preference per share and (ii) a $420.0 million contingent tranche consisting of approximately 13.0 million shares of the Company’s common stock and approximately 359,000 shares of Mandatorily Convertible Preferred Stock. In addition, as part of the non-contingent tranche, the Company issued into escrow 105,002 shares of the Mandatorily Convertible Preferred Stock with a liquidation value of $105.0 million, to be released to purchasers if the Company did not complete an FDIC assisted transaction.
The Company used the net proceeds from the placement of the shares in the Non-Contingent Tranche to provide additional capital to the Company to facilitate the Company (through its wholly owned subsidiary, Doral Bank PR) qualifying as a bidder for the acquisition of certain assets and assumption of certain liabilities of one or more Puerto Rico banks from the FDIC, as receiver.
The Company was approved to bid on the assets and liabilities of all three Puerto Rico banks that failed in April 2010. On April 30, 2010, the Company announced it had been out-bid and would not be acquiring any of the assets or liabilities of any of the three Puerto Rico failed banks resolved in separate FDIC assisted purchase and assumption transactions. As a result, pursuant to the Stock Purchase Agreement and the related
escrow agreement, approximately 105,002 shares of the Mandatorily Convertible Preferred Stock and the $420.0 million of contingent funds were released from escrow to the purchasers and the contingent tranche of securities was not issued.
In connection with the Stock Purchase Agreement, the Company also entered into a Cooperation Agreement with Doral Holdings, Doral Holdings L.P. and Doral GP Ltd. pursuant to which Doral Holdings made certain commitments including the commitment to vote in favor of converting the Mandatorily Convertible Non Cumulative Preferred Stock to common stock and registering the shares issued pursuant to this capital raise and other previously issued unregistered shares of common stock and to dissolve Doral Holdings pursuant to certain terms and conditions.
Accordingly, during the third quarter of 2010, the Company converted 285,002 shares of Mandatorily Convertible Non-Voting Preferred Stock into 60,000,386 shares of common stock. In addition, during the third quarter of 2010, Doral Holdings, previously the controlling shareholder of Doral Financial, distributed its shares in Doral Financial to its investors and dissolved. The Company is no longer a controlled company as a result of this conversion and the dissolution of Doral Holdings. Refer to Note 34 of the Consolidated Financial Statements for additional information on the stock exchanges.
Banking Activities
Doral Financial is engaged in retail banking activities in Puerto Rico through its principal banking subsidiary. Doral Bank PR operates 34 branches in Puerto Rico and offers a variety of consumer loan products as well as deposit products and other retail banking services. Doral Bank PR’s strategy is to combine excellent service with an improved sales process to capture new clients and cross-sell additional products and provide solutions to existing clients. As of December 31, 2010, Doral Bank PR and its subsidiaries had a loan portfolio, classified as loans receivable, of approximately $5.1 billion, of which approximately $4.5 billion consisted of loans secured by residential real estate, including real estate development projects, and a loan portfolio classified as loans held for sale, of approximately $199.4 million.
Doral Bank PR’s lending activities have traditionally focused on the origination of residential mortgage loans. All residential mortgage origination activities are conducted by Doral Bank PR through its wholly-owned subsidiary Doral Mortgage.
Doral Financial is also engaged in the banking business in the New York City metropolitan area through its federal savings bank subsidiary, Doral Bank US. During 2010, Doral Bank US commenced an expansion process opening new branches in New York and in the northwest area of Florida. Doral Bank US, through its internet-based platform and new branches, offers a variety of deposit products. Doral Bank US invests primarily in interim loans secured by multifamily apartment buildings and other commercial properties located in the New York City metropolitan area, as well as in taxi medallion loans.
Doral Money is also engaged in the mortgage banking business in the New York City metropolitan area and since the third quarter of 2009 organized a middle market syndicated lending unit that is engaged in purchasing participations in senior credit facilities in the U.S. syndicated leverage loan market. Starting in 2011, a new healthcare finance product will provide asset-based, working capital lines of credit to providers of goods and services in the healthcare industry nationwide, including hospitals, home healthcare agencies and long-term care facilities with financing needs from $1.0 million to $20.0 million.
Doral Bank PR and Doral Bank US complement their lending activities by earning fee income, collecting service charges for deposit accounts and other traditional banking services.
For detailed information regarding the deposit accounts of Doral Financial’s banking subsidiaries please refer to Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, “- Liquidity and Capital Resources” in this report.
Consumer Lending
Consumer lending operations include residential mortgage lending, consumer loans and leasing activities. Doral Bank PR and its subsidiaries’ consumer loan portfolio totaled $3.5 billion, or 67.4%, of its loans receivable portfolio.
Residential Mortgage Lending
Doral Bank PR is an approved seller/servicer for the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”), an approved issuer for the Government National Mortgage Association (“GNMA”) and an approved servicer under the GNMA, FNMA and FHLMC mortgage-backed securities programs. Doral Financial is also qualified to originate mortgage loans insured by the Federal Housing Administration (“FHA”) or guaranteed by the Veterans Administration (“VA”) or by the Rural Housing Service (“RHS”).
Doral Bank PR originates a wide variety of mortgage loan products, some of which are held for investment and others which are held for sale, that are designed to meet consumer needs and competitive conditions. The principal residential mortgage products are 30-year and 15-year fixed rate first mortgage loans secured by single-family residential properties consisting of one-to-four family units. None of Doral Bank PR’s residential mortgage loans have adjustable interest rate features. Doral Financial generally classifies mortgage loans between those that are guaranteed or insured by FHA, VA or RHS and those that are not. The latter type of loans are referred to as conventional loans. Conventional loans that meet the underwriting requirements for sale or exchange under standard FNMA or FHLMC programs are referred to as conforming loans, while those that do not meet the requirements are referred to as non-conforming loans.
For additional information on Doral Financial’s mortgage loan originations, refer to Table E - Loan Production included in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.
Other Consumer
Doral Bank PR provides consumer credit, personal secured loans, lease financing receivables and loans on savings deposits. At December 31, 2010, consumer loans totaled $59.2 million, or 1.2%, of its loans receivable portfolio.
Doral Bank PR’s consumer loan portfolio is subject to certain risks, including: (i) amount of credit offered to consumers in the market; (ii) interest rate increases; (iii) consumer bankruptcy laws which allow consumers to discharge certain debts; and (iv) continued recessionary conditions and/or additional deterioration of the Puerto Rico and United States economies. Doral Bank PR attempts to reduce its exposure to such risks by: (i) individually reviewing each loan request and renewal; (ii) utilizing a centralized approval system for loans in excess of $25,000; (iii) strictly adhering to written credit policies; and (iv) conducting an independent credit review.
Commercial Lending
Commercial lending operations include commercial real estate, commercial and industrial and construction and land. Doral Bank PR and its subsidiaries’ commercial loan (including construction and land) portfolio totaled $1.7 billion, or 32.6%, of its loans receivable portfolio. Most of the growth in the commercial lending portfolio has been in the U.S. operations as economic conditions have started to improve on the mainland.
Commercial Real Estate and Commercial and Industrial
Due to worsening economic conditions in Puerto Rico, Doral’s new commercial lending activity in Puerto Rico has been limited since early 2008. However, commercial lending activities in the U.S. have grown significantly beginning late in 2009. At December 31, 2010, commercial loans totaled $1.3 billion, or 24.4%, of Doral Bank PR and its subsidiaries’ loans receivable portfolio, which included $653.6 million in commercial loans secured by real estate. Commercial loans include lines of credit and term facilities to finance
business operations and to provide working capital for specific purposes, such as to finance the purchase of assets, equipment or inventory. Since a borrower’s cash flow from operations is generally the primary source of repayment, Doral Bank PR’s analysis of the credit risk focuses heavily on the borrower’s debt repayment capacity.
Lines of credit are extended to businesses based on an analysis of the financial strength and integrity of the borrowers and are generally secured by real estate, accounts receivable or inventory, and have a maturity of one year or less. Such lines of credit bear a floating interest rate that is indexed to a base rate, such as, the prime rate, the London Interbank Offered Rate (“LIBOR”) or another established index.
Commercial term loans are typically made to finance the acquisition of fixed assets, provide permanent working capital or to finance the purchase of businesses. Commercial term loans generally have terms from one to five years. They may be collateralized by the asset being acquired or other available assets and bear a floating interest rate, indexed to the prime rate, LIBOR or another established index, or are fixed for the term of the loan.
As mentioned above, Doral Money’s syndicated lending unit commenced operations during the third quarter of 2009. Syndicated corporate loans are credit facilities sourced primarily from financial institutions that are acting as lenders and arrangers in these syndications. The U.S. based middle market syndicated lending strategy is to acquire $5.0 million to $15.0 million participation interests in loans made to U.S. mainland companies that are first underwritten by money center or regional banks, and re-underwritten by the Company’s U.S. based syndicated lending unit. Borrowers are either domiciled in the U.S. or the vast majority of their revenues are generated in the U.S. All borrowers have external public ratings or a rating letter from Standard & Poor’s and/or Moody’s.
The syndicated lending unit portfolio has been growing within commercial lending. As of December 31, 2010 syndicated loans totaled $507.1 million, or 9.9%, of the consolidated Doral Bank PR loans receivable portfolio. For the year ended December 31, 2010, U.S. syndicated loans accounted for 34.3% of total loans originated during 2010.
Doral Financial’s portfolio of commercial loans is subject to certain risks, including: (i) continued recessionary conditions and/or additional deterioration of the Puerto Rico and United States economies; (ii) interest rate increases; (iii) the deterioration of a borrower’s or guarantor’s financial capabilities; and (iv) environmental risks, including natural disasters. Doral Financial attempts to reduce the exposure to such risks by: (i) reviewing each loan request and renewal individually; (ii) utilizing a centralized approval system for all unsecured and secured loans in excess of $100,000; (iii) strictly adhering to written loan policies; and (iv) conducting an independent credit review. In addition, loans based on short-term asset values are monitored on a monthly or quarterly basis.
Construction Lending
Due to market conditions in Puerto Rico, the Company has ceased financing new construction of single family residential and commercial real estate projects, including land development, in Puerto Rico. Doral will continue to evaluate and appraise market conditions to determine if and when it will resume such financing. Doral Bank had traditionally been a leading player in Puerto Rico in providing interim construction loans to finance residential development projects, primarily in the affordable and mid-range housing markets. In 2006, the Company reassessed its risk exposure to the sector and made a strategic decision to restrict construction lending to established clients with proven track records. In late 2007, as a result of the continued downturn in the Puerto Rico housing market, the Company decided that it would no longer underwrite new development projects and focus its efforts on collections, including assisting developers in marketing their properties to potential home buyers. As of December 31, 2010, Doral Bank PR and its subsidiaries had approximately $421.1 million in construction and land loans. Construction loans extended by the Company to developers are typically adjustable rate loans, indexed to the prime rate, with terms generally ranging from 12 to 36 months.
Doral Bank US and Doral Money extend interim, construction loans and bridge loans secured by multifamily apartment buildings and other commercial properties in the New York City metropolitan area and
in northwest Florida. As of December 31, 2010, Doral Bank US and Doral Money had a portfolio of $18.5 million and $90.3 million in interim construction and bridge loans, respectively.
Doral Financial’s construction loan portfolio is subject to certain risks, including: (i) continued recessionary conditions and/or additional deterioration of the Puerto Rico economy and the United States economy; (ii) continued deterioration of the United States and Puerto Rico housing markets; (iii) interest rate increases; (iv) deterioration of a borrower’s or guarantor’s financial capabilities; and (v) environmental risks, including natural disasters. Doral Financial attempts to reduce the exposure to such risks by: (i) individually reviewing each loan request and renewal; (ii) utilizing a centralized approval system for secured loans in excess of $100,000; (iii) strictly adhering to written loan policies; and (iv) conducting an independent credit review.
Mortgage Origination Channels
Doral Bank PR’s strategy is to defend its mortgage servicing portfolio primarily by internal originations through its retail branch network. Doral Mortgage units are co-located in 33 of the 34 retail bank branches of Doral Bank PR. Doral Bank PR supplements retail originations with wholesale purchases of loans from third parties. The principal origination channels of Doral Financial’s loan origination units are summarized below.
Retail Channel. Doral Bank PR originates loans through its network of loan officers located in each of its 33 retail branches throughout Puerto Rico. Customers are sought through advertising campaigns in local newspapers and television, as well as direct mail and telemarketing campaigns. Doral Bank PR emphasizes quality customer service and offers extended operating hours to accommodate the needs of customers. Doral Bank PR works closely with residential housing developers and specializes in originating mortgage loans to provide permanent financing for the purchase of homes in new housing projects.
Wholesale Correspondent Channel. Doral Bank PR maintains a centralized unit that purchases closed residential mortgage loans from other financial institutions consisting primarily of conventional mortgage loans. Doral Bank PR underwrites each loan prior to purchase. For the years ended December 31, 2010, 2009, and 2008 total loan purchases amounted to approximately $82.0 million, $126.0 million and $181.5 million, respectively.
For more information on Doral Financial’s loan origination channels, refer to Table F - Loan Origination Sources in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.
Mortgage Loan Underwriting
Doral Bank PR’s underwriting standards are designed to comply with the relevant guidelines set forth by the Department of Housing and Urban Development (“HUD”), GNMA, RHS, VA, FNMA, FHLMC, Federal and Puerto Rico banking regulatory authorities, private mortgage investment conduits and private mortgage insurers, as applicable.
Doral Bank PR’s underwriting policies focus primarily on the borrower’s ability to pay and secondarily on collateral value. The maximum loan-to-value (“LTV”) ratio on conventional first mortgages generally does not exceed 80%. Doral Bank PR also offers certain first mortgage products with higher LTV ratios, which may require private mortgage insurance. In conjunction with a first mortgage, Doral Bank PR may also provide a borrower with additional financing through a closed end second mortgage loan, whose combined LTV ratio exceeds 80%. Doral Bank PR does not originate adjustable rate mortgages (“ARM”) or negatively amortizing loans. However, the Company has entered into certain loss mitigation arrangements that provide for a temporary reduction in interest rates. The Company uses external credit scores as a useful measure for assessing the credit quality of a borrower. These scores are supplied by credit information providers, based on statistical models that summarize an individual’s credit record. FICO®
scores, developed by Fair Isaac Corporation, are the most commonly used credit scores.
Doral Bank PR sells the majority of its conforming mortgage loan originations and retains the majority of its non-conforming loan originations in portfolio. The Company’s underwriting process is established to
achieve a uniform rules-based standard while targeting high quality non-conforming loan originations which is consistent with the Company’s goal of retaining a greater portion of its mortgage loan production.
Mortgage Loan Servicing
When Doral Financial sells originated or purchased mortgage loans, it generally retains the right to service such loans and to receive the associated servicing fees. Doral Financial’s principal source of servicing rights has traditionally been its mortgage loan production. Doral Financial also seeks to purchase servicing rights in bulk when it can identify attractive opportunities.
The Company believes that loan servicing for third parties is important to its asset/liability management tools because it provides an asset whose value in general tends to move in the opposite direction to the value of its loan and investment portfolio. The asset also provides additional fee income to help offset the cost of its mortgage operations.
Servicing rights represent a contractual right and not a beneficial ownership interest in the underlying mortgage loans. Failure to service the loans in accordance with contract requirements may lead to the termination of the servicing rights and the loss of future servicing fees. In general, Doral Bank PR’s servicing agreements are terminable by the investors for cause. However, certain servicing arrangements, such as those with FNMA and FHLMC, contain termination provisions that may be triggered by changes in the servicer’s financial condition that materially and adversely affect its ability to provide satisfactory servicing of the loans. As of December 31, 2010, approximately 28%, 6% and 29% of Doral Financial’s mortgage loans serviced for others related to mortgage servicing for FNMA, FHLMC and GNMA, respectively. As of December 31, 2010, Doral Bank PR serviced approximately $8.2 billion in mortgage loans on behalf of third parties. Termination of Doral Bank PR’s servicing rights by any of these agencies could have a material adverse effect on Doral Financial’s results of operations and financial condition. In certain instances, the Company also services loans with no contractual servicing fee. The servicing asset or liability associated with this type of servicing arrangement is evaluated solely based on ancillary income, float, late fees, prepayment penalties and costs.
Doral Bank PR’s mortgage loan servicing portfolio is subject to reduction by reason of normal amortization, prepayments and foreclosure of outstanding mortgage loans. Additionally, Doral Bank PR may sell mortgage loan servicing rights from time to time to other institutions if market conditions are favorable. For additional information regarding the composition of Doral Financial’s servicing portfolio as of each of the Company’s last three fiscal year-ends, refer to Table G - Loans Serviced for Third Parties in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.
The degree of credit risk associated with a mortgage loan servicing portfolio is largely dependent on the extent to which the servicing portfolio is non-recourse or recourse. In non-recourse servicing, the principal credit risk to the servicer is the cost of temporary advances of funds. In recourse servicing, the servicer agrees to share credit risk with the owner of the mortgage loans, such as FNMA or FHLMC, or with a private investor, insurer or guarantor. Losses on recourse servicing occur primarily when foreclosure sale proceeds of the property underlying a defaulted mortgage loan are less than the outstanding principal balance and accrued interest of such mortgage loan and the cost of holding and disposing of the underlying property. Prior to 2006, Doral Financial often sold non-conforming loans on a partial recourse basis. These recourse obligations were retained by Doral Financial when Doral Bank PR assumed the servicing rights from Doral Financial. For additional information regarding recourse obligations, see Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, “- Off-Balance Sheet Activities” in this report.
Sale of Loans and Securitization Activities
Doral Financial sells or securitizes a portion of the residential mortgage loans that it originates and purchases to generate income. These loans are underwritten to investor standards, including the stardards of FNMA, FHLMC, and GNMA. As described below, Doral Financial utilizes various channels to sell its mortgage products. Doral Financial issues GNMA-guaranteed mortgage-backed securities, which involve the packaging of FHA, RHS or VA loans into pools of $1.0 million or more for sale primarily to broker-dealers and other institutional investors. During the years ended December 31, 2010, 2009 and 2008, Doral Financial
issued approximately $311.8 million, $377.3 million and $333.8 million, respectively, in GNMA-guaranteed mortgage-backed securities.
Conforming conventional loans are generally either sold directly to FNMA, FHLMC or private investors for cash, or are grouped into pools of $1.0 million or more in aggregate principal balance and exchanged for FNMA or FHLMC-issued mortgage-backed securities, which Doral Financial sells to broker-dealers. In connection with such exchanges, Doral Financial pays guarantee fees to FNMA and FHLMC. The issuance of mortgage-backed securities provides Doral Financial with flexibility in selling the mortgage loans that it originates or purchases and also provides income by increasing the value and marketability of such loans. For the years ended December 31, 2010, 2009 and 2008, Doral Financial securitized approximately $92.8 million, $53.6 million and $40.4 million, respectively, of loans into FNMA and FHLMC mortgage-backed securities. In addition, for the years ended December 31, 2010, 2009 and 2008, Doral Financial sold approximately $30.7 million, $35.0 million and $54.5 million, respectively, of loans through the FNMA and FHLMC cash window programs. Also, during the fourth quarter of 2010, Doral Bank sold $39.9 million of loans to a private investor.
When the loans backing a GNMA security are initially securitized they are treated as sales and the Company continues to service the underlying loans. The Company is required to bring individual delinquent GNMA loans that it previously accounted for as sold back onto its books as loan assets when, under the GNMA Mortgage-Backed Securities Guide, the loan meets GNMA’s specified delinquency criteria and is eligible for repurchase. The rebooking of GNMA loans is required (together with a liability for the same amount) regardless of whether the bank, as seller-servicer, intends to exercise the repurchase (buy-back option) since the Company is deemed to have regained effective control over these loans.
At December 31, 2010, 2009 and 2008, the loans held for sale portfolio includes $153.4 million, $128.6 million and $165.6 million, respectively, related to defaulted loans backing GNMA securities for which the Company has an unconditional option (but not an obligation) to repurchase the defaulted loans. Payment on these loans is guaranteed by FHA.
Prior to the fourth quarter of 2005, Doral Financial’s non-conforming loan sales were generally made on a limited recourse basis. As of December 31, 2010, 2009 and 2008, Doral Financial’s maximum contractual exposure relating to its portfolio of loans sold with recourse was approximately $0.7 billion, $0.8 billion and $1.0 billion, respectively, which included recourse obligations to FNMA and FHLMC as of such dates of approximately $0.6 billion, $0.7 billion and $1.0 billion, respectively. As of December 31, 2010, 2009 and 2008, Doral Financial had a recourse liability of $10.3 million, $9.4 million and $8.8 million, respectively, to reflect estimated losses from such recourse arrangements.
Doral Financial estimates its liability from its recourse obligations based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment. The Company believes that it has an adequate valuation for its recourse obligation as of December 31, 2010 and 2009, but actual future recourse obligations may differ from expected results.
In the past the Company sold non-conforming loans to financial institutions in the U.S. mainland on a non-recourse basis, except recourse for certain early defaults. Since 2007 the Company is retaining all of its non-conforming loan production in its loan receivable portfolio. While the Company currently anticipates that it will continue to retain its non-conforming loan production in portfolio, in the future, the Company may seek to continue to diversify secondary market outlets for its non-conforming loan products both in the U.S. mainland and Puerto Rico.
In the ordinary course of business, Doral Financial makes certain representations and warranties to purchasers and insurers of mortgage loans at the time of the loan sales to third parties regarding the characteristics of the loans sold, and in certain circumstances, such as in the event of early or first payment default. To the extent the loans do not meet specified criteria, such as a breach of contract of a representation or warranty or an early payment default, Doral Financial may be required to repurchase the mortgage loan and bear any subsequent loss related to the loan. Doral Financial works with purchasers to review the claims and correct alleged documentation deficiencies. For the years ended December 31, 2010, 2009 and 2008
repurchases amounted to $1.0 million, $13.7 million and $9.5 million, respectively. Refer to Item 1A.
Item 1A.
Risk Factors.
Readers should carefully consider, in connection with other information disclosed in this Annual Report on Form 10-K, the risk factors set forth below. The following discussion sets forth some of the more important risk factors that could affect our business, financial condition or results of operations. However, other factors, besides those discussed below or elsewhere in this report or other of our reports filed with or furnished to the SEC, also could adversely affect our business, financial condition or results of operations. We cannot assure you that the risk factors described below or elsewhere in this document are a complete set of all potential risks we may face. These risk factors also serve to describe factors which may cause our results to differ materially from those discussed in forward looking statements included herein or in other documents or statements that make reference to this Annual Report on Form 10-K. Please also refer to the section titled “Forward Looking Statements” in this Annual Report on Form 10-K.
Risks related to the general business environment and our industry
Difficult market conditions have already affected us and our industry and may continue to adversely affect us.
Given that almost all of our business is in Puerto Rico and the United States and given the degree of interrelation between Puerto Rico’s economy and that of the United States, we are particularly exposed to downturns in the U.S. economy. Dramatic declines in the U.S. housing market over the past few years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as major commercial banks and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative and cash securities, in turn, have caused many financial institutions to seek additional capital from private and government entities, to merge with larger and stronger financial institutions and, in some cases, to fail.
Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors reduced or ceased providing funding to borrowers, including other financial institutions. This market turmoil and tightening of credit led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has already adversely affected our industry and has and may continue to adversely affect our business, financial condition and results of operations. The Company experienced increased levels of non-performing assets and OTTI charges on its non-agency MBSs as a result of market conditions. We do not
expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:
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Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future behaviors.
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The processes and models we use to estimate losses inherent in our credit exposure requires difficult, subjective, and complex judgments, including forecast of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans, which may no longer be capable of accurate estimation and which may, in turn, impact the reliability of the processes and models.
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Regulatory agency views of market conditions and the effect of market conditions on our borrowers may differ from those of management, and such variance in views, if any, may contribute to changes in charge-offs and loan loss provisions.
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Our ability to borrow from other financial institutions or to engage in sales of mortgage loans to third parties (including mortgage loan securitization transactions with government sponsored entities) on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events, including deteriorating investor expectations.
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Competition in our industry could intensify as a result of increasing consolidation of financial services companies in connection with current market conditions.
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We expect to face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue certain business opportunities.
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We may be required to pay in the future significantly higher FDIC assessments to insure our deposits if market conditions do not improve or if market conditions deteriorate.
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We may face higher credit losses because of federal or state legislation or regulatory action that either (i) reduces the amount that our borrowers are required to pay us, or (ii) limits our ability to foreclose on properties or collateral or makes foreclosures less economically viable.
If current levels of market disruption and volatility continue or worsen, our ability to access capital and our business, financial condition and results of operations may be materially and adversely affected.
Adverse credit market conditions may affect the Company’s ability to meet its liquidity needs; unforeseen disruptions in the brokered deposits market could compromise the Company’s liquidity position.
The credit markets, although recovering, have experienced extreme volatility and disruption. At times during the past few years, the volatility and disruptions reached unprecedented levels. In some cases, the markets have exerted downward pressure on availability of liquidity and credit capacity of certain issuers, particularly for non-investment grade issuers like us.
We need liquidity to, among other things, pay our operating expenses, interest on our debt and dividends on our preferred stock (if dividends are declared and paid), maintain our lending activities and replace certain maturing liabilities. Without sufficient liquidity, we may be forced to curtail our operations. The availability of additional financing will depend on a variety of factors such as market conditions, the general availability of credit and our credit capacity. Our cash flows and financial condition could be materially affected by continued disruptions in the financial markets.
A relatively large portion of our funding is retail brokered deposits issued by Doral Bank PR. The Company’s total brokered deposits as of December 31, 2010 were $2.4 billion. An unforeseen disruption in the brokered deposits market, stemming from factors such as legal, regulatory or financial risks, could adversely affect our ability to fund a portion of our operations and/or meet obligations.
Our business concentration in Puerto Rico imposes risks.
We conduct our operations in a geographically concentrated area, as our main market is in Puerto Rico. This imposes risks from lack of diversification in the geographical portfolio. The Company’s financial condition and results of operations are highly dependent on the economic conditions of Puerto Rico, where adverse political or economic developments or natural disasters, among other things, could affect the volume of loan originations, increase the level of non-performing assets, increase the rate of foreclosure losses and reduce the value of our loans and loan servicing portfolio.
Our credit quality may continue to be adversely affected by Puerto Rico’s current economic conditions.
The Company’s business activities and credit exposure are concentrated in Puerto Rico. Consequently, our financial condition and results of operations are highly dependent on economic conditions in Puerto Rico.
Puerto Rico’s economy is currently in a recession that began in the fourth quarter of the fiscal year that ended June 30, 2006. Although the Puerto Rico economy is closely linked to the United States economy, for fiscal years 2007, 2008 and 2009, Puerto Rico’s real gross national product decreased by 1.2%, 2.8% and 3.7%, respectively, while the United States economy grew at a rate of 1.8% and 2.8% during fiscal years 2007 and 2008, respectively, and contracted at a rate of 2.5% during fiscal year 2009. According to the Puerto Rico Planning Board’s latest projections, Puerto Rico’s real gross national product was projected to contract by 3.6% during fiscal year 2010. Puerto Rico’s real gross national product for fiscal year 2011, however, is projected to grow by 0.4%. The number of persons employed in Puerto Rico during fiscal year 2010 averaged 1,102,700, a decrease of 5.6% compared to the previous fiscal year. During the first six months of fiscal year 2011, total employment averaged 1,084,500, a decline of 2.5% compared with the same period of the previous fiscal year, and the unemployment rate averaged 15.9%.
Since 2000, the Government of Puerto Rico has experienced a structural imbalance between recurring government revenues and total expenditures. The structural imbalance was exacerbated during fiscal years 2008 and 2009, with recurring government expenditures significantly exceeding recurring government revenues. Prior to fiscal year 2009, the Puerto Rico government bridged the deficit resulting from the structural imbalance through the use of non-recurring measures, such as borrowing from the Government Development Bank for Puerto Rico or in the bond market, postponing the payment of various government expenses, such as payments to suppliers and utilities providers, and other one time measures such as the use of derivatives and borrowings collateralized with government assets such as real estate. Since March 2009, the government has taken multiple steps to address and resolve the structural imbalance.
For fiscal year 2009, the deficit was approximately $3.3 billion, consisting of the difference between revenues and expenses for such fiscal year. The estimated deficit is projected to be approximately $2.1 billion for fiscal year 2010 and approximately $1.0 billion for fiscal year 2011. Measures that the Government of Puerto Rico has implemented have included reducing expenses, including public sector employment through layoffs of employees. Since the Government of Puerto Rico is the largest source of employment in Puerto Rico, these measures have had the effect of increasing unemployment and could have the effect of intensifying the current recessionary cycle. In addition, a payment or other material default by the Government of Puerto Rico or any of its agencies, public corporations or instrumentalities with respect to their municipal bond or note obligations could have a material adverse effect on our financial condition and results of operations.
The current state of the Puerto Rico economy and continued uncertainty in the public and private sectors has had an adverse effect on the credit quality of our loan portfolios and reduced the level of our originations in Puerto Rico. The continuation of the economic slowdown would cause those adverse effects to continue, as delinquency rates may continue to increase in the short term, until sustainable growth of the Puerto Rico economy resumes. Also, potential reduction in consumer spending as a result of continued recessionary conditions may also impact growth in other interest and non-interest revenue sources of the Company.
A prolonged economic slowdown or decline in the residential real estate market in the U.S. mainland and in Puerto Rico and an increase in the continued unemployment in Puerto Rico could continue to adversely affect our results of operations.
The residential mortgage loan origination business has historically been cyclical, enjoying periods of strong growth and profitability followed by periods of shrinking volumes and industry-wide losses. The market for residential mortgage loan originations is currently in decline and this trend could also reduce the level of mortgage loans we may produce in the future and adversely affect our business. During periods of rising interest rates, refinancing originations for many mortgage products tend to decrease as the economic incentives for borrowers to refinance their existing mortgage loans are reduced. In addition, the residential mortgage loan origination business is impacted by home values. Over the past three years, residential real estate values in many areas of the U.S. have decreased significantly, which has led to lower volumes and higher losses across the industry, adversely impacting our mortgage business.
The actual rates of delinquencies, foreclosures and losses on loans have been higher during the recent economic slowdown. Rising unemployment, higher interest rates or declines in housing prices have had a greater negative effect on the ability of borrowers to repay their mortgage loans. Any sustained period of increased delinquencies, foreclosures or losses could continue to harm our ability to sell loans, the prices we receive for loans, the values of mortgage loans held for sale or residual interests in securitizations, which could continue to harm our financial condition and results of operations. In addition, any additional material decline in real estate values would further weaken the collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such loan arising from borrower defaults to the extent not covered by third-party credit enhancement.
The soundness of other financial institutions could affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, investment companies and other institutional clients. In certain of these transactions, we are required to post collateral to secure our obligations to the counterparties. In the event of a bankruptcy or insolvency proceeding involving one of such counterparties, we may experience delays in recovering the assets posted as collateral or may incur a loss to the extent that the counterparty was holding collateral in excess of the obligation to such counterparty.
Many of these transactions expose us to credit risk in the event of a default by our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to us. Any such losses could materially and adversely affect our business, financial condition and results of operations.
Monetary policies and regulations of the Federal Reserve could adversely affect our business, financial condition and results of operations.
In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, adjustments of the discount rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.
On January 6, 2010, the member agencies of the Federal Financial Institutions Examination Council, which includes the Federal Reserve and the FDIC, issued an interest rate risk advisory reminding banks to maintain sound practices for managing interest rate risk, particularly in the current environment of historically low short-term interest rates.
The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our business, financial condition and results of operations may be adverse.
Our income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the Federal Reserve). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the value of loans, investment securities and mortgage servicing assets, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits or other sources of funding.
The Dodd-Frank Wall Street Reform and Consumer Protection Act will affect our business.
On July 21, 2010, President Obama signed into law the Dodd-Frank Act. The legislation is making significant structural reforms to the financial services industry. The legislation, among other things, is:
(i)
establishing a Bureau of Consumer Financial Protection having broad authority to regulate providers of credit, savings and other consumer financial products and services, narrows the scope of federal preemption of state consumer laws and expands the authority of state attorneys general to bring actions to enforce federal consumer protection legislation;
(ii)
creating a structure to regulate systematically important financial companies, and provide regulators with the power to require such companies to sell or transfer assets and terminate activities if the regulators determine the size or the scope of the activities of the company pose a threat to the safety and soundness of the company or the financial stability of the United States;
(iii)
requiring more comprehensive regulation of the over-the-counter derivatives market, including providing for more strict capital and margin requirements, the central clearing of standardized over-the-counter derivatives, and heightened supervision of all over-the-counter derivatives dealers and major market participants;
(iv)
limiting the ability of banking entities to engage in certain proprietary trading activities and restricting their ownership of, investment in or sponsorship of hedge funds and private equity funds;
(v)
restricting the interchange fees payable on debit card transactions;
(vi)
abolishing the Office of Thrift Supervision (“OTS”) and transferring its functions and responsibilities regarding the supervision of federal savings banks, such as Doral Bank US, to the Office of the Comptroller of the Currency (“OCC”);
(vii)
strengthening the regulatory oversight of securities and capital markets activities by the US Securities and Exchange Commission (“SEC”) and enhancing the safety and soundness of the securitization process, including a requirement that securitizers and originators retain a portion of the credit risk for any asset that they securitize or originate;
(viii)
permanently increasing the federal deposit insurance from $100,000 to $250,000, permitting depository institutions to pay interest on demand deposit accounts (such as commercial checking accounts) and permitting de novo interstate branching by federal and state depository institutions alike; and
(ix)
strengthening existing laws and regulations applicable to public companies governing corporate accountability, giving shareholders “say on pay” and other corporate governance rights, and imposing limitations on certain executive compensation practices.
Some of the provisions of the legislation have already become effective. Other provisions will have extended implementation periods and delayed effective dates, and will be required to be implemented through
regulatory action of various federal regulatory authorities. Because many of the provisions require future regulatory actions for their implementation, the ultimate impact of the legislation on the financial services industry and on our business, are not completely known at this time. The implementation of many of the provisions of the legislation will affect our business and are expected to add new regulatory risk and compliance burdens and costs on the financial services industry and us. The implementation of this legislation could result in loss of revenue, limit our ability to pursue certain business opportunities we might otherwise consider engaging in, impact the value of some of the assets we hold, require us to change certain of our business practices, impose additional costs on us, establish more stringent capital, liquidity and leverage ratio requirements, or otherwise adversely affect our business.
The Company operates within a highly regulated industry and its business and results are significantly affected by the regulations to which it is subject; changes in statutes and regulations could adversely affect the Company.
We operate within a highly regulated environment. The regulations to which the Company is subject will continue to have a significant impact on the Company’s operations and the degree to which it can grow and be profitable. Certain regulators which supervise the Company have significant power in reviewing the Company’s operations and approving its business practices. These powers include the ability to place limitations or conditions on activities in which the Company engages or intends to engage. Particularly in recent years, the Company’s businesses have experienced increased regulation and regulatory scrutiny, often requiring additional Company resources.
Current economic conditions, particularly in the financial markets, have resulted in government regulatory agencies and political bodies placing increased focus and scrutiny on the financial services industry. The U.S. Government has intervened on an unprecedented scale, responding to what has been commonly referred to as the financial crisis, by enhancing the liquidity support available to financial institutions, establishing a commercial paper funding facility, temporarily guaranteeing money market funds and certain types of debt issuances, and increasing insurance on bank deposits.
These programs have subjected participating financial institutions to additional restrictions, oversight and costs. In addition, new proposals for legislation continue to be introduced in the U.S. Congress that could further increase regulation of the financial services industry and impose restrictions on the operations and general ability of firms within the industry to conduct business consistent with historical practices. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied.
We cannot predict the substance or impact of any change in regulation, whether by regulators or as a result of legislation enacted by the United States Congress or by the Puerto Rico Legislature, or in the way such statutory or regulatory requirements are interpreted or enforced. Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business practices, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner.
Further increases in the FDIC insurance assessment premiums or required reserves may have a significant impact on us.
The FDIC insures deposits at FDIC-insured depository institutions up to certain limits. The FDIC charges insured depository institutions premiums to maintain the Deposit Insurance Fund (the “DIF”). Current economic conditions have resulted in higher bank failures and expectations of future bank failures. In the event of a bank failure, the FDIC takes control of a failed bank and ensures payment of deposits up to insured limits (which have recently been increased) using the resources of the DIF. The FDIC is required by law to maintain adequate funding of the DIF, and the FDIC may increase premium assessments to maintain such funding.
On November 12, 2009, the FDIC adopted the final rule implementing a prepayment assessment for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 in order to strengthen the cash position of the DIF. The Company’s total prepaid assessment was $67.1 million, which according to the final rule was recorded as
a prepaid expense as of December 30, 2009. The prepaid assessment will be amortized and recognized by the Company as an expense over the period from 2010 to 2012.
The Dodd-Frank Act requires the FDIC to increase the DIF’s reserves against future losses, which will necessitate increased deposit insurance premiums that are expected to be borne primarily by institutions with assets of greater than $10 billion.
In October 2010, the FDIC addressed plans to bolster the DIF by increasing the required reserve ratio for the industry to 1.35 percent (ratio of reserves to insured deposits) by September 30, 2020, as required by the Dodd-Frank Act. In December 2010, the FDIC approved a final rule raising its industry target ratio of reserves to insured deposits to 2 percent, 65 basis points above the statutory minimum, but the FDIC does not project that goal to be met until 2027.
On February 7, 2010, the FDIC approved a final rule that amends its current deposit insurance assessment regulations. The final rule implements a provision in the Dodd-Frank Act that changes the assessment base for deposit insurance premiums from one based on domestic deposits to one based on average consolidated total assets minus average Tier 1 capital. The final rule also changes the assessment rate schedules for insured depository institutions so that approximately the same amount of revenue would be collected under the new assessment base as would be collected under the current rate schedule and the schedules previously proposed by the FDIC in October 2010. The final rule also revises the risk-based assessment system for all large insured depository institutions (generally, institutions with at least $10 billion in total assets). Under the proposed rule, the FDIC would use a scorecard method to calculate assessment rates for all such institutions.
As noted by the FDIC in the final rule it adopted, the final rule should keep the overall amount collected from the industry very close to unchanged, although the amounts that individual institutions pay will be different. The new large bank pricing system is expected to result in higher assessments for banks with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure.
We are generally unable to control the amount of assessments that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, or if our risk rating deteriorates for purposes of determining the level of our FDIC insurance assessments, we may be required to pay even higher FDIC insurance assessments than the recently increased levels. Any future increases in FDIC insurance assessments may materially adversely affect our results of operations.
The consolidation of the Puerto Rico banking industry as a result of bank failures in 2010 may adversely affect us.
In April 2010, the FDIC closed three Puerto Rico banks and sold some of their assets and liabilities to other banks in Puerto Rico. In the future, there may be additional bank failures, mergers and acquisitions in our industry. Any business combinations could significantly alter industry conditions and competition within the Puerto Rico banking industry and could have a material adverse effect on our financial condition and results of operations.
In addition, the strategies adopted by the FDIC and the three acquiring banks in connection with some of the residential, construction and commercial real estate loans acquired may adversely affect residential and commercial real estate values in Puerto Rico. This in turn may adversely affect the value of some of our residential, construction and commercial real estate loans, and our ability to sell or restructure some of our residential, construction and commercial real estate loans.
Changes in accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies may adversely affect the Company’s financial statements.
Our financial statements are subject to the application of GAAP, which are periodically revised and/or expanded. Accordingly, from time to time we are required to adopt new or revised accounting standards issued by the Financial Accounting Standards Board (the “FASB”). The impact of accounting pronouncements that have been issued but not yet implemented is disclosed by the Company in its filings with the SEC. An
assessment of proposed standards is not provided as such proposals are still subject to change. It is possible that future accounting standards that the Company is required to adopt could change the current accounting treatment that the Company applies to its consolidated financial statements and that such changes could have a material adverse effect on the Company’s financial condition and results of operations.
Risks related to our business
Deteriorating credit quality has adversely impacted the Company and may continue to adversely impact the Company.
The Company’s has experienced a downturn in credit quality since 2006. The Company’s credit quality has continued to be under pressure during 2010 as a result of continued recessionary conditions in Puerto Rico and the recent slow down in consumer activity and economic growth in the United States that have led to, among other things, higher unemployment levels, much lower absorption rates for new residential construction projects and further declines in property values. The Company expects that credit conditions and the performance of its loan portfolio may continue to deteriorate in the near future.
Our business depends on the creditworthiness of our customers and counterparties and the value of the assets securing our loans or underlying our investments. If the credit quality of the customer base materially decreases, if the risk profile of a market, industry or group of customers changes materially, our business, financial condition, allowance levels, asset impairments, liquidity, capital and results of operations could be adversely affected.
The allowance for loan losses is an estimate of incurred losses inherent in the loan portfolio and as such it may not be adequate to cover the actual portfolio losses. As a result, future loan loss provisions may be required.
The Company establishes an allowance for loan and lease losses at a level estimated as the amount of incurred losses inherent in the portfolio as of the related financial statement date based upon analysis of past portfolio default trends, severity experience, and fair value estimates, and records a provision for loan and lease losses which adjusts the allowance for loan and lease loss balance to the estimated amount as a charge to current period income.
The allowance for loan and leases is an estimate of incurred losses in the loan portfolio made pursuant to accounting guidance, that by accounting principles does not consider or estimate all future losses that will be incurred. In addition, bank regulatory agencies, such as FDIC and the Office of the Commissioner, periodically review the adequacy of our allowance for loan and lease losses and may require an increase in the provision for loan and lease losses or loan charge-offs. Accordingly, additional loan loss provisions may be required, and such provisions may materially affect our results of operations, financial condition and capital.
Changes in collateral values of properties located in recessionary economies may require increased reserves.
The performance of our loan portfolio and the collateral value backing the loan transactions are dependent upon the performance of and conditions within each specific real estate market. Recent economic reports related to the real estate market in Puerto Rico indicate that certain pockets of the real estate market are subject to readjustments in value driven not by demand but more by the purchasing power of the consumers and general recessionary economic conditions. We measure the impairment of a loan based on the fair value of the collateral, if collateral dependent, which is generally obtained from appraisals. Updated appraisals are requested when we determine that loans are impaired and are updated annually thereafter. In addition, appraisals are also obtained for certain residential mortgage loans on a spot basis based on specific characteristics such as delinquency levels, age of the appraisal and LTV ratios. The appraised value of the collateral may decrease or we may not be able to recover collateral at its appraised value. A significant decline in collateral valuations for collateral dependent loans may require increases in our specific provision for loan losses and an increase in the general valuation allowance. Any such increase would have an adverse effect on our future financial condition and results of operations.
Interest rate shifts may reduce net interest income.
Shifts in short-term interest rates may reduce net interest income, which is the principal component of our earnings. Net interest income is the difference between the amounts received by us on our interest-earning assets and the interest paid by us on our interest-bearing liabilities. When interest rates rise, the rate of interest we pay on our liabilities generally rises more quickly than the rate of interest that we receive on our interest-bearing assets, which may cause our profits to decrease. The impact on earnings is more adverse when the slope of the yield curve flattens, that is, when short-term interest rates increase more than long-term interest rates or when long-term interest rates decrease more than short-term interest rates.
Increases in interest rates may reduce the value of holdings of securities and demand for mortgage and other loans.
Fixed-rate securities acquired by us are generally subject to decreases in market value when interest rates rise, which may require recognition of a loss (e.g., the identification of other-than-temporary impairment on our investments portfolio), thereby adversely affecting our results of operations. Market-related reductions in value also influence our ability to finance these securities.
Higher interest rates also increase the cost of mortgage and other loans to consumers and businesses and may reduce demand for such loans, which may negatively impact our profits by reducing the amount of our loan origination income.
The Company and its banking subsidiaries are subject to regulatory capital adequacy and other supervisory guidelines, and if we fail to meet those guidelines our business and financial condition would be adversely affected.
Under regulatory capital adequacy guidelines and other regulatory requirements, our banking subsidiaries must meet guidelines that include quantitative measures of assets, liabilities and certain off balance sheet items, subject to quantitative judgments by regulators regarding components, risk weightings and other factors. Supervisory guidelines also address, among other things, asset quality and liquidity. If the Company and its banking subsidiaries fail to meet these minimum capital and other supervisory and regulatory requirements, our business and financial condition will be adversely affected. A failure to meet regulatory capital adequacy guidelines, among other things, would affect our banking subsidiaries ability to accept or rollover brokered deposits and could result in supervisory actions by federal and/or Puerto Rico banking authorities.
The hedging transactions that the Company enters into may not be effective in managing the exposure to interest rate risk.
The Company uses derivatives, to a limited extent, to manage part of its exposure to market risk caused by changes in interest rates. The derivative instruments that the Company may use also have their own risks, which include: (i) basis risk, which is the risk of loss associated with variations in the spread between the asset yield and funding and/or hedge cost; (ii) credit or default risk, which is the risk of insolvency or other inability of the counterparty to a particular transaction to perform its obligations; and (iii) legal risk, which is the risk that the Company is unable to enforce the terms of such instruments. All or any of these risks could expose the Company to losses.
Our risk management policies and procedures may leave us exposed to unidentified or unanticipated risk, which could negatively affect us.
Management of risk requires, among other things, policies and procedures to record properly and verify a large number of transactions and events. We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our policies and procedures may not be comprehensive given current market conditions. Some of our methods for managing risk and exposures are based upon the use of observed historical market behavior or statistics based on historical models. As a result, these methods may not fully predict future exposures, which could be significantly greater than our historical measures indicate. Other risk management methods depend on the
evaluation of information regarding markets, clients or other matters that is publicly available or otherwise accessible to us. This information may not always be accurate, complete, up-to-date or properly evaluated.
The preparation of our financial statements requires the use of estimates that may vary from actual results.
The preparation of consolidated financial statements in conformity with GAAP requires management to make significant estimates that affect our financial statements. Three of the Company’s most critical estimates are the level of the allowance for loan and lease losses, the valuation of mortgage servicing rights, and the amount of its deferred tax asset.
Due to the inherent nature of these estimates the Company may significantly increase the allowance for loan and lease losses and/or sustain credit losses that are significantly higher than the provided allowance, and may recognize a significant provision for impairment of its mortgage servicing rights. If the Company’s allowance for loan and lease losses is not adequate, the Company’s business, financial condition, including its liquidity and capital, and results of operations could be materially adversely affected. Additionally, in the future, the Company may increase its allowance for loan and lease losses, which could have a material adverse effect on its capital and results of operations.
As of December 31, 2010, the Company had a deferred tax asset of approximately $105.7 million. The deferred tax asset is net of a valuation allowance of $462.7 million. The realization of the Company’s deferred tax asset ultimately depends on the existence of sufficient taxable income to realize the value of this asset. Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that the Company will be required to record adjustments to the valuation allowance in future reporting periods. The Company’s results of operations would be negatively impacted if it determines that increases to its deferred tax asset valuation allowance are required in a future reporting period.
Defective and repurchased loans may harm our business and financial condition.
In connection with the sale and securitization of mortgage loans, the Company is required to make a variety of customary representations and warranties regarding the Company and the loans being sold or securitized. The Company’s obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and they relate to, among other things:
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compliance with laws and regulations;
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underwriting standards;
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the accuracy of information in the loan documents and loan file; and
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the characteristics and enforceability of the loan.
A loan that does not comply with these representations and warranties may take longer to sell, may impact the Company’s ability to obtain third-party financing for the loan, and be unsalable or salable only at a significant discount. If such a loan is sold before the Company detects a noncompliance, the Company may be obligated to repurchase the loan and bear any associated loss directly, or the Company may be obligated to indemnify the purchaser against any such loss, either of which could reduce the Company’s cash available for operations and liquidity. The Company’s management believes that it has established controls to ensure that loans are originated in accordance with the secondary market’s requirements, but mistakes may be made, or certain employees may deliberately violate the Company’s lending policies. The Company seeks to minimize repurchases and losses from defective loans by correcting flaws, if possible, and selling or re-selling such loans. The Company does not have a reserve on its financial statements for possible losses related to repurchases resulting from representation and warranty violations because it does not expect any such losses to be significant. Losses associated with defective loans may adversely impact our results of operations or financial condition.
We are exposed to credit risk from mortgage loans held pending sale and mortgage loans that have been sold subject to recourse arrangements.
The Company is generally at risk for mortgage loan defaults from the time it funds a loan until the time the loan is sold or securitized into a mortgage-backed security. In the past, the Company retained, through recourse arrangements, part of the credit risk on sales of mortgage loans that did not qualify for GNMA, FNMA or FHLMC sale or exchange programs and consequently may suffer losses on these loans. The Company suffers losses on these loans when the proceeds from a foreclosure sale of the property underlying a defaulted mortgage loan are less than the outstanding principal balance of the loan and the costs of holding and disposing of the related property. The Company estimates the fair value of the retained recourse obligation or any liability incurred at the time of sale and includes such obligation with the net proceeds from the sale, resulting in lower gain-on-sale recognition. The Company evaluates the fair value of its recourse obligation based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment.
We are subject to risks in servicing loans for others.
The Company’s profitability may also be adversely affected by mortgage loan delinquencies and defaults on mortgage loans that it services for third parties. Under many of its servicing contracts, the Company must advance all or part of the scheduled payments to the owner of an outstanding mortgage loan, even when mortgage loan payments are delinquent. In addition, in order to protect their liens on mortgaged properties, owners of mortgage loans usually require that the Company, as servicer, pay mortgage and hazard insurance and tax payments on schedule even if sufficient escrow funds are not available. The Company generally recovers its advances from the mortgage owner or from liquidation proceeds when the mortgage loan is foreclosed. However, in the interim, the Company must absorb the cost of the funds it advances during the time the advance is outstanding. The Company must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a default is not cured, the mortgage loan will be canceled as part of the foreclosure proceedings and the Company will not receive any future servicing income with respect to that loan.
As a result of our credit ratings, we may be subjected to increased collateral requirements and other measures that could have an adverse impact on our results of operations and financial condition.
We have previously sold or securitized mortgage loans in transactions with FNMA and other counterparties subject to partial or full recourse. As of December 31, 2010, the maximum contractual exposure to the Company if it were required to purchase all loans sold subject to partial or full recourse was $0.7 billion, $0.6 billion of which consisted of exposure to FNMA. Our contractual agreements with FNMA authorize FNMA to require us to post additional collateral to secure our recourse obligations with FNMA, and FNMA has the contractual right to request collateral for the full amount of our recourse obligations when, as now, we do not maintain an investment grade rating. In January 2006, we agreed to post with FNMA $44.0 million in collateral to secure our recourse obligations. In addition, certain of our servicing agreements, such as those with FNMA, FHLMC, and GNMA, contain provisions triggered by changes in our financial condition or failure to maintain required credit ratings. We do not currently maintain the credit ratings required by GNMA and possibly other counterparties, which may result in increased collateral requirements and/or require us to engage a substitute fund custodian, or could result in termination of our servicing rights. Termination of our servicing rights, requirements to post additional collateral or the loss of custodian funds could reduce our liquidity and have an adverse impact on our operating results.
Our ability to sell loans and other mortgage products to government-sponsored entities could be impacted by changes in our financial condition or the historical performance of our mortgage products.
Our ability to sell mortgage products to government-sponsored entities (“GSEs”), such as FNMA, FHLMC and GNMA, depends, among other things, on our financial condition and the historical performance of our mortgage products. To protect our ability to continue to sell mortgage products to GNMA and other GSEs, we have and may in the future repurchase defaulted loans from such counterparties. During 2010 and
2009, we repurchased $68.2 million and $127.9 million, respectively, of defaulted FHA guaranteed loans from GNMA. Any such repurchases in the future may negatively impact our liquidity and operating results. Termination of our ability to sell mortgage products to the GSEs would have a material adverse effect on our results of operations and financial condition.
We may engage in FDIC-assisted transactions, which could present additional risks to our business.
We may have opportunities to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. Although these transactions typically provide for FDIC assistance to an acquirer to mitigate certain risks, such as sharing exposure to loan losses and providing indemnification against certain liabilities of the failed institution, we would still be subject to many of the same risks we would face in acquiring another bank in a negotiated transaction, including risks associated with maintaining customer relationships and failure to realize the anticipated acquisition benefits in the amounts and within the timeframes we expect. In addition, because these transactions are structured in a manner that would not allow us the time and access to information normally associated with preparing for and evaluating a negotiated transaction, we may face additional risk in FDIC-assisted transactions, including additional strain on management resources, management of problem loans, problems related to integration of personnel and operating systems and impact to our capital resources requiring us to raise additional capital. We may not be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions. Our inability to overcome these risks could have a material effect on our business, financial condition and results of operations.
We may fail to retain and attract key employees and management personnel.
Our success has been and will continue to be influenced by our ability to retain and attract key employees and management personnel, including senior and middle management. Our ability to attract and retain key employees and management personnel may be adversely affected as a result of the workload and stress associated with the resolution of legacy issues and business transformation efforts, and related risks and uncertainties; the consolidation of the Puerto Rico banking industry; or by additional work relating to any potential or actual acquisition.
Competition with other financial institutions could adversely affect the profitability of our operations.
The Company faces significant competition from other financial institutions, many of which have significantly greater assets, capital and other resources. As a result, many of the Company’s competitors have advantages in conducting certain businesses and providing certain services. This competitive environment could force the Company to increase the rates it offers on deposits or lower the rates it charges on loans and, consequently, could adversely affect the profitability of its operations.
Damage to our reputation could damage our businesses.
Maintaining a positive reputation for the Company is critical to the Company attracting and maintaining customers, investors and employees. Damage to its reputation can therefore cause significant harm to the Company’s business and prospects. Harm to the Company’s reputation can arise from numerous sources, including, among others, employee misconduct, litigation or regulatory outcomes, failing to deliver minimum standards of service and quality, compliance failures, unethical behavior, and the activities of customers and counterparties. Negative publicity regarding the Company, whether or not true, may also result in harm to the Company’s prospects.
We must respond to rapid technological changes, and these changes may be more difficult or expensive than anticipated.
If competitors introduce new products and services embodying new technologies, or if new industry standards and practices emerge, our existing product and service offerings, technology and systems may become obsolete. Further, if we fail to adopt or develop new technologies or to adapt our products and services to emerging industry standards, we may lose current and future customers, which could have a
material adverse effect on our business, financial condition and results of operations. The financial services industry is changing rapidly and in order to remain competitive, we must continue to enhance and improve the functionality and features of our products, services and technologies. These changes may be more difficult or expensive than we anticipate.
Doral Financial and its banking subsidiaries are subject to the supervision and regulation of various banking regulators and have entered into consent orders with these regulators, and these regulators could take action against the Company or its banking subsidiaries.
As a regulated financial services firm, the Company’s good standing with its regulators is of fundamental importance to the continuation and growth of its businesses. Doral Financial is subject to supervision and regulation by the Federal Reserve and the Office of the Commissioner, Doral Bank PR is subject to supervision and regulation by the FDIC and the Office of the Commissioner and Doral Bank US is subject to supervision and regulation by the OTS and the FDIC.
Federal banking regulators, in the performance of their supervisory and enforcement duties, have significant discretion and power to initiate enforcement actions for violations of laws and regulations and unsafe or unsound practices. The enforcement powers available to federal banking regulators include, among others, the ability to assess civil monetary penalties, to issue cease-and-desist or removal orders, to require written agreements and to initiate injunctive actions. Doral Financial and Doral Bank PR have entered into consent orders with the Federal Reserve, the FDIC and the Office of the Commissioner, which, among other things, prohibited the Company’s banking subsidiaries from paying dividends to the parent company, and prohibited Doral Financial from paying dividends to its common and preferred shareholders, without regulatory approval and required Doral Bank PR to take various actions to ensure compliance with the provisions of the Bank Secrecy Act. While the FDIC and the Office of the Commissioner have lifted their consent orders, these banking regulators could take further action with respect to Doral Financial or our banking subsidiaries and, if any such further action were taken, such action could have a material adverse effect on Doral Financial. Doral Financial’s consent order with the Federal Reserve is still in effect and the Company’s banking regulators could take additional actions to protect the Company’s banking subsidiaries or to ensure that the holding company remains as a source of financial and managerial strength to its banking subsidiaries, and such action could have adverse effects on the Company or its stockholders.
Doral Financial has been the subject of an investigation by the U.S. Attorney’s Office for the Southern District of New York, which could require it to pay substantial fines or penalties.
On August 24, 2005, Doral Financial received a grand jury subpoena from the U.S. Attorney’s Office for the Southern District of New York regarding the production of certain documents, including financial statements and corporate, auditing and accounting records prepared during the period relating to the restatement of Doral Financial’s financial statements. Doral Financial cannot predict when this investigation will be completed or what the results of this investigation will be. The effects and results of this investigation could have a material adverse effect on Doral Financial’s business, results of operations, financial condition and liquidity. Adverse developments related to this investigation, including any expansion of its scope, could negatively impact the Company and could divert efforts and attention of its management team from Doral Financial’s ordinary business operations. Doral Financial may be required to pay material fines, judgments or settlements or suffer other penalties, each of which could have a material adverse effect on its business, results of operations, financial condition and liquidity. This investigation could adversely affect Doral Financial’s ability to obtain, and/or increase the cost of obtaining, directors’ and officers’ liability insurance and/or other types of insurance, which could have a material adverse effect on Doral Financial’s businesses, results of operations and financial condition.
Doral Financial may be required to advance significant amounts to cover the reasonable legal and other expenses of its former officers and directors.
Under Doral Financial’s by-laws, Doral Financial is obligated to pay in advance the reasonable expenses incurred by former officers and directors in defending civil or criminal actions or proceedings pending final
disposition of such actions. Since 2005, Doral Financial has been advancing funds on behalf of various former officers and directors in connection with the grand jury proceeding referred to above and ongoing investigations by the SEC relating to the restatement of Doral Financial’s financial statements.
On March 6, 2008, a former treasurer of Doral Financial was indicted for alleged criminal violations involving securities and wire fraud. On April 29, 2010, the former treasurer of Doral was convicted on three of the five counts of securities and wire fraud he was facing after a five-week jury trial.
On August 13, 2009, the former treasurer of Doral filed a complaint against the Company in the Supreme Court of the State of New York. The complaint alleges that the Company breached a contract with the plaintiff and the Company’s by-laws by failing to advance payment of certain legal fees and expenses that Mr. Levis has incurred in connection with a criminal indictment filed against him in the U.S. District Court for the Southern District of New York. Further, the complaint claims that Doral Financial fraudulently induced the plaintiff to enter into agreements concerning the settlement of a civil litigation arising from the restatement of the Company’s financial statements for fiscal years 2000 through 2004. The complaint seeks declaratory relief, damages, costs and expenses. The former treasurer further moved for preliminary injunctive relief. On December 16, 2009, the parties entered into a Settlement Agreement. On December 17, 2009, the former treasurer’s motion for a preliminary injunction was denied as moot, and all further proceedings were stayed, but the procedures for future disputes between the parties and outlined in the Settlement Agreement were not affected by the stay. The amounts required to be advanced in an appeal of the criminal conviction could be substantial and could materially adversely affect Doral Financial’s results of operations.
Our businesses may be adversely affected by litigation.
From time to time, our customers, or the government on their behalf, may make claims and take legal action relating to our performance of fiduciary or contractual responsibilities. We may also face employment lawsuits or other legal claims. In any such claims or actions, demands for substantial monetary damages may be asserted against us resulting in financial liability or an adverse effect on our reputation among investors or on customer demand for our products and services. We may be unable to accurately estimate our exposure to litigation risk when we record balance sheet reserves for probable loss contingencies. As a result, any reserves we establish to cover any settlements or judgments may not be sufficient to cover our actual financial exposure, which may have a material impact on our consolidated results of operations or financial condition.
In the ordinary course of our business, we are also subject to various regulatory, governmental and law enforcement inquiries, investigations and subpoenas. These may be directed generally to participants in the businesses in which we are involved or may be specifically directed at us. In regulatory enforcement matters, claims for disgorgement, the imposition of penalties and the imposition of other remedial sanctions are possible.
Risks related to our common stock
Additional issuances of common stock or securities convertible into common stock may further dilute existing holders of our common stock.
We may determine that it is advisable, or we may encounter circumstances where we determine it is necessary, to issue additional shares of our common stock, securities convertible into or exchangeable for shares of our common stock, or common-equivalent securities to fund strategic initiatives or other business needs or to raise additional capital. Depending on our capital needs, we may make such a determination in the near future or in subsequent periods. The market price of our common stock could decline as a result of any such future offering, as well as other sales of a large block of shares of our common stock or similar securities in the market thereafter, or the perception that such sales could occur.
In addition, such additional equity issuances would reduce any earnings available to the holders of our common stock and the return thereon unless our earnings increase correspondingly. We cannot predict the timing or size of future equity issuances, if any, or the effect that they may have on the market price of the
common stock. The issuance of substantial amounts of equity, or the perception that such issuances may occur, could adversely affect the market price of our common stock.
Dividends on our common stock have been suspended; Doral Financial may not be able to pay dividends on its common stock in the future.
Holders of our common stock are only entitled to receive such dividends as our board of directors may declare out of funds legally available for such payments. On April 25, 2006, we announced that, as a prudent capital management decision designed to preserve and strengthen the Company’s capital, our board of directors had suspended the quarterly dividend on common stock. In addition, we will be unable to pay dividends on our common stock unless and until we resume payments of dividends on our preferred stock, which were suspended by the Board of Directors in March 2009.
The Company’s ability to pay dividends in the future is limited by various regulatory requirements and policies of bank regulatory agencies having jurisdiction over the Company and such other factors deemed relevant by our board of directors. Under an existing consent order with the Federal Reserve, we are restricted from paying dividends on our capital stock without the prior written approval of the Federal Reserve. We are required to request permission for the payment of dividends on our common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date. We may not receive approval for the payment of such dividends in the future or, even with such approval, our board of directors may not resume payment of dividends.
The price of our common stock may be subject to fluctuations and volatility.
The market price of our common stock could be subject to significant fluctuations because of factors specifically related to our businesses and general market conditions. Factors that could cause such fluctuations, many of which could be beyond our control, include the following:
•
changes or perceived changes in the condition, operations, results or prospects of our businesses and market assessments of these changes or perceived changes;
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announcements of strategic developments, acquisitions and other material events by us or our competitors;
•
changes in governmental regulations or proposals, or new government regulations or proposals, affecting us, including those relating to general market or economic conditions and those that may be specifically directed to us;
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the continued decline, failure to stabilize or lack of improvement in general market and economic conditions in our principal markets;
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the departure of key personnel;
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changes in the credit, mortgage and real estate markets;
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operating results that vary from expectations of management, securities analysts and investors;
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operating and stock price performance of companies that investors deem comparable to us;
•
changes in financial reports by securities analysts;
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developments related to investigations, proceedings, or litigation that involves us; and
•
the occurrence of major catastrophic events, including terrorist attacks.
All of our debt obligations and our preferred stock will have priority over our common stock with respect to payment in the event of a liquidation, dissolution or winding up.
In any liquidation, dissolution or winding up of Doral Financial, our common stock would rank below all debt claims against us and all of our outstanding shares of preferred stock. As a result, holders of our common
stock will not be entitled to receive any payment or other distribution of assets upon the liquidation or dissolution until after our obligations to our debt holders and holders of preferred stock have been satisfied.
Our certificate of incorporation, our by-laws and certain banking law provisions contain provisions that could discourage an acquisition or change of control of the Company.
Certain provisions under Puerto Rico and federal banking laws and regulations, together with certain provisions of our certificate of incorporation and by-laws, may make it more difficult to effect a change in control of our company, to acquire us or to replace incumbent management. These provisions could potentially deprive our stockholders of opportunities to sell shares of our common stock at above-market prices.
Our suspension of preferred stock dividends could result in the expansion of our board of directors.
On March 20, 2009, our board of directors announced that it had suspended the declaration and payment of all dividends on all outstanding series of our convertible preferred stock and our noncumulative preferred stock. The suspension of dividends for our noncumulative preferred stock was effective and commenced with the dividends for the month of April 2009. The suspension of dividends for our convertible preferred stock was effective and commenced with the dividends for the quarter commencing in April 2009.
Since we have not paid dividends in full on our noncumulative preferred stock for at least eighteen consecutive monthly periods, or paid dividends in full on our convertible preferred stock for consecutive dividend periods containing in the aggregate a number of days equivalent to at least six fiscal quarters, the holders of our preferred stock, all acting together as a single class, have the right to elect two additional members to our board of directors.
Item 1B.
Item 1B.
Unresolved Staff Comments.
None.
Item 2.
Item 2.
Properties.
Doral Financial maintains its principal administrative and executive offices in an office building known as the Doral Financial Plaza, located at 1451 Franklin D. Roosevelt Avenue in San Juan, Puerto Rico. The Doral Financial Plaza is owned in fee simple by Doral Properties, Inc., a wholly-owned subsidiary of Doral Financial, and has approximately 200,000 square feet of office and administrative space. The cost of the building, related improvements and land was approximately $48.4 million. The building is subject to a mortgage in the amount of $38.4 million.
In addition, Doral Financial maintains 34 retail banking branches in Puerto Rico at which mortgage origination offices are co-located in 33 of these branches. Of the properties on which the 34 branch locations are located, 10 properties are owned by Doral Financial and 24 properties are leased by Doral Financial from third parties.
Also, Doral Financial maintains approximately 31,311 square feet leased to tenants unrelated to the Company.
The administrative and executive offices of Doral Bank US and Doral Money are located at 623 Fifth Avenue in New York, New York, where it leases approximately 19,400 square feet. Also, Doral Bank US opened an additional administrative office located at 100 Richard Jackson Blvd. in Panama City Beach, Florida, where it leases approximately 4,750 square feet. In addition, Doral Bank US opened during 2010 one branch in the metropolitan area of New York City and three branches in the northwest area of Florida. All these new branches are leased by Doral Bank US from third parties. In addition to these new branches, Doral Bank US plans to open during 2011 three additional branches in Florida which are owned by Doral Bank US and at least one additional branch in the metropolitan area of New York that was leased by Doral Bank US from third parties.
Doral Financial considers that its properties are generally in good condition, are well maintained and are generally suitable and adequate to carry on Doral Financial’s business.
Item 3.
Item 3.
Legal Proceedings.
Doral Financial and its subsidiaries are defendants in various lawsuits or arbitration proceedings arising in the ordinary course of business, including employment related matters. Management believes, based on the opinion of legal counsel, that the aggregated liabilities, if any, arising from such actions will not have a material adverse effect on the financial condition or results of operations of Doral Financial.
Since 2005, Doral Financial became a party to various legal proceedings, including regulatory and judicial investigations and civil litigation, arising as a result of the Company’s restatement.
Legal Matters
On August 24, 2005, the U.S. Attorney’s Office for the Southern District of New York served Doral Financial with a grand jury subpoena seeking the production of certain documents relating to issues arising from the restatement, including financial statements and corporate, auditing and accounting records prepared during the period from January 1, 2000 to the date of the subpoena. Doral Financial is cooperating with the U.S. Attorney’s Office in this matter. Doral Financial cannot predict the outcome of this matter and is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact to Doral Financial of this matter.
On August 13, 2009, Mario S. Levis, the former Treasurer of Doral, filed a complaint against the Company in the Supreme Court of the State of New York. The complaint alleges that the Company breached a contract with the plaintiff and the Company’s by-laws by failing to advance payment of certain legal fees and expenses that Mr. Levis has incurred in connection with a criminal indictment filed against him in the U.S. District Court for the Southern District of New York. Further, the complaint claims that Doral Financial fraudulently induced the plaintiff to enter into agreements concerning the settlement of a civil litigation arising from the restatement of the Company’s financial statements for fiscal years 2000 through 2004. The complaint seeks declaratory relief, damages, costs and expenses. On December 18, 2009, the parties entered into a Settlement Agreement. On December 17, 2009, Mr. Levis’ motion for a preliminary injunction was denied as moot, and all further proceedings were stayed, but the procedures for future disputes between the parties and outlined in the Settlement Agreement were not affected by the stay.
Lehman Brothers Transactions
Doral Financial and Doral Bank PR (combined “Doral”), had counterparty exposure to Lehman Brothers, Inc. (“LBI”) in connection with repurchase financing agreements and forward To-Be-Announced (“TBA”) agreements. LBI was placed in a Securities Investor Protection Corporation (“SIPC”) liquidation proceeding after the filing for bankruptcy of its parent Lehman Brothers Holdings, Inc. The filing of the SIPC liquidation proceeding was an event of default under the repurchase financing agreements and the forward TBA agreements resulting in their termination as of September 19, 2008.
The termination of the agreements led to a reduction in the Company’s total assets and total liabilities of approximately $509.8 million and caused Doral to recognize a previously unrealized loss on the value of the securities subject to the agreements, resulting in a $4.2 million charge during the third quarter of 2008. In January 2009, Doral timely filed customer claims against LBI in the SIPC liquidation proceeding for LBI that it is owed approximately $43.3 million, representing the excess of the value of the securities held by LBI above the amounts owed by Doral under the agreements, plus ancillary expenses and interest. Doral has fully reserved ancillary expenses and interest.
On August 19, 2009, the SIPC trustee issued notices of determination to Doral (i) denying Doral’s claims for treatment as a customer with respect to the cash and/or securities held by LBI under the repurchase financing agreements and forward TBA agreements between Doral and LBI, and (ii) converting Doral’s claims to general creditor claims. On September 18, 2009, Doral timely filed its objections in bankruptcy court to these determinations by the SIPC trustee, which objections remain pending.
In December 2008, the SIPC trustee announced that it expected to have enough assets to cover customer claims, but stated that it could not determine at that point what would be available to pay general creditors.
Based on the information available in the fourth quarter of 2008, Doral determined that the process would likely take more than a year and that mounting legal and operating costs would likely impair the ability of LBI to pay 100% of the claims filed against it, especially for general creditors. The fourth quarter of 2008 also saw the continued decline in asset values, and management concluded that it was likely that LBI assets would also decline in value. As a result, Doral accrued as of December 31, 2008, a loss of $21.6 million against the $43.3 million owed by LBI.
On October 5, 2009, the SIPC trustee filed a motion in bankruptcy court seeking leave to allocate property within the LBI estate entirely to customer claims in which it asserted that “the colorable customer claims will approach - and, depending on how certain disputed issues are resolved, could exceed- the assets available to the SIPC trustee for distribution.” Based on the information available in the second quarter of 2010, Doral determined that there was further impairment in the likely ability of LBI to pay 100% of the claims filed against it. As a result, Doral recognized an additional loss of $10.8 million against the $43.3 million owed by LBI. A net receivable of $10.9 million was recorded in “Accounts Receivable” on the Company’s consolidated statements of financial condition.
During the fourth quarter of 2010, Doral sold and assigned to a third party all of Doral’s rights, title, and interest in and to its claims in the SIPC proceeding, including all of its rights to prosecute its claims, as a result of which Doral recognized a loss of $1.5 million on the net receivable.
Banking Regulatory Matters
On March 16, 2006, Doral Financial entered into a consent cease and desist order with the Federal Reserve. The mutually agreed upon order required Doral Financial to conduct reviews of its mortgage portfolio, and to submit plans regarding the maintenance of capital adequacy and liquidity. The consent order contains restrictions on Doral Financial from obtaining extensions of credit from, or entering into certain asset purchase and sale transactions with its banking subsidiaries, without the prior approval of the Federal Reserve. The consent order restricts Doral Financial from receiving dividends from the banking subsidiaries without the approval of the respective primary banking regulatory agency. Doral Financial is also required to request permission from the Federal Reserve for the payment of dividends on its common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date and requires Doral Financial and Doral Bank PR to submit plans regarding the maintenance of minimum levels of capital and liquidity. Doral Financial has complied with these requirements and no fines or civil money penalties were assessed against the Company under the order.
Effective January 14, 2008, the FDIC and the Office of the Commissioner terminated a cease and desist order that had been entered by these regulatory agencies with Doral Bank PR on March 16, 2006 (the “Former Order”). The Former Order was similar to the consent order of Doral Financial with the Federal Reserve described above, and related to safety and soundness issues in connection with the announcement by Doral Financial in April 2005 of the need to restate its financial statements for the period from January 1, 2000 to December 31, 2004.
As a result of an examination conducted during the third quarter of 2008, on July 8, 2009, Doral Bank PR consented with the FDIC and paid civil monetary penalties of $38,030 related to deficiencies in compliance with the National Flood Insurance Act as a result of flood insurance coverage, failure to maintain continuous flood insurance protection and failure to ensure that borrowers obtain flood insurance in a timely manner.
On February 19, 2008, Doral Bank PR entered into a consent order with the FDIC relating to failure to comply with certain requirements of the Bank Secrecy Act (“BSA”). The regulatory findings that resulted in the order were based on an examination conducted for the period ended December 31, 2006, and were related to findings that had initially occurred in 2005 prior to the Company’s change in management and the Recapitalization. The order replaced the Memorandum of Understanding with the FDIC and the Office of the Commissioner dated August 23, 2006. Doral Bank PR was not required to pay any civil monetary penalties in connection with this order. The order required Doral Bank PR to correct certain violations of law, within the timeframes set forth in the order (generally 120 days) including certain violations regarding the BSA, failure to maintain an adequate BSA/Anti-Money Laundering Compliance Program (a “BSA/AML Compliance
Program”) and failure to operate with an effective compliance program to ensure compliance with the regulations promulgated by the United States Department of Treasury’s Office of Foreign Asset Control (“OFAC”). The order further required Doral Bank PR to, among other things, amend its policies, procedures and processes and training programs to ensure full compliance with the BSA and OFAC; conduct an expanded BSA/AML risk assessment of its operations, enhance its due diligence and account monitoring procedures, review its BSA/AML staffing and resource needs, amend its policies and procedures for internal and external audits to include periodic reviews for BSA/AML compliance, OFAC compliance and perform annual independent testing programs for BSA/AML and OFAC requirements. The order also required Doral Bank PR to engage an independent consultant to review account and transaction activity from April 1, 2006 through March 31, 2007 to determine compliance with suspicious activity reporting requirements (the “Look Back Review”). On September 15, 2008, the FDIC terminated this consent order. As the Look Back Review was in process, Doral Bank PR and the FDIC agreed to a Memorandum of Understanding that covered the remaining portion of the Look Back Review. On June 30, 2009, the FDIC terminated this Memorandum of Understanding because the Look Back Review had been completed.
Doral Financial and Doral Bank PR have undertaken specific corrective actions to comply with the requirements of the terminated enforcement actions and the single remaining enforcement action, but cannot give assurance that such actions are sufficient to prevent further enforcement actions by the banking regulatory agencies.
Item 4.
Item 4.
Removed and Reserved
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Doral Financial’s common stock, $0.01 par value per share (the “Common Stock”), is traded and quoted on the New York Stock Exchange (“NYSE”) under the symbol “DRL.”
The table below sets forth, for the calendar quarters indicated, the high and low closing sales prices.
As of February 25, 2011, the approximate number of record holders of Doral Financial’s Common Stock was 431, which does not include beneficial owners whose shares are held in record names of brokers and nominees. The last sales price for the Common Stock as quoted on the NYSE on such date was $1.28 per share.
Preferred Stock
Doral Financial has three outstanding series of nonconvertible preferred stock: 7.25% noncumulative monthly income preferred stock, Series C (liquidation preference $25 per share); 8.35% noncumulative monthly income preferred stock, Series B (liquidation preference $25 per share); and 7% noncumulative monthly income preferred stock, Series A (liquidation preference $50 per share) (collectively, the “Noncumulative Preferred Stock”).
During 2003, Doral Financial issued 1,380,000 shares of its 4.75% perpetual cumulative convertible preferred stock (the “Convertible Preferred Stock”) having a liquidation preference of $250 per share in a private offering to qualified institutional buyers pursuant to Rule 144A. Each share of the Convertible Preferred Stock is currently convertible into 0.31428 shares of common stock, subject to adjustment under specific conditions. The Convertible Preferred Stock ranks on parity with Doral Financial’s outstanding Noncumulative Preferred Stock with respect to dividend rights and rights upon liquidation, winding up or dissolution. As of December 31, 2010, there were 813,526 shares issued and outstanding of the Convertible Preferred Stock.
The terms of Doral Financial’s outstanding preferred stock do not permit Doral Financial to declare, set apart or pay any dividends or make any other distribution of assets, or redeem, purchase, set apart or otherwise acquire shares of the Common Stock, or any other class of Doral Financial’s stock ranking junior to the preferred stock, unless all accrued and unpaid dividends on the preferred stock and any parity stock, at the time those dividends are payable, have been paid and the full dividend on the preferred stock for the current dividend period is contemporaneously declared and paid or set aside for payment. The terms of the preferred stock provide that if Doral Financial is unable to pay in full dividends on the preferred stock and other shares of stock of equal rank as to the payment of dividends, all dividends declared upon the preferred stock and such other shares of stock be declared pro rata.
On May 7, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock and a cash payment in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on May 7, 2009 and expired on June 8, 2009. Each of the series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement that was filed with the SEC on May 7, 2009, as amended. The transaction was settled on June 11, 2009. As a result of the exchange offer, Doral issued an aggregate of 3,953,892 shares of common stock and paid an aggregate of $5.0 million in cash premium payments and recognized a non-cash credit to retained earnings (with a corresponding charge to additional paid in capital) of $9.4 million that was added to net income available to common shareholders in calculating earnings per share. This exchange resulted in an increase in common equity of $100.6 million and a decrease in preferred stock of $105.6 million.
On October 20, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock for a limited number of its Convertible Preferred Stock. The offer to exchange commenced on October 20, 2009 and expired on December 9, 2009. The transaction was settled on December 14, 2009. Pursuant to the terms of the offer to exchange, the Company issued 4,300,301 shares of common stock in exchange for 208,854 shares of Convertible Preferred Stock. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of $52.2 million, as well as a non-cash charge to retained earnings of $18.0 million (with a corresponding credit to additional paid in capital) that was deducted from net income available to common shareholders in calculating earnings per share.
On February 11, 2010, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on February 11, 2010 and expired on March 19, 2010. Each of the four series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement and Prospectus that were filed with the SEC. The transaction was settled on March 24, 2010. As a result of the exchange offer, Doral issued an aggregate of 5,219,066 shares of common stock in exchange for 1,689,459 of the Company’s preferred stock that were retired in connection with this exchange. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of approximately $63.3 million.
On April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers of the Company’s common stock, including certain direct and indirect investors in Doral Holdings, the Company’s parent company, to raise up to $600.0 million of new equity capital for the Company through a private placement. Shares were sold in two tranches: (i) a $180.0 million non-contingent tranche consisting of approximately 180,000 shares of the Company’s Mandatorily Convertible
Non-Cumulative Non-Voting Preferred Stock (the “Mandatorily Convertible Preferred Stock”), $1.00 par value and $1,000 liquidation preference per share and (ii) a $420.0 million contingent tranche consisting of approximately 13.0 million shares of the Company’s common stock and approximately 359,000 shares of the Mandatorily Convertible Preferred Stock. In addition, as part of the non-contingent tranche, the Company issued into escrow 105,002 shares of Mandatorily Convertible Preferred Stock with a liquidation value of $105.0 million, to be released to purchasers if the Company did not complete an FDIC assisted transaction.
Doral used the net proceeds from the placement of the shares in the Non-Contingent Tranche to provide additional capital to the Company to facilitate the Company (through its wholly owned subsidiary, Doral Bank) qualifying as a bidder for the acquisition of certain assets and assumption of certain liabilities of one or more Puerto Rico banks from the FDIC, as receiver.
The Company was approved to bid on the assets and liabilities of any of all of the three Puerto Rico banks that failed in April 2010. On April 30, 2010, the Company announced it had been out-bid and would not be acquiring any of the assets or liabilities of any of the three Puerto Rico failed banks resolved in separate FDIC assisted purchase and assumption transactions. As a result, pursuant to the Stock Purchase Agreement and the related escrow agreement, the 105,002 shares of the Mandatorily Convertible Preferred Stock and the $420.0 million of contingent funds were released from escrow to the purchasers and the contingent tranche of securities was not issued. After giving effect to the release of the 105,002 shares of the Mandatorily Convertible Preferred Stock from escrow, the shares of the Mandatorily Convertible Preferred Stock issued in the capital raise had an effective sale price of $3.00 per common share equivalent.
In connection with the Stock Purchase Agreement, the Company also entered into a Cooperation Agreement with Doral Holdings, Doral Holdings L.P. and Doral GP Ltd. pursuant to which Doral Holdings made certain commitments including the commitment to vote in favor of converting the Mandatorily Convertible Preferred Stock to common stock and registering the shares issued pursuant to this capital raise and other previously issued unregistered shares of common stock and to dissolve Doral Holdings pursuant to certain terms and conditions.
Accordingly, during the third quarter of 2010, the Company converted 285,002 shares of Mandatorily Convertible Non-Voting Preferred Stock into 60,000,386 shares of common stock.
Refer to Note 34 of the accompanying Consolidated Financial Statements for additional information.
Dividends
On April 25, 2006, Doral Financial announced that, as a prudent capital management decision designed to preserve and strengthen the Company’s capital, the Board of Directors had suspended the quarterly dividend on the Common Stock.
Doral Financial’s ability to pay dividends on the shares of Common Stock in the future is limited by various regulatory requirements and policies of bank regulatory agencies having jurisdiction over Doral Financial and its banking subsidiaries, its earnings, cash resources and capital needs, general business conditions and other factors deemed relevant by Doral Financial’s Board of Directors.
Under an existing consent order with the Federal Reserve, Doral Financial is restricted from paying dividends on its capital stock without the prior written approval of the Federal Reserve. Doral Financial is required to request permission for the payment of dividends on its common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date. For the years ended December 31, 2008 and 2007, Doral Financial received permission from the Federal Reserve to pay all of the regular monthly cash dividends on the Noncumulative Preferred Stock and the quarterly cash dividends on the Convertible Preferred Stock, but cannot provide assurance that it will receive approval for the payment of such dividends in the future if it decided to declare dividends.
On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends was effective and commenced with the dividends for
the month of April 2009 for Doral Financial’s three outstanding series of non-cumulative preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock.
The PR Code generally imposes a 10% withholding tax on the amount of any dividends paid by Doral Financial to individuals, whether residents of Puerto Rico or not, trusts, estates, special partnerships and non-resident foreign corporations and partnerships. Prior to the first dividend distribution for the taxable year, individuals who are residents of Puerto Rico may elect to be taxed on the dividends at the regular graduated rates, in which case the special 10% tax will not be withheld from such year’s distributions.
United States citizens who are not residents of Puerto Rico may also make such an election except that notwithstanding the making of such election, a 10% withholding will still apply to the amount of any dividend distribution unless the individual files with Doral Financial’s transfer agent, prior to the first distribution date for the taxable year, a certificate to the effect that said individual’s gross income from sources within Puerto Rico during the taxable year does not exceed $1,300 if single, or $3,000 if married, in which case dividend distributions will not be subject to Puerto Rico income taxes.
U.S. income tax law permits a credit against U.S. income tax liability, subject to certain limitations, for Puerto Rico income taxes paid or deemed paid with respect to such dividends.
Special U.S. federal income tax rules apply to distributions received by U.S. citizens on stock of a passive foreign investment company (“PFIC”) as well as amounts retained from the sale or exchange of stock of a PFIC. Based upon certain provisions of the Internal Revenue Code of 1986, as amended (the “Code”) and proposed Treasury Regulations promulgated thereunder, Doral Financial understands that it has not been a PFIC for any of its prior taxable years.
For information regarding securities authorized for issuance under Doral Financial’s stock-based compensation plans, please refer to the information included in Part III, Item 12 of this Annual Report on Form 10-K, which is incorporated by reference from the 2011 Proxy Statement, and to Note 35, “Stock Options and Other Incentive Plans” of the Consolidated Financial Statements of Doral Financial, which are included as an Exhibit in Part II, Item 15 of this Annual Report on Form 10-K.
Sales of unregistered securities during 2010
As previously disclosed by the Company in Current Reports on Form 8-K that it filed with the SEC on April 20, 2010, April 27, 2010 and May 3, 2010 and as discussed above under “Preferred Stock”, on April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers of the Company’s common stock, including certain direct and indirect investors in Doral Holdings, to raise up to $600.0 million of new equity capital for the Company through a private placement. Shares were sold in two tranches: (i) a $180.0 million non-contingent tranche consisting of approximately 180,000 shares of the Company’s Mandatorily Convertible Preferred Stock and (ii) a $420.0 million contingent tranche consisting of approximately 13.0 million shares of the Company’s common stock and approximately 359,000 shares of Mandatorily Convertible Preferred Stock. In addition, as part of the non-contingent tranche, the Company issued into escrow 105,002 shares of the Mandatorily Convertible Preferred Stock with a liquidation value of $105.0 million, to be released to purchasers if the Company did not complete an FDIC assisted transaction.
Doral used the net proceeds from the placement of the shares in the Non-Contingent Tranche to provide additional capital to the Company to facilitate the Company (through its wholly owned subsidiary, Doral Bank) qualifying as a bidder for the acquisition of certain assets and assumption of certain liabilities of one or more Puerto Rico banks from the FDIC, as receiver.
On April 30, 2010, the Company announced that it had not been selected to acquire the assets and liabilities of any Puerto Rico bank in an FDIC-assisted transaction. As a result, pursuant to the Stock Purchase Agreement and the related escrow agreement, the 105,002 shares of the Mandatorily Convertible Preferred Stock and the $420.0 million of contingent funds were released from escrow to the purchasers and the contingent tranche of securities was not issued. After giving effect to the release of the 105,002 shares of the
Mandatorily Convertible Preferred Stock from escrow, the shares of the Mandatorily Convertible Preferred Stock issued in the capital raise had an effective sale price of $3.00 per common share equivalent.
The shares of Mandatorily Convertible Preferred Stock were offered and sold in private transactions and were not registered under the Securities Act in compliance with an exemption from Securities Act registration provided by Section 4(2) of the Securities Act.
During the third quarter of 2010, the Company converted the 285,002 shares of Mandatorily Convertible Preferred Stock into 60,000,386 shares of common stock. These shares of common stock were registered by the Company under the Securities Act prior to the conversion.
Stock Repurchase
No purchases of Doral Financial’s equity securities were made by or on behalf of Doral Financial during the fourth quarter of 2010.
STOCK PERFORMANCE GRAPH
The following Performance Graph shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act of 1933, as amended (the “Securities Act”) or the Exchange Act, except to the extent that Doral Financial specifically incorporates this information by reference, and shall not otherwise be deemed filed under these Acts.
The following performance graph compares the yearly percentage change in Doral Financial’s cumulative total stockholder return on its common stock to that of the Center for Research in Security Prices, Booth School of Business, the University of Chicago (“CRSP”) NYSE Market Index (U.S. Companies) and the CRSP Index for NYSE Depository Institutions (SIC 6000-6099 U.S. Companies) (the “Peer Group”). The Performance Graph assumes that $100 was invested on December 31, 2005 in each of Doral Financial’s common stock, the NYSE Market Index (U.S. Companies) and the Peer Group. The comparisons in this table are set forth in response to SEC disclosure requirements, and are therefore not intended to forecast or be indicative of future performance of Doral Financial’s common stock.
Item 6.
Item 6.
Selected Financial Data.
The following table sets forth certain selected consolidated financial data as of the dates and for the periods indicated. This information should be read in conjunction with Doral Financial’s consolidated financial statements and the related notes thereto.
(1)
Included net credit related OTTI losses of $14.0 million, $27.6 million and $0.9 million for the years ended December 31, 2010, 2009 and 2008, respectively. Also, includes the net gain on trading activities of $25.4 million and $30.0 million for the years ended December 31, 2010 and 2008, respectively, and a net loss on trading activities of $3.4 million for the year ended December 31, 2009.
(2)
For the years ended December 31, 2010 and 2009, includes $26.6 million and $8.6 million related to the net effect of the conversions of preferred stock during the years indicated.
(3)
For the years ended December 31, 2010, 2009, 2008, 2007 and 2006, net loss per common share represents the basic and diluted loss per share, respectively.
(4)
Includes loans held for sale.
(5)
Average balances are computed on a daily basis.
(6)
Represents the total portfolio of loans serviced for third parties. Excludes $4.4 billion, $4.4 billion, $4.2 billion, $3.6 billion and, $3.1 billion of mortgage loans owned by Doral Financial at December 31, 2010, 2009, 2008, 2007 and 2006, respectively.
Doral Financial’s ratios of earnings to fixed charges and earnings to fixed charges and preferred stock dividends on a consolidated basis for each of the years ended December 31, 2010, 2009, 2008, 2007 and 2006 are as follows:
(A)
During 2010, 2009, 2008, 2007 and 2006, earnings were not sufficient to cover fixed charges or preferred dividends and the ratios were less than 1:1. The Company would have had to generate additional earnings of $285.7 million, $74.6 million, $35.6 million, $361.7 million and $312.5 million, to achieve ratios of 1:1 in 2010, 2009, 2008, 2007 and 2006, respectively.
For purposes of computing these consolidated ratios, earnings consist of pre-tax income from continuing operations plus fixed charges and amortization of capitalized interest, less interest capitalized. Fixed charges consist of interest expensed and capitalized, amortization of debt issuance costs, and Doral Financial’s estimate of the interest component of rental expense. Ratios are presented both including and excluding interest on deposits. The term “preferred stock dividends” is the amount of pre-tax earnings that is required to pay dividends on Doral Financial’s outstanding preferred stock.
On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-cumulative preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock. For the year ended December 31, 2010, the Company accrued $9.1 million related to the cumulative preferred stock. For the year ended December 31, 2009, the Company accrued $15.8 million related to the cumulative preferred stock of which $8.3 million was paid during the first quarter of 2009 prior to the suspension of preferred stock dividends.
The principal balance of Doral Financial’s long-term obligations (excluding deposits) and the aggregate liquidation preference of its outstanding preferred stock on a consolidated basis as of December 31 of each of the five years in the period ended December 31, 2010 is set forth below.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help you understand Doral Financial and its subsidiaries. This MD&A is provided
as a supplement to and should be read in conjunction with Doral Financial’s consolidated financial statements and the accompanying notes. The MD&A includes the following sections:
OVERVIEW OF RESULTS OF OPERATIONS: Provides a brief summary of the most significant events and drivers affecting Doral Financial’s results of operations during 2010.
CRITICAL ACCOUNTING POLICIES: Provides a discussion of Doral Financial’s accounting policies that require critical judgment, assumptions and estimates.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008: Provides an analysis of the consolidated results of operations for 2010 compared to 2009, and 2009 compared to 2008.
OPERATING SEGMENTS: Provides a description of Doral Financial’s three operating segments and an analysis of the results of operations for each of these segments.
BALANCE SHEET AND OPERATING DATA ANALYSIS: Provides an analysis of the most significant balance sheet items and operational data that impact Doral Financial’s financial statements and business. This section includes a discussion of the Company’s liquidity and capital resources, regulatory capital ratios, off-balance sheet activities and contractual obligations.
RISK MANAGEMENT: Provides an analysis of the most significant risks to which Doral Financial is exposed, specifically interest rate risk, credit risk, operational risks and liquidity risk.
MISCELLANEOUS: Provides disclosure about various matters.
Investors are encouraged to carefully read this MD&A together with Doral Financial’s consolidated financial statements, including the Notes to the consolidated financial statements.
As used in this report, references to “the Company” or “Doral Financial” refer to Doral Financial Corporation and its consolidated subsidiaries unless otherwise indicated.
OVERVIEW OF RESULTS OF OPERATIONS
Net loss for the year ended December 31, 2010 amounted to $291.9 million, compared to net losses of $21.1 million and $318.3 million for the years 2009 and 2008, respectively. Doral Financial’s results for the year ended December 31, 2010, compared to the corresponding 2009 period were impacted by (i) an increase of $45.3 million in provision for loan and lease losses; (ii) a non-interest loss of $93.7 million resulting from losses associated to sales of securities; and (iii) an increase in non-interest expense of $80.8 million. Also the recognition of an income tax expense of $14.9 million during 2010 impacted the Company’s results when compared to an income tax benefit of $21.5 million for the corresponding 2009 period.
The significant events affecting the Company’s financial results for the year ended December 31, 2010 included the following:
•
Net loss attributable to common shareholders for the year ended December 31, 2010 of $274.4 million, resulted in a diluted loss per share of $2.96, compared to a net loss attributable to common shareholders for the corresponding 2009 and 2008 periods of $45.6 million and $351.6 million, or a diluted loss per share of $0.81 and $6.53, respectively. For additional information please refer to Note 36 of the accompanying financial statements.
•
Net interest income for the year ended December 31, 2010 was $160.6 million, compared to $167.6 million and $177.5 million for the corresponding 2009 and 2008 periods, respectively. The decrease of $7.0 million in net interest income during 2010, compared to 2009, resulted from a reduction in interest income of $56.7 million, partially offset by a reduction in interest expense of $49.7 million. The reduction in interest income resulted from (i) a reduction of $2.8 million in interest income on loans primarily related to a decrease in interest income on mortgage loans of $9.4 million driven by various factors such as the level of non-accrual loans and yield concessions on loan loss mitigation activities, a reduction of $3.3 million in interest income on construction loans resulting from
the sale of a construction portfolio to a third party and run-off, a reduction of $3.1 million in interest income on consumer portfolio due primarily to charge-offs, partially offset by an increase of $13.0 million on interest income on commercial loans due to increases in the U.S. syndicated loan portfolio; (ii) a decrease of $45.8 million in interest on MBS impacted by the sale of non-agency CMOs and other MBS during the second and third quarter of 2010; and (iii) a decrease in interest on other investment securities due to a reduction in the average balance of other investment securities related to sales, calls and/or maturities. The decrease in interest expense resulted principally from (i) a reduction of $14.3 million in interest expense on deposits driven by the rollover of maturing brokered CDs at lower current market rates, as well as shifts in the composition of the Company’s retail deposits; (ii) a reduction of $18.1 million in interest expense on securities sold under agreements to repurchase driven by a decrease of $248.5 million in the average balance of repurchase agreements and a general decline in interest rates; and (iii) a decrease of $15.8 million in interest on advances from FHLB resulted primarily from the decline in the average balance of advances from FHLB of $421.7 during 2010.
•
Doral Financial’s provision for loan and lease losses for the year ended December 31, 2010 amounted to $99.0 million, compared to $53.7 million and $48.9 million for the corresponding 2009 and 2008 periods, respectively. The higher provision for loan and lease losses in 2010 was driven by increases in the provision for residential, commercial real estate and construction and land portfolios. The $45.3 million increase in the provision for loan and lease losses during 2010 compared to 2009 was due to higher commercial real estate non-performing loans, the effect of charge-offs related to foreclosed loans, and the transfer and subsequent sale of certain construction loans to held for sale, higher loss mitigation volume and an increase in severities (in the determination of the provision) due to strategic decision to accelerate OREO dispositions.
•
Non-interest loss for the year ended December 31, 2010 was $14.1 million, compared to non-interest income of $87.2 million and $79.5 million for the corresponding 2009 and 2008 periods. The non-interest loss of $14.1 during 2010 resulted from (i) an OTTI loss of $14.0 million recognized on eight of the Company’s non-agency CMOs; (ii) a net loss on investment securities of $101.5 million, net of cost to terminate related borrowings, due to the sale of approximately $2.2 billion of mortgage-backed securities at a loss of $138.0 million partially offset by other securities sold at a gain of $36.5 million; (iii) a net gain on trading activities of $25.4 million driven principally by gains on sale of securities held for trading, on the IO valuation and on the MSR economic hedge; and (iv) an increase in other income of $2.2 million due to a gain of $3.0 million on redemption of shares of VISA, Inc.
•
Non-interest expense for the year ended December 31, 2010 was $324.6 million, compared to $243.8 million and $240.4 million for the years ended December 31, 2009 and 2008, respectively. Non-interest expenses for the year ended December 31, 2010 were impacted by (i) an increase of $26.2 million in total OREO and other related expenses due to the recognition of an additional provision of $17.0 million to account for the effect of management’s strategic decision to reduce pricing in order to accelerate OREO sales, adjustments driven by lower values of certain of Doral’s OREO properties, higher levels of repossessed units and higher expenses to maintain the properties in saleable conditions; (ii) an increase of $22.3 million in professional services expenses driven by amounts advanced to cover legal expenses of the Company’s former officers, for the management of legacy portfolios and expenses associated with non-recurring transactions that occurred during 2010; (iii) an increase of $6.4 million in compensation and employee benefits mainly related to bonuses and other compensation paid to certain officers of the Company, (vi) an additional $12.3 million loss on Lehman Brothers, Inc. and a subsequent loss on the sale of the claim; and (v) other increases in occupancy and advertising expenses.
•
An income tax expense of $14.9 million for the year ended December 31, 2010 compared to an income tax benefit of $21.5 million and an income tax expense of $286.0 million for the corresponding 2009 and 2008 periods. The recognition of an income tax expense for 2010 was related to taxes on U.S. source income and to recognize additional deferred tax assets, primarily NOLs, net of amortization of existing DTAs and a net increase in the deferred tax asset valuation allowance. The income tax benefit for 2009 was related to the effect on DTAs of certain tax agreements.
•
The Company reported other comprehensive income of $115.6 million for the year ended December 31, 2010, compared to other comprehensive income of $11.7 million and other comprehensive loss of $90.1 million for the corresponding 2009 and 2008 periods. The increase in other comprehensive income for the year ended December 31, 2010 resulted principally from sale of the Company’s non-agency CMOs during the second quarter of 2010, that drove the realization of a loss of approximately $129.7 million at the time of the sale.
•
Doral Financial’s loan production for the year ended December 31, 2010 was $1.4 billion, compared to $1.1 billion and $1.3 billion for the comparable 2009 and 2008 periods. The increase in Doral Financial’s loan production during 2010 resulted from an increase in commercial production of $286.8 million generated by the Company’s U.S. based middle market syndicated lending unit which is engaged in acquiring participating interests in credit facilities in the syndicated loan market and to an increase in construction loans largely due to the issuance of a note receivable of $96.9 million related to the sale of a construction loan portfolio to a third party.
•
Total assets as of December 31, 2010 totaled to $8.6 billion compared to $10.2 billion as of December 31, 2009. The decrease in total assets was due to a reduction of $1.3 billion in the Company’s investment securities portfolio that resulted from a combination of a sale of $2.3 billion of MBS, primarily CMOs, and other securities partially offset by purchases totalling $1.6 billion, primarily of shorter duration MBS, as part of interest rate risk management strategies. There was also a decrease in cash and cash equivalents of $307.9 million used to finance the purchase of investments.
•
Non-performing loans (“NPLs”) as of December 31, 2010 were $626.5 million, a decrease of $211.5 million from December 31, 2009. During the third quarter of 2010, the Company sold certain construction loans and OREO to a third party resulting in a reduction of $63.2 million in construction and land loans that were non-performing. The remainder of the decrease resulted from expanded collection activities and loss mitigation efforts across all portfolios. Non-performing assets (“NPAs”) as of December 31, 2010 were $851.8 million, a decrease of $90.8 million compared to December 31, 2009. Non-performing FHA/VA guaranteed loans, which are guaranteed by an agency of the United States government and present little credit risk to Doral, were $121.3 million, an increase of $111.0 million from December 31, 2009.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in Doral Financial’s consolidated financial statements and accompanying notes. Certain of these estimates are critical to the presentation of Doral Financial’s financial condition since they are particularly sensitive to the Company’s judgment and are highly complex in nature. Doral Financial believes that the judgments, estimates and assumptions used in the preparation of its consolidated financial statements are appropriate given the factual circumstances as of December 31, 2010. However, given the sensitivity of Doral Financial’s consolidated financial statements to these estimates, the use of other judgments, estimates and assumptions could result in material differences in Doral Financial’s results of operations or financial condition.
Various elements of Doral Financial’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. Note 2 to Doral Financial’s consolidated financial statements contains a summary of the most significant accounting policies followed by Doral Financial in the preparation of its financial statements. The accounting policies that have a significant impact on Doral Financial’s statements and that require the most judgment are set forth below.
Fair Value Measurements
The Company uses fair value measurements to state certain assets and liabilities at fair value and to support fair value disclosures. Securities held for trading, securities available for sale, derivatives and servicing assets are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be
required to record other financial assets at fair value on a nonrecurring basis, such as loans held for sale, loans receivable and certain other assets. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.
The Company discloses for interim and annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not in the statement of financial condition.
Fair Value Hierarchy
The Company categorized its financial instruments based on the priority of inputs to the valuation technique into a three level hierarchy described below:
•
Level 1 - Valuation is based upon unadjusted quoted prices for identical instruments traded in active markets.
•
Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market, or are derived principally from or corroborated by observable market data, by correlation or by other means.
•
Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Determination of Fair Value
The Company bases fair values on the price that would be received upon sale of an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. It is Doral Financial’s intent to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy.
Fair value measurements for assets and liabilities where there is limited or no observable market data are based primarily upon the Company’s estimates, and are generally calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the fair values represent management’s estimates and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.
The Company relies on appraisals for valuation of collateral dependent impaired loans and other real estate owned. An appraisal of value is obtained at the time the loan is originated. New estimates of collateral value are obtained when a loan that has been performing becomes delinquent and is determined to be collateral dependent, and at the time an asset is acquired through foreclosure. Updated reappraisals are requested at least every two years for collateral dependent loans and other real estate owned.
Residential mortgage loans are considered collateral dependent when they are 180 days past due (collateral dependent residential mortgage loans are those past due loans whose borrowers’ financial condition has deteriorated to the point that Doral considers only the collateral when determining its allowance for loan loss estimate). An updated estimate of the property’s value is obtained when the loan in 180 days past due, and a second assessment of value is obtained when the loan is 360 days past due. The Company generally uses broker price opinions (“BPOs”) as an assessment of value of collateral dependent residential mortgage loans.
As it takes a period of time for commercial loan appraisals to be completed once they are ordered, Doral must at times estimate its allowance for loan and lease losses for an impaired loan using a dated, or stale, appraisal. As Puerto Rico has experienced some decrease in property values during its extended recession, the reported values of the stale appraisals must be adjusted to recognize the “fade” in market value. In order to
estimate the value of collateral with stale appraisals, Doral has developed separate collateral price indices for small commercial loans and large commercial loans that are used to measure the market value fade in appraisals completed in one year to the current year. The indices provide a measure of how much the property value has changed from the year in which the most recent appraisal was received to the current year. In estimating its allowance for loan and lease losses on collateral dependent loans using outdated appraisals, Doral uses the original appraisal as adjusted for the estimated fade in property value less selling costs to estimate the current fair value of the collateral. That current adjusted estimated fair value is then compared to the reported investment, and if the adjusted fair value is less than reported investment, that amount is included in the allowance for loan and lease loss estimate.
Residential development construction loans that are collateral dependent present unique challenges to estimating the fair value of the underlying collateral. Residential development construction loans are partially completed with additional construction costs to be incurred, have units being sold and released from the construction loan, and may have additional land collateralizing the loan on which the developer hopes or expects to build additional units. Therefore, the value of the collateral is regularly changing and any appraisal has a limited useful life. Doral uses an internally developed estimate of value that considers Doral’s exit strategy of foreclosing and completing the construction started and selling the individual units constructed for residential buildings, and separately uses the most recent appraised value for any remnant land adjusted for the fade in value since the appraisal date as described above. This internally developed estimate is prepared in conjunction with a third party servicer of the portfolio who validates and determines the inputs used to arrive at the estimate of value (e.g. units sold, expected sales, cost to complete, etc.)
Once third party appraisals are obtained the previously estimated property values are updated with the actual values reflected in the appraisal and any additional loss incurred is recognized in the period when the appraisal is received. The internally developed collateral price index is also updated and any changes resulting from the update in the index are also recognized in the period.
Refer to Note 38 of the accompanying Consolidated Financial Statements for a discussion about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used and its impact on earnings.
Gain or Loss on Mortgage Loan Sales
The Company generally sells or securitizes a portion of the residential mortgage loans that it originates. FHA and VA loans are generally securitized into GNMA mortgage-backed securities and held as trading securities. After holding these securities for a period of time, usually less than one month, Doral Financial sells these securities for cash through broker-dealers. Conforming conventional loans are generally sold directly to FNMA, FHLMC or institutional investors or exchanged for FNMA or FHLMC-issued mortgage-backed securities, which Doral Financial also sells for cash through broker-dealers.
As part of its mortgage loan sale and securitization activities, Doral Financial generally retains the right to service the mortgage loans it sells. Doral Financial determines the gain on sale of a mortgage-backed security or loan pool by allocating the carrying value, also known as basis, of the underlying mortgage loans between the mortgage-backed security or mortgage loan pool sold and its retained interests, based on their relative estimated fair values. The gain on sale reported by Doral Financial is the difference between the proceeds received from the sale and the cost allocated to the loans sold. The proceeds include cash and other assets received in the transaction (primarily MSRs) less any liabilities incurred (i.e., representations and warranty provisions). The reported gain or loss is the difference between the proceeds from the sale of the security or mortgage loan pool and its allocated cost. The amount of gain on sale is therefore influenced by the values of the MSRs and retained interest recorded at the time of sale. See “- Retained Interest Valuation” below for additional information.
If in a transfer of financial assets in exchange for cash or other consideration (other than beneficial interests in transferred assets), Doral Financial has not surrendered control over the transferred assets, Doral Financial accounts for the transfer as a secured borrowing (loan payable) with a pledge of collateral.
Retained Interest Valuation
The Company routinely originates, securitizes and sells mortgage loans into the secondary market. The Company generally retains the servicing rights and, in the past, also retained IOs. MSRs represent the estimated present value of the normal servicing fees (net of related servicing costs) expected to be received on a loan being serviced over the expected term of the loan. MSRs entitle Doral Financial to a future stream of cash flows based on the outstanding principal balance of the loans serviced and the contractual servicing fee. The annual servicing fees generally range between 25 and 50 basis points, less, in certain cases, any corresponding guarantee fee. In addition, MSRs may entitle Doral Financial, depending on the contract language, to ancillary income including late charges, float income, and prepayment penalties net of the appropriate expenses incurred for performing the servicing functions. In certain instances, the Company also services loans with no contractual servicing fee. The servicing asset or liability associated with such loans is evaluated based on ancillary income, including float, late fees, prepayment penalties and costs. The Company’s interests that continue to be held (“retained interest”) are subject to prepayment and interest rate risk. MSRs are classified as servicing assets in Doral Financial’s Consolidated Statements of Financial Condition. Any servicing liability recognized is included as part of accrued expenses and other liabilities in Doral Financial’s Consolidated Statements of Financial Condition.
The fair value of the Company’s MSRs is determined based on a combination of market information on trading activity (servicing trades and broker valuations), benchmarking of servicing assets (valuation surveys) and cash-flow modeling. The valuation of the Company’s MSRs incorporate two sets of assumptions: (i) market derived assumptions for discount rates, servicing costs, escrow earnings rate, float earnings rate and cost of funds and (ii) market derived assumptions adjusted for the Company’s loan characteristics and portfolio behavior for escrow balances, delinquencies and foreclosures, late fees, prepayments and prepayment penalties. For the year ended December 31, 2010, the fair value of the MSRs amounted to $114.3 million, which represents a value decline of $4.2 million compared to December 31, 2009.
IOs represent the estimated present value of cash flows retained by the Company that are generated by the underlying fixed rate mortgages (as adjusted for prepayments) after subtracting: (i) the interest rate payable to the investor (adjusted for any embedded cap, if applicable); and (ii) a contractual servicing fee. As of December 31, 2010, the carrying value of the IOs of $44.3 million is related to $302.4 million of outstanding principal balance of mortgage loans sold to investors. IOs are classified as securities held for trading in Doral Financial’s Consolidated Statements of Financial Condition.
To determine the value of its portfolio of variable IOs, Doral Financial uses an internal valuation model that forecasts expected cash flows using forward LIBOR rates derived from the LIBOR/Swap yield curve at the date of the valuation. The characteristics of the variable IOs result in an increase in cash flows when LIBOR rates fall and a reduction in cash flows when LIBOR rates rise. This provides a mitigating effect on the impact of prepayment speeds on the cash flows, with prepayments expected to rise when long-term interest rates fall reducing the amount of expected cash flows and the opposite when long-term interest rise. Prepayment assumptions incorporated into the valuation model for variable and fixed IOs are based on publicly available, independently verifiable, prepayment assumptions for FNMA mortgage pools and statistically derived prepayment adjusters based on observed relationships between the Company’s and FNMA’s U.S. mainland mortgage pool prepayment experiences.
This methodology resulted in a CPR of 9.0% for 2010, 10.4% for 2009 and 12.7% for 2008. The change in the CPR between 2010 and 2009 was due mostly to reflect changes in experienced prepayments speeds.
The Company continues to benchmark its assumptions for setting its liquidity/credit risk premium to a third party valuation provider. This methodology resulted in a discount rate 13.0% that was used for the years ended December 31, 2010, 2009 and 2008, respectively.
For IOs, Doral Financial recognizes as interest income (through the life of the IO) the excess of all estimated cash flows attributable to these interests over their recorded balance using the effective yield method. The Company updates its estimates of expected cash flows periodically and recognizes changes in calculated effective yield on a prospective basis.
Valuation of Trading Securities and Derivatives
Doral Financial’s net gain (loss) on trading activities includes gains and losses, whether realized or unrealized, on securities accounted for as held for trading, including IOs, as well as various other financial instruments, such as derivative contracts, that Doral Financial uses to manage its interest rate risk. Securities held for trading and derivatives are recorded at fair values with increases or decreases in such values reflected in current earnings. The fair values of many of Doral Financial’s trading securities (other than IOs) are based on market prices obtained from market data sources. For instruments not traded on a recognized market, Doral Financial generally determines fair value by reference to quoted market prices for similar instruments. The fair values of derivative instruments are obtained using internal valuation models based on financial modeling tools and using market derived assumptions obtained from market data sources.
Until the second quarter of 2009, securities accounted as held for trading included U.S. Treasury security positions, taken as economic hedges against the valuation adjustment of the Company’s capitalized mortgage servicing rights. Subsequently, the U.S. Treasury positions were unwound and other derivative instruments were used as economic hedges on the MSR.
Generally, derivatives are financial instruments with little or no initial net investment in comparison to their notional amount and whose value is based on the value of an underlying asset, index, reference rate or other variable. They may be standardized contracts executed through organized exchanges or privately negotiated contractual agreements that can be customized to meet specific needs, including certain commitments to purchase and sell mortgage loans and mortgage-backed securities. The fair value of derivatives is generally reported net by counterparty, provided that a legally enforceable master agreement exists. Derivatives in a net asset position are reported as part of securities held for trading, at fair value. Similarly, derivatives in a net liability position are reported as part of accrued expenses and other liabilities, at fair value.
For those derivatives not designated as an accounting hedge, fair value gains and losses are reported as part of net gain (loss) on trading activities in the Consolidated Statements of Operations.
Other Than Temporary Impairment
The Company performs an assessment of OTTI whenever the fair value of an investment security is less than its amortized cost basis at the balance sheet date. Amortized cost basis includes adjustments made to the cost of a security for accretion, amortization, collection of cash, previous OTTI recognized into earnings (less any cumulative effect adjustments) and fair value hedge accounting adjustments. OTTI is considered to have occurred under the following circumstances:
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If the Company intends to sell the investment security and its fair value is less than its amortized cost.
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If, based on available evidence, it is more likely than not that the Company will decide or be required to sell the investment security before the recovery of its amortized cost basis.
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If the Company does not expect to recover the entire amortized cost basis of the investment security. This occurs when the present value of cash flows expected to be collected is less than the amortized cost basis of the security. In determining whether a credit loss exists, the Company uses its best estimate of the present value of cash flows expected to be collected from the investment security. Cash flows expected to be collected are estimated based on a careful assessment of all available information. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.
The Company evaluates its individual available for sale investment securities for OTTI on at least a quarterly basis. As part of this process, the Company considers its intent to sell each investment security and whether it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of these conditions is met, the Company recognizes an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities that meet neither of these conditions, an analysis is performed to determine if any of these securities are at risk for OTTI. To determine which securities are at risk for OTTI and should be quantitatively evaluated
utilizing a detailed cash flow analysis, the Company evaluates certain indicators which consider various characteristics of each security including, but not limited to, the following: the credit rating and related outlook or status of the securities; the creditworthiness of the issuers of the securities; the value and type of underlying collateral; the duration and level of the unrealized loss; any credit enhancements; and other collateral-related characteristics such as the ratio of credit enhancements to expected credit losses. The relative importance of this information varies based on the facts and circumstances surrounding each security, as well as the economic environment at the time of assessment. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.
Other Income Recognition Policies
Interest income on loans is accrued by Doral Financial when earned. Loans are placed on non-accrual status when any portion of principal or interest is more than 90 days past due, except for revolving lines of credit and credit cards that are still accruing until 180 days past due and FHA and VA loans that are still accruing until 270 days past due, or earlier if concern exists as to the ultimate collectability of principal or interest. When a loan is placed on non-accrual status, all accrued but unpaid interest to date is reversed against interest income and the loan is accounted for on the cash or cost recovery method, until it qualifies for return to accrual status. Loans return to accrual status when principal and interest become current under the terms of the loan agreement or when the loan is both well-secured and in the process of collection and collectability is no longer doubtful.
Loan origination fees, as well as discount points and certain direct origination costs for loans held for sale, are deferred at origination of the loan and are recognized in non-interest income when the loan is sold or securitized into a mortgage-backed security. In the case of loans held for investment, such fees and costs are deferred and amortized to income as adjustments to the yield of the loan.
Allowance for Loan and Lease Losses
Doral Financial maintains an allowance for loan and lease losses to absorb probable credit-related losses on its loans receivable portfolio. The allowance consists of specific and general components and is based on Doral Financial’s assessment of default probabilities, internal risk ratings (based on borrowers’ financial stability, external credit ratings, management strength, earnings and operating environment), probable loss and recovery rates, and the degree of risk inherent in the loans receivable portfolio. The allowance is maintained at a level that Doral Financial considers to be adequate to absorb probable losses. Credit losses are charged and recoveries are credited to the allowance, while increases to the allowance are charged to operations. Unanticipated increases in the allowance for loan and lease losses could adversely impact Doral Financial’s net income in the future.
Doral estimates and records its ALLL on a monthly basis. For all performing loans and non-performing small balance homogeneous loans the ALLL is estimated based upon estimated probability of default and loss given default by shared product characteristics using Doral Financial’s historical experience. For larger construction, commercial real estate, commercial and industrial loans and TDRs that are 90 or more days past due or are otherwise considered to be impaired, management estimates the related ALLL based upon an analysis of each individual loans’ characteristics. The ALLL estimate methodologies are described more fully in the following paragraphs.
Residential mortgage. The general allowance for residential mortgage loans is calculated based on the probability that loans within different delinquency buckets will default and, in the case of default, the extent of losses that the Company expects to realize. In determining the probabilities of default, the Company considers recent experience of rolls of loans from one delinquency bucket into the next. Roll rates as of year-end show that the proportion of loans rolling into subsequent buckets has remained constant. In determining the allowance for loan and lease losses for residential mortgage loans, given the current economic trends in Puerto Rico, for purposes of forecasting the future behavior of the portfolio, Doral Financial determined that it should only use the roll-rates of relatively recent months, which show a more aggressive deteriorating trend than those in older periods. Using the older historical performance would yield lower probabilities of default that may not
reflect recent macroeconomic trends. Severity of loss is calculated based on historical results from foreclosure and ultimate disposition of collateral. Historical results are adjusted for the Company’s expectation of housing prices. Severity assumptions for the residential portfolio range between 3% and 40% depending on the different loan types and loan-to-value ratios, and up to 75% for second mortgages.
Construction and land, commercial real estate and commercial and industrial. The ALLL for performing construction and land, commercial real estate and commercial and industrial is estimated considering either the probability of the loan defaulting in the next twelve months and the estimated loss incurred in the event of default or the loan quality assigned to each loan and the estimated expected loss associated with that loan grade. The probability of a loan defaulting is based upon Doral Financial’s experience with its current portfolio. The loss grade is assigned based upon management’s review of the specific facts and circumstances associated with a particular credit. The loss incurred upon default is based upon Doral’s actual experience in resolving defaulted loans.
Construction and land, commercial real estate and commercial and industrial loans with principal balances greater than $1.0 million that are not performing, or when management estimates it may not collect all contractual principal and interest, are considered impaired and are measured for impairment individually.
Loans are considered impaired when, based on current information and events it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. Due to the current economic environment and management’s perceived increase in risk in the commercial loan portfolio, during the third quarter of 2010 management individually reviewed for impairment all commercial loans over $50,000 that were over 90 days past due to better estimate the amount the Company expects to receive. During the fourth quarter of 2010, management individually reviewed all commercial real estate loans over $500,000 that were over 90 days past due, 25% of all commercial loans between $50,000 and $500,000 and over 90 days past due, as well as all new loans classified as substandard during the quarter. In future periods, and while management’s assessment of the inherent credit risk in the commercial portfolio continues to be high, the Company will continue to evaluate on a quarterly basis 25% of all commercial loans over 90 days past due and between $50,000 and $500,000 so that in any one year period it would have individually evaluated for impairment 100% of all substandard commercial loans between $50,000 and $500,000, as well as all substandard commercial real estate loans over $500,000 and all substandard commercial and construction loans over $1.0 million.
The impairment loss, if any, on each individual loan identified as impaired is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, net of disposition costs, if the loan is collateral dependent. If foreclosure is probable, accounting guidance requires the measurement of impairment to be based on the fair value of the collateral, net of disposition costs. Since current appraisals were not available on all properties at quarter end, management determined its loss reserve estimates for these loans by estimating the fair value of the collateral. In doing so, management considered a number of factors including the general change in price levels as indicated by appraisals received compared to earlier appraisals of the same property, the price at which individual units could be sold in the current market, the period of time over which the units would be sold, the estimated cost to complete the units, the risks associated with completing and selling the units, the required rate of return on investment a potential acquirer may have and current market interest rates in the Puerto Rico market.
Consumer. The ALLL for consumer loans is estimated based upon the historical charge-off rate using Doral Financial’s historical experience. The ALLL is supplemented by Doral’s policy to charge-off all amounts in excess of the collateral value when the loan principal or interest is 120 days or more days past due.
TDRs. In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, on a monthly basis, the Company pools TDRs with similar characteristics and performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of loans, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in
the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records an impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.
Generally, the percentage of the allowance for loan and lease losses to non-performing loans will not remain constant due to the nature of Doral Financial’s loan portfolios, which are primarily collateralized by real estate. The collateral for each non-performing mortgage loan is analyzed to determine potential loss exposure, and, in conjunction with other factors, this loss exposure contributes to the overall assessment of the adequacy of the allowance for loan and lease losses. On an ongoing basis, management monitors the loan portfolio and evaluates the adequacy of the allowance for loan and lease losses. In determining the adequacy of the allowance, management considers such factors as default probabilities, internal risk ratings (based on borrowers’ financial stability, external credit ratings, management strength, earnings and operating environment), probable loss and recovery rates, and the degree of risk inherent in the loan portfolios. Allocated general reserves are supplemented by a macroeconomic or emerging risk reserve. This portion of the total allowance for loan and lease losses reflects management’s evaluation of conditions that are not directly reflected in the loss factors used in the determination of the allowance. The conditions evaluated in connection with the macroeconomic and emerging risk allowance include national and local economic trends, industry conditions within the portfolios, recent loan portfolio performance, loan growth, changes in underwriting criteria and the regulatory and public policy environment.
Loans considered by management to be uncollectible are charged to the allowance for loan and lease losses. Recoveries on loans previously charged-off are credited to the allowance. Provisions for loan and lease losses are charged to expenses and credited to the allowance in amounts deemed appropriate by management based upon its evaluation of the known and inherent risks in the loan portfolio.
The Company also engages in the restructuring and/or modifications of the debt of borrowers, who are delinquent due to economic or legal reasons, if the Company determines that it is in the best interest for both the Company and the borrower to do so. In some cases, due to the nature of the borrower’s financial condition, the restructure or loan modification fits the definition of Troubled Debt Restructuring (“TDR”). Such restructures are identified as TDRs and accounted for as impaired loans.
Estimated Recourse Obligation
In the past, the Company sold mortgage loans and MBS subject to recourse provisions. Pursuant to these recourse arrangements, the Company agreed to retain or share the credit risk with the purchaser of such mortgage loans for a specified period or up to a certain percentage of the total amount in loans sold. The Company estimates the fair value of the retained recourse obligation or any liability incurred at the time of sale and includes such obligation with the net proceeds from the sale, resulting in a lower gain on sale recognition. Doral estimates the fair value of its recourse obligation based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment.
Income Taxes
The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities based on current tax laws. To the extent tax laws change, deferred tax assets and liabilities are adjusted, as necessary, in the period that the tax change is enacted. The Company recognizes income tax benefits when the realization of such benefits is probable. A valuation allowance is recognized for any deferred tax asset which, based on management’s evaluation, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded against deferred tax assets. In assessing the realization of deferred tax assets, the Company considers the expected reversal of its deferred tax assets and liabilities, projected future taxable income, cumulative losses in recent years and tax planning strategies. The determination of a valuation allowance on deferred tax assets requires judgment based on
weight of all available evidence and considering the relative impact of negative and positive evidence. These estimates are projected through the life of the related deferred tax assets based on assumptions that we believe to be reasonable and consistent with current operating results. Changes in future operating results not currently forecasted may have a significant impact on the realization of deferred tax assets.
The Company classifies all interest and penalties related to tax uncertainties as income tax expense.
Income tax benefit or expense includes (i) deferred tax expense or benefit, which represents the net change in the deferred tax assets or liability balance during the year plus any change in the valuation allowance, if any; and (ii) current tax expense.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND
Net Interest Income
Net interest income is the excess of interest earned by Doral Financial on its interest-earning assets over the interest incurred on its interest-bearing liabilities. Doral Financial’s net interest income is subject to interest rate risk due to the repricing and maturity mismatch in the Company’s assets and liabilities. Generally, Doral Financial’s assets have a longer maturity and a later repricing date than its liabilities, which results in lower net interest income in periods of rising short-term interest rates and higher net interest income in periods of declining short-term interest rates. Refer to “Risk Management” below for additional information on the Company’s exposure to interest rate risk.
Net interest income for the years 2010, 2009 and 2008, was $160.6 million, $167.6 million and $177.5 million, respectively.
2010 compared to 2009. Total interest income for the years ended December 31, 2010 and 2009 was $401.5 million and $458.3 million, respectively, a decrease of $56.7 million, or 12.4%. Significant variances impacting interest income for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follows:
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A reduction of $2.8 million in interest income on loans due to:
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A reduction in interest on mortgage loans of $9.4 million driven by: (i) reversal of interest income on loans entering non-accrual of approximately $12.0 million; (ii) reversal of interest income due to loss mitigation on loans in early delinquency stages, together with the impact of yield concessions on these loans of approximately $3.8 million; and (iii) partially offset by the impact of loans leaving non-accrual due to collection efforts and loss mitigation transactions on non-performing loans of approximately $6.4 million.
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A reduction in interest on construction and land loans of $3.3 million as a result of lower average construction and land loans related to the sale of a construction loan portfolio to a third party and run-off of the portfolio.
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A reduction of $3.1 million in interest income on consumer loans due primarily to charge-offs and run-off of the portfolio.
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Partially offset by an increase of $13.0 million in interest income on commercial loans primarily driven by increases in the U.S. syndicated loan portfolio.
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A decrease of $45.8 million in interest income on MBS primarily due to a reduction of $900.1 million in the average balance of MBS during 2010 resulting from the sale of non-agency CMOs and other MBS during the second and third quarters of 2010. Total MBS’ sales amounted to $2.2 billion during 2010, partially offset by purchases of $1.6 billion primarily of shorter duration as part of the interest rate risk management strategies. The average interest rate on MBS decreased 57 basis points for the year ended December 31, 2010 compared to the same period in 2009.
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A reduction of $8.7 million in interest income on investment securities was primarily due to a reduction in the average balance of investment securities of $262.2 million during 2010. The average interest rate on investment securities decreased by 108 basis points during 2010.
Total interest expense for the years ended December 31, 2010 and 2009 was $240.9 million and $290.6 million, respectively, a decrease of approximately $49.7 million, or 17.1%. Significant variances impacting interest expense for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follows:
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A decrease of $14.3 million in interest expense on deposits driven by the rollover of maturing brokered CDs at lower current market rates as well as shifts in the composition of the Company’s retail deposits. The average balance of interest bearing deposits increased $494.3 million during 2010, while the cost of deposits decreased 67 basis points for the same period. These shifts were driven by the Company’s pricing strategy and campaigns to expand its deposit base as a result of bank failures in P.R. during the second quarter of 2010.
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A decrease of $18.1 million in the interest expense on securities sold under agreements to repurchase was driven by a decrease of $248.5 million in the average balance of repurchase agreements during 2010 and a general decline in interest rates that also resulted in a reduction of 53 basis points in the average interest cost during 2010.
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A reduction of $15.8 million in interest expense on advances from FHLB resulted from the decrease in the average balance of advances from FHLB of $421.7 million and partially offset by an increase of 8 basis points in average cost during 2010.
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A decrease of $1.2 million in interest expense on other short-term borrowings. There were no borrowings outstanding at any month end during 2010.
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A decrease of $3.1 million in interest expense on loans payable directly related to a reduction of $33.2 million in the average balance of loans payable as a result of the regular repayment of borrowings. The average cost on loans payable during 2010 decreased by 69 basis points compared to the corresponding 2009 period as a result of the general decline in interest rates, which reflects the re-pricing nature of most of the Company’s loans payable, which are floating rate notes indexed to the 3-month LIBOR.
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An increase of $2.8 million in interest expense on notes payable related to the increase of $114.6 million in average balance of notes payable resulting from a $250.0 million debt issued by Doral CLO I, Ltd. in July 2010 at a rate of 3-month LIBOR plus 1.85%.
2009 compared to 2008. Total interest income for the years ended December 31, 2009 and 2008 was $458.3 million and $524.7 million, respectively, a decrease of approximately $66.4 million, or 13%. Significant variances impacting interest income for the year ended December 31, 2009, when compared to the corresponding 2008 period, are as follows:
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A reduction of $21.2 million in interest income on loans primarily related to the lower interest rate environment and an increase in non-performing loans in the Company’s loan portfolio. The average interest rate on loans decreased 50 basis points for the year ended December 31, 2009 compared to the same period in 2008, while non-performing loans increased by $125.6 million during 2009.
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An increase of $2.1 million in interest income on mortgage-backed securities resulted from the net effect and timing of the sale of approximately $2.0 billion of securities and the purchase of approximately $2.3 billion of securities during the year for the purpose of increasing interest margin in the first six months and reducing the Company’s interest rate exposure in the latter part of the year. These transactions resulted in an increase in the average balance of mortgage-backed securities of $768.0 million.
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A decrease of $1.0 million in interest income on IOs was mainly driven by a decrease of $1.3 million in the average balance of IOs during 2009 due to the portfolio run-off.
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A reduction of $37.4 million in interest income on investment securities was primarily due to a reduction in the average balance of investment securities of $711.1 million as a result of sales, calls and the settlement of the position with Lehman during 2008 the full impact of which was reflected in 2009. The average rate of investment securities decreased 127 basis points during 2009.
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A decrease of $8.9 million on interest income of other interest-earning assets resulted from a net decrease of $76.1 million in the average balance of other interest-earning assets resulting from the sale of these instruments to finance the purchase of securities. The average rate of other interest-earning assets decreased by 146 basis points during 2009.
Total interest expense for the years ended December 31, 2009 and 2008 was $290.6 million and $347.2 million, respectively, a decrease of approximately $56.6 million, or 16%. Significant variances impacting interest expense for the year ended December 31, 2009, when compared to the corresponding 2008 period, are as follows:
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A decrease of $31.6 million in interest expense on deposits driven by the rollover of maturing brokered CDs at lower current market rates even though the Company lengthened maturities, as well as shifts in the composition of the Company’s retail deposits and the general decline in interest rates. A reduction of $41.7 million in the average balance of deposits during 2009, combined with the decrease in the interest expense thereon resulted in a decrease in the average cost of deposits during 2009 of 75 basis points compared to the corresponding 2008 period.
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A decrease of $9.8 million in the interest expense on securities sold under agreements to repurchase was mainly driven by the general decline in interest rates that resulted in a reduction of 35 basis points in the average interest cost during 2009.
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A reduction of $6.7 million in interest expense on advances from FHLB resulted primarily from the general decline in interest rates that allowed the Company’s to maintain its balance of advances at lower fixed rates. While the average balance of advances from FHLB decreased $73.9 million during 2009, the average cost decreased by 23 basis points for the year ended December 31, 2009.
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An increase of $1.0 million in interest expense on other short-term borrowings is directly related to the increase of $0.4 billion in the average balance of other short-term borrowings for the year ended December 31, 2009, when compared to 2008 corresponding period. The higher average balance of other short-term borrowings is related to the Company’s focus on the repositioning of borrowings to lower cost instruments such as the auction of term funds to depository institutions granted by the FED under the Term Auction Facility (“TAF”).
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A decrease of $9.0 million in interest expense on loans payable directly related to a reduction of $27.2 million in the average balance of loans payable as a result of the regular repayment of borrowings. The average cost on loans payable during 2009 decreased by 216 basis points compared to the corresponding 2008 period as a result of the general decline in interest rates, which reflects the re-pricing nature of most of the Company’s loans payable, which are floating rate notes indexed to the 3-month LIBOR.
The following table presents Doral Financial’s average balance sheet for the years indicated, the total dollar amount of interest income from its average interest-earning assets and the related yields, as well as the interest expense on its average interest-bearing liabilities, expressed in both dollars and rates, and the net interest margin and spread. The table does not reflect any effect of income taxes. Average balances are based on average daily balances.
Table A - Average Balance Sheet and Summary of Net Interest Income
(1)
Average loan balances include the average balance of non-accruing loans, on which interest income is recognized when collected. Also includes the average balance of GNMA defaulted loans for which the Company has an unconditional buy-back option.
(2)
Interest income on loans includes $0.6 million, $1.1 million and $1.3 million for 2010, 2009 and 2008, respectively, of income from prepayment penalties related to the Company’s loan portfolio.
(3)
Interest rate spread represents the difference between Doral Financial’s weighted-average yield on interest-earning assets and the weighted-average rate on interest-bearing liabilities.
(4)
Interest rate margin represents net interest income on an annualized basis as a percentage of average interest-earning assets.
(5)
Net interest-earning assets ratio represents average interest-earning assets as a percentage of average interest-bearing liabilities.
The following table describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Doral Financial’s interest income and interest expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate); (ii) changes in rate (change in rate multiplied by current year volume); and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated in proportion to the absolute dollar amounts of the changes due to rate and volume.
Table B - Net Interest Income Variance Analysis
Average interest-earning assets decreased from $9.5 billion for the year ended December 31, 2009 to $8.8 billion for the corresponding 2010 period, while average interest-bearing liabilities also decreased from $8.5 billion to $8.0 billion, respectively. The sales of MBS and other debt securities during the second and third quarters of 2010 and the purchase of investments of shorter duration, as well as the shifts in the composition of average interest bearing liabilities from higher cost borrowing to less expensive sources of financing, such as new money market accounts with a cost of less than 0.4%, is part of the execution of the Company strategy to de-lever the balance sheet. The repositioning of the balance sheet during 2010, and other management actions, resulted in a 7 basis point improvement in net interest margin from 1.76% for the year ended December 31, 2009 to 1.83% for the corresponding 2010 period.
Average interest-earning assets increased from $9.4 billion for the year ended December 31, 2008 to $9.5 billion for the corresponding 2009 period. This increase combined with a decline in net interest income of $9.9 million during 2009, resulted in a contraction of the net interest margin from 1.88% for the year ended December 31, 2008 to 1.76% in the corresponding 2009 period.
Provision for Loan and Lease Losses
The provision for loan and lease losses is charged to earnings to bring the total allowance for loan and lease losses to a level considered appropriate by management considering all losses inherent in the portfolio and based on Doral Financial’s historical loss experience, current delinquency rates, known and inherent risks
in the loan portfolio, individual assessment of significant impaired loans, the estimated value of the underlying collateral or discounted expected cash flows, and an assessment of current economic conditions and emerging risks. While management believes that the current allowance for loan and lease losses is adequate, future additions to the allowance could be necessary if economic conditions change or if credit losses increase substantially from those estimated by Doral Financial in determining the allowance. Unanticipated increases in the allowance for loan and lease losses could materially affect Doral Financial’s net income in future periods.
2010 compared to 2009. Doral Financial’s provision for loan and lease losses for the year ended December 31, 2010 increased by $45.3 million, or 84.4%, to $99.0 million compared to $53.7 million for 2009. The higher provision for loan and lease losses in 2010 was driven by increases in the provision for residential, commercial real estate and construction and land portfolios. Please refer to the discussions under Credit Risk for further analysis of the allowance for loan and lease losses and non-performing assets and related ratios.
The provision for loan and lease losses for the residential mortgage portfolio increased by $12.3 million, or 52.9%, from $23.2 million for 2009 to $35.5 million for the year ended December 31, 2010. The higher provision for residential mortgage loans was driven by the level of loan modifications considered TDRs and for which a temporary interest reduction was granted. These TDRs are measured individually for impairment based on the discounted cash flow method. The use of the discounted cash flow method resulted in higher levels of allowance when compared with the general reserve, depending on the level of concession granted. Net charge-offs on residential mortgage loans increased due to the implementation at the beginning of 2010 of the Company’s real estate valuation policy under which the Company obtains assessments of collateral value for residential mortgage loans over 180 days past due and any outstanding balance in excess of the value of the property less cost to sell is classified as loss and written down by charging the allowance for loan and lease losses. The increase in the provision for loan losses on residential mortgage loans was driven by: (i) an increase of $6.8 million due to TDRs individually evaluated for impairment; (ii) an increase of $3.0 million related to the impact of net charge offs on the allowance; (iii) $6.3 million due to transfers of foreclosed loans to OREO; and this was partially offset by $3.8 million due to delinquency improvement.
The provision for loan and lease losses for the commercial real estate portfolio increased by $25.5 million for the year ended December 31, 2010, when compared to the corresponding 2009 period due to (i) a $4.5 million provision related to a reduction in the threshold for individually evaluated impaired loans from $1.0 million to $50,000, (ii) an $8.4 million provision due to the adverse classification of a participation interest in a current paying loan of $37.7 million for which a charge-off over allowance was recorded during the year, (iii) an $8.2 million additional provision on loans individually measured for impairment, (iv) a $1.0 million provision due to TDRs during the year which are individually evaluated for impairment, and (v) a $2.5 million provision as loans rolled to delinquency.
The provision for loan and lease losses on the construction and land loan portfolio increased $10.7 million during 2010 primarily due to the sale of a construction portfolio to a third party during the third quarter of 2010 that resulted in additional provisions of $12.7 million, this was partially offset by the release of $2 million in reserve as one project loan was worked-out.
The provisions for the other consumer loan portfolio and the commercial and industrial loan portfolio reflected decreases of $2.3 million and $0.8 million, respectively in 2010 compared to 2009. The decrease in the provision for the consumer loan portfolio was due to lower delinquency and the runoff of the portfolio. For commercial and industrial loans the reduction is also the result of reduction in the Puerto Rico portfolio.
The provision for loan and lease losses was also impacted by the effect of charge-offs related to foreclosed loans, higher loss mitigation volume and an increase in severities (in the determination of the provision) due to strategic decision to accelerate OREO dispositions. The provision for loan and lease losses was offset by net charge-offs of $116.1 million for the year ended December 31, 2010 which included $35.8 million related to the sale of certain construction loans, $8.8 million related to a classified participation interest as well as charge-offs of previously reserved balances and the implementation of the Company’s real estate valuation policy.
The sector of the economy most affecting Doral Financial, directly and indirectly, is the sale of new home construction in Puerto Rico. The market absorption on new construction homes continued at a low level in 2010. The slowdown in new construction has resulted in lost jobs, which has further increased mortgage and commercial loan delinquencies as the overall level of economic activity declines. The Company expects that absorption will continue to be at low levels due to the current economic environment although a significant improvement was detected during the last quarter of the year. In September 2010, the Governor of Puerto Rico signed into law Act. No. 132 of 2010, which established various housing, tax and other incentives to stimulate the sale of new and existing housing units. The tax and other incentives, which include reductions relating to capital gains, property taxes and property recording fees and stamps, will be effective until June 30, 2011.
2009 compared to 2008. Doral Financial’s provision for loan and lease losses for the year ended December 31, 2009 totaled $53.7 million, compared to $48.9 million for the corresponding 2008 period, an increase of $4.8 million, or 10%. For 2009, the provision for all portfolios increased except for the provision for the commercial real estate loan portfolio which is the portfolio where a higher provision was established at the end of 2008. The level of the provision in 2009 was largely driven by higher delinquencies (primarily in the construction, residential mortgage and commercial loan portfolios) during the period and continued deterioration in the Puerto Rico economy.
Mortgage lending is the Company’s principal line of business and has historically reflected low levels of losses. Nevertheless, due to current economic conditions in Puerto Rico, which have resulted in higher non-performing loans and loss severities in the residential mortgage loan portfolio, the Company increased its allowance and provision for loan and lease losses for this portfolio during 2009.
Perhaps the sector of the economy most affecting Doral Financial, directly and indirectly, is the sale of new home construction in Puerto Rico. For the year ended December 31, 2009, the market absorption of new construction homes decreased significantly, principally due to the termination, late in the fourth quarter of 2008, of the tax incentive for new and existing home purchases provided by Law 197. This circumstance required modifications in absorption estimates, resulting in higher loan loss provisions. Furthermore, the slowdown in new construction has resulted in lost jobs, which has further increased mortgage and commercial loan delinquencies as the overall level of economic activity declines. The Company expects that absorption will continue to be at low levels due to the current economic environment.
In optimizing its recovery of non-performing construction loans, as of December 31, 2009, management decided to foreclose approximately 20 non-performing residential development properties with an outstanding balance of approximately $125.8 million in order to accelerate sales of the individual units. Most of these projects were in a mature stage of the development with approximately 85% complete or close to completion. As foreclosure was probable, accounting guidance required the measurement of impairment to be based on the fair value of the collateral. Since current appraisals were not available on all these properties at year end, management determined its loss reserve estimates for these loans by estimating the fair value of the collateral. In doing so, management considered a number of factors including the price at which individual units could be sold in the current market, the period of time over which the units would be sold, the estimated cost to complete the units, the risks associated with completing and selling the units, the required rate of return on investment a potential acquirer may have and current market interest rates in the Puerto Rico market. Management continues to evaluate the best course of action to optimize loan recoveries on all non-performing properties, and will regularly assess all projects in choosing its course of action.
The provisions for loan and lease losses were partially offset by net charge-offs of $44.9 million, the net of which resulted in an increase in the allowance for loan and lease losses of $8.8 million for the year ended December 31, 2009.
Non-interest (loss) income
A summary of non-interest (loss) income for the years ended December 31, 2010, 2009 and 2008 is provided below.
Table C - Non-interest (loss) income
2010 compared to 2009. Significant variances in non-interest income for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follow:
•
During 2010 OTTI losses were recognized on eight of the Company’s non-agency CMOs totaling $14.0 million for the year ended December 31, 2010. Five of the eight OTTI securities resulted in the recognition of an OTTI loss of $13.3 million during the first quarter of 2010. These five securities were sold during the second quarter of 2010. Three securities from the P.R. non-agency CMO portfolio with an amortized cost of $11.1 million as of December 31, 2010 reflected an OTTI loss of $0.7 million. Refer to Note 8 in the accompanying Notes to the Consolidated Financial Statements for additional information on OTTI.
•
A decrease of $1.1 million in net gain on mortgage loan sales and fees due to higher loan basis during 2010. During 2009 average loan basis was approximately 98.8%, while the average loan basis during 2010 was close to par.
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An increase of $28.8 million on net gain on trading activities resulted from:
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A gain on sale of GNMA and FNMA securities consisting of loans originated by the Company of $11.8 million as a result of higher MBS coupon prices during 2010.
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A gain on the IO valuation of $8.8 million related to decreases in the market interest rates.
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A gain on MSR economic hedge of $7.5 million compared to a loss of $8.7 million in 2009, primarily related to a change in the hedging strategy during the second quarter of 2009 from the use of U.S. Treasuries to forward contracts and to the decrease in forecasted prepayment speeds.
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A net loss on investment securities of $93.7 million resulted from a loss of $136.7 million during the second quarter of 2010, from the sale of certain non-agency CMOs with an amortized cost basis of $378.0 million, offset in part by the sale of certain agency securities in the first and third quarters of 2010 that generated net gains of $26.4 million and $17.1 million, respectively, together with a net loss on an early repayment debt of $7.7 million.
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A reduction of $8.4 million in servicing income during 2010 driven by a decrease in value of the mortgage servicing assets due to changes in valuation inputs or assumptions and a reduction in loan balances.
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An increase in other income of $2.2 million related to a gain of $3.0 million on redemption of shares of VISA, Inc.
2009 compared to 2008. Significant variances in non-interest income for the year ended December 31, 2009, when compared to the corresponding 2008 period, are as follow:
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During 2009 OTTI losses were recognized on seven of the Company’s non-agency CMOs, representing an aggregate amortized cost of $246.7 million as of December 31, 2009 and recognized a credit loss of $27.6 million on these securities for the year ended December 31, 2009. Three of these securities were P.R. non-agency CMO’s with an amortized cost of $11.6 million and a recognized credit loss of $1.2 million, and the additional four securities that reflected OTTI were U.S. non-agency CMOs with an amortized cost of $235.1 million and a recognized credit loss of $26.4 million.
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A decrease in net gain on mortgage loan sales and fees was due to lower origination fees in 2009 of approximately $3.0 million compared to 2008.
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The net loss on trading activities was driven principally by a loss of $13.8 million related to the U.S. Treasuries that were serving as an economic hedge on the Company’s capitalized MSR during the first half of 2009 as the spreads between declining mortgage rates and the U.S. Treasury curve compressed as a result of the U.S. Federal Reserve Bank Monetary Policy implemented at the end of 2008 designed to promote mortgage loan originations and reduce mortgage loan interest rates. This loss was partially offset by an improvement on the economic hedge on the MSRs due to a change in the hedging strategy during the second quarter of 2009 from the use of U.S. Treasuries to forward contracts and to the decrease in forecasted prepayment speeds.
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Net gain on investment securities of $34.9 million resulted from the sale of approximately $2.0 billion of mortgage-backed securities, primarily CMO floaters, and other debt securities during 2009 as a result of the execution of the Company’s decision to obtain higher yielding securities in the second quarter and shorten security duration in the fourth quarter of 2009.
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An improvement in the mark-to-market adjustment of mortgage servicing assets of $39.5 million was principally related to the decrease in mortgage rates triggering higher prepayment speed assumptions and reduced MSR valuations in the 2008 calculation combined with more stable and slower prepayment speed assumptions used in the 2009 calculation consistent with observed trends in benchmark
prepayment speeds and recent trends in the Puerto Rico mortgage origination and prepayment experience.
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A decrease in other income of $5.9 million due to a lower gain on redemption of shares of VISA, Inc. in 2009 and to lower income associated with the sale of certain units of a residential housing project which the Company took possession of in 2005 of $1.3 million.
Non-interest expense
A summary of non-interest expense for the years ended December 31, 2010, 2009 and 2008 is provided below.
Table D - Non-interest expense
2010 compared to 2009. Non-interest expense increased $80.8 million for the year ended December 31, 2010 compared to the corresponding 2009 period. Approximately, $57.6 million of the non-interest expense increase resulted from costs incurred to collect, restructure or modify certain loans, to recognize decreases in estimated values, or recognize the costs of estimated Doral credit related obligations. These credit related costs were incurred to support the Company’s efforts to reduce its non-performing loans and improve the quality of the Company’s balance sheet. The credit related expenses are included in “Compensation and employee benefits”, “Professional services”, “Other “and “Other reserves and OREO” and are described in more detail below.
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An increase of $6.4 million in compensation and employee benefits was due to: (i) higher salary expenses of $1.0 million, (ii) higher benefits of $3.7 million and (iii) lower deferral of compensation
costs related to loan origination of $2.3 million. The higher salary expense of $1.0 million was the result of higher expenses for temporary personnel of $3.1 million mainly related to collection efforts and other temporary projects, offset by lower severance expense of $3.8 million and higher salaries of $1.7 million related to incremental workforce during 2010. The increase in benefits of $3.7 million was driven by retention bonuses and restricted stock compensation granted to certain officers of the Company of $3.3 million and $1.4 million, respectively, partially offset by lower performance bonuses of $1.0 million. The decrease in deferral of compensation costs related to loan originations was due to lower loan originations during 2010.
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An increase in professional services of $22.3 million driven by:
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An increase of $2.1 million in defense litigation costs of former company officers, as certain matters went to trial in 2010.
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An increase of $4.1 million in legal expenses to support corporate litigation (approximately $2.3 million) and collection efforts (approximately $1.8 million).
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An increase of $16.1 million in other professional services primarily related to non-recurring transactions during 2010: (i) approximately $0.9 million of expenses incurred on the CLO transaction and (ii) higher servicing costs related to the construction and large commercial loan portfolios of $8.8 million. In addition, there were higher expenses of approximately $6.9 million for other transactions, such as expense related to bidding for FDIC assisted transactions of approximately $5.1 million, the sale of construction and other loans of $1.0 million, expenses related to the 2010 preferred stock exchange of $0.5 million, and the dissolution of Doral Holdings of $0.3 million.
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An increase of $1.6 million in FDIC insurance expense due to an increase in rates and assessment bases compared to 2009.
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An increase of $2.4 million in occupancy expenses due to an increase in utilities expense of $1.0 million due to higher fees and higher energy costs in Puerto Rico during 2010. There was a $0.4 million impairment charge on a property related to residential housing project that the Company has possession of, an increase in rent expense of $0.6 million related to new facilities in the U.S. for branch openings in New York and Florida as well as expanded administrative facilities as well as an increase in building repairs and maintenance of $0.6 million.
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An increase of $1.1 million in taxes, other than payroll and income taxes due to higher real property tax assessment in Puerto Rico during 2010 that drove $0.5 million of the increase and higher volume of business in 2010 resulting in an increase of $0.6 million.
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An increase of $2.3 million in advertising expenses related to campaigns to gain market share in deposits and mortgage origination subsequent to the local market bank failures and asset acquisitions in April.
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An increase of $1.0 million in corporate insurance expense due to higher premiums in 2010, a consequence of bank failures in Puerto Rico.
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An increase in credit related expenses of approximately $57.6 million was composed of the following items in “Other” and “Other reserves and OREO”:
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Other expenses increased $4.1 million compared to 2009 due to higher foreclosure and other repossessed asset expenses of $2.1 million, a one-time expense of $1.1 million related to representations and warranties and other operating losses of $1.1 million.
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An additional $10.8 million reserve for the Company’s claim on Lehman Brothers, Inc. established during the second quarter of 2010. The receivable related to this claim was sold during the fourth quarter of 2010, recognizing an additional loss of $1.5 million.
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An increase in total OREO and other related expense of $26.2 million primarily related to the recognition of an additional provision of $17.0 million to account for the effect of management’s strategic decision to reduce pricing in order to accelerate OREO sales, adjustments driven by lower
values of certain of Doral’s OREO properties, higher levels of repossessed units and higher expenses to maintain the properties in saleable conditions. Also, a loss on sales of OREO of $5.0 million was recognized during 2010.
The following item are “credit related expenses” included in the “Compensation and employee benefits” and “Professional services” captions above:
•
The increase in compensation and employee benefits explained above includes an increase of approximately $3.0 million related to additional cost in collection efforts.
•
The increase in professional services explained above includes approximately $11.3 million related to legal and professional expenses for collections and workout efforts on the Company’s portfolio.
2009 compared to 2008. Significant variances in non-interest expenses for the year ended December 31, 2009, when compared to the corresponding 2008 period, are as follow:
•
A decrease of $1.8 million in compensation and employee benefits was driven by reduction in workforce during 2009, partially offset by one-time severance expenses. The number of full-time equivalent employees decreased by 252 to 1,154 in 2009 from 1,406 in 2008.
•
A decrease in advertising expenses of $1.9 million resulted from the cost control measures implemented by the Company since 2008. Also, during 2008 advertising expenses included some additional expenses related to the Company’s refreshed branding program initiated late in 2007.
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An increase of $7.4 million in professional services expenses was driven by amounts advanced to cover legal expenses of the Company’s former officers, for the management of legacy portfolios and expenses associated with the preferred stock exchanges.
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An increase of $2.6 million in EDP expenses was primarily related to certain initiatives to optimize and update the Company’s banking and mortgage platforms and to an increase in the Company’s outsourced services.
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A decrease of $3.1 million in occupancy expenses partially driven by decreases in utilities expenses resulting from the Company implementation of cost control measures and controls established to reduce energy consumption together with lower fuel costs. Also, this decrease in occupancy expenses was related to a non-recurring impairment charge of $1.4 million made during the third quarter of 2008 on a residential housing project which the Company took possession of in 2005.
•
A decrease of $3.2 million in depreciation expenses related to intangibles, software and building improvements fully depreciated or amortized during 2009.
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An increase of $13.6 million in the FDIC insurance expense primarily related to (i) $4.2 million of the FDIC special assessment expense during the second quarter of 2009 and (ii) an increase of $7.8 million during the second half of 2009 resulting from a final rule adopted by the FDIC in May 2009, effective June 30, 2009 that caused a significant increase in rates and assessment bases.
•
An increase of $13.7 million in OREO losses and other related expenses as a result of significant appraisal adjustments driven by a devaluation of OREO properties in Puerto Rico made during the second half of 2009, higher levels of repossessed units and higher expenses to maintain the properties in saleable condition.
•
A significant decrease in other expenses resulted from a provision of $21.6 million recognized during 2008 related to the LBI transaction mentioned above.
Income Taxes
The recognition of an income tax expense of $14.9 million for the year ended December 31, 2010 resulted from a current tax expense of $7.4 million and a deferred income tax expense of $7.5 million. The current income tax expense was related to U.S. source income. The deferred income tax expense was related
to the recognition of additional deferred tax assets, primarily NOLs, net of amortization of existing DTAs and net of an increase in the valuation allowance.
As of December 31, 2010, the Company had two Puerto Rico entities which were in a cumulative loss position. For purposes of assessing the realization of the DTAs, the cumulative taxable loss position for these two entities is considered significant negative evidence that has caused management to conclude that the Company will not be able to fully realize the deferred tax assets related to these two entities in the future. Accordingly, as of December 31, 2010 and 2009, the Company determined that it was more likely than not that $462.7 million and $385.9 million, respectively, of its gross deferred tax asset would not be realized and maintained a valuation allowance for those amounts.
For Puerto Rico taxable entities with positive core earnings, a valuation allowance on deferred tax assets was not recorded since they are expected to continue to be profitable. At December 31, 2010, the net deferred tax asset associated with these two companies was $9.0 million, compared to $14.4 million at December 31, 2009. In addition, approximately $94.4 million of the IO tax asset would be realized through these entities. In management’s opinion, for these companies, the positive evidence of profitable core earnings outweighs any negative evidence.
The valuation allowance also includes $1.3 million and $3.0 million related to deferred taxes on unrealized losses on cash flow hedges as of December 31, 2010 and 2009, respectively.
For the year ended December 31, 2009, income tax benefit of $21.5 million, resulted from a current tax benefit of $11.5 million and a deferred tax benefit of $10.0 million. The current tax benefit is primarily related to the release of unrecognized tax benefits due to the expiration of the statute of limitations on certain tax positions net of the recognition of certain unrecognized tax benefits during the year. This net benefit was partially offset by the recognition of tax expense related to intercompany transactions in the federal tax jurisdiction which had not been previously recognized net of current tax benefit related to the Company’s U.S. affiliates. The deferred tax benefit is primarily related to the effect of the Company entering into an agreement with the Puerto Rico Treasury Department during the third quarter of 2009 amending the previous agreement regarding amortization of certain prepaid taxes, net of the amortization of existing deferred tax assets.
Management does not establish a valuation allowance on the deferred tax assets generated on the unrealized gains or losses of its securities available for sale because the Company does not intend to sell the securities before recovery of value, and based on available evidence it is not more likely than not that the Company will decide or be required to sell the securities before the recovery of its amortized cost basis. Management has therefore determined that a valuation allowance on deferred tax assets generated on the unrealized losses of its securities available for sale is not necessary at this time.
Failure to achieve sufficient projected taxable income in the entities where a valuation allowance on deferred tax assets has not been established, might affect the ultimate realization of the net deferred tax asset.
On January 31, 2011, the Governor signed into law the Internal Revenue Code of 2011 (“2011 Code”) making the PR Code ineffective, for the most part, for years commenced after December 31, 2010. Under the provisions of the 2011 Code, the maximum statutory corporate income tax rate is 30% for years commenced after December 31, 2010 and ending before January 1, 2014; if the Government meets its income generation and expense control goals, for years commenced after December 31, 2013, the maximum corporate tax rate will be 25%. The 2011 Code, however, eliminated the special 5% surtax on corporations for tax year 2011. In general, the 2011 Code maintains the increase in carry forward periods for net operating losses generated between 2005 and 2011 from 7 to 10 years as provided for in Act 171; maintains the concept of the alternative minimum tax although it changed the way it is computed; and specifies what types of auditors’ report will be acceptable when audited financial statements are required to be filed with the income tax return. Notwithstanding, a corporation may be subject to the provisions of the PR Code if it so elects it by the time it files its income tax return for the first year commenced after December 31, 2010 and ending before January 1, 2012. Once the election is made, it will be effective for such year and the next 4 succeeding years.
Management assesses the realization of its deferred tax assets at each reporting period. To the extent that earnings improve and the deferred tax assets become realizable, the Company may be able to reduce the valuation allowance through earnings.
Refer to Note 28 of the accompanying Consolidated Financial Statements for additional information related to the Company’s income taxes.
OPERATING SEGMENTS
Doral Financial manages its business in three operating segments: mortgage banking activities, banking (including thrift operations), and insurance agency activities. The Company’s segment reporting is organized by legal entity and aggregated by line of business. Legal entities that do not meet the threshold for separate disclosure are aggregated with other legal entities with similar lines of business. Management made this determination based on operating decisions particular to each business line and because each one targets different customers and requires different strategies. The majority of the Company’s operations are conducted in Puerto Rico. The Company also operates in the mainland United States, principally in the New York City metropolitan area and since the third quarter of 2010 in the northwest area of Florida.
In the past, the Company managed a fourth operating segment, institutional securities operations, but effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial.
Banking
The banking segment includes Doral Financial’s banking operations in Puerto Rico, currently operating through 34 retail bank branches, and in the mainland United States, principally in the New York City metropolitan area and in the northwest area of Florida through 6 branches. Doral Financial accepts deposits from the general public and institutions, obtains borrowings, originates and invests in loans, and invests in mortgage-backed securities as well as in other investment securities and offers traditional banking services. Net loss for the banking segment amounted to $261.9 million during 2010, compared to a net loss of $32.3 million during 2009 and $123.4 million during 2008, respectively.
This segment also includes the operations conducted through Doral Bank PR’s subsidiaries, Doral Money, which engages in commercial and construction lending in the New York City metropolitan area, and CB, LLC, a Puerto Rico limited liability company organized in connection with the receipt, in lieu of foreclosure, of real property securing an interim construction loan. During the third quarter of 2009, Doral Money organized a middle market syndicated lending unit that is engaged in purchasing participations in senior credit facilities in the U.S. syndicated leverage loan market.
On July 8, 2010, the Company entered into a CLO arrangement with a third party in which up to $450.0 million of U.S. mainland based commercial loans are pledged to collateralize AAA rated debt of $250.0 million paying three month LIBOR plus 1.85 percent issued by Doral CLO I, Ltd. Doral CLO I. Ltd. is a variable interest entity created to hold the commercial loans and issue the previously noted debt and $200.0 million of subordinated notes to the Company whereby the Company receives any excess proceeds after the payment of the senior debt interest and other fees and charges specified in the indenture agreement. The Company also serves as collateral manager of the assets of Doral CLO I. Ltd. The Company has concluded that it is the primary beneficiary, and the Company will consolidate Doral CLO I. Ltd., as a subsidiary of Doral Bank PR.
On July 1, 2008, Doral International, Inc., which was a subsidiary of Doral Bank PR licensed as an international banking entity under the IBC Act, was merged with and into Doral Bank PR in a transaction structured as a tax-free reorganization. On December 16, 2008, Doral Investment was organized to become a new subsidiary of Doral Bank PR. On February 2, 2010, Doral Investment was granted license to operate as an international banking entity under the IBC Act. Doral Investment remained inactive as of December 31, 2010.
2010 compared to 2009. Net interest income for the banking segment was $146.9 million for 2010, compared to $149.3 million for 2009. The decrease in net interest income was principally driven by a reduction of $48.9 million in interest income during 2010, partially offset by a reduction of $46.4 million in interest expense for the same period. The reduction in interest income was principally related to (i) an increase of $2.6 million resulted from an increase in interest income of commercial loans due to increases during 2010 in the U.S. syndicated loan portfolio, partially offset by yield concessions on loans loss mitigation activities, levels of non-performing loans and run-offs on portfolios such as construction and consumer; (ii) a decrease of $43.5 million in interest on MBS impacted by a reduction in the average balance of MBS of $857.5 million during 2010 resulting from the sale of non-agency CMOs and other MBS during the second and third quarters of 2010; and (iii) a decrease of $8.3 million in interest on investment securities due to a reduction in the average balance of investment securities of $222.7 million related to sales, calls and/or maturities.
The decrease in interest income was partially offset by a decrease in interest expense of $46.4 million for the year ended December 31, 2010, when compared to the corresponding 2009 period. The decrease in interest expense was driven by (i) a reduction of $14.6 million in interest expense on deposits driven by the rollover of maturing brokered CDs at lower current market rates, as well as shifts in the composition of the Company’s retail deposits; (ii) a reduction of $18.1 million in interest expense on securities sold under agreements to repurchase driven by a decrease of $248.2 million in the average balance of repurchase agreements and a general decline in interest rates; (iii) a decrease of $15.8 million in interest on advances from FHLB resulted primarily from the decline in the average balance of advances from FHLB of $421.7 during 2010; (iv) a decrease of $1.2 million in interest expense on other short-term borrowings, because there were no outstanding borrowings at any month end during 2010; and (vi) an increase of $3.2 million in interest expense on notes payable resulting from $250.0 million of new debt issued by Doral CLO I. Ltd. in July 2010 at a rate of 3-month LIBOR plus 1.85%.
Average interest-earning assets decreased from $8.8 billion for the year ended December 31, 2009 to $8.2 billion for the corresponding 2010 period, while the average interest-bearing liabilities also decreased from $8.0 billion to $7.4 billion, respectively. The sales of MBS and other debt securities during the second and third quarters of 2010 and the purchase of investments of shorter duration, as well as the shifts in the composition of average interest bearing liabilities from higher cost borrowing to less expensive sources of financing, such as money market accounts with cost of less than 0.4%, is part of the execution of the Company strategy to de-lever the balance sheet. The repositioning of the balance sheet during 2010, and other management actions, resulted in a 9 basis point improvement in net interest margin from 1.70% for the year ended December 31, 2009 to 1.79% for the corresponding 2010 period.
Non-interest loss for the banking segment was $44.7 million for 2010, compared to a non-interest income of $62.9 million for 2009. The decrease in non-interest income of $107.6 million was driven by (i) an OTTI loss of $13.3 million on five of the Company’s non-agency CMOs; (ii) a net loss on investment securities of $93.7 million resulted from a loss of $136.7 million during the second quarter of 2010, from the sale of certain non-agency CMOs with an amortized cost basis of $378.0 million, offset in part by the sale of certain agency securities in the first and third quarters of 2010 that generated net gains of $26.4 million and $17.1 million, respectively, together with a net loss of an early repayment debt of $7.7 million; (iii) a reduction in servicing income of $8.9 million primarily driven by a decrease in the value of the mortgage servicing assets due to changes in valuation inputs or assumptions and a reduction in loan balances; partially offset by (iv) a gain of $16.6 million in trading activities primarily driven by a gain of $11.8 million on sale of securities and a gain of $7.5 million on the MSR economic hedge; and (v) an increase of $1.0 million in commissions, fees and other income driven by a gain of $3.0 million on redemption of shares of VISA, Inc.
Non-interest expense for the banking segment was $261.0 million for 2010, compared to $192.3 million for 2009. The increase in non-interest expense of $68.7 million was mainly driven by (i) an increase of $20.0 million in professional services related to non-recurring transactions during 2010 and also to legal expenses to support corporate litigation and collection efforts; (ii) a $16.2 million increase in OREO and other related expenses primarily related to the recognition of additional provision to account for the effect of management’s strategic decision to reduce pricing in order to accelerate OREO sales as well as other expenses to maintain properties in saleable conditions; (iii) a $9.0 million increase in compensation and benefit expenses
primarily driven by increases in workforce of regular and temporary employees; (iii) $6.6 million related to a reserve for the Company’s claim on LBI established during the second quarter of 2010 and an additional $1.1 million related to the loss recognized as a result of the sale of such receivable during the fourth quarter of 2010; (iv) an increase of $3.8 million in occupancy expenses driven by increases in utilities and rent expenses; and (v) additional increases in other expenses, such as $1.7 million increase in FDIC insurance expense, and $1.6 million in foreclosure expenses, among others.
2009 compared to 2008. Net interest income for the banking segment was $149.3 million for 2009, compared to $158.0 million for 2008. The decrease in net interest income was principally driven by a reduction of $48.7 million in interest income during 2009, partially offset by a reduction of $40.0 million in interest expense for the same period. The decrease in interest income was driven by a reduction in interest income on investment securities of $32.7 million that resulted from a reduction in the average balance of investment securities of $600.1 million as a result of sales, calls and the settlement of the position with Lehman during 2008, the full impact of which was reflected in 2009. The reduction in interest expense was driven by a decrease of $32.5 million in interest expense on deposits that resulted from the rollover of maturing brokered CDs at lower current market rates even though the Company lengthened maturities, as well as shifts in the composition of the Company’s retail deposits and the general decline in interest rates during 2009.
Total average balance of interest-earning assets increased by $0.3 billion during 2009, from $8.5 billion for the year ended December 31, 2008 to $8.8 billion for the corresponding 2009 period. The increase in the average balance of interest-earning assets together with the increase in the average balance of interest-bearing liabilities of $0.3 billion during 2009 and the corresponding decrease in net interest income of $8.7 million resulted in a decrease of 17 basis points in the net interest margin, from 1.87% during 2008 to 1.70% during 2009.
Non-interest income for the banking segment was $62.9 million for 2009, compared to $56.4 million for 2008. The increase in non-interest income of $6.5 million resulted mainly by (i) an increase of $36.5 million in servicing income during 2009 driven by an improvement of $39.5 million in the mark-to-market adjustment of the mortgage servicing assets; (ii) an increase of $38.1 million in gain on investment securities that resulted from the sale of $2.0 billion of principally MBS during 2009; partially offset by (iii) an OTTI loss of $26.4 million in the Company’s investment securities portfolio; and (iv) by a reduction of $30.3 million in trading activities related to a loss on the MSR economic hedge of $36.2 million when compared to 2008, due to a loss of $13.8 million related to the U.S. Treasuries that were serving as an economic hedge on the Company’s capitalized MSR during 2008 and the first four months of 2009.
Non-interest expense for the banking segment was $192.3 million for 2009, compared to $180.5 million for 2008. The increase in non-interest expense of $11.8 million was mainly driven by (i) an increase of $4.1 million in professional services related to the management of legacy portfolios; (ii) a $2.5 million increase in EDP expenses related to certain initiatives to optimize and update the Company’s banking platforms; (iii) an increase of $11.2 million in other expenses mainly related to an increase of $13.6 million in the FDIC insurance expense during 2009; partially offset by (iv) a decrease in compensation and employee benefits of $4.7 million, associated to the reduction in workforce during 2009.
Mortgage Banking
The Company’s mortgage origination business is conducted by Doral Mortgage, a wholly-owned subsidiary of Doral Bank PR. The Company’s mortgage servicing business is operated by Doral Bank PR. Substantially all new loan origination and investment activities at the holding company level were terminated.
2010 compared to 2009. Net interest income for the mortgage banking segment was $7.5 million for 2010, compared to $14.7 million for 2009. The decrease in net interest income was principally driven by a reduction of $10.8 million in the interest income during 2010, partially offset by a reduction of $3.6 million in interest expense for the same period. The decrease in interest income was driven principally by (i) a reduction in interest income of loans of $8.0 million primarily resulted from the transfer during the second quarter of 2010 of $25.2 million of performing loans to Doral Bank PR as part of a capital contribution; and (ii) a
reduction of $2.3 million in interest income of MBS related to a decrease in the average balance of MBS of $42.7 million during 2010 due to securities sold during 2009 and not replaced during 2010. The reduction in interest expense during 2010 was driven by a decrease of $3.1 million in the interest expense of loans payable resulting from the general decline in interest rates, which reflects the re-pricing nature of most of the Company’s loans payable, which are floating rate notes indexed to the 3-month LIBOR.
Total average balance of interest-earning assets decreased by $0.2 billion during 2010, from $0.8 billion for the year ended December 31, 2009 to $0.6 billion for the corresponding 2010 period. The decrease in the average balance of interest-earning assets during 2010 and the corresponding decrease in net interest income of $7.2 million resulted in a decrease of 55 basis points in the net interest margin, from 1.84% during 2009 to 1.29% during 2010.
Non-interest income for the mortgage banking segment was $45.0 million for 2010, compared to $46.1 million for 2009. The decrease in non-interest income of $1.1 million resulted mainly due to an increase of $6.0 million in net gain on trading activities driven by an increase in the IO valuation. This increase in non-interest income was partially offset by a decrease of $6.1 million related to lower dividends paid by Doral Insurance to its parent company, Doral Financial. During 2009, Doral Insurance paid $18.0 million in dividends to Doral Financial, compared to $11.9 million during 2010.
Non-interest expense for the mortgage banking segment was $69.6 million for 2010, compared to $56.4 million for 2009. The increase in non-interest expense of $13.2 million during 2010 was mainly driven by (i) $4.2 million related to a reserve for the Company’s claim on LBI established during the second quarter of 2010 and an additional $445,000 related to the loss recognized as a result of the sale of such receivable during the fourth quarter of 2010; and (ii) an increase of $9.9 million in OREO and other related expenses related to the recognition of additional provision to account for the effect of management’s strategic decision to reduce pricing in order to accelerate OREO sales as well as other expenses to maintain properties in saleable conditions.
2009 compared to 2008. Net interest income for the mortgage banking segment was $14.7 million for 2009, compared to $17.4 million for 2008. The decrease in net interest income was principally driven by a reduction of $20.2 million in the interest income during 2009, partially offset by a reduction of $17.5 million in interest expense for the same period. The decrease in interest income was driven principally by a reduction in interest income of loans of $9.9 million that resulted from the lower interest rate environment and the increase in non-performing loans in the Company’s loan portfolio. The average interest rate on loans decreased 40 basis points for the year ended December 31, 2009 compared to the same period in 2008. The reduction in interest expense was driven by a decrease of $9.0 million in interest expense on loans payable driven primarily by a reduction in rates during 2009 and to a reduction of $8.0 million in interest expense on securities sold under repurchase agreements as a result of the Company not entering in these agreements for the mortgage banking segment during 2009.
Total average balance of interest-earning assets decreased by $0.3 billion during 2009, from $1.1 billion for the year ended December 31, 2008 to $0.8 billion for the corresponding 2009 period. The decrease in the average balance of interest-earning assets together with the decrease in the average balance of interest-bearing liabilities of $0.2 billion during 2009 and the corresponding decrease in net interest income of $2.7 million resulted in an increase of 26 basis points in the net interest margin, from 1.58% during 2008 to 1.84% during 2009.
Non-interest income for the mortgage banking segment was $46.1 million for 2009, compared to $35.5 million for 2008. The increase in non-interest income of $10.6 million resulted mainly by an increase of $18.0 million in other income during 2009 related to dividends paid by Doral Insurance to its parent company, partially offset by a reduction of $3.1 million in trading activities that resulted from lower gains in the value of IOs.
Non-interest expense for the mortgage banking segment was $56.4 million for 2009, compared to $65.4 million for 2008. The decrease in non-interest expense of $9.0 million during 2009 was mainly driven by the elimination of charges made in 2008, such as a loss of $3.4 million related to the elimination of tax
credits granted to customers under Law 197 and a reduction of $11.6 million related to the provisions for sales of delinquent loans and for other receivables.
Insurance Agency
Doral Financial operates its insurance agency activities through its wholly-owned subsidiary Doral Insurance Agency. Doral Insurance Agency’s principal insurance products are hazard, title and flood insurance, which are sold primarily to Doral Financial’s mortgage customers. Doral Insurance Agency also offers a diversified range of insurance products such as auto, life, home protector and disability, among others. Net income for this segment amounted to $6.3 million, $8.0 million and $6.3 million for years ended December 31, 2010, 2009 and 2008, respectively. The decrease in net income during 2010 was principally related to an increase of $2.8 million in deferred income tax provision resulting from the use of its NOLs (refer to Note 28 of the Consolidated Financial Statements for additional information). For the year ended December 31, 2010, insurance fees and commissions amounted to $13.3 million, compared to $12.0 million in 2009 and $12.8 million in 2008.
Institutional Securities Operations
In the past, the Company operated an institutional securities business through Doral Securities. During the third quarter of 2007, Doral Securities voluntarily withdrew its license as a broker-dealer with the SEC and its membership with the FINRA. Doral Securities’ operations were limited during 2008 to acting as a co-investment manager to a local fixed-income investment company. Doral Securities provided notice to the investment company in December 2008 of its intent to assign its rights and obligations under the investment advisory agreement to Doral Bank PR. The assignment was completed in January 2009 and Doral Securities did not conduct any other operations in 2009. During the third quarter of 2009, this investment advisory agreement was terminated by the investment company. Effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial.
Net loss for this segment amounted to approximately $141,000 for the year ended December 31, 2008.
BALANCE SHEET AND OPERATING DATA ANALYSIS
Loan Production
Loan production includes loans internally originated by Doral Financial as well as residential mortgage loans purchased from third parties with the related servicing rights. Purchases of mortgage loans from third parties were $99.9 million, $126.0 million and $182.2 million for the years ended December 31, 2010, 2009 and 2008, respectively.
The following table sets forth the number and dollar amount of Doral Financial’s loan production for the periods indicated:
Table E - Loan Production
(1)
Includes $1.4 million, $2.5 million and $29.2 million in second mortgages for the years ended December 31, 2010, 2009 and 2008, respectively.
(2)
For the year ended December 31, 2010, includes $96.9 million related to a single construction loan.
(3)
Commercial and consumer lines of credit are included in the loan production according to the credit limit approved.
(4)
Consists of multifamily loans.
The increase of $291.6 million, or 25.4%, in loan production for the year ended December 31, 2010, when compared to the corresponding 2009 period, was primarily due to an increase in commercial loans related to loan production generated by the Company’s U.S. based middle market syndicated lending unit which is engaged in purchasing participation interest in senior credit facilities in the syndicated loan market. Syndicated loans originated during 2010 amounted to $494.1 million, representing 34.3% of total loan production. The U.S. based middle market syndicated lending strategy is to acquire $5.0 million to $15.0 million participation interests in U.S. mainland companies that are first underwritten by money center or regional banks, and re-underwritten by the Company’s U.S. based syndicated lending unit. Also, the loan production during 2010 was impacted by an increase in the construction portfolio due to a single construction loan amounting to $96.9 million and to $41.6 million in construction production from U.S. subsidiaries.
The decrease in Doral Financial’s originated residential mortgage loans is due to a number of factors including continuing challenging economic conditions in Puerto Rico, competition from other financial institutions, and changes in laws and regulations.
Total loan production for 2009 decreased by $179.8 million, or 14%, when compared to the 2008 corresponding period. The reduction in loan production was impacted by (i) a decrease of $123.6 million, or 11% in loans originated by the Company during 2009, and (ii) a decrease of $56.2 million, or 31%, associated to production purchased from third parties. The decrease in Doral Financial’s loan production for the year ended December 31, 2009 resulted from significant decreases in residential mortgage and construction lending activity in Puerto Rico, partially offset by an increase in the commercial production related to participation in syndicated loans in the U.S. mainland.
A substantial portion of Doral Financial’s total residential mortgage loan originations has consistently been composed of refinancing transactions. For the years ended December 31, 2010, 2009, and 2008, refinancing transactions represented approximately 85%, 82% and 53%, respectively, of the total dollar volume of internally originated mortgage loans. Doral Financial’s future results could be adversely affected by a significant increase in mortgage interest rates that may reduce refinancing activity. However, the Company believes that refinancing activity in Puerto Rico is less sensitive to interest rate changes than in the mainland United States because a significant number of refinance loans in the Puerto Rico mortgage market are made for debt consolidation purposes rather than interest savings due to lower rates.
Loan Origination Channels
In Puerto Rico, Doral Financial relies primarily on Doral Bank PR’s extensive branch network to originate loans. It supplements these originations with wholesale purchases from other financial institutions. Purchases generally consist of conventional mortgage loans. Doral Financial also originates consumer, commercial, construction and land loans primarily through its banking subsidiaries. Due to worsening economic conditions in Puerto Rico, new lending activity in Puerto Rico has been limited since 2008.
The following table sets forth the sources of Doral Financial’s loans production as a percentage of total loan originations for the years indicated:
Table F - Loan Origination Sources
(1)
Refers to purchases of mortgage loans from other financial institutions and mortgage lenders.
(2)
Includes new construction development loans and the disbursement of existing construction development loans.
(3)
Refers to commercial real estate, consumer and multifamily loans originated through the banking subsidiaries.
The increase in U.S. loan originations during 2010 and 2009 is related to originations of the new syndicated lending unit. These loans are participations in larger loans and are originated though large commercial banks.
Mortgage Loan Servicing
Doral Financial’s principal source of servicing rights has traditionally been sales of loans from its internal loan production. However, Doral Financial also purchases mortgage loans. Doral Financial intends to continue growing its mortgage-servicing portfolio primarily by internal loan originations, but may also continue to seek and consider attractive opportunities for wholesale purchases of loans with the related servicing rights and bulk purchases of servicing rights from third parties.
The following table sets forth certain information regarding the total mortgage loan-servicing portfolio of Doral Financial for the periods indicated:
Table G - Loans serviced for third parties
(1)
Excludes $4.4 billion, $4.4 billion and $4.2 billion of mortgage loans owned by Doral Financial at December 31, 2010, 2009 and 2008, respectively.
(2)
Includes portfolios of $139.6 million, $154.2 million and $177.0 million at December 31, 2010, 2009 and 2008, respectively, of delinquent FHA/VA and conventional mortgage loans sold to third parties.
(3)
Run-off refers to regular amortization of loans, prepayments and foreclosures.
(4)
Excludes the average balance of mortgage loans owned by Doral Financial of $4.4 billion, $4.3 billion and $3.9 billion at December 31, 2010, 2009 and 2008, respectively.
(5)
Includes reserves for possible losses on P&I advances of $9.0 million, $8.8 million and $9.7 million as of December 31, 2010, 2009 and 2008, respectively.
The main component of Doral Financial’s servicing income is loan servicing fees, which depend on the type of mortgage loan being serviced. The servicing fees on residential mortgage loans generally range from 0.25% to 0.50% of the outstanding principal balance of the serviced loan.
Most of the mortgage loans in Doral Financial’s servicing portfolio are secured by single (one-to-four) family residences located in Puerto Rico. At December 31, 2010, 2009 and 2008 less than one percent of Doral Financial’s mortgage-servicing portfolio was related to mortgages secured by real property located on the U.S.
The amount of principal prepayments on mortgage loans serviced for third parties by Doral Financial was $0.4 billion, $0.7 billion and $0.6 billion for the years ended December 31, 2010, 2009 and 2008, respectively. Total delinquencies excluding foreclosures increased from 6.99% to 8.12% from 2009 to 2010 as a result of the economic recession and general deterioration of the mortgage sector, while pending foreclosures increased from 2.99% to 3.36%, respectively. The Company does not expect significant losses related to these delinquencies since it has established a reserve for loans under recourse agreements, and for other non recourse loans has not experienced significant losses in the past.
As part of its servicing responsibilities, in some servicing agreements, Doral Financial is required to advance the scheduled payments of principal or interest whether or not collected from the underlying borrower. While Doral Financial generally recovers funds advanced pursuant to these arrangements within 30 days, it must absorb the cost of funding the advances during the time the advance is outstanding. In the past, Doral
Financial sold pools of delinquent FHA and VA and conventional mortgage loans. Under these arrangements, Doral Financial is required to advance the scheduled payments whether or not collected from the underlying borrower. While Doral Financial expects to recover a significant portion of the amounts advanced through foreclosure or, in the case of FHA and VA loans, under the applicable FHA and VA insurance and guarantee programs, the amounts advanced tend to be greater than normal arrangements because of the large number of delinquent loans.
Loans Held for Sale
Loans held for sale are carried at the lower of net cost or market value on an aggregate portfolio basis. The amount by which cost exceeds market value, if any, is accounted for as a loss through a valuation allowance. Changes in the valuation allowance are included in the determination of income in the period in which those changes occur and are reported under net gain on mortgage loan sales and fees in the Consolidated Statements of Operations. Given traditional consumer preferences in Puerto Rico, substantially all of Doral Financial’s residential loans held for sale are fixed-rate loans. Please refer to Note 10 of the Consolidated Financial Statements accompanying this Annual Report on Form 10-K for additional information regarding Doral Financial’s portfolio of loans held for sale.
As of December 31, 2010, loans held for sale amounted to $319.3 million, of which approximately $291.5 million consisted of residential mortgage loans.
GNMA programs allow financial institutions to buy back individual delinquent mortgage loans that meet certain criteria from the securitized loan pool for which the Company provides servicing. At the Company’s option and without GNMA prior authorization, Doral Financial may repurchase such delinquent loans for an amount equal to 100% of the loan’s remaining principal balance. This buy-back option is considered a conditional option until the delinquency criteria are met, at which time the option becomes unconditional (but not an obligation). When the loans backing a GNMA security are initially securitized, the Company treats the transaction as a sale for accounting purposes and the loans are removed from the balance sheet because the conditional nature of the buy-back option means that the Company does not maintain effective control over the loans. When individual loans later meet GNMA’s specified delinquency criteria and are eligible for repurchase, Doral Financial is deemed to have regained effective control over these loans. In such case, for financial reporting purposes, the delinquent GNMA loans are brought back into the Company’s portfolio of loans held for sale, regardless of whether the Company intends to exercise the buy-back option. An offsetting liability is also recorded. As of December 31, 2010, the portfolio of loans held for sale includes $153.4 million related to GNMA defaulted loans, compared to $128.6 million and $165.6 million as of December 31, 2009 and 2008, respectively.
During 2010, the Company repurchased $68.2 million of GNMA defaulted loans, which were classified as loans held for investment, compared to $127.9 million during 2009.
Loans Held for Investment
Doral Financial originates mortgage loans secured by income-producing residential and commercial properties, construction and land loans, certain residential mortgage loans and other commercial and consumer loans that are held for investment and classified as loans receivable. Loans receivable are originated primarily through Doral Financial’s banking subsidiaries. A significant portion of Doral Financial’s loans receivable consists of loans made to entities or individuals located in Puerto Rico. During 2009, Doral Financial started a syndicated lending unit operating out of one of its New York subsidiaries. This unit is engaged in purchasing senior credit facilities in the syndicated leverage loan market.
The maximum aggregate amount in unsecured loans that Doral Bank PR could make to a single borrower under Puerto Rico banking regulations as of December 31, 2010, was approximately $101.6 million. Puerto Rico banking regulations permit larger loans to a single borrower to the extent secured by qualifying collateral. The maximum aggregate amount in loans that Doral Bank NY could make to a single borrower under the OTS banking regulations as of December 31, 2010, was $2.2 million. Doral Financial’s largest aggregated indebtedness to a single borrower or a group of related borrowers as of December 31, 2010 was $97.7 million.
The following table set forth certain information regarding Doral Financial’s loans receivable:
Table H - Loans receivable, net
The following table sets forth certain information as of December 31, 2010, regarding Doral Financial’s loans receivable portfolio based on the remaining contractual maturity. Expected maturities may differ from contractual maturities because of prepayments and other market factors. Loans having no stated maturity are reported as due in one year or less.
Table I - Loans receivable by contractual maturities
Scheduled contractual amortization of loans receivable does not reflect the expected life of Doral Financial’s loans receivable portfolio. The average life of these loans is substantially less than their contractual terms because of prepayments and, with respect to conventional mortgage loans, due-on-sale clauses, which
give Doral Financial the right to declare a conventional mortgage loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan rates are lower than rates on existing mortgage loans. Under the latter circumstance, the weighted-average yield on loans decreases as higher-yielding loans are repaid or refinanced at lower rates.
The following table sets forth the dollar amount of total loans receivable at December 31, 2010, as shown in the preceding table, which have fixed interest rates or which have floating or adjustable interest rates that have a contractual maturity of more than one year.
Table J - Loans receivable by fixed and floating or adjustable rates
Doral Financial’s banking subsidiaries originate floating or adjustable and fixed interest-rate loans. Unlike its portfolio of residential mortgage loans, which is comprised almost entirely of fixed rate mortgage loans, a significant portion of Doral Financial’s construction and land, and other commercial loans classified as loans receivable carry adjustable rates. At December 31, 2010, 2009 and 2008, approximately 16%, 13% and 13%, respectively, of Doral Financial’s gross loans receivable were adjustable rate loans. The increase in the percentage of adjustable rate loans from 2009 to 2010 was due to the increase in the syndicated loan portfolio. The adjustable rate construction and land and commercial loans have interest rate adjustment limitations and are generally tied to the prime rate, and often provide for a maximum and minimum rate beyond which the applicable interest rate will not fluctuate. Future market factors may affect the correlation of the interest rate adjustment with the rate Doral Financial pays on the different funding sources used to finance these loans. Please refer to Note 10 of the consolidated financial statements accompanying this Annual Report on Form 10-K for additional information regarding Doral Financial’s portfolio of loans receivable.
Investment and Trading Activities
As part of its mortgage securitization activities, Doral Financial is involved in the purchase and sale of mortgage-backed securities. At December 31, 2010, Doral Financial, principally through its banking subsidiaries, held securities for trading with a fair market value of $45.0 million.
Securities held for trading are reflected on Doral Financial’s consolidated statement of financial condition at their fair market value with resulting gains or losses included in current period earnings as part of net gain (loss) on trading activities. See “Critical Accounting Policies - Valuation of Trading Securities and Derivatives” above for additional information on how Doral Financial determines the fair values of its trading securities.
Securities held for trading also includes derivatives that serve as economic hedges on the Company’s MSRs and secondary market activities.
As part of its strategy to diversify its revenue sources and maximize net interest income, Doral Financial also invests in securities that are classified as available for sale. As of December 31, 2010, Doral Financial, principally through its banking subsidiaries, held $1.5 billion of investment securities that were classified as available for sale and reported at fair value based on quoted or evaluated market prices, with unrealized gains or losses included in stockholders’ equity and reported as accumulated other comprehensive income (“AOCI”), net of income tax expense in Doral Financial’s consolidated statement of financial condition. At December 31, 2010, Doral Financial had unrealized gains in AOCI of $7.4 million, compared to unrealized losses of $103.9 million at December 31, 2009 related to its available for sale portfolio.
The securities held by the Company are principally mortgage-backed securities or securities backed by a U.S. government sponsored agencies and therefore, principal and interest on the securities are deemed recoverable. Doral Financial’s investment portfolio consists primarily of AAA rated debt securities, except for the Non-Agency Collateralized Mortgage Obligations (“CMO”) as well as a few other positions.
During 2010, the Company sold approximately $2.3 billion of investment securities, and also purchased $1.6 billion of shorter duration securities. These actions are part of the execution of the Company strategy to de-lever and reposition the balance sheet. For the year ended December 31, 2010, the Company recognized losses on sale of investment securities of $93.7 million as a result of the sale on certain non-agency securities at a loss of $136.7 million, offset by the sale of mortgage-backed securities and other debt securities at a gain of $43.0 million as part of Doral’s strategic balance sheet restructuring efforts.
The Company performs an assessment of OTTI whenever the fair value of an investment security is less than its amortized cost basis at the balance sheet date. Amortized cost basis includes adjustments made to the cost of a security for accretion, amortization, collection of cash, previous OTTI recognized into earnings (less any cumulative effect adjustments) and fair value hedge accounting adjustments. OTTI is considered to have occurred under the following circumstances:
•
If the Company intends to sell the investment security and its fair value is less than its amortized cost.
•
If, based on available evidence, it is more likely than not that the Company will decide or be required to sell the investment security before the recovery of its amortized cost basis.
•
If the Company does not expect to recover the entire amortized cost basis of the investment security. This occurs when the present value of cash flows expected to be collected is less than the amortized cost basis of the security. In determining whether a credit loss exists, the Company uses its best estimate of the present value of cash flows expected to be collected from the investment security. Cash flows expected to be collected are estimated based on a careful assessment of all available information. The difference between the present value of the cash flows expected to be collected and the amortized cost basis represents the amount of credit loss.
The Company evaluates its individual available for sale investment securities for OTTI on at least a quarterly basis. As part of this process, the Company considers its intent to sell each investment security and whether it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of these conditions is met, the Company recognizes an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities that meet neither of these conditions, an analysis is performed to determine if any of these securities are at risk for OTTI. To determine which securities are at risk for OTTI and should be quantitatively evaluated utilizing a detailed cash flow analysis, the Company evaluates certain indicators which consider various characteristics of each security including, but not limited to, the following: the credit rating and related outlook or status of the securities; the creditworthiness of the issuers of the securities; the value and type of underlying collateral; the duration and level of the unrealized loss; any credit enhancements; and other collateral-related characteristics such as the ratio of credit enhancements to expected credit losses. The relative importance of this information varies based on the facts and circumstances surrounding each security, as well as the economic environment at the time of assessment. The negative difference between the estimate of the
present value of the cash flows expected to be collected and the amortized cost basis is considered to be a credit loss.
As a result of its review of the portfolio as of December 31, 2010, the Company performed a detailed cash flow analysis of certain securities in unrealized loss positions to assess whether they were OTTI. The Company uses a third party provider to generate cash flow forecasts of each security reviewed based on a combination of management and market driven assumptions and securitization terms, including remaining payment terms of the security, prepayment speeds, the estimated amount of loans to become seriously delinquent over the life of the security, the estimated life-time severity rate, estimated losses over the life of the security, loan characteristics, the level of subordination within the security structure, expected housing price changes and interest rate assumptions.
During 2010, it was determined that eight securities reflected OTTI. The characteristics of these securities that led to the OTTI conclusion included: (i) the cumulative level and estimated future delinquency levels; (ii) the effect of severely delinquent loans on forecasted defaults; (iii) the cumulative severity and expected severity in resolving the defaulted loans; and (iv) the current subordination of the securities that resulted in the present value of the forecast cash flows being less than the cost basis of the security. Management estimated that credit losses of $14.0 million were incurred on these securities for the year ended December 31, 2010.
Five of the eight OTTI securities were subordinated interests in a securitization structure collateralized by option adjustable rate mortgage (“ARM”) loans and resulted in the recognition of an OTTI loss of $13.3 million in the first quarter of 2010. On April 23, 2010, the Company sold the entire portfolio of U.S. non-agency CMOs, including the five securities that were OTTI, and recognized a loss of $136.7 million, of which $129.7 million had previously been reflected in other comprehensive income (loss).
Non-Agency CMOs include subordinated tranches of 2006 securitizations of Doral originated mortgage loans primarily composed of 2003 and 2004 vintages. Doral purchased these CMOs at a discounted price of 61% of par value, anticipating a partial loss of principal and interest value. These original three securities have an amortized cost of $11.1 million as of December 31, 2010 including an OTTI loss of $0.7 million due to credit. Higher default and loss assumptions driven by higher delinquencies in Puerto Rico, primarily due to the impact of inflationary pressures on the consumer, the high rate of unemployment and general recessionary condition on the Island, has resulted in higher default and loss estimates on the P.R. Non-Agency CMOs. The higher default and loss estimates have resulted in lower bond prices and higher levels of unrealized losses on the bonds. It is possible that future loss assumptions could change and cause future OTTI charges in these securities.
As of December 31, 2010 and 2009, the Company did not intend to sell the remaining securities which were evaluated for OTTI and concluded it was not more likely than not that it would be required to sell these securities before the anticipated recovery of each security’s remaining amortized cost basis. Therefore, the difference between the amortized cost basis and the market value of the securities is recorded in accumulated other comprehensive income.
For the remainder of the Company’s securities portfolio that have experienced decreases in the fair value, the decline is considered to be temporary as the Company expects to recover the entire amortized cost basis on the securities and neither intends to sell these securities nor is it more likely than not that it will be required to sell these securities.
In subsequent periods the Company will account for the securities judged to be OTTI as if the securities had been purchased at the previous amortized cost less the credit related OTTI. Once a credit loss is recognized, the investment will be adjusted to a new amortized cost basis equal to the previous amortized cost basis less the amount recognized in earnings. For the investment securities for which OTTI was recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted as interest income.
The following table summarizes Doral Financial’s securities holdings as of December 31, 2010.
Table K - Investment Securities
For additional information regarding the composition of Doral Financial’s investment securities, please refer to Notes 6, 7 and 8 to the accompanying consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Doral Financial has an ongoing need for capital to finance its lending, servicing and investing activities. Doral Financial’s cash requirements arise mainly from loan originations and purchases, purchases and holding of securities, repayment of debt upon maturity, payment of operating and interest expenses, servicing advances and loan repurchases pursuant to recourse or warranty obligations. Sources of funds include deposits, advances from FHLB and other borrowings, proceeds from the sale of loans, and of certain available for sale investment securities and other assets, payment from loans held on the balance sheet, and cash income from assets owned, including payments from owned mortgage servicing rights and interest only strips. The Company’s Asset and Liability Committee (“ALCO”) establishes and monitors liquidity guidelines to ensure the Company’s ability to meet these needs. Doral Financial currently has and anticipates that it will continue to have adequate liquidity, financing arrangements and capital resources to finance its operations in the ordinary course of business.
Liquidity of the Holding Company
The holding company’s principal uses of funds are the payment of its obligations, primarily the payment of principal and interest on its debt obligations. The holding company no longer directly funds any mortgage banking activities. Beyond the amount of unencumbered liquid assets at the holding company, the principal sources of funds for the holding company are principal and interest payments on the portfolio of loans, securities retained on its balance sheet and dividends from its subsidiaries, including Doral Bank PR, Doral Bank US and Doral Insurance Agency. The existing cease and desist order applicable to the holding company requires prior regulatory approval for the payment of any dividends from Doral Bank PR to the holding company. In addition, various federal and Puerto Rico statutes and regulations limit the amount of dividends that the Company’s banking and other subsidiaries may pay without regulatory approval. No restrictions exist on the dividends available from Doral Insurance Agency, other than those generally applicable under the Puerto Rico corporation law.
Doral Financial has not paid dividends on the Company’s common stock since April 2006.
On March 20, 2009, the Company announced that in order to preserve capital the Board of Directors approved the suspension of the payment of dividends on all of its outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends is effective and commenced with the dividends for
the month of April 2009 for Doral Financial’s noncumulative preferred stock and the dividends for the second quarter of 2009 for Doral Financial’s cumulative preferred stock.
Liquidity is managed at the holding company level that owns the banking and non-banking subsidiaries. It is also managed at the level of the banking and non-banking subsidiaries.
The following items have impacted the Company’s liquidity, funding activities and strategies during 2010 and 2009:
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changes in short-term borrowings and deposits in the normal course of business;
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repayment of certain long-term callable certificate of deposits;
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sales of securities;
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early repayment of debt;
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adoption of an initiative to lengthen the brokered certificates term to structurally reduce interest rate sensitivity;
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the sale of the Company’s exposure to LBI;
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capital contributions to Doral Bank;
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suspension of payment of dividends on outstanding preferred stock;
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prepayment of FDIC insurance assessments for the years 2010-2012;
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repurchase of GNMA defaulted loans in 2010 and 2009;
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inducement on preferred stock conversions;
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capital raise of $171.0 million in the second quarter of 2010;
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efforts to increase retail deposits in the wake of failed Puerto Rico banks; and
•
On July 8, 2010, the Company entered into a collateralized loan arrangement in which $450.0 million of U.S. based commercial loans are funded $250.0 million by a third party paying 3-month LIBOR plus 1.85%, and $200.0 million by Doral. The entity holding the loans is consolidated by Doral and the third party financing is reported as a note payable. The third party funding provides an additional source of liquidity for the Company’s U.S. operations.
The following sections provide further information on the Company’s major funding activities and needs. Also, refer to the consolidated statements of cash flows in the accompanying Consolidated Financial Statements for further information.
Liquidity of the Banking Subsidiaries
Doral Financial’s liquidity and capital position at the holding company differ from the liquidity and capital positions of the Company’s banking subsidiaries. Doral Financial’s banking subsidiaries rely primarily on deposits, including brokered deposits, borrowings under advances from FHLB and repurchase agreements secured by pledges of their mortgage loans, mortgage-backed securities and other borrowings. The banking subsidiaries have significant investments in loans and investment securities, which together with the owned mortgage servicing rights, serve as a source of cash from interest and principal received from loan customers. To date, these sources of liquidity for Doral Financial’s banking subsidiaries have not been materially adversely impacted by the current challenging liquidity conditions in the U.S. mortgage and credit markets.
Cash Sources and Uses
Doral Financial’s sources of cash as of December 31, 2010 include retail and commercial deposits, borrowings under advances from FHLB, repurchase financing agreements, principal repayments and sales of loans and securities.
Management does not contemplate material uncertainties in the rolling over of deposits, both retail and wholesale, and is not engaged in capital expenditures that would materially affect the capital and liquidity positions. In addition, the Company’s banking subsidiaries maintain borrowing facilities with the FHLB and have a considerable amount of collateral that can be used to raise funds under these facilities.
Doral Financial’s uses of cash as of December 31, 2010 include origination and purchase of loans, purchase of investment securities, repayment of obligations as they become due, dividend payments related to the preferred stock (which were suspended by the Company’s Board of Directors on March 2009 effective during the second quarter of 2009), and other operational needs. The Company also is required to deposit cash or qualifying securities to meet margin requirements. To the extent that the value of securities previously pledged as collateral declines because of changes in interest rates, a liquidity crisis or any other factors, the Company will be required to deposit additional cash or securities to meet its margin requirements, thereby adversely affecting its liquidity.
Primary Sources of Cash
The following table shows Doral Financial’s sources of borrowings and the related average interest rates as of December 31, 2010 and 2009:
Table L - Sources of Borrowings
As of December 31, 2010, Doral Financial’s banking subsidiaries held approximately $4.4 billion in interest-bearing deposits at a weighted-average interest rate of 2.31%. For additional information on the Company’s sources of borrowings please refer to Notes 20 to 26 of the accompanying consolidated financial statements.
The following table presents the average balance and the annualized average rate paid on each deposit type for the periods indicated:
Table M - Average Deposit Balance
The following table sets forth the maturities of certificates of deposit having principal amounts of $100,000 or more at December 31, 2010.
Table N - Certificates of Deposit Maturities
The amounts in Table N, include $2.4 billion in brokered deposits issued in denominations greater than $100,000 to broker-dealers. As of December 31, 2010 and December 31, 2009, all brokered deposits were within the applicable FDIC insurance limit. On October 3, 2008, President Bush signed the Emergency Economic Stabilization Act of 2008 (“EESA”), which among other things temporarily raised the basic limit on FDIC deposit insurance from $100,000 to $250,000. The temporary increase in the deposit insurance, after an amendment adopted in May 20, 2009, was set to expire on December 31, 2013. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act which, among other things, made permanent the increase in the standard maximum deposit insurance amount from $100,000 to $250,000.
As of December 31, 2010 and 2009, Doral Financial’s retail banking subsidiaries had approximately $2.4 billion and $2.7 billion in brokered deposits, respectively. Brokered deposits are used by Doral Financial’s retail banking subsidiaries as a source of long-term funds, and Doral Financial’s retail banking subsidiaries have traditionally been able to replace maturing brokered deposits. Brokered deposits, however, are generally considered a less stable source of funding than core deposits obtained through retail bank branches. Brokered-deposit investors are generally very sensitive to interest rates and will generally move funds from one depository institution to another based on minor differences in rates offered on deposits.
Doral Financial’s banking subsidiaries, as members of the FHLB, have access to collateralized borrowings from the FHLB up to a maximum of 30% of total assets. In addition, the FHLB makes available additional borrowing capacity in the form of repurchase agreements on qualifying high grade securities. Advances and
reimbursement obligations with respect to letters of credit must be secured by qualifying assets with a market value of 100% of the advances or reimbursement obligations. As of December 31, 2010, Doral Financial’s banking subsidiaries had $0.9 billion in outstanding advances from FHLB at a weighted-average interest rate cost of 3.49%. Please refer to Note 23 to the consolidated financial statements accompanying this Annual Report on Form 10-K for additional information regarding such advances.
Doral Financial also derives liquidity from the sale of mortgage loans in the secondary mortgage markets. The U.S. (including Puerto Rico) secondary mortgage market is the most liquid in the world in large part because of the sale or guarantee programs maintained by FHA, VA, HUD, FNMA and FHLMC. To the extent these programs are curtailed or the standard for insuring or selling loans under such programs is materially increased, or, for any reason, Doral Financial were to fail to qualify for such programs, Doral Financial’s ability to sell mortgage loans and consequently its liquidity would be materially adversely affected.
Other Uses of Cash
Servicing agreements relating to the MBS programs of FNMA, FHLMC and GNMA, and to mortgage loans sold to certain other investors, require Doral Financial to advance funds to make scheduled payments of principal, interest, taxes and insurance, if such payments have not been received from the borrowers. While Doral Financial generally recovers funds advanced pursuant to these arrangements within 30 days, it must absorb the cost of funding the advances during the time the advance is outstanding. For the year ended December 31, 2010, the monthly average amount of funds advanced by Doral Financial under such servicing agreements was approximately $48.9 million, compared to $34.8 million for the corresponding period of 2009. To the extent the mortgage loans underlying Doral Financial’s servicing portfolio experience increased delinquencies, Doral Financial would be required to dedicate additional cash resources to comply with its obligation to advance funds as well as incur additional administrative costs related to increases in collection efforts. In the past, Doral Financial sold pools of delinquent FHA and VA and conventional mortgage loans. Under these arrangements, Doral Financial is required to advance the scheduled payments whether or not collected from the underlying borrower. While Doral Financial expects to recover the amounts advanced through foreclosure or, in the case of FHA/VA loans, under the applicable FHA and VA insurance and guarantee programs, the amounts advanced tend to be greater than normal arrangements because of the delinquent status of the loans. As of December 31, 2010 and 2009, the outstanding principal balance of such delinquent loans was $139.6 million and $154.2 million, respectively, and the aggregate monthly amount of funds advanced by Doral Financial was $12.1 million and $13.9 million, respectively.
When Doral Financial sells mortgage loans to third parties, which serve as a source of cash, it also generally makes customary representations and warranties regarding the characteristics of the loans sold. To the extent the loans do not meet specified characteristics investors are generally entitled to cause Doral Financial to repurchase such loans.
In addition to its servicing and warranty obligations, in the past Doral Financial’s loan sale activities have included the sale of non-conforming mortgage loans subject to recourse arrangements that generally require Doral Financial to repurchase or substitute the loans if the loans are 90 days or more past due or otherwise in default up to a specified amount or limited to a period of time after the sale. To the extent the delinquency ratios of the loans sold subject to recourse are greater than anticipated and Doral Financial is required to repurchase more loans than anticipated, Doral Financial’s liquidity requirements would increase. Please refer to “Off-Balance Sheet Activities” below for additional information on these arrangements.
In the past, Doral Financial sold or securitized mortgage loans with FNMA on a partial or full recourse basis. Doral Financial’s contractual agreements with FNMA authorize FNMA to require Doral Financial to post collateral in the form of cash or marketable securities to secure such recourse obligation to the extent Doral Financial does not maintain an investment grade rating. As of December 31, 2010, Doral Financial’s maximum recourse exposure with FNMA amounted to $572.7 million and required the posting of a minimum of $44.0 million in collateral to secure recourse obligations. While deemed unlikely by Doral Financial, FNMA has the contractual right to request collateral for the full amount of Doral Financial’s recourse obligations. Any such request by FNMA would have a material adverse effect on Doral Financial’s liquidity and business. Please refer to Note 31 of the accompanying consolidated financial statements and “Off-Balance Sheet Activities” below for additional information on these arrangements.
Under Doral Financial’s repurchase lines of credit and derivative contracts, Doral Financial is required to deposit cash or qualifying securities to meet margin requirements. To the extent that the value of securities previously pledged as collateral declines because of changes in interest rates or other market conditions, Doral Financial will be required to deposit additional cash or securities to meet its margin requirements, thereby adversely affecting its liquidity.
Assets and Liabilities
Doral Financial’s total assets were $8.6 billion at December 31, 2010, compared to $10.2 billion at 2009.
Total assets at December 31, 2010, when compared to 2009 were affected by a decrease of $1.3 billion in the Company’s investment securities portfolio that resulted from sales of mortgage-backed and other securities during the year as part of the execution of the Company’s strategy to de-lever the balance sheet while continuing to shorten the duration of the investment portfolio. Also, during the second quarter of 2010, in connection with its efforts to bid for the assets and liabilities of certain failed banks, the Company sold $378.0 million of non-agency CMOs whose future performance was considered risky. The decrease in assets from securities sales was partially offset by an increase in net loans of $88.2 million. Loan growth is primarily the result of acquiring commercial and industrial loan participation interests in loan syndications led by major U.S. banks, offset in part by decreases in the Puerto Rico commercial real estate and construction loan portfolios from loan sales, charge-offs and collections.
Total liabilities were $7.8 billion at December 31, 2010, compared to $9.4 billion at December 31, 2009. Total liabilities as of December 31, 2010 were principally affected by a decrease in borrowings of $1.6 billion and a decrease in deposits of $24.5 million.
Capital
Doral Financial reported total equity of $862.2 million at December 31, 2010, compared to $875.0 million at December 31, 2009. The Company reported accumulated other comprehensive income (net of tax) (“OCI”) of $4.2 million as of December 31, 2010, compared to accumulated other comprehensive loss (net of tax) of $111.5 million as of December 31, 2009. This improvement in OCI was due to the sale of the non-agency securities in 2010 as the loss was recognized in the period of the sale, and the remaining portfolio of securities reflects net unrealized gains.
On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-cumulative preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock.
On May 7, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock and a cash payment in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on May 7, 2009 and expired on June 8, 2009. Each of the series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement that was filed with the SEC on May 7, 2009, as amended. The transaction was settled on June 11, 2009.
Pursuant to the terms of the offer to exchange, the Company issued 2,619,710 shares of common stock and paid $3.7 million in cash in exchange for 298,986 shares of convertible preferred stock; issued 493,058 shares of common stock and paid $0.5 million in cash in exchange for 228,173 shares of Series A preferred stock; issued 234,929 shares of common stock and paid $0.2 million in cash in exchange for 217,339 shares of Series B preferred stock; and issued 606,195 shares of common stock and paid $0.6 million in cash in exchange for 560,798 shares of Series C preferred stock. Overall, $105.6 million liquidation preference of the Company’s preferred stock were validly tendered, not withdrawn and exchanged upon the terms and subject to the conditions set forth in the offer to exchange and the related letter of transmittal,
which then represented 18.4% of the aggregate liquidation preference of its preferred shares. An aggregate of 1,305,296 shares of preferred stock were retired upon receipt. As a result of the exchange offer, Doral issued an aggregate of 3,953,892 shares of common stock and paid an aggregate of $5.0 million in cash premium payments. After settlement of the exchange offer, 1,266,827 shares of Series A preferred stock, 1,782,661 shares of Series B preferred stock, 3,579,202 shares of Series C preferred stock, and 1,081,014 shares of convertible preferred stock remained outstanding.
The exchange by holders of shares of the non-cumulative preferred stock for shares of common stock and payment of a cash premium resulted in the extinguishment and retirement of such shares of non-cumulative preferred stock and an issuance of common stock. The carrying (liquidation) value of each share of non-cumulative preferred stock retired and the fair value of the consideration exchanged (cash plus fair value of common stock) was treated as an increase to retained earnings and income available to common shareholders for earnings per share purposes upon the cancellation of shares of non-cumulative preferred stock acquired by the Company pursuant to the offer to exchange, in accordance with guidance of ASC 260, Earnings per Share.
The exchange by holders of convertible preferred stock for common stock and a cash premium was accounted for as an induced conversion. Common stock and additional paid-in-capital was increased by the carrying (liquidation) value of the amount of convertible preferred stock exchanged. The fair value of common stock issued and the cash premium in excess of the fair value of securities issuable pursuant to the original exchange terms was treated as a reduction to retained earnings and net income available to common shareholders for earnings per share purposes.
As a result of the exchange offer, Doral issued an aggregate of 3,953,892 shares of common stock and paid an aggregate of $5.0 million in cash premium payments and recognized a non-cash credit to retained earnings (with a corresponding charge to additional paid in capital) of $9.4 million that was added to net income available to common shareholders in calculating earnings per share. This exchange resulted in an increase in common equity of $100.6 million and a decrease in preferred stock of $105.6 million, resulting in an increase in book value per common share of $1.63.
On November 20, 2009, the Company filed an amendment to its Registration Statement on Form S-4 announcing a new offer to exchange a number of properly tendered and accepted shares of its Cumulative Convertible Preferred Stock for newly issued shares of its common stock. The offer to exchange expired on December 9, 2009 and was settled on December 14, 2009. Pursuant to the terms of the offer to exchange, the Company issued 4,300,301 shares of common stock in exchange for 208,854 shares of Convertible Preferred Stock. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of $52.2 million, as well as a non-cash charge to retained earnings of $18.0 million (with a corresponding credit to additional paid in capital) that was deducted from net income available to common shareholders in calculating earnings per share.
The effect of the two preferred stock exchanges in 2009 was to increase common equity by $152.8 million, increase book value per common share by $2.47, decrease preferred equity by $157.8 million and decrease net income available to common shareholders by $8.6 million.
On March 15, 2010, the Company filed a Registration Statement on Form S-4 announcing its offer to exchange a number of properly tendered and accepted shares of its (i) 4.75% Perpetual Cumulative Convertible Preferred Stock (Convertible Preferred Stock), (ii) 7.00% Noncumulative Monthly Income Preferred Stock, Series A (“Series A preferred stock”), (iii) 8.35% Noncumulative Monthly Income Preferred Stock, Series B (“Series B preferred stock”), and (iv) 7.25% Noncumulative Monthly Income Preferred Stock, Series C (“Series C preferred stock”), for newly issued shares of its common stock. The offer to exchange expired on March 19, 2010 and was settled on March 24, 2010. Pursuant to the terms of the offer to exchange, the Company issued 1,207,268 shares of common stock in exchange for 58,634 shares of Convertible Preferred Stock. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of $14.7 million, as well as a non-cash charge to retained earnings of $5.1 million (with a corresponding credit to additional paid in capital) that was deducted from net income (loss) available to common shareholders in calculating earnings (loss) per share. Pursuant to the terms of the offer to exchange, the Company issued 1,304,636 shares of common stock in exchange for 314,661 shares of Series A preferred stock; issued
928,984 shares of common stock in exchange for 450,967 shares of Series B preferred stock; and issued 1,778,178 shares of common stock in exchange for 863,197 shares of Series C preferred stock. Overall, $63.3 million liquidation preference of the Company’s preferred stock were validly tendered, not withdrawn, and exchanged upon the terms and subject to the conditions set forth in the offer to exchange. An aggregate of 1,689,459 shares of preferred stock were retired upon receipt. As a result of the exchange offer, Doral Financial issued an aggregate of 5,219,066 shares of common stock. After settlement of the exchange offer, 950,166 shares of Series A preferred stock, 1,331,694 shares of Series B preferred stock, 2,716,005 shares of Series C preferred stock, and 813,526 shares of convertible preferred stock remained outstanding.
On April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers, including certain direct and indirect investors in Doral Holdings, the Company’s parent company, pursuant to a private placement of Mandatorily Convertible Non-Cumulative Non-Voting Preferred Stock, $1.00 par value and $1,000 liquidation preference per share. In the aggregate, as part of the private placement, the Company raised $180.0 million of new equity capital and issued 285,002 shares of Mandatorily Convertible Non-Cumulative Non-Voting Preferred Stock for an effective sale price of $3.00 per common share equivalent.
In connection with the Stock Purchase Agreement, the Company also entered into a Cooperation Agreement with Doral Holdings, Doral Holdings L.P. and Doral GP Ltd. pursuant to which Doral Holdings made certain commitments including the commitment to vote in favor of converting the Mandatorily Convertible Non Cumulative Preferred Stock to common stock and registering the shares issued pursuant to this capital raise and other previously issued unregistered shares of common stock and to dissolve Doral Holdings pursuant to certain terms and conditions.
During the third quarter of 2010, the Company converted 285,002 shares of Mandatorily Convertible Non-Voting Preferred Stock into 60,000,386 shares of common stock. In addition, during the third quarter of 2010, Doral Holdings LLC, previously the controlling shareholder of Doral Financial, distributed its shares in Doral Financial to its investors and dissolved. The Company is no longer a controlled company as a result of this conversion and the dissolution of Doral Holdings LLC.
Off-balance sheet activities
In the ordinary course of the business, Doral Financial makes certain representations and warranties to purchasers and insurers of mortgage loans at the time of the loan sales to third parties regarding the characteristics of the loans sold, and in certain circumstances, such as in the event of early or first payment default. To the extent the loans do not meet specified characteristics, if there is a breach of contract of a representation or warranty or if there is an early payment default, Doral Financial may be required to repurchase the mortgage loan and bear any subsequent loss related to the loan. For the years ended December 31, 2010 and 2009, repurchases amounted to approximately $1.0 million and $13.7 million, respectively. These repurchases were at fair value and no significant losses were incurred.
In the past, in relation to its asset securitization and loan sale activity, the Company sold pools of delinquent FHA, VA and conventional mortgage loans on a servicing retained basis. Following these transactions, the loans are not reflected on Doral Financial’s Consolidated Statements of Financial Condition. Under these arrangements, as part of its servicing responsibilities, Doral Financial is required to advance the scheduled payments of principal and interest regardless of whether they are collected from the underlying borrower. While Doral Financial expects to recover a significant portion of the amounts advanced through foreclosure or, in the case of FHA and VA loans, under the applicable FHA and VA insurance and guarantee programs, the amounts advanced tend to be greater than normal arrangements because of delinquent status of the loans. As of December 31, 2010 and 2009, the outstanding principal balance of such delinquent loans amounted to $139.6 million and $154.2 million, respectively.
In addition, Doral Financial’s loan sale activities in the past included certain mortgage loan sale and securitization transactions subject to recourse arrangements that require Doral Financial to repurchase or substitute the loan if the loans are 90-120 days or more past due or otherwise in default. The Company is also required to pay interest on delinquent loans in the form of servicing advances. Under certain of these
arrangements, the recourse obligation is terminated upon compliance with certain conditions, which generally involve: (i) the lapse of time (normally from four to seven years), (ii) the lapse of time combined with certain other conditions such as the unpaid principal balance of the mortgage loans falling below a specific percentage (normally less than 80%) of the appraised value of the underlying property or (iii) the amount of loans repurchased pursuant to recourse provisions reaching a specific percentage of the original principal amount of loans sold (generally from 10% to 15%). As of December 31, 2010 and 2009, the Company’s records reflected that the outstanding principal balance of loans sold subject to full or partial recourse was $0.8 billion and $0.9 billion, respectively. As of such dates, the Company’s records also reflected that the maximum contractual exposure to Doral Financial if it were required to repurchase all loans subject to recourse was $0.7 billion and $0.8 billion, respectively. Doral Financial’s contingent obligation with respect to such recourse provision is not reflected on Doral Financial’s consolidated financial statements, except for a liability of estimated losses from such recourse agreements, which is included as part of “Accrued expenses and other liabilities.” The Company discontinued the practice of selling loans with recourse obligations in 2005. Doral Financial’s current strategy is to sell loans on a non-recourse basis, except recourse for certain early payment defaults. For the years ended December 31, 2010 and 2009, the Company repurchased at fair value $28.6 million and $27.3 million, respectively, pursuant to recourse provisions.
The Company estimates its liability for expected losses from recourse obligations based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment.
Doral Financial reserves for its exposure to recourse amounted to $10.3 million and $9.4 million and the reserve for other credit-enhanced transactions explained above amounted $9.0 million and $8.8 million as of December 31, 2010 and 2009, respectively. For additional information regarding sales of delinquent loans please refer to “Liquidity and Capital Resources” above. The following table shows the changes in the Company’s liability of estimated losses from recourse agreements, included in the Statement of Financial Condition, for each of the periods shown:
Table O - Recourse Estimated Losses
The Company enters into financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments may include commitments to extend credit and sell loans. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.
The contractual amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company’s exposure to credit losses in the event of non-performance by the other party to the financial instrument for commitments to extend credit or for forward sales is represented by the contractual amount of these instruments. Doral Financial uses the same credit policies in making these commitments as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as the conditions established in the contract are met. Commitments generally have fixed expiration dates or other termination clauses. Generally, the Company does not enter into interest rate lock agreements with borrowers.
The Company purchases mortgage loans and simultaneously enters into a sale and securitization agreement with the same counterparty during the period between trade and settlement date.
A letter of credit is an arrangement that represents an obligation on the part of the Company to a designated third party, contingent upon the failure of the Company’s customer to perform under the terms of the underlying contract with a third party. The amount of the letter of credit represents the maximum amount of credit risk in the event of non-performance by these customers. Under the terms of a letter of credit, an obligation arises only when the underlying event fails to occur as intended, and the obligation is generally up to a stipulated amount and with specified terms and conditions. Letters of credit are used by the customer as a credit enhancement and typically expire without having been drawn upon.
The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty.
Contractual obligations and other commercial commitments
The tables below summarize Doral Financial’s contractual obligations, on the basis of contractual maturity or first call date, whichever is earlier, and other commercial commitments as of December 31, 2010.
Table P - Contractual Obligations
(1)
Amounts included in the table above do not include interest.
(2)
Includes $100.0 million of a repurchase agreement with a fixed rate of 2.98% and $80.0 million of advances from FHLB with a fixed rate of 5.04%, which the lenders have the right to call before their contractual maturities. The repurchase agreement and the advances from FHLB are included in the less-than-one year category in the above table but have actual contractual maturities ranging from March 2012 to February 2014. They are included on the first call date basis because increases in interest rates over the average rate of the Company’s borrowings may induce the lenders to exercise their right.
(3)
Consist of secured borrowings with local financial institutions, collateralized by residential mortgage loans at variable interest rates tied to 3-month LIBOR. These loans are not subject to scheduled payments, but are required to be repaid according to the regular amortization and prepayments of the underlying mortgage loans. For purposes of the table above, the Company used a CPR of 9.0% to estimate the repayments.
Table Q - Other Commercial Commitments (1)
(1)
Refer to “Off-Balance Sheet Activities” above for additional information regarding other commercial commitments of the Company.
RISK MANAGEMENT
Doral Financial’s business is subject to four broad categories of risks: interest rate risk, credit risk, operational risk and liquidity risk. Doral Financial has specific policies and procedures which have been designed to identify, measure and manage risks to which the Company is exposed.
Interest Rate and Market Risk Management
Interest rate risk refers to the risk that changes in interest rates may adversely affect the value of Doral Financial’s assets and liabilities and its net interest income.
Doral Financial’s risk management policies are designed with the goal of maximizing shareholder value with emphasis on stability of net interest income and market value of equity. These policies are also targeted to remain well capitalized, preserve adequate liquidity, and meet various regulatory requirements. The objectives of Doral Financial’s risk management policies are pursued within the limits established by the Board of Directors of the Company. The Board of Directors has delegated the oversight of interest rate and liquidity risks to its Risk Policy Committee.
Doral Financial’s Asset/Liability Management Committee (“ALCO”) has been created under the authority of the Board of Directors to manage the Company’s interest rate, market value of equity and liquidity risk. The ALCO is primarily responsible for ensuring that Doral Financial operates within the Company’s established asset/liability management policy guidelines and procedures. The ALCO reports directly to the Risk Policy Committee of the Board of Directors.
The ALCO is responsible for:
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developing the Company’s asset/liability management and liquidity strategy;
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establishing and monitoring of interest rate, pricing and liquidity risk limits to ensure compliance with the Company’s policies;
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overseeing product pricing and volume objectives for banking and treasury activities; and
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overseeing the maintenance of management information systems that supply relevant information for the ALCO to fulfill its responsibilities as it relates to asset/liability management.
Risk Identification Measurement and Control
Doral Financial manages interest rate exposure related to its assets and liabilities on a consolidated basis. Changes in interest rates can affect the volume of Doral Financial’s mortgage loan originations, the net interest income earned on Doral Financial’s portfolio of loans and securities, the amount of gain on the sale of loans and the value of Doral Financial’s servicing assets, loans, investment securities and other retained interests.
As part of its interest rate risk management practices, Doral Financial has implemented measures to identify the interest rate risk associated with the Company’s assets, liabilities and off-balance sheet activities. The Company has also developed policies and procedures to control and manage these risks and continues to improve its interest rate risk management practices. The Company currently manages its interest rate risk by principally focusing on the following metrics: (i) net interest income sensitivity; (ii) market value of equity sensitivity; (iii) effective duration of equity; and (iv) maturity/repricing gaps. Doral Financial’s Asset/Liability Management Policies provide a limit structure based on these four metrics. A single limit is defined for effective duration of equity. Net interest income sensitivity limits are set for instantaneous parallel rate shifts. Specific parallel rate shifts defined for net interest income and market value equity limits are -300 bps, -200 bps, -100 bps, +100 bps, +200 bps, and +300 bps. Net interest income sensitivity limits are established for different time horizons. Additional limits are defined for maturity/repricing mismatches, however management continues to emphasize risk management and controls based on net interest income and market value of equity sensitivity as these measures incorporate the effect of existing asset/liability mismatches. The explanations below provide a brief description of the metrics used by the Company and the methodologies/assumptions employed in the estimation of these metrics:
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Net Interest Income Sensitivity. Refers to the relationship between market interest rates and net interest income due to the maturity mismatches and repricing characteristics of Doral Financial’s interest-earning assets, interest-bearing liabilities and off-balance sheet positions. To measure net interest income exposure to changes in market interest rates, the Company uses earnings simulation techniques. These simulation techniques allow for the forecasting of net interest income and expense under various rate scenarios for the measurement of interest rate risk exposures of Doral Financial. Primary scenarios include instantaneous parallel and non-parallel rate shocks. Net interest income sensitivity is measured for time horizons ranging from twelve to sixty months and as such, serves as a measure of short to medium term earnings risk. The basic underlying assumptions used in net interest income simulations are: (i) the Company maintains a static balance sheet; (ii) full reinvestment of funds in similar product/instruments with similar maturity and repricing characteristics; (iii) spread assumed constant; (iv) prepayment rates on mortgages and mortgage related securities are modeled using multi-factor prepayment model; (v) non-maturity deposit decay and price elasticity assumptions are incorporated, and (vi) evaluation of embedded options is also taken into consideration. To complement and broaden the analysis of earnings at risk the Company also performs earning simulations for longer time horizons.
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Market Value of Equity Sensitivity. Used to capture and measure the risks associated with longer-term maturity and re-pricing mismatches. Doral Financial uses value simulation techniques for all financial components of the Statement of Financial Condition. Valuation techniques include static cash flows analyses, stochastic models to qualify value of embedded options and prepayment modeling. To complement and broaden the risk analysis, the Company uses duration and convexity analysis to measure the sensitivity of the market value of equity to changes in interest rates. Duration measures the linear change in market value of equity caused by changes in interest rates, while, convexity measures the asymmetric changes in market value of equity caused by changes in interest rates due to the presence of options. The analysis of duration and convexity combined provide a better understanding of the sensitivity of the market value of equity to changes in interest rates.
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Effective Duration of Equity. The effective duration of equity is a broad measure of the impact of interest rate changes on Doral Financial’s economic capital. The measure summarizes the net sensitivity of assets and liabilities, adjusted for off-balance sheet positions.
Interest Rate Risk Management Strategy
Doral Financial’s current interest rate management strategy is implemented by the ALCO and is focused on reducing the volatility of the Company’s earnings as a result of changes in interest rates and to protect the market value of equity. While the current strategy will also use a combination of derivatives and balance sheet management, more emphasis is placed on balance sheet management.
Net Interest Income Risk. In order to protect net interest income against interest rate risk, the ALCO employs a number of tactics which are evaluated and adjusted in relation to prevailing market conditions. Internal balance sheet management practices are designed to reduce the re-pricing gaps of the Company’s assets and liabilities. However, the Company will use derivatives, mainly interest rate swaps and interest rate caps, as part of its interest rate risk management activities. Interest rate swaps represent a mutual agreement to exchange interest rate payments; one party pays fixed rate and the other pays a floating rate. For net interest income protection, Doral Financial typically enters into a fixed rate payer-float receiver swaps to eliminate the variability of cash flows associated with the floating rate debt obligations.
Market Value of Equity. Due to the composition of Doral Financial’s assets and liabilities, the Company has earnings exposure to rising interest rates. The Company measures the market value of all rate sensitive assets, liabilities and off-balance sheet positions; and the difference between assets and liabilities, adjusted by off-balance sheet positions, is termed market value of equity. The Company measures how the market value of equity fluctuates with different rate scenarios to measure risk exposure of economic capital or market value of equity. Management uses duration matching strategies to manage the fluctuations of market value of equity within the long-term targets established by the Board of Directors of the Company.
Duration Risk. Duration is a measure of the impact (in magnitude and direction) of changes on interest rates in the economic value of financial instruments. In order to bring duration measures within the policy thresholds established by the Company, management may use a combination of internal liability management techniques and derivative instruments. Derivatives such as interest rate swaps, treasury futures, Eurodollar futures and forward contracts may be entered into as part of the Company’s risk management.
Convexity Risk. Convexity is a measure of how much duration changes as interest rates change. For Doral Financial, convexity risk primarily results from mortgage prepayment risk. As part of managing convexity risk management may use a combination of internal balance sheet management instruments or derivatives, such as swaptions, caps, floors, put or call options on interest rate indexes or related fixed income underlying securities (i.e. Eurodollar, treasury notes).
Hedging related to Mortgage Banking Activities. As part of Doral Financial’s risk management of mortgage banking activities, such as secondary market and servicing assets, the Company enters into forward agreements to buy or sell MBS to protect the Company against changes in interest rates that may impact the economic value of servicing assets or the pricing of marketable loan production.
Hedging the various sources of interest rate risks related to mortgage banking activities is a complex process that requires sophisticated modeling, continuous monitoring and active management. While Doral Financial balances and manages the various aspects relating to mortgage activities, there are potential risks to earnings associated to them. The following bullets summarize some of these potential risks:
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The valuation of MSRs are recorded in earnings immediately within the accounting period in which the changes in value occur, whereas the impact of changes in interest rates are reflected in originations with a time lag and effects on servicing fee income occurs over time. Thus, even when mortgage activities could be protected from adverse changes in interest rates over a period of time (on a cumulative basis) they may display large variations in income from period to period.
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The degree to which the “natural hedge” associated to mortgage banking (i.e. originating and servicing) offsets changes in servicing asset valuations may be imperfect, as it may vary over time.
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Origination volumes, the valuation of servicing assets, economic hedging activities and other related costs are impacted by multiple factors, which include, changes in the mix of new business, changes in the term structure of interest rates, changes in mortgage spreads (mortgage basis) to other rate benchmarks, and rate volatility, among others. Interrelation of all these factors is hard to predict and, as such, the ability to perfectly hedge their effects is limited.
Doral Financial’s Risk Profile
Doral Financial’s goal is to manage market and interest rate risk within targeted levels established and periodically reviewed by the Board of Directors. Interest rate sensitivity represents the relationship between market interet rates and the net interest income due to existing maturity and repricing imbalances between interest-earning assets and interest-bearing liabilities. Interest rate sensitivity is also defined as the relationship between market interest rates and the economic value of equity (referred to market value of equity or “MVE”). The interest risk profile of the Company is measured in the context of net interest income, market value of equity, maturity/repricing gaps and effective duration of equity.
The risk profile of the Company is managed by use of natural offsets generated by the different components of the balance sheet as a result of the normal course of business operations and through active hedging activities by means of both on-balance sheet and off-balance sheet transactions (i.e. derivative instruments) to achieve targeted risk levels.
The Company’s interest rate risk exposure may be asymmetric due to the presence of embedded options in products and transactions which allow clients and counterparties to modify the maturity of loans, securities, deposits and/or borrowings. Examples of embedded options include the ability of a mortgagee to prepay his/her mortgage or a counterparty exercising its puttable option on a structured funding transaction. Assets and liabilities with embedded options are evaluated taking into consideration the presence of options to estimate their economic price elasticity and also the effect of options in assessing maturity/repricing characteristics of the Company’s balance sheet. The embedded optionality is primarily managed by purchasing or selling options or by other active risk management strategies involving the use of derivatives, including the forward sale of MBS.
The Company measures interest rate risk and has specific targets for various market rate scenarios. General assumptions for the measurement of interest income sensitivity are: (i) rate shifts are parallel and instantaneous throughout all benchmark yield curves and rate indexes; (ii) behavioral assumptions are driven by simulated market rates under each scenario (i.e. prepayments, repricing of certain liabilities); (iii) static balance sheet assumed with cash flows reinvested at forecasted market rates (i.e. forward curve, static spreads) in similar instruments. For net interest income the Company monitors exposures and has established limits for time horizons ranging from one up to three years, although for risk management purposes earning exposures are forecasted for longer time horizons.
The tables below show the risk profile of Doral Financial (taking into account the derivatives set forth below) under 100-basis point parallel and instantaneous increases or decreases of interest rates, as of December 31, 2010 and 2009.
(1)
Based on 12-month forward change in net interest income.
The net interest income (“NII”) sensitivity measure to a one hundred (100) basis point parallel and instantaneous rate increase, based on a 12-month horizon, changed from (3.4)% to (0.9)% when comparing December 31, 2009 to 2010. The effect is driven by the continued efforts to reduce maturity/repricing mismatches by extending the maturity in certain wholesale liabilities, sale of investments and the growth of variable rate syndicated loans.
As of December 31, 2010 the market value of equity (“MVE”) showed lower sensitivity to rising interest rates when compared to December 31, 2009. MVE sensitivity to an increase of one hundred (100) basis points in market rates changed from (9.4)% to (8.5)%. The Company has been actively managing the balance sheet to maintain the interest rate risk measures in line with targets mainly by the use of on-balance sheet strategies. The sale of certain investment securities, the capital raise, the continued focus on extending maturity of wholesale funding, issuance of callable funding and growth in variable rate assets, have all contributed to reducing MVE exposure.
The following table shows the Company’s investment portfolio sensitivity to changes in interest rates. The table below assumes parallel and instantaneous increases and decreases of interest rates as of December 31, 2010 and 2009.
Derivatives. As described above, Doral Financial uses derivatives to manage its exposure to interest rate risk caused by changes in interest rates. Derivatives are generally either privately negotiated over-the-counter (“OTC”) contracts or standard contracts transacted through regulated exchanges. OTC contracts generally consist of swaps, caps and collars, forwards and options. Exchange-traded derivatives include futures and options.
The Company is subject to various interest rate cap agreements to manage its interest rate exposure. Interest rate cap agreements generally involve purchase of out of the money caps to protect the Company from larger rate moves and to provide the Company with positive convexity. Non-performance by the counterparty exposes Doral Financial to interest rate risk. The following table summarizes the Company’s interest rate caps outstanding at December 31, 2010.
Table R - Interest Rate Caps
The Company is subject to various interest rate swap agreements to manage its interest rate exposure. Interest rate swap agreements generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal. The Company principally uses interest rate swaps to convert floating rate liabilities to fixed rate by entering into pay fixed receive floating interest rate swaps.
Non-performance by the counterparty exposes Doral Financial to interest rate risk. The following table summarizes the Company’s interest rate swaps outstanding at December 31, 2010.
Table S - Interest Rate Swaps
Freestanding Derivatives. Doral Financial uses derivatives to manage its market risk and generally accounts for such instruments on a mark-to-market basis with gains or losses charged to current operations as part of net gain (loss) on trading activities as they occur. Contracts with positive fair values are recorded as assets and contracts with negative fair values as liabilities, after the application of netting arrangements. Fair values of derivatives such as interest rate futures contracts or options are determined by reference to market prices. Fair values for derivatives purchased in the over-the-counter market are determined by valuation models and validated with prices provided by external sources. The notional amounts of freestanding derivatives totaled $310.0 million and $480.0 million as of December 31, 2010 and 2009, respectively. Notional amounts indicate the volume of derivative activity, but do not represent Doral Financial’s exposure to market or credit risk. The decrease in the notional amount of freestanding derivatives with respect to December 31, 2009 was due mainly to the rebalancing of economic hedges related to management of risks associated to servicing assets and secondary marketing activities.
Derivatives - Hedge Accounting. Doral Financial seeks to designate derivatives under hedge accounting guidelines when it can clearly identify an asset or liability that can be hedged pursuant to the strict hedge accounting guidelines. The notional amount of swaps treated under hedge accounting totaled $74.0 million and $305.0 million as of December 31, 2010 and 2009, respectively. The Company typically uses interest rate swaps to convert floating rate advances from FHLB to fixed rate by entering into pay fixed receive floating swaps. In these cases, the Company matches all of the terms in the advance from FHLB to the floating leg of the interest rate swap. Since both transactions are symmetrically opposite the effectiveness of the hedging relationship is high.
The following table summarizes the total derivatives positions at December 31, 2010 and 2009, respectively, and their different designations.
Table T - Derivative positions
The following tables summarize the fair values of Doral Financial’s freestanding derivatives as well as the source of the fair values.
Table U - Fair value reconciliation
Table V - Sources of fair value
The use of derivatives involves market and credit risk. The market risk of derivatives arises principally from the potential for changes in the value of derivative contracts based on changes in interest rates.
The credit risk of OTC derivatives arises from the potential of counterparties to default on their contractual obligations. To manage this credit risk, Doral Financial deals with counterparties of good credit standing, enters into master netting agreements whenever possible and monitors market on pledged collateral to minimize credit exposure. Master netting agreements incorporate rights of set-off that provide for the net settlement of contracts with the same counterparty in the event of default. As a result of the ratings downgrades affecting Doral Financial, counterparties to derivative contracts used for interest rate risk management purposes could increase the applicable margin requirements under such contracts, or could require the Company to terminate such agreements.
Table W - Derivative counterparty credit exposure
(1)
Based on the S&P Long-Term Issuer Credit Ratings.
(2)
Based on legal entities. Affiliated legal entities are reported separately.
(3)
For each counterparty, this amount includes derivatives with a positive fair value including the related accrued interest receivable/payable (net.)
Credit Risk
Doral Financial is subject to credit risk, particularly with respect to its investment securities and loans receivable. For a discussion of credit risk on investment securities refer to Note 8 of the accompanying financial statements.
Loans receivable are loans that Doral Financial holds for investment and, therefore, the Company is at risk for the term of the loans. Because most of Doral Financial’s loans are made to borrowers located in Puerto Rico and secured by properties located in Puerto Rico, the Company is subject to credit risk tied to adverse economic, political or business developments and natural hazards, such as hurricanes, that may affect Puerto Rico. The Puerto Rico economy has been in a recession since 2006. This has affected borrowers’ disposable incomes and their ability to make payments when due, causing an increase in delinquency and foreclosure rates. The Company believes that these conditions will continue to affect its credit quality. In addition, there is evidence that property values have declined from their peak. This has reduced borrowers’ capacity to refinance and increased the exposure to loss upon default. This decline in prices and increases in expected defaults are incorporated into the loss rates used for calculating the Company’s allowance for loan and lease losses. Loans collateralized by land are under regulatory review in the U.S. and its territories. As of December 31, 2010 land collateralized loans totalled to $143.6 million. In addition, Doral has outstanding a few construction loans with remnant land totaling $25.3 million. Should our estimated land value change significantly, it may be necessary to record additional provisions for loan losses or charge-offs that may be material to the Company’s Financial Statements. The Company also has a growing portfolio of commercial, construction and syndicated loans, geographically dominated by U.S. loans, and performance of such loans is subject to the strength of the U.S. economy.
With respect to mortgage loans originated for sale as part of its mortgage banking business, Doral Financial is generally at risk for any mortgage loan default from the time it originates the mortgage loan until the time it sells the loan or packages it into an MBS. For residential mortgage loans that are retained as a loan investment, Doral retains the credit risk from the time the loan is originated until the loan is paid. With respect to FHA loans, Doral Financial is insured as to principal by the HUD against foreclosure loss. VA loans are guaranteed within a range of 25% to 50% of the principal amount of the loan subject to a maximum, ranging from $22,500 to $50,750, in addition to the mortgage collateral. Prior to 2006, the Company sold loans on a
recourse basis as part of the ordinary course of business. As part of such transactions, the Company committed to make payments to remedy loan defaults or to repurchase defaulted loans. Refer to “Off-Balance Sheet Activities” above for additional information regarding recourse obligations. In mid 2005, the Company discontinued the practice of selling mortgage loans with recourse, except for recourse related to early payment defaults.
The residential mortgage portfolio includes loans that, at some point were repurchased pursuant to recourse obligations and, as a result, have a higher credit risk. Repurchases of delinquent loans from recourse obligations for the year ended December 31, 2010 amounted to $28.6 million and resulted in a loss of $3.9 million. When repurchased from recourse obligations, loans are recorded at their market value, which includes a discount for poor credit performance.
Doral Financial provided land acquisition, development, and construction financing to developers of residential housing projects and, as consequence, has credit risk exposure to this sector. Construction loans extended to developers are typically adjustable rate loans, indexed to the prime interest rate with terms ranging generally from 12 to 36 months. Doral Financial principally targeted developers of residential construction for single-family primary-home occupancy. As a result of the negative outlook for the Puerto Rico economy and its adverse effect on the construction industry, in the fourth quarter of 2007, the Company ceased financing new housing projects in Puerto Rico. The recorded balance for the Puerto Rico residential housing construction sector has decreased from $275.3 million as of December 31, 2009, to $181.5 million as of December 31, 2010. Management expects that the amount of construction loans will continue to decrease in future years.
For the year ended December 31, 2010, the construction and land portfolio reflected lower delinquency when compared to December 31, 2009 due to the sale of a portfolio of construction loans and similar real estate owned property during the third quarter of 2010 for $102.0 million to a third party, that included $63.2 million of non-performing loans as of June 30, 2010, net of $35.8 million of charge-offs (approximately $108.5 million as of December 31, 2009). Puerto Rico and the Company have experienced low levels of new home absorption in recent years due to the current economic environment. However, in September 2010, the Governor of PR signed into law Act No. 132 of 2010 which established various housing tax and other incentives to stimulate the sale of new and existing housing units. The tax and other incentives, which include incentives or reductions relating to capital gains taxes, property taxes and property recording fees and stamps, will be effect until June 30, 2011 and are expected to have a favorable impact in the current economic environment and new home absorption in PR.
For the year ended December 31, 2010, the commercial real estate portfolio experienced an increase in late stage delinquency mainly attributed to adverse performance of the small commercial portfolio related to the continued recessionary conditions in Puerto Rico. Also, this portfolio was impacted by the classification to non-performing loans of a current paying loan of $37.7 million (net of a charge-off of $8.8 million) during the third quarter of 2010. Management has taken certain actions to mitigate the risk in the portfolio, including retaining advisory services of third party providers in order to work-out delinquent loans and prevent performing loans from becoming delinquent.
Loan Modifications and Troubled Debt Restructurings (“TDR”)
With Puerto Rico unemployment of 15% many borrowers have temporarily lost the means to pay their loan contractual principal and interest obligations. As a result of the economic hardships, a number of borrowers have defaulted on their debt obligations, including residential mortgage and other consumer loans. The lower level of income and economic activity has also led to fewer new construction residential home sales, increased commercial real estate vacancy, and lower business revenues, which has led to increased defaults on commercial real estate, construction and land loans. Doral management has concluded that it is in the Company’s best interest, and in the best interest of the Puerto Rican economy and citizenry, if certain defaulted loans are restructured in a manner that keeps borrowers in their homes, or businesses operating, rather than foreclosing on the loan collateral if it is concluded that the borrower’s payment difficulties are temporary and Doral will in time collect the loan principal and agreed upon interest.
Doral has created a number of loan modification programs to help borrowers stay in their homes and operate their businesses which also optimizes borrower performance and returns to Doral. In these cases, the restructure or loan modification fits the definition of TDR. The programs are designed to provide temporary relief and, if necessary, longer term financial relief to the consumer loan customer and commercial borrower. Doral’s consumer loan loss mitigation program (including consumer loan products and residential mortgage loans), grants a concession for economic or legal reasons related to the borrowers’ financial difficulties that Doral would not otherwise consider. Doral’s loss mitigation programs can provide for one or a combination of the following: (i) movement of unpaid principal and interest due to the end of the loan, (ii) extension of the loan term for up to ten years, (iii) deferral of principal payments for a period of time (temporary interest only), and (iv) reduction of interest rates either permanently (feature discontinued in 2010) or for a period of up to two years. No programs adopted by Doral provide for the forgiveness of contractually due principal or interest. Deferred principal and uncollected interest are added to the end of the loan term at the time of the restructuring and deferred interest is not recognized as income until collected. Doral wants to make these programs available only to those borrowers who have defaulted, or are likely to default, permanently on their loan and would lose their homes in foreclosure action absent some lender concession. However, Doral will move borrowers and properties to foreclosure if the Company is not reasonably assured that the borrower will be able to repay all contractual principal or interest (which is not forgiven in part or whole in any current or contemplated program).
In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, on a monthly basis, the Company pools TDRs with similar characteristics and performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of loans, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records an impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.
Regarding the commercial loan loss mitigation programs (including commercial real estate, commercial and industrial, construction and land loan portfolios), the determination is made on a loan by loan basis at the time of restructuring as to whether a concession was made for economic or legal reasons related to the borrower’s financial difficulty that Doral would not otherwise consider. Concessions made for commercial loans could include reductions in interest rates, extensions of maturity, waiving of borrower covenants, or other contract changes that would be considered a concession. Doral mitigates loan defaults for its commercial loan portfolios loans through its Collections function. The function’s objective is to minimize both early stage delinquencies and losses upon default of larger credit relationships. The group utilizes existing collections infrastructure of front-end dialers, doorknockers, work-out agents and third-party consultants. In the case of residential construction projects, the function uses a third-party consultant to manage the projects in terms of construction, marketing and sales.
Residential, other consumer or commercial loan modifications can result in returning a loan to accrual status when the criteria for returning a loan to performing status are met. Loan modifications also increase Doral’s interest income by returning a non-performing loan to performing status, and cash flows by providing for payments to be made by the borrower, and decreases foreclosure and other real estate owned (“OREO”) costs by decreasing the number of foreclosed properties. Loan modifications can result in lower interest income to Doral if executed on performing loans by deferring previously recognized interest and by temporarily lowering the interest rate on a loan. Doral continues to consider the modified loan as a non-performing asset for purposes of estimating its allowance for loan and lease losses until the borrower has made at least six consecutive contractual payments (or the equivalent in a lump sum). At such time the loan will be treated as any other performing loan for purposes of estimating the allowance for loan and lease losses.
Loan modifications that are considered troubled debt restructurings completed as of December 31, 2010 and 2009 were as follows:
Table X - TDRs
Non-performing Loans
Non-performing assets consist of loans in non-accrual status, other real estate owned and other non-performing assets. Doral discontinues interest income recognition and considers financial assets non-performing when they are 90 days or more past due, except for revolving lines of credit and credit cards which are considered non-performing when they are 180 days or more past due, FHA and VA loans which are considered non-performing when they are 270 days past due, and certain loans determined to be well collateralized so that ultimate collection of principal and interest is not in question (current loan and interest balance as a percentage of collateral value is less than 60%). In addition, any financial asset for which management estimates it will not collect contractual principal or interest is considered non-performing when such judgment is made. When income recognition is discontinued for a loan, all accrued but unpaid interest to date is reversed against current period income. Such interest, if collected in the future, is credited to income in the period of the recovery, and the loan returns to accrual status when it becomes current and/or collectability is reasonably assured. The Company also places in non-accrual status all residential construction loans classified as substandard whose sole source of payment is interest reserves funded by Doral Financial. For the year ended December 31, 2010, Doral Financial would have recognized $36.6 million, compared to $49.4 million and $43.7 million for the corresponding 2009 and 2008 periods, in additional interest income had all delinquent loans (except FHA/VA guaranteed loans) been accounted for on an accrual basis. This amount includes interest reversal on loans placed on non-accrual status during the period.
For consumer loans (primarily residential mortgage), all of Doral’s loss mitigation tools require that the borrower demonstrate the intent and ability to pay principal and interest on the loan. Doral must receive at least three consecutive monthly payments prior to qualifying the borrower for a loss mitigation product. Doral’s loan underwriters must be reasonably assured of the borrower’s future repayment and performance from their review of the borrower’s circumstances, and when all the conditions are met, the customer is approved for a loss mitigation product and placed on a probation period. When the loan is returned to accrual status, Doral monthly reviews the loan to ensure that payments are made during the probationary period. If a payment is not made during this probationary period the loan is immediately returned to non-accrual status. Also, if a payment is missed during the probationary period, the loan reverts to its original terms, and collections/foreclosure procedures begin from the point at which they stood prior to the restructure. Consumer loans not delinquent 90 days or more that are eligible for loss mitigation products are subject to the same requirements as the delinquent consumer loans except the receipt of the three months of payment in advance of the restructures is waived.
For commercial loan loss mitigation (which includes commercial real estate, commercial and industrial, construction and land loans), the loans are underwritten by the Collections function, the intent and ability of the borrower to service the debt under the revised terms is scrutinized, and if approved for the TDR, the borrower is placed on a six month probationary period during which the customer is required to make six consecutive payments (or equivalent in a lump sum) before the loan is returned to accrual status. Upon receiving six consecutive months
of payments, the commercial loan is returned to accrual status. If the loan was in accrual status at the time of the TDR, the loan is kept in accrual status if the ultimate collection of principal and interest is not in question, and placed in a probationary period. If a payment is missed during the probationary period, the loan reverts to its original terms and collections/foreclosure procedures begin from the point at which they stood prior to the restructure.
The following table sets forth information with respect to Doral Financial’s non-accrual loans, OREO and other NPAs as of the dates indicated:
Table Y - Non-performing assets
(1)
FHA/VA delinquent loans are separated from the non-performing loans that present substantial credit risk to the Company in order to recognize the different risk of loss presented by these assets.
(2)
Includes delinquency related personal, revolving lines of credit and other consumer loans.
(3)
Does not include approximately $112.8 million, $86.8 million, $120.4 million, $87.6 million and $67.1 million of GNMA defaulted loans over 90 days delinquent (for which the Company has the option, but not an obligation, to buy back from the pools serviced), included as part of the loans held for sale portfolio as of December 31, 2010, 2009, 2008, 2007 and 2006, respectively.
(4)
In November 2009, the Company evaluated its non-performing assets policy and placed in accrual status all FHA loans until 270 days delinquent because the principal balance of these loans is insured or guaranteed under applicable FHA program and interest is, in most cases, fully recovered in foreclosures proceedings. As a result of the change in policy, total non-performing FHA guaranteed residential mortgage loans exclude $31.5 million and $105.5 million of FHA loans as of December 31, 2010 and 2009, respectively, that were 90 days or more past due.
(5)
Excludes FHA and VA claims amounting to $12.5 million, $15.6 million, $17.0 million, $18.3 million and $11.5 million as of December 31, 2010, 2009, 2008, 2007 and 2006, respectively.
The following tables provide the non-performing loans activity by portfolio for the periods indicated.
Table Z - Non-performing loans activity by portfolio
Non-performing assets decreased by $90.8 million, or 9.6%, during the year ended December 31, 2010, primarily as a result of a decrease of $117.6 million in total non-performing consumer loans excluding FHA/VA and a decrease of $158.2 million in total construction and land loans, partially offset by increases of $111.0 million in non-performing FHA/VA guaranteed residential loans, $62.7 million in commercial real estate loans, $6.0 million in OREO and repossessed units and $3.7 million in other non-performing assets. Non-performing loans, excluding FHA/VA guaranteed residential loans decreased $211.5 million, or 25.2%, to $626.5 million as of December 31, 2010, compared to $838.0 million as of December 31, 2009. This decrease resulted from a decline in total non-performing consumer loans of $117.6 million and in total non-performing commercial loans of $93.9 million. Of the total non-performing consumer loans, non-performing residential mortgage loans, excluding FHA/VA guaranteed loans, decreased $116.9 million since December 31, 2009 due
primarily to loss mitigation and front-end collections efforts as well as charge-offs. The decrease in non-performing commercial loans was due primarily to the sale of a construction portfolio to a third party during the third quarter of 2010 that included approximately $108.5 million of non-performing loans as of December 31, 2009. There were also certain loan restructurings during 2010 which returned loans to performing status and a reduction in non-performing U.S. construction loans of $20.0 million as one large loan was worked out. The decrease in non-performing construction and land loans was partially offset by an increase in non-performing commercial real estate loans of $62.7 million, or 48.0%, due to the classification of a participation interest in a current paying loan of $37.7 million (net of a charge-off of $8.8 million in 2010) and deterioration in the performance of the small commercial loan portfolio.
The net decrease in non-performing loans was offset by an increase of $111.0 million in non-performing FHA/VA guaranteed residential loans as a result of Doral’s decision to repurchase FHA insured loans from GNMA securitizations in June 2010 and December 2009 as the non-performance of Doral originated loans exceeded certain GNMA standards. Approximately $54.8 million of the June 2010 repurchase were non-performing, in addition to December repurchases which rolled into non-performing loans during 2010 of approximately $58.6 million. These loans, while non-performing, retain their FHA insurance and present little credit loss potential to Doral.
The increase in OREO and repossessed units of $6.0 million resulted from increases of $15.4 million in construction and land OREOs, as the Company foreclosed on a significant residential development during the third quarter of 2010 and $3.3 million in commercial OREOs due to foreclosure on three large loans during 2010, partially offset by a $12.7 million decrease in residential OREOs. The decrease in residential OREOs is due to a $17.0 million provision for OREO losses in the second quarter of 2010 as Doral undertook efforts to ensure it was properly positioned to sell the residential OREOs and looked to accelerate its OREO dispositions and sales of properties during the year. During 2010, Doral sold 399 properties out of the OREO, 278 of these were sold in the second half of the year due to the change in policy for disposition and sales of properties. As a result of differences in the mortgage foreclosure process between Puerto Rico and the states of the United States, the Company does not expect to have any of the documentation and notarization problems in the mortgage foreclosure process that have been reported by other financial institutions in the United States.
As of December 31, 2010, the Company reported a total of $280.8 million of non-performing residential mortgage loans excluding FHA/VA guaranteed loans, which represents 7.6% of total residential loans (excluding FHA/VA guaranteed loans) and 44.8% of total non-performing loans.
Doral Financial does not hold a significant amount of adjustable interest rate, negative amortization, or other exotic credit features that are common in other parts of the United States. However, as part of its loss mitigation programs, the Company has granted certain concessions to borrowers in financial difficulties that have proven payment capacity which may include interest only periods or temporary interest rate reductions. The payments for these loans will reset at the former payment amount unless the loan is restructured again or the restructured terms are extended. Substantially all residential mortgage loans are conventional 30 and 15 year amortizing fixed rate loans at origination. There has been significantly less fade in residential real estate values in homes under $250,000 in Puerto Rico, the price point for the preponderance of Doral’s residential mortgage loan portfolio. The following table shows the composition of the mortgage non-performing loans according to their actual LTV and whether they are covered by mortgage insurance. LTV ratios are calculated based on current unpaid balances and original property values.
Table AA - Composition of mortgage non-performing assets
December 31,
Actual LTV ratios, calculated based on current unpaid balances and original (or updated, if available) property values, are considered when establishing the levels of general reserves for the residential mortgage portfolio. Assumed loss severity fluctuates depending on the different LTV levels of individual loans.
A significant portion of Doral’s restructured residential mortgage loans were current or paid-off as of December 31, 2010, as illustrated by the table of restructured loans that are non-performing at December 31, 2010 by year of restructure:
Doral’s construction and land loan portfolio reflected a decrease in non-performing loans due primarily to the sale of a portion of the portfolio to a third party in the third quarter of 2010, and certain restructures during the year. Construction and land had non-performing loans of $148.7 million as of December 31, 2010, or 23.7% (98.9% of which are in Puerto Rico), of total non-performing loans. As of December 31, 2010 and 2009, 32.4% and 55.6%, respectively, of the loans within the construction and land portfolio were considered non-performing loans. The sale of the construction loan portfolio during 2010 reduced the Company’s non-performing loans in this sector, however, the remaining construction portfolio is directly affected by the continuing Puerto Rico recession as the underlying loans’ repayment capacity is dependent on the ability to attract buyers.
During the past two years, the Company’s construction and land loan portfolio has experienced a significant increase in default rates resulting from borrowers not being able to sell finished units within the loan term. Although the Company has taken (and continues to take) steps to mitigate the credit risk underlying these loans, their ultimate performance will be affected by each borrower’s ability to complete the project, maintain the pricing level of the housing units within the project, and sell the inventory of units within a reasonable timeframe.
For the years ended December 31, 2010 and 2009, Doral Financial did not enter into commitments to fund new construction loans for residential housing projects in Puerto Rico, other than a new commitment of $28.0 million entered into during the third quarter of 2010, related to the sale of an asset portfolio to a third party in July 2010 and subsequent funding to complete the acquired projects. The portfolio sold consisted of performing and non-performing late-stage residential construction and development loans and real estate.
Commitments to fund new construction loans in the U.S. amounted to $133.9 million for the year ended December 31, 2010, compared to $90.5 million for the corresponding 2009 period.
The following table presents additional further information on the Company’s construction portfolio.
Table BB - Construction and land loan portfolio analysis
(1)
Includes undisbursed funds to matured loans and loans in non-accrual status that are still active.
The following table sets forth information with respect to Doral Financial’s loans past due 90 days and still accruing as of the dates indicated. Loans included in this table are 90 days or more past due as to interest or principal and still accruing, because they are either well-secured and in the process of collection or charged-off prior to being placed in non-accrual status.
Table CC - Loans past due 90 days and still accruing
(1)
Credit cards until 180 days delinquent.
(2)
Revolving lines of credit until 180 days delinquent.
The following table sets forth information on loans 30 to 89 days past due as of the periods indicated. This table excludes GNMA defaulted loans 30 to 89 days past due (for which the Company has the option, but not an obligation, to buy back from the pools serviced) and FHA/VA guaranteed loans.
Table DD - Loans past due 30-89 days
(1)
Excludes $7.4 million, $7.4 million, $1.5 million, $0.3 million and $0.2 million of FHA/VA guaranteed loans, as of December 31, 2010, 2009, 2008, 2007 and 2006, respectively.
(2)
Regulatory guidance regarding days past due followed by many banks provides that the number of days past due may be based upon the number of payments missed. According to this regulatory guidance, monthly pay loans are reported as 30 days past due when the borrower has missed two payments. Doral follows this guidance in its reporting except that it more conservatively reports loans 90 days past due based upon the contractual number of days past due.
Other Real Estate Owned (“OREO”)
Doral Financial believes that the value of the OREO reflected in its Consolidated Statements of Financial Condition represents a reasonable estimate of the properties’ sales price, net of disposition costs. The fair value of the OREO is normally determined on the basis of internal and external appraisals and physical inspections. A charge to the allowance for loan and lease losses is recognized for any initial write down to fair value less cost to sell. Any losses in the carrying value of the properties arising from periodic appraisals are charged to expense in the period incurred. Holding costs, property taxes, maintenance and other similar expenses are charged to expense in the period incurred.
OREO foreclosures have increased in recent periods as the volume of the NPLs has increased and as Doral has shortened the period from the initiation of foreclosure to possession of property by approximately 10 months. OREO sales improved in 2010 compared to 2009 due to the Company’s strategic decision to reduce pricing on the OREO portfolio in order to accelerate sales. The accelerated disposition of OREO is expected to reduce the carrying costs of OREO.
For the year ended December 31, 2010, the Company sold 399 OREO properties, representing $54.2 million in unpaid balance. Total proceeds amounted to $33.6 million, representing the recovery of 52% and 60% of unpaid principal balance and appraised value, respectively. For the year ended December 31, 2009, the Company sold 404 OREO properties, representing $35.3 million in unpaid principal balance. Total proceeds amounted to $33.3 million, representing the recovery of 94% and 103% of unpaid principal balance and appraised value, respectively. Management made the strategic decision to accelerate sales in 2010 to move a significant portion of the foreclosed home inventory out. Gains and losses on sales of OREO are recognized in other expenses in the Company’s Consolidated Statements of Operations.
The following tables provide the real estate owned activity for the periods indicated.
Table EE - Other real estate owned activity by portfolio
Allowance for Loan and Lease Losses (“ALLL”)
Doral estimates and records its ALLL on a monthly basis. For all performing loans and non-performing small balance homogeneous loans the ALLL is estimated based upon estimated probability of default and loss given default by shared product characteristics using Doral Financial’s historical experience. For larger construction, commercial real estate, commercial and industrial loans and TDRs that are 90 or more days past due or are otherwise considered to be impaired, management estimates the related ALLL based upon an analysis of each individual loans’ characteristics. The ALLL estimate methodologies are described more fully in the following paragraphs.
Residential mortgage. The general allowance for residential mortgage loans is calculated based on the probability that loans within different delinquency buckets will default and, in the case of default, the extent of losses that the Company expects to realize. In determining the probabilities of default, the Company considers recent experience of rolls of loans from one delinquency bucket into the next. Roll rates as of year-end show that the proportion of loans rolling into subsequent buckets has remained constant. In determining the allowance for loan and lease losses for residential mortgage loans, given the current economic trends in Puerto
Rico, for purposes of forecasting the future behavior of the portfolio, Doral Financial determined that it should use the roll-rates of relatively recent months, which show a more aggressive deteriorating trend than those in older periods. Using the older historical performance would yield lower probabilities of default that may not reflect recent macroeconomic trends. Severity of loss is calculated based on historical results from foreclosure and ultimate disposition of collateral. Historical results are adjusted for the Company’s expectation of housing prices. Severity assumptions for the residential portfolio range between 3% and 40% depending on the different loan types and loan-to-value ratios, and up to 75% for second mortgages.
Construction and land, commercial real estate and commercial and industrial. The ALLL for performing construction and land, commercial real estate and commercial and industrial is estimated considering either the probability of the loan defaulting in the next twelve months and the estimated loss incurred in the event of default or the loan quality assigned to each loan and the estimated expected loss associated with that loan grade. The probability of a loan defaulting is based upon Doral Financial’s experience with its current portfolio. The loan grade is assigned based upon management’s review of the specific facts and circumstances associated with a particular credit. The loss incurred upon default is based upon Doral’s actual experience in resolving defaulted loans.
Construction and land, commercial real estate and commercial and industrial loans with principal balances greater than $1.0 million that are not performing, or when management estimates it may not collect all contractual principal and interest, are considered impaired and are measured for impairment individually.
Loans are considered impaired when, based on current information and events it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement. Due to the current economic environment and management’s perceived increase in risk in the commercial loan portfolio, during the third quarter of 2010, management individually reviewed for impairment all commercial loans over $50,000 that were over 90 days past due to better estimate the amount the Company expects to receive. During the fourth quarter of 2010, management individually reviewed all commercial real estate loans over $500,000 that were over 90 days past due, 25% of all commercial loans between $50,000 and $500,000 and over 90 days past due, as well as all new loans classified as substandard during the quarter. In future periods, and while management’s assessment of the inherent credit risk in the commercial portfolio continues to be high, the Company will continue to evaluate on a quarterly basis 25% of all commercial loans over 90 days past due and between $50,000 and $500,000 so that in any one year period it would have individually evaluated for impairment 100% of all substandard commercial loans between $50,000 and $500,000, as well as all substandard commercial real estate loans over $500,000 and all substandard commercial and construction loans over $1.0 million.
The impairment loss, if any, on each individual loan identified as impaired is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral net of disposition costs, if the loan is collateral dependent. If foreclosure is probable, accounting guidance requires the measurement of impairment to be based on the fair value of the collateral, net of disposition costs. Since current appraisals were not available on all properties at quarter end, management determined its loss reserve estimates for these loans by estimating the fair value of the collateral. In doing so, management considered a number of factors including the general change in price levels as indicated appraisals received compared to earlier appraisals of the same property, the price at which individual units could be sold in the current market, the period of time over which the units would be sold, the estimated cost to complete the units, the risks associated with completing and selling the units, the required rate of return on investment a potential acquirer may have and current market interest rates in the Puerto Rico market.
Consumer. The ALLL for consumer loans is estimated based upon the historical charge-off rate using Doral Financial’s historical experience. The ALLL is supplemented by Doral’s policy to charge-off all amounts in excess of the collateral value when the loan principal or interest is 120 days or more days past due.
TDRs. In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, on a monthly basis, the Company pools TDRs with similar characteristics and
performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of loans, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records an impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.
Generally, the percentage of the allowance for loan and lease losses to non-performing loans will not remain constant due to the nature of Doral Financial’s loan portfolios, which are primarily collateralized by real estate. The collateral for each non-performing mortgage loan is analyzed to determine potential loss exposure, and, in conjunction with other factors, this loss exposure contributes to the overall assessment of the adequacy of the allowance for loan and lease losses. On an ongoing basis, management monitors the loan portfolio and evaluates the adequacy of the allowance for loan and lease losses. In determining the adequacy of the allowance, management considers such factors as default probabilities, internal risk ratings (based on borrowers’ financial stability, external credit ratings, management strength, earnings and operating environment), probable loss and recovery rates, and the degree of risk inherent in the loan portfolios. Allocated general reserves are supplemented by a macroeconomic or emerging risk reserve. This portion of the total allowance for loan and lease losses reflects management’s evaluation of conditions that are not directly reflected in the loss factors used in the determination of the allowance. The conditions evaluated in connection with the macroeconomic and emerging risk allowance include national and local economic trends, industry conditions within the portfolios, recent loan portfolio performance, loan growth, changes in underwriting criteria and the regulatory and public policy environment.
Loans considered by management to be uncollectible are charged to the allowance for loan and lease losses. Recoveries on loans previously charged-off are credited to the allowance. Provisions for loan and lease losses are charged to expenses and credited to the allowance in amounts deemed appropriate by management based upon its evaluation of the known and inherent risks in the loan portfolio. While management believes that the current allowance for loan and lease losses is adequate, future additions to the allowance may be necessary. If economic conditions change substantially from the assumptions used by Doral Financial in determining the allowance for loan and lease losses further changes in the allowance may be required.
The following tables summarize Doral Financial’s provisions, charge-offs and recoveries for the ALLL for the indicated periods and provide allocations by loan categories.
Table EE - Allowance for loan and leases losses
The following table sets forth information concerning the allocation of Doral Financial’s allowance for loans and lease losses by category and the percentage of loans in each category to total loans as of the dates indicated:
Table FF - Allocation of allowance for loan and lease losses
As of December 31, 2010, the Company’s allowance for loan and lease losses was $123.7 million, a decrease of $17.1 million from $140.8 million as of December 31, 2009. This decrease was driven by a decrease of $29.4 million in the allowance for loan and lease losses of the construction and land portfolio primarily as a result of the sale of a portion of performing and non-performing construction loans to a third party during the third quarter of 2010. The allowance for the residential mortgage and commercial real estate portfolios increased $4.7 million and $7.8 million, respectively.
The provision for loan and lease losses for the year ended December 31, 2010, reflected an increase of $45.3 million compared to the corresponding 2009 period, primarily in non- FHA/VA residential mortgage, commercial real estate and construction and land portfolios. The provision for loan and lease losses for the residential mortgage portfolio increased by $12.3 million, or 52.9%, for the year ended December 31, 2010, when compared to the corresponding 2009 period. The increase in the provision for loan losses on residential mortgage loans was driven by: (i) an increase of $6.8 million due to TDRs individually evaluated for impairment; (ii) an increase of $3.0 million related to the impact of net charge offs on the allowance; (iii) $6.3 million due to transfers of foreclosed loans to OREO; and this was partially offset by $3.8 million due to delinquency improvement. The provision for loan and lease losses for the commercial real estate portfolio increased by $25.5 million for the year ended December 31, 2010, when compared to the corresponding 2009 period due to (i) a $4.5 million provision related to a reduction in the threshold for individually evaluating impaired loans from $1.0 million to $50,000, (ii) an $8.4 million provision due to the adverse classification of a participation interest in a current paying loan of $37.7 million for which a charge-off over allowance was recorded during the year, (iii) an $8.2 million additional provision on loans individually measured for impairment, (iv) a $1.0 million provision due to TDRs during the year which are individually evaluated for impairment, and (v) a $2.5 million provision as loans rolled to delinquency. The provision for loan and lease losses on the construction and land loan portfolio increased $10.7 million during 2010 primarily due to the sale of a construction portfolio to a third party during the third quarter of 2010 that resulted in
additional provisions of $12.7 million, this offset by the release of $2 million in reserve as one project loan was worked-out. In general, the increase in the provision for loan and lease losses during 2010 was largely driven by the impact of loss mitigation efforts including the sale of a portion of the construction loan portfolio, delinquencies trends, properties in foreclosure, decreases in real estate values, an increase in severities (in the determination of the provision) due to strategic decision to accelerate OREO dispositions and the continued deterioration in the Puerto Rico economy.
The provision for loan and lease losses for the year ended December 31, 2010, was offset by net charge-offs of $116.1 million, which included $35.8 million related to the sale of certain construction loans, $8.8 million related to a classified participation interest, $31.0 million related to partial charge-offs on residential mortgage loans during the period, $8.9 million related to other consumer loans as those rolled to the 120 and over delinquency bucket, as well as charge-offs of previously reserved balances as a confirmed loss determinations are reached. Net charge offs on residential mortgage loans increased due to the implementation in 2010 of the Company’s real estate valuation policy under which the Company obtains assessments of collateral value for residential mortgage loans over 180 days past due and any outstanding balance in excess of the value of the property less cost to sell is classified as loss and written down by charging the allowance for loan and lease losses.
The allowance for loan and lease losses coverage ratios as of December 31, 2010 and 2009 (including and excluding the effect of partial charge-offs and credit related discounts) were as follows:
Table GG - Allowance for loans and lease losses coverage ratios
(1)
Loans and NPL amounts are increased by the amount of partial charge-offs and discounts.
(2)
Loans and NPL amounts are not increased by the amount of partial charge-offs and discounts.
(3)
Excludes FHA/VA guaranteed loans and loans on saving deposits.
After consideration of partial charge-offs and credit related discounts, and in part due to the decrease in non-performing loans, the coverage ratios are up 123 basis points (36.0%) and 19.09 basis points (86.2%) for the allowance plus partial charge-offs and credit related discounts and as a percentage of all loans, and percentage of non-performing loans, respectively. Doral discontinued new construction lending in Puerto Rico in 2007, new commercial real estate and commercial and industrial lending in Puerto Rico in 2008, and significantly tightened its residential underwriting standards in 2009. Doral’s seasoned vintages, where problems have been identified and addressed in previous periods, require smaller additional provisions at this time. Considering the effect of the partial charge-offs and credit related discounts, the Company’s coverage ratio was 4.65% as of December 31, 2010 and 3.42% as of December 31, 2009. In addition to the partial charge-offs reflected in the ratios above, the Company took a charge-off of $35.8 million during the second quarter of 2010, on loans sold to a third party during the third quarter of 2010 in exchange for cash and a note
receivable of $96.9 million. Doral reports the $96.9 million note received as a construction loan. Giving consideration to these additional charge-offs, the adjusted coverage ratio (allowance for and lease losses adjusted for partial charge-offs, credit related discounts and construction loan charge-offs on the portfolio sold, to loans receivable) would be 5.09%, an increase of 167 basis points compared to the same ratio as of December 31, 2009. The adjusted coverage ratio for the construction loan portfolio after giving consideration to the charge-off of construction loans sold in 2010 would be 18.65%, an increase of 574 basis compared to the same ratio as of December 31, 2009.
The allowance for loan and lease losses was 2.29% of period-end loans receivable (excluding FHA/VA guaranteed loans and loans on savings deposits) at December 31, 2010, a decrease of 34 basis points compared with 2.63% at December 31, 2009. The allowance for loan and lease losses to non-performing loans (excluding non-performing loans held for sale) was 19.82%, an increase of 291 basis points compared to 16.91% as of December 31, 2009.
Mortgage lending is the Company’s principal line of business and has historically reflected significant recoveries and low levels of losses. Nevertheless, due to current economic conditions in Puerto Rico, and increases in loss severities in this portfolio, the Company increased its allowance during 2010. Non-performing residential mortgage loans excluding FHA/VA guaranteed loans decreased $116.9 million, or 29.4%, and the related allowance for loan and lease losses increased $4.7 million or 9.0% during the year ended December 31, 2010 compared with 2009. In 2010, charge-offs of residential mortgage loans were driven by the implementation of the Company’s real estate valuation policy under which the Company obtains assessments of collateral value for residential mortgage loans that are over 180 days past due and any outstanding balance in excess of the value of the property less cost to sell is classified as loss and written down by charging the allowance for loans and lease losses.
The construction and land loans portfolio decreased $93.2 million for the year ended December 31, 2010, mainly due to net charge-offs of $55.9 million. Construction and land NPLs decreased $158.2 million as a result of the sale of construction loan portfolio that included approximately $108.5 million non-performing loans as of December 31, 2009. There were also certain restructures and a reduction in non-performing US construction loans of $21.6 million as one large loan was worked out.
The commercial real estate loan portfolio decreased $49.9 million during 2010 since the Company is not actively lending in this line of business and due to partial charge-offs. Non-performing commercial real estate loans increased $62.7 million in 2010 as a result of the deterioration in economic conditions in Puerto Rico and the classification of a participation in interest in a current paying loan of $37.7 million. The allowance for loan and lease losses for this portfolio increased $7.8 million during 2010.
The following table summarizes the Company’s loans individually reviewed for impairment and its related allowance:
Table HH - Impaired loans and related allowance
As part of the regular loan workout cycle, the Company charges-off the portion of impaired loans that it considers a confirmed loss. Accordingly, certain loans considered impaired and loans individually measured for impairment are carried at book balance that has already been reduced by charge-offs, and therefore, carry a lower dollar allowance. Under some circumstances, the economics of a particular credit relationship suggest that the underlying loans are sufficiently collateralized and that no specific reserve is necessary. The Company
does not allocate general reserves for those loans for which an impairment analysis has been conducted and for which the impairment measure was zero.
Counterparty Risk
The Company has exposure to many different counterparties, and it routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients. Loans, derivatives investments, repurchase agreements, other borrowings, and receivables, among others, expose the Company to counterparty risk. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. In addition, the Company’s credit risk may be impacted when the collateral held by it cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to the Company. There can be no assurance that any such losses would not materially and adversely affect the Company’s results of operations.
The Company has procedures in place to mitigate the impact of default among its counterparties. The Company requests collateral for most credit exposures with other financial institutions and monitors these on a regular basis. Nevertheless, market volatility could impact the valuation of collateral held by the Company and result in losses.
Operational Risk
Operational risk includes the potential for financial losses resulting from failed or inadequate controls. Operational risk is inherent in every aspect of business operations, and can result from a range of factors including human judgment, process or system failures, or business interruptions. Operational risk is present in all of Doral Financial’s business processes, including financial reporting. The Company has adopted a policy governing the requirements for operational risk management activities. This policy defines the roles and responsibilities for identifying key risks, key risks indicators, estimation of probabilities and magnitudes of potential losses and monitoring trends.
Overview of Operational Risk Management
Doral Financial has a corporate-wide Chief Risk Officer, who is responsible for implementing the process of managing the risks faced by the Company. The Chief Risk Officer is responsible for coordinating risk identification and monitoring throughout Doral Financial with the Company’s Internal Audit group. In addition, the Internal Audit function provides support to facilitate compliance with Doral Financial’s system of policies and controls and to ensure that adequate attention is given to correct issues identified.
Internal Control Over Financial Reporting
For a detailed discussion of the Management’s Report on Internal Control Over Financial Reporting as of December 31, 2010, please refer to Part II, Item 9A. Controls and Procedures.
Liquidity Risk
For a discussion of the risks associated with Doral Financial’s ongoing need for capital to finance its lending, servicing and investing activities, please refer to “Liquidity and Capital Resources” above.
General Business, Economic and Political Conditions; Puerto Rico Economy and Fiscal Condition
The Company’s business and earnings are sensitive to general business and economic conditions in Puerto Rico and the United States. Significant business and economic conditions include short-term and long-term interest rates, inflation and the strength of the Puerto Rico and U.S. economies and housing markets. If any of these conditions deteriorate, the Company’s business and earnings could be adversely affected. For example, business and economic conditions that negatively impact household income could decrease the demand for residential mortgage loans and increase the number of customers who become delinquent or default on their
loans; or, a dramatically rising interest rate environment could decrease the demand for loans and negatively affect the value of the Company’s investments and loans.
Inflation also generally results in increases in general and administrative expenses. Interest rates normally increase during periods of high inflation and decrease during periods of low inflation. Please refer to “Risk Management” above for a discussion of the effects of changes of interest rates on Doral Financial’s operations.
Markets in the United States and elsewhere have experienced extreme volatility and disruption for over two years, continuing through the year ended December 31, 2010. The United States, Europe and Japan entered into recessions during 2008 that persisted through most of 2009, despite past and expected governmental intervention in the world’s major economies.
Doral Financial’s business activities and credit exposure are concentrated in Puerto Rico. Consequently, its financial condition and results of operations are highly dependent on economic conditions in Puerto Rico.
The economy of Puerto Rico is closely linked to the United States economy, as most of the external factors that affect the Puerto Rico economy (other than the price of oil) are determined by the policies of, and economic conditions prevailing in, the United States. These external factors include exports, direct investment, the amount of federal transfer payments, the level of interest rates, the rate of inflation, and tourist expenditures. During the fiscal year ended June 30, 2010, approximately 68.1% of Puerto Rico’s exports went to the U.S. mainland, which was also the source of approximately 51.2% of Puerto Rico’s imports. In the past, the economy of Puerto Rico has generally followed economic trends in the overall United States economy. However, in recent years, economic growth in Puerto Rico has lagged behind growth in the United States.
The dominant sectors of the Puerto Rico economy in terms of production and income are manufacturing and services. The manufacturing sector has undergone fundamental changes over the years as a result of an increased emphasis on higher-wage, high-technology industries, such as pharmaceuticals, biotechnology, computers, microprocessors, professional and scientific instruments, and certain high-technology machinery and equipment. The services sector, including finance, insurance, real estate, wholesale and retail trade, and tourism, also plays a major role in the economy. It ranks second to manufacturing in contribution to Puerto Rico’s gross domestic product and leads all sectors in providing employment.
Puerto Rico’s economy is currently in a recession that began in the fourth quarter of the fiscal year that ended June 30, 2006. Although the Puerto Rico economy is closely linked to the United States economy, for fiscal years 2007, 2008 and 2009, Puerto Rico’s real gross national product decreased by 1.2%, 2.8% and 3.7%, respectively, while the United States economy grew at a rate of 1.8% and 2.8% during fiscal years 2007 and 2008, respectively, and contracted at a rate of 2.5% during fiscal year 2009. According to the Puerto Rico Planning Board’s latest projections, Puerto Rico’s real gross national product was projected to contract by 3.6% during fiscal year 2010. Puerto Rico’s real gross national product for fiscal year 2011, however, is projected to grow by 0.4%.
The number of persons employed in Puerto Rico during fiscal year 2010 averaged 1,102,700, a decrease of 5.6% compared to the previous fiscal year. During the first six months of fiscal year 2011, total employment averaged 1,084,500, a decline of 2.5% compared with the same period of the previous fiscal year, and the unemployment rate averaged 15.9%.
Future growth of the Puerto Rico economy will depend on several factors including the condition of the United States economy, the relative stability of the price of oil imports, the exchange value of the United States dollar, the level of interest rates, the effectiveness of the recently approved changes to the Puerto Rico income tax code and other tax laws, and the continuing economic uncertainty generated by the Puerto Rico government’s fiscal condition. The economy of Puerto Rico is very sensitive to the price of oil in the global market. Puerto Rico does not have significant mass transit available to the public and most of its electricity is currently powered by oil, making it highly sensitive to fluctuations in oil prices. A substantial increase in the price of oil could impact adversely the economy by reducing disposable income and increasing the operating costs of most businesses and government. Consumer spending is particularly sensitive to wide fluctuations in oil prices.
For additional information relating to the fiscal situation and challenges of the Government of Puerto Rico and various initiatives it has undertaken during the last two fiscal years, please refer to the sections titled “Fiscal Condition,” “Fiscal Stabilization Plan,” “Government Reorganization Plan,” “Unfunded Pension Benefit Obligations and Funding Shortfalls of the Retirement System,” “Economic Reconstruction Plan,” and “Economic Development Plan” under “Business-The Commonwealth” in Item 1 of this Annual Report on Form 10-K.
The Company cannot predict at this time the impact that the current fiscal situation of the Commonwealth of Puerto Rico and the various legislative and other measures adopted by the Puerto Rico government in response to such fiscal situation will have on the Puerto Rico economy and on Doral Financial’s financial condition and results of operations.
The Company operates in a highly competitive industry that could become even more competitive as a result of economic, legislative, regulatory and technological changes. The Company faces competition in such areas as mortgage and banking product offerings, rates and fees, and customer service. In addition, technological advances and increased e-commerce activities have, generally, increased accessibility to products and services for customers which has intensified competition among banking and non-banking companies in the offering of financial products and services, with or without the need for a physical presence.
MISCELLANEOUS
Refer to Note 2 of the accompanying financial statements for a discussion of changes in accounting standards adopted in the 2010 financial statements
CEO and CFO Certifications
Doral Financial’s Chief Executive Officer and Chief Financial Officer have filed with the Securities and Exchange Commission the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as Exhibits 31.1 and 31.2 to this Annual Report on Form 10-K.
In addition, in 2010 Doral Financial’s Chief Executive Officer certified to the New York Stock Exchange that he was not aware of any violation by the Company of the NYSE corporate governance listing standards.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
The information required by this Item is incorporated by reference to the information included under the subcaption “Risk Management” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section in this Form 10-K.
Item 8.
Item 8.
Financial Statements and Supplementary Data.
The consolidated financial statements of Doral Financial, together with the report thereon of PricewaterhouseCoopers LLP, Doral Financial’s independent registered public accounting firm, are included herein beginning on page of this Form 10-K.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
Disclosure Controls and Procedures
Doral Financial’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) under the Exchange Act) as of December 31, 2010. Disclosure controls and procedures are defined under SEC rules as controls and other procedures that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon this evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company’s disclosure controls and procedures, at a reasonable level of assurance, are effective as of December 31, 2010.
Management’s Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, and for the assessment of the effectiveness of internal control over financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes controls over the preparation of financial statements to comply with the reporting requirements of Section 112 of FDICIA.
A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In making its assessment, management, including the Chief Executive Officer and Chief Financial Officer, used the criteria set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
As a result of its assessment, management has concluded that the Company’s internal control over financial reporting is effective as of December 31, 2010.
The effectiveness of the Company’s internal control over financial reporting as of December 31, 2010 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears under Item 8 of this Annual Report on Form 10-K.
Changes in Internal Control Over Financial Reporting
There have been no changes to the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15(d)-15(f) under the Exchange Act) during the year ended December 31, 2010, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B.
Other Information.
As previously announced, on December 2, 2010, the Company sent a letter to the Board of Directors of First BanCorp proposing the acquisition of First BanCorp by the Company subject to certain terms and conditions. On December 6, 2010, First BanCorp issued a press release announcing that it had received and rejected such proposal. The Company’s invitation to the First BanCorp Board of Directors to commence discussions with respect to its proposal remains open.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
The information required by this Item 10 is hereby incorporated by reference to the sections titled “Election of Directors,” “Corporate Governance,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in Doral Financial’s proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the 2010 fiscal year.
Item 11.
Item 11.
Executive Compensation.
The information required by this Item 11 is hereby incorporated by reference to the sections titled “2010 Director Compensation,” “Compensation Committee Interlocks and Insider Participation,” “Executive Compensation” (including “Compensation Committee Report,” and the various compensation tables), “Equity Compensation Plan Information”, and “Potential Payments upon Termination or Change in Control” contained in Doral Financial’s proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the 2010 fiscal year.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this Item 12 is hereby incorporated by reference to the section titled “Security Ownership of Management, Directors and Principal Holders” contained in Doral Financial’s proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the 2010 fiscal year.
Item 13.
Item 13.
Certain Relationships and Related Transactions.
The information required by this Item 13 is hereby incorporated by reference to the sections titled “Certain Relationships and Related Transactions” and “Corporate Governance” contained in Doral Financial’s proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the 2010 fiscal year.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information required by this Item 14 is hereby incorporated by reference to the section titled “Ratification of Independent Registered Public Accounting Firm” contained in Doral Financial’s proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of the 2010 fiscal year.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules.
(a) List of documents filed as part of this report.
(1) Financial Statements.
The following consolidated financial statements of Doral Financial, together with the report thereon of Doral Financial’s independent registered public accounting firm, PricewaterhouseCoopers LLP, dated March 7, 2011, are included herein beginning on page:
•
Report of Independent Registered Public Accounting Firm
•
Consolidated Statements of Financial Condition as of December 31, 2010 and 2009
•
Consolidated Statements of Income for each of the three years in the period ended December 31, 2010, 2009 and 2008
•
Consolidated Statements of Changes in Stockholders’ Equity for each of the three years in the period ended December 31, 2010, 2009 and 2008
•
Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31, 2010, 2009 and
•
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2010, 2009 and 2008
•
Notes to consolidated financial statements
(2) Financial Statement Schedules.
All financial schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(3) Exhibits.
The exhibits to this Annual Report on Form 10-K are listed in the exhibit index below.
The Company has not filed as exhibits certain instruments defining the rights of holders of debt of the Company not exceeding 10% of the total assets of the Company and its consolidated subsidiaries. The Company will furnish copies of any such instruments to the Securities and Exchange Commission upon request.
SIGNATURES
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 hereunto duly authorized.
DORAL FINANCIAL CORPORATION
(Registrant)
/s/ Glen R. Wakeman
Glen R. Wakeman
Chief Executive Officer and President
Date: March 7, 2011
/s/ Robert E. Wahlman
Robert E. Wahlman
Executive Vice President and
Chief Financial Officer
Date: March 7, 2011
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
Doral Financial Corporation Index Page
Report of Independent Registered Public Accounting Firm
To the Board of Directors and
Shareholders of Doral Financial Corporation:
In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Doral Financial Corporation and its subsidiaries at December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management’s assessment and our audit of Doral Financial Corporation’s internal control over financial reporting also included controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C) to comply with the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA). A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
San Juan, Puerto Rico
March 7, 2011
CERTIFIED PUBLIC ACCOUNTANTS
(OF PUERTO RICO)
License No. 216 Expires Dec. 1, 2013
Stamp 2493532 of the P.R. Society of
Certified Public Accountants has been
affixed to the file copy of this report
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
The accompanying notes are an integral part of these financial statements.
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(1)
For the years ended December 31, 2010, 2009 and 2008, net loss per common share represents basic and diluted loss per common share, respectively, for each of the periods presented. Refer to Note 36 for additional information regarding net loss attributable to common shareholders.
(2)
For the years ended December 31, 2010 and 2009, net loss per common share included an income of $26.6 million and a loss of $8.6 million, respectively, related to the effect of the preferred stock exchange. Refer to Note 36 for additional information.
The accompanying notes are an integral part of these financial statements.
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these financial statements.
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPRENHENSIVE LOSS
(1)
As of December 31, 2010 and 2009, other comprehensive loss on cash flow hedges includes $1.3 million and $3.0 million related to a deferred tax asset valuation allowance.
The accompanying notes are an integral part of these financial statements.
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
DORAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
The accompanying notes are an integral part of these financial statements.
DORAL FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION
FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008
1.
Nature of Operations and Basis of Presentation
Doral Financial Corporation (“Doral,” “Doral Financial” or the “Company”) is a bank holding company engaged in banking (including thrift operations), mortgage banking and insurance agency activities through its wholly-owned subsidiaries Doral Bank (“Doral Bank PR”), Doral Bank, FSB (“Doral Bank US”), Doral Insurance Agency, Inc. (“Doral Insurance Agency”), and Doral Properties, Inc. (“Doral Properties”). Doral Bank PR operates three wholly-owned subsidiaries, Doral Mortgage, LLC (“Doral Mortgage”), Doral Money, Inc. (“Doral Money”), engaged in commercial and middle market syndicated lending primarily in the New York metropolitan area and since September 2010, in the northwest region of Florida, and CB, LLC, an entity formed to dispose of a real estate project of which Doral Bank PR took possession during 2005. Doral Money consolidates two variable interest entities created for the purpose of entering into a collateralized loan arrangement with a third party.
In the past, the Company operated an institutional securities business through Doral Securities, Inc. (“Doral Securities”), a wholly-owned subsidiary of Doral Financial. During the third quarter of 2007, Doral Securities voluntarily withdrew its license as broker dealer with the SEC and its membership with the Financial Industry Regulatory Authority (“FINRA”). As a result of this decision, Doral Securities’ operations during 2008 were limited to acting as a co-investment manager to a local fixed-income investment company. Doral Securities provided notice to the investment company in December 2008 of its intent to assign its rights and obligations under the investment advisory agreement to Doral Bank PR. The assignment was completed in January 2009 and Doral Securities did not conduct any other operations in 2009. During the third quarter of 2009, this investment advisory agreement was terminated by the investment company. Effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial Corporation.
On July 1, 2008, Doral International, Inc. (“Doral International”), an international banking entity (“IBE”), subject to supervision, examination and regulation by the Commissioner of Financial Institutions under the International Banking Center Regulatory Act (the “IBC Act”), was merged with and into Doral Bank PR, Doral International’s parent company, with Doral Bank PR being the surviving corporation, in a transaction structured as a tax free reorganization.
On December 16, 2008, Doral Investment International, LLC (“Doral Investment”) was organized to become a new subsidiary of Doral Bank PR, but is not operational.
Certain amounts reflected in the 2009 and 2008 Consolidated Financial Statements have been reclassified to conform with the presentation for 2010.
2.
Summary of Significant Accounting Policies
The accompanying Consolidated Financial Statements include the accounts of Doral Financial Corporation and its wholly-owned subsidiaries. The Company’s accounting and reporting policies conform with the generally accepted accounting principles in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation.
The following summarizes the most significant accounting policies followed in the preparation of the accompanying Consolidated Financial Statements:
Use of Estimates in the Preparation of Financial Statements
The preparation of the Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements as well as the reported
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
amounts of revenues and expenses during the reporting periods. Because of uncertainties inherent in the estimation process, it is possible that actual results could differ from those estimates.
The accounting policies that have a significant impact on Doral Financial’s statements and that require the most judgment are those relating to the assumptions underlying the valuation of its MSRs, IOs, investments (including OTTI), collectibility of accounts receivable, the value of repossessed assets, income taxes, the allowance for loan and lease losses and recourse obligations.
The estimation of fair value for financial instruments, including derivative instruments, required to be recorded at fair value under GAAP permeates the financial statements. Fair value estimates are included in Doral Financial’s financial condition and results of operations and, in many instances, requires management to make complex judgments. Fair value is generally based on quoted prices, including dealer marks or direct market observations. If quoted prices or market parameters are not available, fair value is based on internal and external valuation models using market data inputs adjusted by the Company’s particular characteristics, when appropriate. The use of different models and assumptions could produce materially different estimates of fair value.
Other Interest-Earning Assets
Other interest-earning assets include time deposits, short-term investments and cash pledged to counterparties, among others. These investments are carried at cost, which approximates fair value due to their short-term nature (less than three months). In the case of securities purchased under agreements to resell, it is the Company’s policy to require and take possession of collateral whose fair value exceeds the balance of the related receivable. The collateral is valued daily, and the Company may require counterparties to deposit additional collateral or return collateral pledged when appropriate. The securities underlying the agreements are not recorded in the asset accounts of the Company since the counterparties retain effective control of such securities. Also, other interest-earning assets include cash pledged with counterparties to back the Company’s securities sold under agreements to repurchase and/or derivative positions.
Investment Securities
Investment securities are recorded on trade date basis, except for securities underlying forward purchases and sales contracts which are recorded on contractual settlement date. At the end of the period, unsettled purchase transactions are recorded in the Company’s investment portfolio and as a liability, while unsettled sale transactions are deducted from the Company’s investment portfolio and recorded as an other asset. Investment securities are classified as follows:
Securities Held for Trading: Securities that are bought and held principally for the purpose of selling them in the near term are classified as securities held for trading and reported at fair value generally based on quoted market prices or quoted market prices for similar instruments. If quoted market prices are not available, fair values are estimated based on dealer quotes, pricing models, discounted cash flow methodologies, or similar techniques where the determination of fair value may require significant management judgment on estimation. Realized and unrealized changes in market value are recorded in net gain or loss on trading activities in the period in which the changes occur. Interest income and expense arising from trading instruments are included in net interest income in the Consolidated Statements of Operations.
Forwards, caps and swap contracts are accounted for as derivative instruments. Doral Financial recognizes a derivative at the time of the execution of the contract and marks to market the contracts against current operations until settlement as part of its trading activities. The securities underlying the forward contracts are recorded at settlement at their market value and generally classified as available for sale.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Securities Held to Maturity: Securities that the Company has the ability and intent to hold until their maturities are classified as held to maturity and reported at amortized cost.
Securities Available for Sale: Securities not classified as either securities held to maturity or securities held for trading are classified as available for sale and reported at fair value, with unrealized non-credit gains and losses excluded from net income (loss) and reported, net of tax, in other comprehensive income (loss). The cost of securities sold is determined on the specific identification method.
For most of the Company’s investment securities, deferred items, including premiums, and discounts, are amortized into interest income over the contractual life of the securities adjusted for actual prepayments using the effective interest method.
The Company regularly evaluates each security whose value has declined below amortized cost to assess whether the decline in fair value is other-than-temporary. Amortized cost basis includes adjustments made to the cost of a security for accretion, amortization, collection of cash, previous OTTI recognized into earnings (less any cumulative effect adjustments) and fair value hedge accounting adjustments. OTTI is considered to have occurred under the following circumstances:
•
If the Company intends to sell the investment security and its fair value is less than its amortized cost.
•
If, based on available evidence, it is more likely than not that the Company will decide or be required to sell the investment security before the recovery of its amortized cost basis.
•
If the Company does not expect to recover the entire amortized cost basis of the investment security. This credit loss occurs when the present value of cash flows expected to be collected is less than the amortized cost basis of the security. In determining whether a credit loss exists, the Company uses its best estimate of the present value of cash flows expected to be collected from the investment security. Cash flows expected to be collected are estimated based on a careful assessment of all available information. The difference between the present value of the cash flows expected to be collected and the amortized cost basis represents the amount of credit loss.
Beginning in 2009, the credit component of OTTI losses is recognized in earnings and the non-credit component is recognized in accumulated other comprehensive income (loss). Prior to 2009, the credit and non-credit components of OTTI losses were included in current period earnings.
Other Investment Securities: Investments in equity that do not have readily determinable fair values, are classified as other securities in the Consolidated Statement of Financial Condition. These securities are stated at cost. Stock that is owned by the Company to comply with regulatory requirements, such as FHLB stock, is included in this category.
Loans Held for Sale
Loans held for sale are carried at the lower of net cost or market value on an aggregate portfolio basis. The amount by which cost exceeds market value, if any, is accounted for as a loss through a valuation allowance. Changes in the valuation allowance are included in the determination of income in the period in which those changes occur and are reported under net gain on mortgage loan sales and fees in the Consolidated Statements of Operations. Loan origination fees and direct loan origination costs related to loans held for sale are deferred as an adjustment to the carrying basis of such loans until these are sold or securitized. Premiums and discounts on loans classified as held for sale are not amortized as interest income while such loans are classified as held for sale. See “Servicing Assets and Servicing Activities,” below for a description of the sales and securitization process. Loans held for sale consist primarily of mortgage loans held for sale. The market value of mortgage loans held for sale is generally based on quoted market prices for
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
MBS adjusted by particular characteristics like guarantee fees, servicing fees, actual delinquency and the credit risk associated to the individual loans.
The Company recognizes interest income on loans held for sale on an accrual basis, except when management believes the collection of principal or interest is doubtful. Loans held for sale are placed on non-accrual status when any portion of principal or interest is more than 90 days past due, except for FHA/VA guaranteed loans that are still accruing until 270 days past due. When a loan is placed on non-accrual status, all accrued but unpaid interest to date is reversed against interest income. Such interest, if collected, is credited to income in the period of the recovery and the loan is accounted for on the cash or cost recovery method until it qualifies for return to accrual status. Loans return to accrual status when principal and interest become current under the terms of the loan agreement or when the loan is both well-secured and in the process of collection and collectibility is no longer doubtful.
The Company regularly reviews its loans held for sale portfolio and may transfer loans from the loans held for sale portfolio to its loans receivable portfolio. At the time of such transfers, the Company recognizes a market value adjustment charged against earnings based on the lower of aggregate cost or market value.
Loans held for sale include GNMA defaulted loans which have a conditional buy-back option (refer to Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities below for more information). If the Company exercises the buy-back options, the loans are repurchased and the composition of the Statement of Financial Condition is affected. The loans are removed from the held for sale portfolio and are classified as part of the held for investment (loans receivable) portfolio, and the cash and the payable previously recorded are reduced accordingly. If the Company exercises the buy-back options it may incur a loss to the extent of any interest advanced through its servicing.
Loans Receivable
Loans receivable are those held principally for investment purposes. These consist of construction and land, residential mortgage, commercial real estate, commercial and industrial, and consumer loans which the Company does not expect to sell in the near future.
Loans receivable are carried at their unpaid principal balance, less unearned interest, net of deferred loan fees or costs (including premiums and discounts), undisbursed portion of construction loans and an allowance for loan and lease losses. These items, except for the undisbursed portion of construction loans and the allowance for loan and lease losses, are deferred at inception and amortized into interest income throughout the lives of the underlying loans using the effective interest method.
The Company recognizes interest income on loans receivable on an accrual basis, except when management believes the collection of principal or interest is doubtful. Loans receivable are placed on non-accrual status when any portion of principal or interest is more than 90 days past due, except for revolving lines of credit and credit cards that are still accruing until 180 days past due and FHA/VA guaranteed loans that are still accruing until 270 days past due. When a loan is placed on non-accrual status, all accrued but unpaid interest to date is reversed against interest income. Such interest, if collected, is credited to income in the period of the recovery and the loan is accounted for on the cash or cost recovery method until it qualifies for return to accrual status. Loans return to accrual status when principal and interest become current under the terms of the loan agreement or when the loan is both well-secured and in the process of collection and collectibility is no longer doubtful. In the case of loans under troubled debt restructuring agreements, the Company continues to place them in non-accrual status and reports them as non-performing loans unless the Company expects to collect all contractual principal and interest and the loans have proven repayment capacity for a sufficient amount of time at which time the loans are returned to accrual status.
The Company also engages in the restructuring and/or modifications of the debt of borrowers, who are delinquent due to economic or legal reasons, if the Company determines that it is in the best interest for both
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
the Company and the borrower to do so. In some cases, due to the nature of the borrower’s financial condition, the restructure or loan modification fits the definition of Troubled Debt Restructuring (“TDR”). Such restructures are identified as TDRs and accounted for as impaired loans (described below).
Allowance for Loan and Lease Losses
The Company’s allowance for loan and lease losses (“ALLL”) is established to provide for probable credit losses inherent in the portfolio of loans receivable as of the balance sheet date. Management estimates the ALLL separately for each product category (non-FHA/VA residential mortgage loans, other consumer, commercial real estate, construction and land and other commercial and industrial) and geography (Puerto Rico and U.S. mainland), and combines the amounts in reaching its estimate for the full portfolio. The Company performs periodic and systematic detailed reviews of its lending portfolios to identify credit risks and to assess the overall collectability of those portfolios. The allowance for certain homogeneous loan portfolios, which generally consist of consumer loans and certain commercial loans, is based on aggregated portfolio segment evaluations generally by product type. The remaining commercial portfolios (including commercial real estate, construction and land, and large commercial and industrial loans) are reviewed on an individual loan basis. Loans subject to individual reviews are analyzed and segregated by risk according to the Company’s internal risk rating scale. The ALLL for these portfolios is based on these risk classifications, in conjunction with an analysis of historical loss experience, current economic conditions, industry performance trends, geographic or obligor concentrations and any other pertinent information.
Management’s product category loss reserve estimate consists of one or more of the following methodologies for performing loans: (i) the reserve is estimated based upon the probability a loan will proceed through foreclosure and the collateral will be repossessed, and recognizing the loss that will be realized on the repossessed collateral, if any (mortgage loans, certain commercial real estate and small land loans), (ii) historical experience of charge-offs related to the outstanding principal balance, or (iii) historical experience of charge-offs as related to credit grade and outstanding principal balances (construction loans, commercial loans, some commercial real estate loans, and some land loans).
For non-performing loans, the reserve is estimated either by (i) considering the loans’ current level of delinquency and the probability that the loan will be foreclosed upon from that delinquency stage, and the loss that will be realized assuming foreclosure (mortgage loans), or (ii) measuring impairment for individual loans considering the specific facts and circumstances of the borrower, guarantors, collateral, legal matters, market matters, and other circumstances that may affect the borrower’s ability to repay their loan, Doral’s ability to repossess and liquidate the collateral, and Doral’s ability to pursue and enforce any deficiency in payment received. The probability of a loan migrating to foreclosure whether a current loan or a past due loan, and the amount of loss given foreclosure, is based upon the Company’s own experience, with more recent experience judgmentally weighted more heavily in the calculated factors. With this practice management believes the factors used better represent existing economic conditions. In estimating the loss given foreclosure factor, management differentiates the foreclosure factor based upon the loans’ loan-to-value ratio (calculated as current loan balance divided by the original appraisal value).
In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, on a monthly basis, the Company pools TDRs with similar characteristics and performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of loans, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records an impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Doral charges loans off when it is determined that the likelihood of collecting the amount is so low the continuation of their recognition as an asset is not warranted. For residential mortgage loans, the reported loan investment is reduced, by a charge to the ALLL, to an updated appraised amount less estimated costs to sell the property when the loan is 180 days past due. For consumer loans, the reported loan balance is reduced by a charge to the ALLL when the loan is 120 days past due, except for revolving lines of credit (typically credit cards) which are charged off to the estimated value of the collateral (if any) at 180 days. For all commercial loans the determination of whether a loan should be fully or partially charged off is much more subjective, and must consider the results of an operating business, the value of the collateral, the financial strength of the guarantors, the likelihood of different outcomes of pending litigation affecting the borrower, the potential effect of new laws or regulations, and other matters. Doral’s commercial loan charge-offs are determined by the Charge-off Committee, which is a subcommittee of the Credit Committee.
Doral evaluates all commercial real estate, construction and land and other commercial loans classified as substandard or lower by its internal loan classification processes for impairment, either individually or collectively, with other loans generally of the same risk characteristics. Loans are considered substandard when, based on current information and events, it is probable that the borrower will not be able to fulfill their contractual obligations pursuant to the loan agreement. Commercial and construction and land substandard loans with balances greater than $1.0 million are reviewed individually for impairment, though management may elect to individually review smaller balance loans that are considered higher risk. Substandard commercial real estate loans greater than $0.5 million are also individually evaluated for impairment and 25% of substandard commercial loans between $50,000 and $500,000 are individually evaluated for impairment each quarter so that in a one year period all substandard commercial loans over $50,000 have been individually evaluated for impairment. If a loan is determined to be impaired, the impairment is generally measured as the difference between the loan balance and present value of expected cash flows associated with the loan at the loan’s effective interest rate less costs to sell. As a practical expedient, and for all collateral dependent loans for which foreclosure is probable, Doral measures impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from appraisals, but if a current appraisal is not available it may be estimated using forecasted cash flows discounted at a rate that provides for a reasonable builder return on the investment equity and market borrowing rates for similar assets.
An allowance reserve is established for individual impaired loans. Loans are considered impaired when, based on current information and events it is probable that the borrower will not be able to fulfill its obligation under the contractual terms of the loan agreement. The impairment loss measurement, if any, on each individual loan identified as impaired is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent. If foreclosure is probable, the Company is required to measure impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from appraisals or is based on management’s estimates of future cash flows discounted at the contractual interest rate, or for loans probable of foreclosure, discounted at a rate reflecting the principal market participant cost of funding, required rate of return and risks associated with the cash flows forecast. Consistent with management’s intention of preserving capital, its strategy is to maximize proceeds from the disposition of foreclosed assets as opposed to rapid liquidation. Accordingly, the market value of appraisals is used. In the event that appraisals show a deficiency, the Company includes the deficiency in its loss reserve estimate. Although accounting guidance for loan impairment excludes large groups of smaller balance homogeneous loans that are collectively evaluated for impairment (e.g. mortgage loans), it specifically requires that loan modifications considered TDRs be analyzed for impairment in the same manner described above.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Troubled Debt Restructurings
Doral has created a number of loan modification programs to help borrowers stay in their homes and operate their businesses which also optimizes borrower performance and returns to Doral. In these cases, the restructure or loan modification fits the definition of a TDR. The programs are designed to provide temporary financial relief and, if necessary, longer term financial relief to the consumer loan customer. Doral’s consumer loan loss mitigation program (including consumer loan products and residential mortgage loans), grants a concession for economic or legal reasons related to the borrowers’ financial difficulties Doral would not otherwise consider. Doral’s loss mitigation programs can provide for one or a combination of the following: movement of unpaid principal and interest to the end of the loan, extension of the loan term for up to ten years, deferral of principal payments for a period of time, and reduction of interest rates either permanently (feature discontinued in 2010) or for a period of up to two years. No programs adopted by Doral provide for the forgiveness of contractually due principal or interest. Deferred principal and uncollected interest are added to the end of the loan term at the time of the restructuring and uncollected interest is not recognized as income until collected or when the loan is paid off or at the end of the loan term. Doral wants to make these programs available only to those borrowers who have defaulted, or are likely to default, permanently on their loan and would lose their homes in foreclosure action absent some lender concession. However, Doral will move borrowers and properties to foreclosure if the Company is not reasonably assured that the borrower will be able to repay all contractual principal or interest (which is not forgiven in part or whole in any current or contemplated program).
In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, on a monthly basis, the Company pools TDRs with similar characteristics and performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of loans, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records an impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.
Regarding the commercial loan loss mitigation programs (including commercial real estate, commercial, land and construction loan portfolios), the determination is made on a loan by loan basis at the time of restructuring as to whether a concession was made for economic or legal reasons related to the borrower’s financial difficulty that Doral would not otherwise consider. Concessions made for commercial loans could include reductions in interest rates, extensions of maturity, waiving of borrower covenants, or other contract changes that would be considered a concession. Doral mitigates loan defaults for its commercial loan portfolios loans through its Collections function. The function’s objective is to minimize losses upon default of larger credit relationships. The group uses relationship officers, collection specialists, attorneys and third party service providers to supplement its internal resources. In the case of residential construction projects, the workout function monitors project specifics, such as project management and marketing.
Residential or other consumer or commercial loan modifications can result in returning a loan to accrual status when the criteria for returning a loan to performing status are met. Loan modifications also increase Doral’s interest income by returning a non-performing loan to performing status and cash flows by providing for payments to be made by the borrower, and decreases foreclosure and real estate owned (“REO”) costs by decreasing the number of foreclosed properties. Loan modifications completed on loans less than 90 days past due may reduce interest income due to the reversal of previous past due interest and reducing the interest earned on the loans. Doral continues to consider a modified loan as a non-performing asset for purposes of estimating its allowance for loan and lease losses until the borrower has made at least six consecutive contractual payments. At such time the loan will be treated as any other performing loan for purposes of estimating the allowance for loan and lease losses.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Servicing Assets and Servicing Activities
The Company pools FHA-insured and VA-guaranteed mortgages for issuance of GNMA MBS. Conforming loans are pooled and issued as FNMA or FHLMC MBS as well as sold in bulk to investors with servicing retained.
Mortgage servicing rights (“MSRs” or “servicing assets”) retained in a sale or securitization arise from contractual agreements between the Company and investors in mortgage securities and mortgage loans. The value of MSRs is derived from the net positive cash flows associated with the servicing contracts. Under these contracts, the Company performs loan servicing functions in exchange for fees and other remuneration. The servicing function typically includes: collecting and remitting loan payments, responding to borrower inquiries, accounting for principal and interest, holding custodial funds for payment of property taxes and insurance premiums, supervising foreclosures and property dispositions, and generally administering the loans. The servicing rights entitle the Company to annual servicing fees based on the outstanding principal balance of the mortgage loans and the contractual servicing rate. The annual servicing fees generally fluctuate between 25 and 50 basis points. The servicing fees are credited to income on a monthly basis when collected. In addition, the Company generally receives other remuneration consisting of mortgagor-contracted fees such as late charges and prepayment penalties, which are credited to income when collected.
Considerable judgment is required to determine the fair value of the Company’s servicing assets. Unlike the market value of highly liquid investments, the market value of servicing assets cannot be readily determined because these assets are not actively traded in securities markets. The initial carrying value of the servicing assets is generally determined based on an allocation of the carrying amount of the loans sold (adjusted for deferred fees and costs related to loan origination activities) and the retained interest (MSRs) based on their relative fair value.
The fair value of the Company’s MSRs is determined based on a combination of market information, benchmarking of servicing assets (valuation surveys) and cash flow modeling. The valuation of the Company’s MSRs incorporates two sets of assumptions: (i) market derived assumptions for discount rates, servicing costs, escrow earnings rate, float earnings rate and cost of funds and (ii) market derived assumptions adjusted for the Company’s loan characteristics and portfolio behavior for escrow balances, delinquencies and foreclosures, late fees, prepayments and prepayment penalties.
Under many of its servicing contracts, Doral must advance all or part of the scheduled payments to the owner of an outstanding mortgage loan, even when mortgage loan payments are delinquent. In addition, in order to protect their liens on mortgaged properties, owners of mortgage loans usually require that Doral, as servicer, pay mortgage and hazard insurance and tax payments on schedule even if sufficient escrow funds are not available. Doral generally recovers its advances from the mortgage owner or from liquidation proceeds when the mortgage loan is foreclosed. However, in the interim, Doral must absorb the cost of the funds it advances during the time the advance is outstanding. Doral must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a default is not cured, the mortgage loan will be canceled as part of the foreclosure proceedings and Doral will not receive any future servicing income with respect to that loan.
In the ordinary course of business, Doral makes certain representations and warranties to purchasers and insurers of mortgage loans at the time of the loan sales to third parties regarding the characteristics of the loans sold. To the extent the loans do not meet specified characteristics, if there is a breach of contract of a representation or warranty, or if there is an early payment default, Doral may be required to repurchase the mortgage loan and bear any subsequent loss related to the loan. Doral does not have a reserve on its financial statements for possible losses related to repurchases resulting from representation and warranty violations because it does not expect any such losses to be material.
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DORAL FINANCIAL CORPORATION - (Continued)
In the past, the Company sold mortgage loans and MBS subject to recourse provisions. Pursuant to these recourse arrangements, the Company agreed to retain or share the credit risk with the purchaser of such mortgage loans for a specified period or up to a certain percentage of the total amount in loans sold. The Company estimates the fair value of the retained recourse obligation or any liability incurred at the time of sale and includes such obligation with the net proceeds from the sale, resulting in a lower gain on sale recognition. Doral estimates the fair value of its recourse obligation based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment.
Interest-Only Strips
IOs represent the estimated present value of the estimate future cash flows retained by the Company as part of its past sale and securitization activities. The Company no longer engages in this activity and classifies its existing IOs as trading securities. In order to determine the value of its IOs, the Company uses a valuation model that calculates the present value of estimated cash flows. The model incorporates the Company’s own estimates of assumptions market participants use in determining the fair value, including estimates of prepayment speeds, discount rates, defaults and contractual fee income. Changes in fair value of IOs held in the trading portfolio are recorded in earnings as incurred.
Real Estate Held for Sale
The Company acquires real estate through foreclosure proceedings. Legal fees and other direct costs incurred in a foreclosure are expensed as incurred. These properties are held for sale and are stated at the lower of cost or fair value (after deduction of estimated disposition costs). A charge to ALLL is recognized for any initial write down to fair value less costs to sell. Any losses in the carrying value arising from periodic appraisals of the properties after foreclosures are charged to expense in the period incurred. The cost of maintaining and operating such properties is expensed as incurred. Gains and losses not previously recognized that result from disposition of real estate held for sale are recorded in non-interest expense within the other expenses caption in the accompanying Consolidated Statements of Operations.
Premises and Equipment
Premises, equipment and leasehold improvements are carried at cost, less accumulated depreciation and amortization. Depreciation of premises and equipment is provided on a straight-line basis. Amortization of leasehold improvements is provided on a straight-line basis over the lesser of the estimated useful lives of the assets or the terms of the leases. The lease term is defined as the contractual term plus lease renewals that are considered to be “reasonably assured.” Useful lives range from three to ten years for leasehold improvements and equipment, and thirty to forty years for retail branches and office facilities.
The Company measures impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.
Rent expense under operating leases is recognized on a straight-line basis over the lease term taking into consideration contractual rent increases. The difference between rent expense and the amount actually paid during a period is charged to a “Deferred rent obligation” account, included in accrued expenses and other liabilities in the Consolidated Statements of Financial Condition.
Goodwill and Other Intangible Assets
Goodwill is recognized when the purchase price is higher than the fair value of net assets acquired in business combinations under the purchase method of accounting. Goodwill is not amortized, but is tested for impairment at least annually or more frequently if events or circumstances indicate possible impairment. In
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DORAL FINANCIAL CORPORATION - (Continued)
determining the fair value of a reporting unit the Company uses a discounted cash flow analysis. Goodwill impairment losses are recorded as part of operating expenses in the Consolidated Statement of Operations.
Impairment testing of goodwill follows a two-step process. The first step is used to identify potential impairment and requires comparison of the estimated fair value of the reporting unit with its carrying amount including goodwill. If the estimated fair value of the reporting unit exceeds its carrying value, goodwill is considered not to be impaired. If the carrying value exceeds the estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment.
If needed, the second step consists of calculating an implied fair value of goodwill. If the implied fair value of the reporting unit goodwill exceeds the carrying value of that goodwill, there is no impairment. If the carrying value of goodwill exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment is not permitted.
Finite lived intangibles are amortized over their estimated life, generally on a straight-line basis, and are reviewed periodically for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable.
Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities
The Company recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.
A transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which Doral surrenders control over those financial assets shall be accounted for as a sale if, and only if, all of the following conditions are met:
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The transferred financial assets have been isolated from Doral - put presumptively beyond the reach of Doral and its creditors, even in bankruptcy or other receivership.
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Each transferee has the right to pledge or exchange the assets it received, and no condition both constrains the transferee from taking advantage of its rights to pledge or exchange and provides more than a trivial benefit to Doral.
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Doral, its consolidated affiliates included in these financial statements, or its agents do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets. Examples of Doral’s effective control over the transferred financial assets include, but are not limited to (i) an agreement that both entitles and obligates Doral to repurchase or redeem them before their maturity, (ii) an agreement that provides Doral with both the unilateral ability to cause the holder to return specific financial assets and a more-than-trivial benefit attributable to that ability, other than through a cleanup call, or (iii) an agreement that permits the transferee to require Doral to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require Doral to repurchase them.
If a transfer of financial assets in exchange for cash or other consideration (other than beneficial interests in the transferred assets) does not meet the criteria for a sale as described above, Doral accounts for the transfer as a secured borrowing with pledge of collateral.
GNMA programs allow financial institutions to buy back individual delinquent mortgage loans that meet certain criteria from the securitized loan pool for which the Company provides servicing. At the Company’s option and without GNMA prior authorization, Doral may repurchase such delinquent loans for an amount equal to 100% of the loan’s remaining principal balance. This buy-back option is considered a conditional option until the delinquency criteria is met, at which time the option becomes unconditional. When the loans
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DORAL FINANCIAL CORPORATION - (Continued)
backing a GNMA security are initially securitized, the Company treats the transaction as a sale for accounting purposes because the conditional nature of the buy-back option means that the Company does not maintain effective control over the loans and therefore these are derecognized from the balance sheet. When individual loans later meet GNMA’s specified delinquency criteria and are eligible for repurchase, Doral is deemed to have regained effective control over these loans and they must be brought back onto the Company’s books as assets at fair value, regardless of whether the Company intends to exercise the buy-back option. An offsetting liability is also recorded in “Accrued Expenses and Other Liabilities.”
Securities Sold under Agreements to Repurchase
As part of its financing activities the Company enters into sales of securities under agreements to repurchase the same or substantially similar securities. The Company retains control over such securities. Accordingly, the amounts received under these agreements represent borrowings, and the securities underlying the agreements remain in the asset accounts. These transactions are carried at the amounts at which transactions will be settled. The counterparties to the contracts generally have the right to repledge the securities received as collateral. Those securities are presented in the Consolidated Statements of Financial Condition as part of pledged investment securities and its interest is accounted for on an accrual basis in the Consolidated Statement of Operations.
Insurance Agency Commissions
Commissions generated by the Company’s insurance agency operation are recorded when earned. The Company’s insurance agency earns commissions when the insurance policies are issued by unaffiliated insurance companies. An allowance is created for expected adjustments to commissions earned relating to policy cancellations.
Derivatives and Interest Rate Risk Management
Doral Financial uses derivatives to manage its exposure to interest rate risk caused by changes in interest rates, to changes in fair value of assets and liabilities and to secure future cash flows. Derivatives are generally either privately negotiated over-the-counter (“OTC”) contracts or standard contracts transacted through regulated exchanges. OTC contracts generally consist of swaps, caps and collars, forwards and options. Exchange-traded derivatives include futures and options.
All derivatives are recognized as either assets or liabilities on the balance sheet and are measured at fair value through adjustments to accumulated other comprehensive income (loss) and/or current earnings, as appropriate. On the date the Company enters into a derivative contract, it designates the derivative instrument as either a fair value hedge, cash flow hedge or as a free-standing derivative instrument. In the case of a qualifying fair value hedge, changes in the value of the derivative instruments that have been highly effective are recognized in current period earnings along with the change in value of the designated hedged item. If the hedge relationship is terminated, hedge accounting is discontinued and changes in the value of the derivative instrument continue to be recognized in current period earnings, the hedged item is no longer adjusted for fair value changes, and the fair value adjustment to the hedged item, while it was designated as a hedge, continues to be reported as part of the basis of the item and is amortized to earnings as a yield adjustment. In the case of a qualifying cash flow hedge, changes in the value of the derivative instruments that have been highly effective are recognized in other comprehensive income, until such a time as those earnings are affected by the variability of the cash flows of the underlying hedged item. If the hedge relationship is terminated, the net derivative gain or loss related to the discontinued cash flow hedge should continue to be reported in accumulated other comprehensive income (loss) and will be reclassified into earnings when the cash flows that were hedged occur, or when the forecasted transaction affects earnings or if it is no longer expected to occur. After a cash flow hedge is discontinued, future changes in the fair value of the derivative instrument are recognized in current period earnings. In either a fair value hedge or a cash flow hedge, net earnings may be
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DORAL FINANCIAL CORPORATION - (Continued)
impacted to the extent the changes in the value of the derivative instruments do not perfectly offset changes in the value of the hedged items. For freestanding derivative instruments, changes in fair values are reported in current period income.
Prior to entering a hedge transaction, the Company formally documents the relationship between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivative instruments that are designated as fair value or cash flow hedges to specific assets and liabilities on the statement of condition or to specific forecasted transactions or firm commitments along with a formal assessment, at both inception of the hedge and on an ongoing basis, as to the effectiveness of the derivative instrument in offsetting changes in fair values or cash flows of the hedged item. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued and the adjustment to fair value of the derivative instrument is recorded in current period earnings.
Fair Value Measurements
The Company measures the fair values of its financial instruments in accordance with accounting guidance that requires an entity to base fair value on exit price and to maximize the use of observable inputs and minimize the use of unobservable inputs to determine the exit price. The Company categorizes its financial instruments, based on the priority of inputs to the valuation technique, into a three level hierarchy described below. Securities held for trading, securities available for sale, derivatives and servicing assets are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record other financial assets at fair value on a nonrecurring basis, such as loans held for sale, loans receivable and certain other assets. These adjustments to fair value usually result from applications of lower-of-cost-or-market accounting or write-downs of individual assets. These nonrecurring fair value adjustments typically involve application of the lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the three level hierarchy:
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Level 1 - Valuation is based upon unadjusted quoted prices for identical instruments traded in active markets.
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Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market, or are derived principally from or corroborated by observable market data, by correlation or by other means.
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Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Please refer to Note 38 for additional information.
Income Taxes
Doral Financial recognizes deferred tax assets and liabilities based upon the expected future tax consequences of existing temporary differences between the carrying amounts and the tax bases of assets and liabilities based on applicable tax laws. To the extent tax laws change, deferred tax assets and liabilities are adjusted, when necessary, in the period that the tax change is enacted and recognizes income tax benefits when the realization of such benefits is probable. A valuation allowance is recognized for any deferred tax asset for which, based on management’s evaluation, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded
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DORAL FINANCIAL CORPORATION - (Continued)
against deferred tax assets. In determining the realizability of deferred tax assets the Company considers, among others matters, all sources of taxable income including the future reversal of existing temporary differences, future taxable income, carryforwards and tax planning strategies. In the determination of the realizability of the deferred tax asset, the Company evaluates both positive and negative evidence regarding the ability of the Company to generate sufficient taxable income. In making its assessment, significant weight is given to evidence that can be objectively verified.
Income tax benefit or expense includes: (i) deferred tax expense or benefit, which represents the net change in the deferred tax liability or asset during the year plus any change in the valuation allowance, if any, and (ii) current tax expense. Income tax expense excludes the tax effects related to adjustments recorded to accumulated other comprehensive income (loss).
Legal Surplus
The Banking Act of the Commonwealth of Puerto Rico requires that a minimum of 10% of Doral Bank PR’s net income for the year be transferred to a legal surplus account until such surplus equals its paid-in capital. The surplus account is not available for payment of dividends.
Statements of Cash Flows
Cash and cash equivalents include cash and due from banks and other interest-earning assets. The statement of cash flows excludes restricted cash accounted for as other interest-earning assets.
Earnings (Losses) per Share
Basic net income (loss) per share is determined by dividing net income, after deducting any dividends declared on preferred stock (whether paid or not) or any inducement charges on preferred stock conversions, by the weighted-average number of common shares outstanding during the period.
Diluted net income (loss) per share is computed based on the assumption that all of the shares of convertible instruments will be converted into common stock, if dilutive, and considers the dilutive effect of stock options using the Treasury stock method.
During 2010 and 2009, the Company made offers to holders of convertible and non-convertible preferred stock to exchange their preferred shares for the Company’s common stock. The accounting treatment for exchanges of convertible and non-convertible preferred stock is different. The exchange to holders of shares of non-convertible preferred stock resulted in the extinguishment and retirement of such shares of non-convertible preferred stock and the issuance of common stock. The carrying (liquidation) value of each share of non-convertible preferred stock retired is reduced and common stock and additional paid-in-capital increased in the amount of the fair value of the common stock and other consideration issued. Upon the cancellation of such shares of non-convertible preferred stock acquired by the Company, the difference between the carrying (liquidation) value of shares of non-convertible preferred stock retired and the fair value of the exchange offer consideration exchanged is treated as an increase or decrease to retained earnings and income available to common shareholders, for earnings per share purposes.
The exchange to holders of convertible preferred stock is accounted for as an induced conversion (except for the Mandatorily Convertible Preferred Stock). Common stock and additional paid-in-capital is increased by the carrying (liquidation) value of the amount of convertible preferred stock exchanged. The fair value of common stock and other consideration issued in excess of the fair value of securities issuable pursuant to the original exchange terms is treated as a reduction to retained earnings and net income available to common shareholders for earnings per share purposes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Stock Based Compensation
The Company has a Stock Incentive Plan that was approved in 2008. Stock options and restricted stock units granted under the plan are expensed over the vesting period based on fair value at the date the awards are granted. In accordance with applicable accounting guidance for stock based compensation, compensation cost recognized includes the cost for all share-based awards based on the fair value of awards at the date granted.
Comprehensive Income (Loss)
Comprehensive income (loss) includes net income and other transactions, except those with stockholders, which are recorded directly in equity. In the Company’s case, in addition to net income, other comprehensive income (loss) results from the changes in the unrealized gains and losses on securities that are classified as available for sale and unrealized gains and losses classified as cash flow hedges.
Segment Information
The Company reports financial and descriptive information about its reportable segments. Please refer to Note 41 for additional information. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by management and is used by the Company’s executive management team to decide how to allocate resources and assess performance.
The Company’s segment information is organized by legal entity and aggregated by line of business consistent with the Company’s business model. Legal entities that do not meet the threshold for separate disclosure are aggregated with other legal entities with similar lines of business. Doral’s management made this determination based on operating decisions particular to each line of business.
Reclassifications
Certain amounts reflected in the 2009 and 2008 Consolidated Financial Statements have been reclassified to conform to the presentation for 2010.
3.
Recent Accounting Pronouncements
Accounting Standards Update (“ASU”) No. 2011-01 Receivables (Topic 310): Deferral of the Effective date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. In January 2011, FASB issued ASU No. 2011-01 to defer the effective date of the disclosure requirements for public entities about troubled debt restructurings in Accounting Standards Update No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, to be concurrent with the effective date of the guidance for determining what constitutes a troubled debt restructuring, as presented in proposed Accounting Standards Update, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors.
The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011. The deferral in this amendment is effective upon issuance. Management valuation discloses the information subject to the topic and, therefore, does not expect any effect on the financial statements as a result of this update.
Accounting Standards Update No. 2010-29 Business Combinations (Topic 805): Disclosures of Supplementary Pro Forma Information for Business Combinations (a consensus of the FASB Emerging Issues Task Force). In December 2010, FASB issued ASU No. 2010-29 to address diversity in practice about the interpretation of the pro forma revenue and earnings disclosure requirements for business combinations. The amendments in this update clarify the acquisition date that should be used for reporting the pro forma financial information disclosures in
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DORAL FINANCIAL CORPORATION - (Continued)
Topic 805 when comparative financial statements are presented. The amendments also improve the usefulness of the pro-forma revenue and earnings disclosures by requiring a description of the nature and amount of material, nonrecurring pro forma adjustments that are directly attributable to the business combination(s).
The amendments in this Update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. Management does not expect any effect on the financial statements as a result of this update.
Accounting Standards Update No. 2010-28 Intangibles-Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of the FASB Emerging Issues Task Force). In December 2010, FASB issued ASU No. 2010-28 to address questions about entities with reporting units with zero or negative carrying amounts because some entities concluded that Step 1 of the test is passed in those circumstances because the fair value of their reporting unit will generally be greater than zero. As a result of that conclusion, some constituents raised concerns that Step 2 of the test is not performed despite factors indicating that goodwill may be impaired. The amendments in this Update modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples in paragraph 350-20-35-30, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
For public entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. Upon adoption of the amendments, an entity with reporting units that have carrying amounts that are zero or negative is required to assess whether it is more likely than not that the reporting units’ goodwill is impaired. If the entity determines that it is more likely than not that the goodwill of one or more of its reporting units is impaired, the entity should perform Step 2 of the goodwill impairment test for those reporting unit(s). Any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings in the period of adoption. Any goodwill impairments occurring after the initial adoption of the amendments should be included in earnings as required by Section 350-20-35. Management does not expect any effect on the financial statements as a result of this update.
Changes in Accounting Standards Adopted in the Financial Statements
Accounting Standards Update No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (“ASU No. 2010-20”). This ASU requires new disclosures and clarifies existing disclosure requirements about an entity’s allowance for credit losses and credit quality of its financing receivables. The FASB’s objective is to improve these disclosures and, thus, increase the transparency in financial reporting, as well as clarify the requirements of existing disclosures. ASU 2010-20 is effective the first fiscal quarter ending after December 15, 2010, except for certain disclosure requirements about activity that occurs during a reporting period which are effective the first fiscal quarter beginning after December 15, 2010. This ASU was adopted by the Company and is reflected in the enhanced disclosures in the financial statements.
Accounting Standards Update No. 2010-18 Receivables (Topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset, a consensus of the FASB Emerging Issues Task Force (“ASU No. 2010-18”). In April 2010, FASB issued ASU No. 2010-18 to address diversity in practice on whether a loan that is part of a pool of loans accounted for as a single asset (Subtopic 310-30,
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality) should be removed from that pool upon a modification that would constitute a troubled debt restructuring. As a result of the amendments in this ASU, modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. The amendments in this Update are effective for modifications of loans accounted for within pools under Subtopic 310-30 occurring in the first interim or annual period ending on or after July 15, 2010. The amendments are to be applied prospectively. Early application is permitted. This ASU was adopted by the Company with no significant impact on the financial statements.
Accounting Standard Update No. 2010-11 Derivatives and Hedging (Topic 815): Scope Exception Related to Embedded Credit Derivatives (“ASU No. 2010-11”). In March 2010, the FASB Issued ASU No. 2010-11, to clarify the practice of the embedded credit derivative scope exception in Topic 815 Derivatives and Hedging. The amendment in this ASU addresses how to determine which embedded credit derivative features, including those in collateralized debt obligations and synthetic collateralized debt obligations are considered to be embedded derivatives that should not be analyzed under Topic 815 for potential bifurcation and separate accounting.
The amendment in this ASU is effective for each reporting entity at the beginning of its first fiscal quarter beginning after June 15, 2010. The adoption of this guidance effective with the interim reporting period ending September 30, 2010 did not have a material effect on the Company’s Financial Statements.
Accounting Standard Update No. 2010-09 Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU No. 2010-09”). In February 2010, the FASB issued ASU No. 2010-09, an amendment to Topic 855 Subsequent Events, to address potentially conflicting interactions of the requirements in this Topic with the SEC’s reporting requirements. This update amends Topic 855 as follows: (i) an entity that either is an SEC filer or a conduit bond obligor is required to evaluate subsequent events through the date that the financial statements are issued; if the entity does not meet either of these criteria then it should evaluate subsequent events through the date the financial statements are available to be issued; (ii) an SEC filer is not required to disclose the date through which subsequent events have been evaluated. All amendments in this ASU are effective upon issuance of this ASU, except for the use of the issued date for conduit debt obligors which effective date is for interim and annual periods ending after June 15, 2010. This ASU was adopted by the Company with no significant impact on the financial statements.
Accounting Standard Update No. 2010-06- Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU No. 210-06”). In January 2010 FASB issued ASU No. 2010-06, an amendment to Subtopic 820-10 Fair Value Measurements and Disclosures-Overall, to improve required disclosures and increase transparency in financial reporting. This ASU requires new disclosures in: (i) transfers in and transfers out of Levels 1 and 2; and (ii) activity (purchases, sales, issuances and settlements) in Level 3 fair value measurements. It also provides amendments to existing disclosures related to: (i) level of disaggregation, (ii) disclosures about inputs and valuation techniques, and iii) amendments to the guidance on employers’ disclosures about postretirement benefit plan assets.
The new disclosures and clarifications to existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of the activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. This ASU was adopted by the Company effective January 1, 2010, with no significant impact on the financial statements. Management does not expect prospective disclosures to have a material effect on the financial statements as a result of this update.
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Accounting Standard Codification (“ASC”) 860, Transfer and Servicing - In June 2009, the FASB issued ASC 860 to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets. ASC 860 became effective as of January 1, 2010. Earlier application was prohibited. ASC 860 was evaluated and adopted by the Company, and such adoption did not have a significant impact on the financial statements.
ASC 810, Consolidation - In June 2009, the FASB issued ASC 810, to amend certain requirements of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. This Statement carries forward the scope of ASC 810, with the addition of entities previously considered qualifying special-purpose entities, as the concept of these entities was eliminated in ASC 860, Transfers and Servicing.
This Statement became effective as of January 1, 2010. Earlier application was prohibited. Management adopted the accounting and disclosure requirements for reporting period beginning January 1, 2010. Please refer to Note 40 for additional information.
4.
Cash and due from banks
At December 31, 2010 and 2009, the Company’s cash amounted to $355.8 million and $725.3 million, respectively, which includes non-interest bearing balance deposits with other banks amounting to $10.4 million and $2.4 million, respectively.
As of December 31, 2010 and 2009, the Company’s cash balances included interest bearing balances with the Federal Reserve of $218.9 million and $658.8 million, respectively, and with the Federal Home Loan Bank of $92.0 million and $26.9 million, respectively.
The Company’s bank subsidiaries are required by federal and state regulatory agencies to maintain average reserve balances with the Federal Reserve Bank or other banks. Those required average reserve balances were $115.9 million and $153.8 million as of December 31, 2010 and 2009, respectively.
As of December 31, 2010 and 2009, restricted cash and due from banks amounted to $2.6 million and $0.3 million, respectively.
5.
Other Interest-Earning Assets
At December 31, 2010 and 2009, the Company’s other interest-earning assets totaled $156.6 million and $95.0 million, respectively. Other interest-earning assets includes short-term investments, securities purchased under agreements to resell, cash pledged with counterparties to back the Company’s securities sold under agreements to repurchase and/or derivatives positions, among others.
As of December 31, 2010 and 2009, $126.6 million and $95.0 million was included as restricted other interest-earning assets.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
6.
Securities Held for Trading
The following table summarizes the fair value of Doral Financial’s securities held for trading as of December 31, 2010 and 2009.
(1)
Doral Financial uses derivatives to manage its exposure to interest rate risk caused by changes in interest rates. Derivatives include interest rate caps and forward contracts. Doral Financial’s general policy is to account for derivatives on a mark-to-market basis with gains or losses charged to operations as they occur. Derivatives not accounted for as hedges in a net asset position are recorded as securities held for trading, and derivatives in a net liability position are reported as liabilities. The gross notional amount of derivatives recorded as held for trading totaled $310.0 million as of December 31, 2010 and $480.0 million as of 2009. Notional amounts indicate the volume of derivatives activity, but do not represent Doral Financial’s exposure to market or credit risk.
The weighted-average yield is computed based on amortized cost and, therefore, does not give effect to changes in fair value. As of December 31, 2010 and 2009 weighted-average yield, including IOs, was 13.38% and 12.02%, respectively.
The components of net gain (loss) on trading activities are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
7.
Securities Available for Sale
The following tables summarize the amortized cost, gross unrealized gains and losses, approximate fair value, weighted-average yield and contractual maturities of securities available for sale as of December 31, 2010 and 2009.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The weighted-average yield is computed based on amortized cost and, therefore, does not give effect to changes in fair value.
Expected maturities of MBS and certain debt securities might differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of securities available for sale during 2010 were approximately $2.3 billion (2009 - $2.0 billion and 2008 - $234.3 million). For 2010, gross gains of $43.0 million and gross losses of $136.7 million were realized on those sales, in addition to losses of $14.0 million related to the recognition of OTTI on securities from this portfolio. For 2009 and 2008, gross gains of $35.4 million and $0.2 million, respectively, were realized on sales. For 2009, the Company realized gross losses of $0.5 million on sales, in addition to losses of $27.6 million related to the recognition of OTTI on securities from this portfolio. For 2008, the Company recognized gross losses of $0.9 million related to the recognition of OTTI on securities from this portfolio, and a gross gain of $2.1 million and a gross loss of $6.3 million were recognized related to the Lehman transaction. For 2008, the Company did not realize gross losses on sales of securities. Refer to Note 13 for additional information related to the Lehman Transaction.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
8.
Investments in an Unrealized Loss Position
The following tables show Doral Financial’s gross unrealized losses and fair value for available for sale investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2010 and 2009:
The securities held by the Company are principally MBS or securities backed by a U.S. government sponsored entity and therefore, principal and interest on the securities are considered recoverable. During 2010 and 2009, Doral Financial’s investment portfolio consisted primarily of AAA rated debt securities, except for the Non-Agency Collateralized Mortgage Obligations (“CMO”), which are non-investment grade.
The Company performs an assessment of OTTI whenever the fair value of an investment security is less than its amortized cost basis at the balance sheet date. Amortized cost basis includes adjustments made to the cost of a security for accretion, amortization, collection of cash, previous OTTI recognized into earnings (less any cumulative effect adjustments) and fair value hedge accounting adjustments. OTTI is considered to have occurred under the following circumstances:
•
If the Company intends to sell the investment security and its fair value is less than its amortized cost.
•
If, based on available evidence, it is more likely than not that the Company will decide or be required to sell the investment security before the recovery of its amortized cost basis.
•
If the Company does not expect to recover the entire amortized cost basis of the investment security. This occurs when the present value of cash flows expected to be collected is less than the amortized cost basis of the security. In determining whether a credit loss exists, the Company uses its best estimate of the present value of cash flows expected to be collected from the investment security. Cash flows expected to be collected are estimated based on a careful assessment of all available information. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company evaluates its individual available for sale investment securities for OTTI on at least a quarterly basis. As part of this process, the Company considers its intent to sell each investment security and whether it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of these conditions is met, the Company recognizes an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities that meet neither of these conditions, an analysis is performed to determine if any of these securities are at risk for OTTI. To determine which securities are at risk for OTTI and should be quantitatively evaluated utilizing a detailed cash flow analysis, the Company evaluates certain indicators which consider various characteristics of each security including, but not limited to, the following: the credit rating and related outlook or status of the securities; the creditworthiness of the issuers of the securities; the value and type of underlying collateral; the duration and level of the unrealized loss; any credit enhancements; and other collateral-related characteristics such as the ratio of credit enhancements to expected credit losses. The relative importance of this information varies based on the facts and circumstances surrounding each security, as well as the economic environment at the time of assessment. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.
As a result of its review of the portfolio as of December 31, 2010, the Company performed a detailed cash flow analysis of certain securities in unrealized loss positions to assess whether they were OTTI. The Company uses a third party provider to generate cash flow forecasts of each security reviewed based on a combination of management and market driven assumptions and securitization terms, including remaining payment terms of the security, prepayment speeds, the estimated amount of loans to become seriously delinquent over the life of the security, the estimated life-time severity rate, estimated losses over the life of the security, loan characteristics, the level of subordination within the security structure, expected housing price changes and interest rate assumptions.
During 2010, it was determined that eight securities reflected OTTI. The characteristics of these securities that led to the OTTI conclusion included: (i) the cumulative level and estimated future delinquency levels; (ii) the effect of severely delinquent loans on forecasted defaults; (iii) the cumulative severity and expected severity in resolving the defaulted loans; and (iv) the current subordination of the securities that resulted in the present value of the forecast cash flows being less than the cost basis of the security. Management estimated that credit losses of $14.0 million were incurred during the year on these securities for the year ended December 31, 2010.
Five of the eight OTTI securities were subordinated interests in a securitization structure collateralized by option adjustable rate mortgage (“ARM”) loans and resulted in the recognition of an OTTI loss of $13.3 million in the first quarter of 2010. On April 23, 2010, the Company sold the entire portfolio of U.S. non-agency CMOs, including the five securities that were OTTI, and recognized a loss of $136.7 million, of which $129.7 million had previously been reflected in other comprehensive income (loss).
Non-Agency CMOs include subordinated tranches of 2006 securitizations of Doral originated mortgage loans primarily composed of 2003 and 2004 vintages. Doral purchased these CMOs at a discounted price of 61% of par value, anticipating a partial loss of contractual principal and interest value. These original three securities have an amortized cost of $11.1 million as of December 31, 2010 including an OTTI loss of $0.7 million due to credit. Higher default and loss assumptions driven by higher delinquencies in Puerto Rico, primarily due to the impact of inflationary pressures on the consumer, the high rate of unemployment and general recessionary condition on the Island, has resulted in higher default and loss estimates on the P.R. Non-Agency CMOs. The higher default and loss estimates have resulted in lower bond prices and higher levels of unrealized losses on the bonds. It is possible that future loss assumptions could change and cause future OTTI charges in these securities.
As of December 31, 2010 and 2009, the Company did not intend to sell the remaining securities which were evaluated for OTTI and concluded it was not more likely than not that it would be required to sell these
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
securities before the anticipated recovery of each security’s remaining amortized cost basis. Therefore, the difference between the amortized cost basis and the market value of the securities is recorded in accumulated other comprehensive income (loss).
For the remainder of the Company’s securities portfolio that have experienced decreases in the fair value, the decline is considered to be temporary as the Company expects to recover the entire amortized cost basis on the securities and neither intends to sell these securities nor is it more likely than not that it will be required to sell these securities.
In subsequent periods the Company will account for the securities judged to be OTTI as if the securities had been purchased at the previous amortized cost less the credit related OTTI. Once a credit loss is recognized, the investment will be adjusted to a new amortized cost basis equal to the previous amortized cost basis less the amount recognized in earnings. For the investment securities for which OTTI was recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted as interest income.
The following table presents the securities for which an OTTI was recognized based on the Company’s impairment analysis of its investment portfolio at December 31, 2010 and 2009:
(1)
OTTI related to non-credit loss was recognized during the first quarter of 2010. These securities were subsequently sold and the loss was recognized in non-interest loss.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following table presents activity related to the credit losses recognized in earnings on debt securities held by the Company for which a portion of OTTI remains in accumulated other comprehensive income (loss):
The Company will continue to monitor and analyze the performance of its securities to assess the collectability of principal and interest as of each balance sheet date. As conditions in the housing and mortgage markets continue to change over time, the amount of projected credit losses could also change. Valuation and OTTI determinations will continue to be affected by external market factors including default rates, severity rates, and macro-economic factors in the United States and Puerto Rico. Doral Financial’s future results may be affected by worsening defaults and severity rates related to the underlying collateral.
9.
Pledged Assets
At December 31, 2010 and 2009, certain securities and loans, as well as cash and other interest-earning assets, were pledged to secure public and trust deposits, assets sold under agreements to repurchase, other borrowings and credit facilities available.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
10.
Loans Held for Sale and Loans Receivable
Loans held for sale consist of the following:
(1)
At both, December 31, 2010 and 2009, the loans held for sale portfolio includes $0.1 million related to U.S. subsidiaries’ loans.
(2)
At both, December 31, 2010 and 2009, the loans held for sale portfolio includes $1.1 million of interest-only loans.
(3)
Includes $21.4 million and $28.6 million of balloon loans, as of December 31, 2010 and 2009, respectively.
At December 31, 2010 and 2009, the loans held for sale portfolio includes $153.4 million and $128.6 million, respectively, of defaulted loans collateralizing Ginnie Mae (“GNMA”) securities for which the Company has an unconditional option (but not an obligation) to repurchase the defaulted loans. Payment of principal and a portion of the interest on these loans is guaranteed by the Federal Housing Administration (“FHA”).
As of December 31, 2010 and 2009, the Company had a net deferred origination fee on loans held for sale amounting to approximately $0.7 million and $84,000, respectively.
Non-performing loans held for sale totaled $2.7 million and $5.6 million as of December 31, 2010 and 2009, respectively, excluding FHA/VA guaranteed loans and GNMA defaulted loans.
Doral’s exposure to credit risk associated with its lending activities is measured on a customer basis as well as by groups of customers that share similar attributes. In the normal course of business, the Company has a concentration of loan credit risk in Puerto Rico and the mainland U.S., with the preponderance of its loans receivable credit exposure in Puerto Rico.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The table below presents the Company’s loans receivable by product and geographic location:
(1)
Includes $565.9 million and $604.6 million of balloon loans, as of December 31, 2010 and 2009, respectively.
(2)
Includes $442.6 million and $388.2 million of interest-only loans, as of December 31, 2010 and 2009, respectively.
Fixed-rate loans and adjustable-rate loans were approximately $4.7 billion and $0.9 billion at December 31, 2010, and $4.8 billion and $0.7 billion, at December 31, 2009, respectively.
The adjustable rate loans, consisting of construction, land and commercial loans have interest rate adjustment limitations and are generally tied to interest rate market indices (primarily Prime Rate and 3-month London Interbank Offered Rate (“LIBOR”)). Future market factors may affect the correlation of the interest rate adjustment with the rate the Company pays on the short-term deposits that have primarily funded these loans.
Loan origination fees, as well as discount points and certain direct origination costs for loans held for sale, are initially recorded as an adjustment to the cost basis of the loan and reflected in Doral Financial’s earnings as part of the net gain on mortgage loan sales and fees when the loan is sold or securitized into a MBS. In the case of loans held for investment, such fees and costs are deferred and amortized to income as adjustments to the yield of the loan. As of December 31, 2010 and 2009, the Company had a net deferred origination fee on loans held for investment amounting to approximately $24.0 million and $22.4 million, respectively.
The Company has not traditionally made variable interest rate residential mortgage loans, option adjustable rate mortgages, or many of the higher risk mortgage loans made by a number of U.S. mainland banks. However, as part of its loss mitigation programs, the Company has granted certain concessions to borrowers in financial difficulties that have proven payment capacity which may include interest only periods or temporary interest rate reductions. Loans with temporarily reduced principal and interest payments may be subject to significant increases in loan payments as the temporary payment periods end which may lead to
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DORAL FINANCIAL CORPORATION - (Continued)
higher level of re-defaults. Doral works with the borrowers to establish terms and conditions (at the payment reset date) in order to optimize the Company’s interests.
Non-accrual and Past Due Loans and Leases
Doral recognizes interest income on loans receivable on an accrual basis unless it is determined that collection of all contractual principal or interest is unlikely. Doral discontinues recognition of interest income, when a loan receivable is delinquent on principal or interest for more than 90 days, except for revolving lines of credit and credit cards (non-accrual at 180 days), mortgage loans insured by FHA/VA (non-accrual at 270 days), and certain loans determined to be well collateralized so that ultimate collection of principal and interest is not in question (for example, when the outstanding loan and interest balance as a percentage of current collateral value is less than 60%). When a loan is placed on non-accrual, all accrued but unpaid interest is reversed against interest income in that period. Loans return to accrual status when principal and interest become current under the terms of the loan agreement or when the loan is both well-secured and in the process of collection and collectability is no longer doubtful. In the case of loans under troubled debt restructuring agreements, the Company continues to place them in non-accrual status and reports them as non-performing loans unless the Company expects to collect all contractual principal and interest and the loans have proven repayment capacity for a sufficient amount of time the loans are returned to accrual status. Previously reversed or not accrued interest will be credited to income in the period of recovery. Interest income is recognized when a payment is received on a non-accrual loan if ultimate collection of principal is not in doubt.
For consumer loans (primarily residential real estate), all of Doral’s loss mitigation tools require that the borrower demonstrate the intent and ability to pay all principal and interest on the loan. Doral must receive at least three consecutive monthly payments prior to qualifying the borrower for a loss mitigation product. Doral’s loan underwriters must be reasonably assured of the borrower’s future repayment and performance from their review of the borrower’s circumstances, and when all the conditions are met, the customer is approved for a loss mitigation product and placed on a probation period. When the loan is returned to accrual status, on a monthly basis Doral reviews the loan to ensure that payments are made during the probationary period. If a payment is not made during this probationary period the loan is immediately returned to non-accrual status. Also, if a payment is missed during the probationary period, the loan reverts to its original terms, and collections/foreclosure procedures begin from the point at which they stood prior to the restructure. Consumer loans not delinquent 90 days or more that are eligible for loss mitigation products are subject to the same requirements as the delinquent consumer loans, except that the requirement of making three consecutive payments prior to the restructure is waived.
For commercial loan loss mitigation (which includes commercial real estate, commercial and industrial and construction and land loans), the loans are underwritten by the Collections function, the intent and ability of the borrower to service the debt under the revised terms is studied, and if approved for the troubled debt restructuring, the customer is placed on a six month probationary period during which the customer is required to make six consecutive payments before the loan is returned to accrual status.
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DORAL FINANCIAL CORPORATION - (Continued)
Loans receivable on which accrual of interest income had been discontinued as of December 31, 2010 and 2009 were as follows:
(1)
Includes personal, revolving lines of credit and other consumer loans.
(2)
Excludes $2.7 million and $5.6 million in loans held for sale on which accrual of interest had been discontinued as of December 31, 2010 and 2009, respectively.
(3)
Excludes $121.3 million and $10.3 million of non-performing FHA/VA guaranteed loans that due to the nature of their guarantees, present little risk to the Company as of December 31, 2010 and 2009, respectively.
Doral’s aging of past due loan receivables as of December 31, 2010 and 2009 were as follows:
As of December 31, 2010
(1)
In accordance with regulatory guidance, Doral defines 30 days past due as when the borrower is delinquent two payments. Doral defines 90 days past due based upon the actual number of days past due.
(2)
As of December 31, 2010 excludes $128.5 million of total past due FHA/VA guaranteed loans, respectively, that due to the nature of their guarantees, present little credit risk to the Company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
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As of December 31, 2009
(1)
In accordance with regulatory guidance, Doral defines 30 days past due as when the borrower is delinquent two payments. Doral defines 90 days past due based upon the actual number of days past due.
(2)
As of December 31, 2009 excludes $17.3 million of total past due FHA/VA guaranteed loans, respectively, that due to the nature of their guarantees, present little credit risk to the Company.
The Company would have recognized additional interest income had all delinquent loans been accounted for on an accrual basis as follows:
(1)
Excludes $7.6 million, $0.7 million and $0.3 million in additional interest income the Company would have recognized if FHA/VA non-accrual loans been accounted for on an accrual status.
Credit Quality
The Company’s lending activity is its core function and as such the quality and effectiveness of the loan origination and credit risk areas are imperative to its long term success. The Company manages credit risk by
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DORAL FINANCIAL CORPORATION - (Continued)
maintaining sound underwriting standards, monitoring and evaluating loan portfolio quality (including trends and collectability) and assessing reserves and loan concentrations. Critical risk management responsibilities include establishing sound lending standards, monitoring the quality of the loan portfolio performance, establishing loan rating systems, assessing reserves and loan concentrations, supervising document control and accounting, providing necessary training and resources to credit officers, implementing lending policies and loan documentation procedures, identifying problem loans as early as possible, and instituting procedures to ensure appropriate actions to comply with laws and regulations.
Credit risk management begins with initial underwriting and continues throughout the borrower’s credit cycle. Management judgment in conjunction with statistical analysis is used in underwriting, credit decisions, product pricing, risk appetite and setting credit limits, operating processes and metrics to limit the risks inherent in the loan portfolio and returns. Tolerance levels are set to decrease the percentage of approvals as the risk profile of the customer increases. Statistical models are based on detailed behavioral information from external sources such as credit bureaus, external credit scores and/or internal historical experience. These models are an integral part of our credit management process and are used in the assessment of both new and existing credit decisions, portfolio management strategies, collection practices and in the determination of the allowance for loan and lease losses. The Company has also established an internal risk rating system and internal classifications which provide timely identification of potential deterioration in loan quality attributes in the loan portfolio. In addition, the Company has independent Loan Review and Internal Audit departments, each of which conduct monitoring and evaluation of loan portfolio quality, loan administration, and other related activities.
The risks involved in a loan decision are thoroughly analyzed prior to approval. Certain characteristics are indicators of risk, such as loan amount, purpose, product type, property type, loan amount in relation to the borrower’s previous credit experience and loan to value, cash out of the transaction, time of occupancy, and others. Many lending risks can be mitigated by requiring higher levels of borrower equity, risk pricing, additional documentation or collateral or other compensating factors.
The Company follows the established guidelines and requirements for government insured or guaranteed loans such as FHA, VA, Rural and Government subsidies, as well as conforming loans sold to FHLMC and FNMA. The Company also provides conventional loans for borrowers that do not qualify for a conforming loan. Doral’s underwriting policies focus primarily on the borrower’s ability to pay and secondarily on collateral value. The maximum loan to value ratio on conventional first mortgages generally does not exceed 80%. Loans with higher loan to value ratios may require private mortgage insurance.
Due to the current economic conditions, the Company has limited new lending activities in Puerto Rico in the construction, commercial and consumer (excluding mortgage) markets. The strategy adopted by the Company in relation to its loan exposures is to maintain a strong collection process that will ensure the orderly recovery of all loans by means of normal collection efforts or restructuring of the loan. Lending activities in the United States increased in 2010 as management determined that the U.S. market was improving. Loans in the U.S. increased $399.3 million as of December 31, 2010 compared to December 31, 2009, while loans in P.R. decreased $326.5 million over the same periods.
Delinquency is the primary indicator of credit quality the Company uses to monitor the credit quality of its portfolios, and is the basis for internal risk rating of loans. Refreshed LTVs and, to a lesser extent, FICO scores are also considered in analyzing credit quality. On a daily basis, Doral monitors the delinquency of its loan portfolios and uses this information to calibrate its collection, restructuring and foreclosure targets. Portfolios are managed by different teams with expertise in their assigned tranches. For example, loans are segregated geographically, P.R. vs. U.S.; by portfolio, residential mortgage, small commercial, consumer, large commercial and construction and land loans; and by overlapping delinquency buckets, less than 90 days past due, over 90 days past due, loss mitigation, foreclosure and OREO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company has various classes of consumer loans that present unique credit risks. For the consumer loan portfolio the Company uses historical delinquency data to arrive at a probability of default for delinquency buckets starting at inception through 240 and over days past due with higher delinquency buckets resulting in higher loss severities until the time they are charged-off. For the residential mortgage portfolio the Company also considers refreshed LTVs (or original LTVs in the absence of updated valuations) in determining the severity of loss. The aging of the delinquent residential mortgage portfolio in the table below is a result of the prolonged foreclosure process and the Company’s efforts to help customers stay in their homes through various loss mitigation programs.
For large commercial loans (including commercial real estate, commercial and industrial, construction and land loan portfolios), the Company uses workout agents, collection specialists, attorneys and third party service providers to supplement the management of the portfolio, including the credit quality and loss mitigation alternatives. In the case of residential construction projects, the workout function is primarily handled by a third party servicer that monitors the end-to-end process including, but not limited to, completion of construction, necessary restructuring, pricing, marketing and unit sales. For large commercial and construction loans the initial risk rating is driven by performance and delinquency. On an ongoing basis, the risk rating of large credits is managed by the portfolio management and collections function and reviewed and validated by the loan review function. Commercial loans over 90 days past due are evaluated individually for impairment with loans under $1.0 million monitored quarterly and individually evaluated for impairment on an annual basis. There is a high level of surveillance and monitoring in place to manage these assets and mitigate any loss exposure.
As a result of the economic situation in P.R., Doral has created a number of loan modification programs to help borrowers stay in their homes and operate their businesses which also optimizes borrower performance and returns to Doral (refer to the discussion on loan modifications and troubled debt restructurings below for further information on the programs). Residential, other consumer or commercial loan modifications can result in returning a loan to accrual status when the criteria for doing so are met, resulting in increasing interest income and cash flows as previously non-performing loans begin to perform, and decreases in foreclosure and OREO costs by decreasing the number of foreclosed properties.
Detailed below is a table of the recorded investment in loans (including FHA/VA loans and loans held for sale) by the delinquency buckets the Company uses to monitor the credit quality of its loans as of December 31, 2010 and 2009:
As of December 31, 2010
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
As of December 31, 2009
Loan modifications and troubled debt restructurings
Doral has created a number of loan modification programs to help borrowers stay in their homes and operate their businesses which also optimizes borrower performance and returns to Doral. In these cases, the restructure or loan modification fits the definition of TDR. The programs are designed to provide temporary relief and, if necessary, longer term financial relief to the consumer loan customer. Doral’s consumer loan loss mitigation program (including consumer loan products and residential mortgage loans), grants a concession for economic or legal reasons related to the borrowers’ financial difficulties that Doral would not otherwise consider. Doral’s loss mitigation programs can provide for one or a combination of the following: movement of unpaid principal and interest to the end of the loan, extension of the loan term for up to ten years, deferral of principal payments for a period of time, and reduction of interest rates either permanently (feature discontinued in 2010) or for a period of up to two years. No programs adopted by Doral provide for the forgiveness of contractually due principal or interest. Deferred principal and uncollected interest are added to the end of the loan term at the time of the restructuring and uncollected interest is not recognized as income until collected or when the loan is paid off. Doral wants to make these programs available only to those borrowers who have defaulted, or are likely to default, permanently on their loan and would lose their homes in foreclosure action absent some lender concession. However, Doral will move borrowers and properties to foreclosure if the Company is not reasonably assured that the borrower will be able to repay all contractual principal or interest (which is not forgiven in part or whole in any current or contemplated program).
Regarding the commercial loan loss mitigation programs (including commercial real estate, commercial and industrial, land and construction loan portfolios), the determination is made on a loan by loan basis at the time of restructuring as to whether a concession was made for economic or legal reasons related to the borrower’s financial difficulty that Doral would not otherwise consider. Concessions made for commercial loans could include reductions in interest rates, extensions of maturity, waiving of borrower covenants, or other contract changes that would be considered a concession. Doral mitigates loan defaults for its commercial loan portfolios through its Collections function. The functions’ objective is to minimize both early stage delinquencies and losses upon default of commercial assets. The group utilizes existing collections infrastructure of front-end dialers, doorknockers, work-out agents, and third-party consultants. In the case of residential construction projects, the function utilizes third-party vendors to manage the projects.
Residential, other consumer or commercial loan modifications can result in returning a loan to accrual status when the criteria for returning a loan to performing status are met (refer to Doral’s non-accrual policies
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
previously described). Loan modifications also increase Doral’s interest income by returning a non-performing loan to performing status, and cash flows by providing for payments to be made by the borrower, and decreases foreclosure and real estate owned costs by decreasing the number of foreclosed properties. Doral continues to consider a modified loan as a non-performing asset for purposes of estimating its allowance for loan and lease losses until the borrower has made at least six consecutive contractual payments. At such time the loan will be treated as any other performing loan for purposes of estimating the allowance for loan and lease losses.
Loan modifications that are considered TDRs completed during the years ended December 31, 2010, 2009 and 2008 were as follows (all loan modifications related to loans to Puerto Rico residents):
Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Loan modifications considered troubled debt restructurings made during the twelve months previous to December 31, 2010, 2009 or 2008, respectively, that defaulted during the years ending December 31, 2010, 2009 and 2008, respectively were as follows:
For the year ended December 31, 2010, 2009 and 2008, the Company would have recognized $7.8 million, $10.5 million and $6.2 million, respectively, in additional interest income had all TDR loans been accounted for on an accrual basis.
As of December 31, 2010 and 2009, construction TDRs include an outstanding principal balance of $40.4 million and $35.5 million with commitments to disburse additional funds of $9.3 million and $5.5 million, respectively.
11.
Allowance for Loan and Lease Losses and Impaired Loans
Doral’s allowance for loan and lease losses (“ALLL”) is management’s estimate of credit losses inherent in the reported loan investment balance as of the financial statement date. Management estimates the ALLL separately for each product category (non-FHA/VA residential mortgage loans, other consumer, commercial real estate, construction and land, and commercial and industrial) and geography (Puerto Rico and U.S. mainland), and combines the amounts in reaching its estimate for the full portfolio.
Changes in the allowance for loan and lease losses were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The activity of Doral’s allowance for loan and lease losses account for the years ending December 31, 2010 and 2009 were as follows:
(1)
Excludes reported balance of FHA/VA guaranteed loans and loans on savings deposits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
(1)
Excludes reported balance of FHA/VA guaranteed loans and loans on savings deposits.
Doral sold certain construction loans totaling $95.6 million in exchange for cash and a note receivable during the third quarter of 2010 (total assets sold included $4.8 million of other real estate owned). During the second quarter of 2010, the Company transferred the loans to be sold to the held for sale portfolio resulting in total charge-offs against the allowance for loan and lease losses of $35.8 million to reduce the loans to lower of cost or market. The transfer of the loans to held for sale resulted in additional provisions for loan and lease losses of $12.6 million for the second quarter of 2010. Loans collateralized by land are under regulatory review in the U.S. and its territories. As of December 31, 2010 land collateralized loans totalled to $143.6 million. In addition, Doral has outstanding a few construction loans with remnant land totaling $25.3 million. Should our estimated land value change significantly, it may be necessary to record additional provisions for loan losses or charge-offs that may be material to the Company’s financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following table provides Doral’s recorded investment in impaired loans which reflects partial charge-offs and other amounts which reduce credit risk, the contractual unpaid principal balance (“UPB”) and the related allowance in impaired loans as of December 31, 2010 and 2009.
(1)
Gross reserve percent represents the amount of the allowance to the recorded investment and indicates the total estimated loss on the remaining balance of impaired assets.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following table provides Doral’s average recorded investment in impaired loans and the related interest income recognized during the time within that period that the loans were impaired for the years ended December 31, 2010, 2009 and 2008.
12.
Related Party Transactions
The following table summarizes certain information regarding Doral Financial’s loans outstanding to officers, directors and common stockholders controlling 5% or more for the periods indicated.
(1)
At December 31, 2010 and 2009, none of the loans outstanding to officers, directors and 5% or more stockholders were delinquent.
At December 31, 2010 and 2009, the amount of loans outstanding to officers, directors and 5% or more stockholders secured by mortgages on real estate amounted to $1.2 million and $2.7 million, respectively.
Since 2000, Doral Financial has conducted business with an entity that provides property inspection services and is co-owned by the spouse of a former Executive VP (employed through third quarter of 2010) of the Company. The amount paid by the Company to this entity for the nine month period ended September 30, 2010 amounted to $1.7 million, compared to $1.8 million for the year ended December 31, 2009.
For the year ended December 31, 2010, the Company assumed approximately $0.6 million of the professional services expense related to Doral Holdings compared to $0.3 million for 2009.
At December 31, 2010 and 2009, Doral Financial’s banking subsidiaries had deposits from officers, directors, employees and principal stockholders of the Company amounting to approximately $5.7 million and $3.0 million, respectively. The increase in deposits from officers, directors, employees and principal stockholders was driven primarily by the opening of new accounts during 2010.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
13.
Accounts Receivable and Other Assets
The Company reported accounts receivable of $28.7 million and $60.5 million as of December 31, 2010 and 2009, respectively. Total accounts receivable included $12.5 million and $15.6 million related to claims of loans foreclosed to FHA and VA as of December 31, 2010 and 2009, respectively. Accounts receivable also included $21.7 million as of December 31, 2009, related to the Lehman Brothers Transaction described below.
Lehman Brothers Transaction
Doral Financial and Doral Bank PR (combined “Doral”), had counterparty exposure to Lehman Brothers, Inc. (“LBI”) in connection with repurchase financing agreements and forward To-Be-Announced (“TBA”) agreements. LBI was placed in a Securities Investor Protection Corporation (“SIPC”) liquidation proceeding after the filing for bankruptcy of its parent Lehman Brothers Holdings, Inc. The filing of the SIPC liquidation proceeding was an event of default under the repurchase agreements and the forward TBA agreements resulting in their termination as of September 19, 2008.
The termination of the agreements led to a reduction in the Company’s total assets and total liabilities of approximately $509.8 million and caused Doral to recognize a previously unrealized loss on the value of the securities subject to the agreements, resulting in a $4.2 million charge during the third quarter of 2008. In January 2009, Doral timely filed customer claims against LBI in the SIPC liquidation proceeding for LBI that it is owed approximately $43.3 million, representing the excess of the value of the securities held by LBI above the amounts owed by Doral under the agreements, plus ancillary expenses and interest. Doral fully reserved ancillary expenses and interest.
On August 19, 2009, the SIPC trustee issued notices of determination to Doral (i) denying Doral’s claims for treatment as a customer with respect to the cash and/or securities held by LBI under the repurchase financing agreements and forward TBA agreements between Doral and LBI, and (ii) converting Doral’s claims to general creditor claims. On September 18, 2009, Doral timely filed its objections in bankruptcy court to these determinations by the SIPC trustee, which objections remain pending.
In December 2008, the SIPC trustee announced that it expected to have enough assets to cover customer claims, but stated that it could not determine at that point what would be available to pay general creditors. Based on the information available in the fourth quarter of 2008, Doral determined that the process would likely take more than a year and that mounting legal and operating costs would likely impair the ability of LBI to pay 100% of the claims filed against it, especially for general creditors. The fourth quarter of 2008 also saw the continued decline in asset values, and management concluded that it was likely that LBI assets would also decline in value. As a result, Doral accrued as of December 31, 2008, a loss of $21.6 million against the $43.3 million owed by LBI.
On October 5, 2009, the SIPC trustee filed a motion in bankruptcy court seeking leave to allocate property within the LBI estate entirely to customer claims in which it asserted that “the colorable customer claims will approach - and, depending on how certain disputed issues are resolved, could exceed- the assets available to the SIPC trustee for distribution.” Based on the information available in the second quarter of 2010, Doral determined that there was further impairment in the likely ability of LBI to pay 100% of the claims filed against it. As a result, Doral recognized an additional loss of $10.8 million against the $43.3 million owed by LBI. A net receivable of $10.9 million was recorded in “Accounts Receivable” on the Company’s consolidated statements of financial condition.
During the fourth quarter of 2010, Doral sold and assigned to a third party all of Doral’s rights, title, and interest in and to its claims in the SIPC proceeding, including all of its rights to prosecute its claims, as a result of which Doral recognized a loss of $1.5 million on financial disposition the net receivable.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
14.
Servicing Activities
The Company routinely originates, securitizes and sells mortgage loans into the secondary market. The Company generally retains the servicing rights and, in the past, also retained IOs. MSRs represent the estimated present value of the normal servicing fees (net of related servicing costs) expected to be received on a loan being serviced over the expected term of the loan. MSRs entitle Doral Financial to a future stream of cash flows based on the outstanding principal balance of the loans serviced and the contractual servicing fee. The annual servicing fees generally range between 25 and 50 basis points, less, in certain cases, any corresponding guarantee fee. In addition, MSRs may entitle Doral Financial, depending on the contract language, to ancillary income including late charges, float income, and prepayment penalties net of the appropriate expenses incurred for performing the servicing functions. In certain instances, the Company also services loans with no contractual servicing fee. The servicing asset or liability associated with such loans is evaluated based on ancillary income, including float, late fees, prepayment penalties and costs.
The components of net servicing income (loss) are shown below:
The changes in servicing assets measured using the fair value method for the years ended December 31, 2010, 2009 and 2008 are shown below:
(1)
Amount represents MSRs sales related to $24.0 million and $7.1 million in principal balance of mortgage loans for the corresponding years ended December 31, 2010 and 2009, respectively.
(2)
Amount represents the adjustment of MSR fair value related to the repurchase of $102.8 million, $178.7 million and $64.0 million in principal balance of mortgage loans serviced for others for the years ended December 31, 2010, 2009 and 2008, respectively.
(3)
Outstanding balance of loans serviced for third parties amounted to $8.2 billion, $8.7 billion and $9.5 billion as of December 31, 2010, 2009 and 2008, respectively, which includes $2.8 million, $3.1 million and $3.4 million, respectively, of loans being serviced under sub-servicing arrangements.
The Company recognizes as assets the rights to service loans for others and records these assets at fair value. The fair value of the Company’s MSRs is determined based on a combination of market information on
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
trading activity (servicing asset trades and broker valuations), benchmarking of servicing assets (valuation surveys) and cash flow modeling. The valuation of the Company’s servicing assets incorporates two sets of assumptions: (i) market derived assumptions for discount rates, servicing costs, escrow earnings rate, float earnings rate and cost of funds and (ii) market derived assumptions adjusted for the Company’s loan characteristics and portfolio behavior for escrow balances, delinquencies and foreclosures, late fees, prepayments and prepayment penalties. The constant prepayment rate (“CPR”) assumptions employed for the valuation of the Company’s servicing assets for the year ended December 31, 2010 was 8.1% compared to 9.1% for the corresponding 2009 period.
Discount rate assumptions (weighted average) for the Company’s servicing assets were stable for the years ended December 31, 2010 and 2009, which were 11.3% and 11.4%, respectively.
Based on recent prepayment experience, the expected weighted-average remaining life of the Company’s servicing assets at December 31, 2010 and 2009 was 7.0 years and 6.6 years, respectively. Any projection of the expected weighted-average remaining life of servicing assets is limited by conditions that existed at the time the calculations were performed.
At December 31, 2010 and 2009, fair values of the Company’s retained interest were based on valuation models that incorporate market driven assumptions, such as discount rates, prepayment speeds and implied forward LIBOR rates (in the case of variable IOs), adjusted by the particular characteristics of the Company’s servicing portfolio.
The weighted-averages of the key economic assumptions used by the Company in its valuation models and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent adverse changes in those assumptions for mortgage loans at December 31, 2010, were as follows:
These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which may magnify or offset the sensitivities.
To determine the value of its portfolio of variable IOs, Doral Financial uses a valuation model that forecasts expected cash flows using forward LIBOR rates derived from the LIBOR/Swap yield curve at the date of the valuation. The characteristics of the variable IOs result in an increase in cash flows when LIBOR rates fall and a reduction in cash flows when LIBOR rates rise. This provides a mitigating effect on the impact of prepayment speeds on the cash flows, with prepayment expected to rise when long-term interest rates fall reducing the amount of expected cash flows and the opposite when long-term interest rates rise. Prepayment assumptions incorporated into the valuation model for variable and fixed IOs are based on publicly available,
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
independently verifiable, prepayment assumptions for FNMA mortgage pools and statistically derived prepayment adjusters based on observed relationships between the Company’s and the FNMA’s U.S. mainland mortgage pool prepayment experiences.
This methodology resulted in a CPR of 9.0% and 10.4% for the years ended December 31, 2010 and 2009, respectively. The change in the CPR between 2010 and 2009 was due mostly to a general decrease in market interest rates.
For IOs, Doral Financial recognizes as interest income (through the life of the IO) the excess of all estimated cash flows attributable to these interests over their recorded balance using the effective yield method. Doral Financial recognizes as interest income the excess of the cash collected from the borrowers over the yield payable to investors, up to an amount equal to the yield on the IOs. Doral Financial accounts for any excess retained spread as amortization to the gross IO capitalized at inception. The Company updates its estimates of expected cash flows periodically and recognizes changes in calculated effective yield on a prospective basis.
The activity of interest-only strips is shown below:
The gain on the valuation of the IO for the year ended December 31, 2010, when compared to the corresponding 2009 period, resulted mainly from a decrease in LIBOR rates and slower prepayment speed assumptions. The increase in value of the variable IO was offset by the decrease in value of embedded caps.
The following table presents a detail of the cash flows received on Doral Financial’s portfolio of IOs for 2010, 2009 and 2008:
The following table summarizes the estimated change in the fair value of the Company’s IOs, the constant prepayment rate and the weighted-average expected life under the Company’s valuation model, given several hypothetical (instantaneous and parallel) increases or decreases in interest rates. As of December 31, 2010, all
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
of the mortgage loan sales contracts underlying the Company’s floating rate IOs were subject to interest rate caps.
15.
Sale and Securitization of Mortgage Loans
As disclosed in Note 14, the Company routinely originates, securitizes and sells mortgage loans into the secondary market. As a result of this process, the Company typically retains the servicing rights and, in the past, also retained IOs. The Company’s retained interests are subject to prepayment and interest rate risk.
Key prepayment and discount rate assumptions used in determining the fair value at the time of sale for MSRs ranged as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company’s mortgage servicing portfolio amounted to approximately $12.6 billion, $13.1 billion and $13.7 billion at December 31, 2010, 2009 and 2008, respectively, including $4.4 billion, $4.4 billion and $4.2 billion, respectively, of mortgage loans owned by the Company for which no servicing asset has been recognized.
For the years ended December 31, 2010 and 2009, the unpaid principal balance of loan sales and securitizations totaled to $475.2 million and $465.9 million, respectively, while the servicing released or derecognized due to repurchases amounted to $102.8 million and $178.7 million, respectively.
Under most of the servicing agreements, the Company is required to advance funds to make scheduled payments to investors, if payments due have not been received from the mortgagors. At December 31, 2010 and 2009, mortgage servicing advances amounted to $51.5 million and $19.6 million, respectively, net of a reserve of $9.0 million and $8.8 million, respectively.
In general, Doral Financial’s servicing agreements are terminable by the investors for cause. The Company’s servicing agreements with FNMA permit FNMA to terminate the Company’s servicing rights if FNMA determines that changes in the Company’s financial condition have materially adversely affected the Company’s ability to satisfactorily service the mortgage loans. Approximately 28% of Doral Financial’s mortgage loan servicing on behalf of third parties relates to mortgage servicing for FNMA. Termination of Doral Financial’s servicing rights with respect to FNMA or other parties for which it provides servicing could have a material adverse effect on the results of operations and financial condition of Doral Financial.
16.
Servicing Related Matters
At December 31, 2010 and 2009, escrow funds and custodial accounts included approximately $85.4 million and $206.6 million, respectively, deposited with Doral Bank PR. These funds are included in the Company’s consolidated financial statements. At December 31, 2010 and 2009, escrow funds and custodial accounts also included approximately $27.6 million and $17.9 million, respectively, deposited with other banks, which were excluded from the Company’s assets and liabilities. The Company had fidelity bond and errors and omissions coverage of $30.0 million and $17.0 million, respectively, as of December 31, 2010 and 2009 to cover these amounts.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
17.
Premises and Equipment
Premises and equipment and useful lives used in computing depreciation consisted of:
Approximately 31,311 square feet are leased to tenants unrelated to Doral Financial. As of December 31, 2010 and 2009, the amount of accumulated depreciation on property held for leasing purposes amounted to $2.5 million and $2.2 million, respectively.
For the years ended December 31, 2010, 2009 and 2008, depreciation and amortization expenses amounted to $12.4 million, $12.4 million and $15.0 million, respectively.
18.
Other Real Estate Owned (“OREO”)
The Company acquires real estate through foreclosure proceedings. Legal fees and other direct costs incurred in a foreclosure are expensed as incurred. Real estate held for sale totaled to $100.3 million and $94.2 million as of December 31, 2010 and 2009, respectively.
The following tables provide the balances and activity of other real estate held owned for the periods indicated:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following table presents activity of OREO for the periods indicated:
During the second quarter of 2010, the Company established an additional provision of $17.0 million to recognize the effect of management’s strategic decision to reduce pricing in order to accelerate OREO sales.
During 2009, the Company improved its foreclosure functions resulting in shorter foreclosure periods, and units are entering the OREO portfolio at faster rates than in previous years, which together with the deteriorating economic conditions in Puerto Rico, resulted in a higher level of real estate owned. Retirements represent properties transferred to loan portfolio or claims receivable.
19.
Goodwill
At both December 31, 2010 and 2009, goodwill amounted to $4.4 million and was assigned principally to the mortgage banking segment. Goodwill is recorded in “Other assets” on the Consolidated Statements of Financial Condition.
The Company performed impairment tests of its goodwill for the years ended December 31, 2010, 2009 and 2008 using a discounted cash flow analysis and determined that there was no impairment.
20.
Sources of Borrowing
At December 31, 2010, the scheduled aggregate annual contractual maturities (or estimates in the case of loans payable and a note payable with a local institution) of the Company’s borrowings were approximately as follows:
(1)
Includes $100.0 million of repurchase agreements with a rate of 2.98% and $80.0 million in advances from FHLB with a rate of 5.04%, which the lenders have the right to call before their contractual maturities beginning in February 2011.
(2)
Secured borrowings with local financial institutions, collateralized by real estate mortgages at fixed and variable interest rates tied to 3-month LIBOR. These loans are not subject to scheduled principal payments, but are payable according to the regular schedule
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
amortization and prepayments of the underlying mortgage loans. For purposes of the table above the Company used a CPR of 9.0% to estimate the repayments.
(3)
The Company has a policy and procedures to manage counterparty risk associated to securities sold under agreements to repurchase and subsequent monitoring controls related to approved limits, concentration and exposure.
21.
Deposit Accounts
At December 31, deposits and their weighted-average interest rates are summarized as follows:
At both, December 31, 2010 and 2009, the Company reclassified from deposit accounts to loan balances $0.6 million of overdrafts.
At December 31, 2010 and 2009, certificates of deposit over $100,000 amounted to approximately $2.8 billion and $2.9 billion, respectively. Also at December 31, 2010 and 2009, certificates of deposits over $250,000 amounted to approximately $2.6 billion and $2.8 billion, respectively.
The banking subsidiaries had brokered certificate of deposits maturing as follows:
22.
Securities Sold Under Agreements to Repurchase
As part of its financing activities the Company enters into sales of securities under agreements to repurchase the same or substantially similar securities. The Company retains control over such securities. Accordingly, the amounts received under these agreements represent borrowings, and the securities underlying the agreements remain in the Company’s asset accounts. These transactions are carried at the amounts at which transactions will be settled. The counterparties to the contracts generally have the right to repledge the securities received as collateral. Those securities are presented in the Consolidated Statements of Financial Condition as part of pledged investment securities.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following summarizes significant data about securities sold under agreements to repurchase for the years ended December 31, 2010 and 2009:
Securities sold under agreements to repurchase as of December 31, 2010, grouped by counterparty, were as follows:
The following table presents the carrying and market values of securities available for sale pledged as collateral at December 31, shown by maturity of the repurchase agreement. The information in this table excludes repurchase agreement transactions which were collateralized with securities or other assets held for trading or which have been obtained under agreement to resell:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
23.
Advances from FHLB
Advances from FHLB consisted of the following:
(1)
Includes one structured advance with an outstanding balance of $50.0 million.
Maximum advances outstanding at any month end during the year ended December 31, 2010 were $1.6 billion. The approximate average daily outstanding balance of advances from FHLB for the year ended December 31, 2010 was $1.2 billion. The weighted-average interest of such advances, computed on a daily basis was 4.0% for the year ended December 31, 2010.
At December 31, 2010, the Company had pledged qualified collateral in the form of residential mortgage loans with an estimated market value of $1.4 billion to secure the above advances from FHLB, which generally the counterparty is not permitted to sell or repledge.
The FHLB advances are subject to early termination fees.
In January 2011, the Company entered into an agreement with the FHLB to restructure $555.4 million of its non-callable term advances, reducing the average interest rate on those restructured advances to 1.7% from 4.1% and extending the average maturities to 39 months from 14 months. This transaction resulted in a $22.0 million fee paid to the FHLB.
24.
Other Short-Term Borrowings
There were no borrowings outstanding at any month end during 2010. The approximate average daily outstanding balance of short-term borrowings during the year ended December 31, 2010 was $5.0 million. The weighted-average interest rate of such borrowings, computed on a daily basis, was 0.30% for the year ended December 31, 2010.
As of December 31, 2009 other short-term borrowings with the Federal Reserve Bank, collaterized by securities at a fixed rate of 0.25%, amounted to $110.0 million. These borrowings matured on January 14, 2010.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
25.
Loans Payable
At December 31, 2010 and 2009, loans payable consisted of financing agreements with local financial institutions secured by mortgage loans.
Outstanding loans payable consisted of the following:
The expected maturity date of secured borrowings based on collateral is from present to December 2025.
Maximum borrowings outstanding at any month end during the year ended December 31, 2010 were $334.7 million. The approximate average daily outstanding balance of loans payable for the year ended December 31, 2010 was $320.3 million. The weighted-average interest of such borrowings, computed on a daily basis was 2.10% for the year ended December 31, 2010.
At December 31, 2010 and 2009, the Company had $122.0 million and $143.1 million, respectively, of loans held for sale and $180.4 million and $192.7 million, respectively, of loans receivable that were pledged to secure financing agreements with local financial institutions. Such loans can be repledged by the counterparty.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
26.
Notes Payable
Notes payable consisted of the following:
On July 8, 2010, the Company, through its subsidiary, Doral Money, entered into a collateralized loan obligation (“CLO”) arrangement with a third party in which up to $450.0 million of largely U.S. mainland based commercial loans are pledged to collateralize AAA rated debt of $250.0 million paying three month LIBOR plus 1.85 percent issued by Doral CLO I, Ltd. Doral CLO I, Ltd. is a variable interest entity created to hold the commercial loans and issue the previously noted debt and $200.0 million of subordinated notes to the Company whereby the Company receives any excess proceeds after payment of the senior debt interest and other fees and charges specified in the indenture agreement. The Company also serves as collateral manager of the assets of Doral CLO I, Ltd. Doral CLO I, Ltd. is consolidated with the Company in these financial statements.
DLAM, LLC, is a subsidiary of Doral Money and holds the $200.0 million of subordinated notes issued by Doral CLO I, Ltd. DLAM, LLC, is consolidated with the Company.
Doral Financial is the guarantor of various unregistered serial and term bonds issued by Doral Properties, a wholly-owned subsidiary, through the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority (“AFICA”). The bonds were issued to finance the construction and development of the Doral Financial Plaza building, the headquarters facility of Doral Financial. As of December 31, 2010, the outstanding principal balance of the bonds was $45.8 million with fixed interest rates, ranging from 6.25% to 6.90%, and maturities ranging from June 2011 to December 2029. Certain series of the bonds are secured by a mortgage on the building and underlying real property.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
27.
Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following:
28.
Income Taxes
Background
Income taxes include Puerto Rico income taxes as well as applicable U.S. federal and state taxes. As Puerto Rico corporations, Doral Financial and all of its Puerto Rico subsidiaries are generally required to pay U.S. income taxes only with respect to their income derived from the active conduct of a trade or business in the United States (excluding Puerto Rico) and certain investment income derived from U.S. assets. Any such tax is creditable, with certain limitations, against Puerto Rico income taxes. Except for the operations of Doral Bank US and Doral Money, substantially all of the Company’s operations are conducted through subsidiaries in Puerto Rico. Doral Bank US and Doral Money are U.S. corporations and are subject to U.S. income-tax on their income derived from all sources.
Under Puerto Rico Income Tax Law, the Company and its subsidiaries are treated as separate taxable entities and do not file consolidated tax returns.
The maximum statutory corporate income tax rate in Puerto Rico is 39.00%. On March 9, 2009, the Governor of Puerto Rico signed into law the Special Act Declaring a State of Fiscal Emergency and Establishing an Integral Plan of Fiscal Stabilization to Save Puerto Rico’s Credit, Act No. 7 (the “Act”). Pursuant to the Act, Section 1020A was introduced to the Code to impose a 5% surtax over the total tax determined for corporations, partnerships, trusts, estates, as well as individuals whose combined gross income exceeds $100,000 or married individuals filing jointly whose gross income exceeds $150,000. This surtax is effective for tax years commenced after December 31, 2008 and before January 1, 2012. This increases the Company’s income tax rate from 39.00% to 40.95% for tax years from 2009 through 2011.
On November 15, 2010, certain amendments to the Puerto Rico Income Tax Act were approved which, among other things, increased the NOL carry forward period from seven to ten years for NOLs generated between 2005 and 2011.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
On January 31, 2011, the Governor signed into law the Internal Revenue Code of 2011 (“2011 Code”) making the PR Code ineffective, for the most part, for years commenced after December 31, 2010. Under the provisions of the 2011 Code, the maximum statutory corporate income tax rate is 30% for years commenced after December 31, 2010 and ending before January 1, 2014; if the Government meets its income generation and expense control goals, for years commenced after December 31, 2013, the maximum corporate tax rate will be 25%. The 2011 Code, however, eliminated the special 5% surtax on corporations for tax year 2011. In general, the 2011 Code maintains the increase in carry forward periods for net operating losses generated between 2005 and 2011 from 7 to 10 years as provided for in Act 171; maintains the concept of the alternative minimum tax although it changed the way it is computed; and specifies what types of auditors’ report will be acceptable when audited financial statements are required to be filed with the income tax return. Notwithstanding, a corporation may be subject to the provisions of the PR Code if it so elects it by the time it files its income tax return for the first year commenced after December 31, 2010 and ending before January 1, 2012. Once the election is made, it will be effective for such year and the next 4 succeeding years. The Company is evaluating the impact of the tax reform on its results of operations, however the change in the statutory tax rate will result in a reduction in the net deferred tax asset with a corresponding charge to deferred tax expense.
Doral Financial’s interest income derived from FHA and VA mortgage loans financing the original acquisition of newly constructed housing in Puerto Rico and securities backed by such mortgage loans is exempt from Puerto Rico income taxes. Doral Financial also invests in U.S. Treasury and agency securities that are exempt from Puerto Rico taxation and are not subject to federal income taxation because of the portfolio interest deduction to which Doral Financial is entitled as a foreign corporation.
Income Tax Expense (Benefit)
The components of income tax expense (benefit) for the years ended December 31, are summarized below:
The current income tax expense of $7.4 million as of December 31, 2010, was related to taxes on U.S. source income. The deferred income tax expense of $7.5 million was related to the recognition of additional deferred tax assets, primarily NOLs, net of amortization of existing DTAs and net of an increase in the valuation allowance.
The recognition of income tax benefit of $21.5 million for the year ended December 31, 2009 is composed of a current tax benefit of $11.4 million and a deferred tax benefit of $10.0 million. The current tax benefit is primarily related to the release of unrecognized tax benefits due to the expiration of the statute of limitations on certain tax positions net of the recognition of certain unrecognized tax benefits during that year. This net benefit was partially offset by the recognition of tax expense related to intercompany transactions in the federal tax jurisdiction which had not been previously recognized, net of current tax benefit related to the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Company’s U.S. affiliates. The deferred tax benefit is primarily due to the effect of entering into an agreement with the Puerto Rico Treasury Department during the third quarter of 2009 (please refer to the “Deferred Tax Components” below), net of the amortization of existing deferred tax asset (“DTAs”).
The tax expense recognized for the year ended December 31, 2008 was primarily related to a charge through earnings of an additional valuation allowance on its deferred tax asset of approximately $295.9 million.
The provision for income taxes of the Company differs from amounts computed by applying the applicable Puerto Rico statutory rate to income before taxes as follows:
(1)
Excludes the change in the valuation allowance for unrealized losses on cash flow hedges.
Deferred Tax Components
The Company’s DTA consists primarily of the differential in the tax basis of IOs sold, net operating loss carry-forwards and other temporary differences arising from the daily operations of the Company.
The Company has entered into several agreements with the Puerto Rico Treasury Department related to the intercompany transfers of IOs (The “IO Tax Asset” or “IO”) and its tax treatment thereon. Under the agreements, the Company established the tax basis of all the IO transfers, clarified that for Puerto Rico income tax purpose, the IO Tax Asset is a stand-alone intangible asset subject to straight-line amortization based on a useful life of 15 years, and established that the IO Tax Asset could be transferred to any entity within the Doral Financial corporate group, including the Puerto Rico banking subsidiary. During the third quarter of 2009, the Company entered into an agreement with the Puerto Rico Treasury Department that granted the Company a two year moratorium of the amortization of the IO Tax Asset. This agreement resulted in a benefit of $11.2 million for the third quarter of 2009 and was effective for the taxable year beginning January 1, 2009. The realization of the deferred tax asset related to the differential in the tax basis of IOs sold is dependent upon the existence of, or generation of, taxable income during the remaining 12 year (15 year original amortization period, 17 year original amortization period including the two year moratorium) period in which the amortization of the IO Tax Asset is available. The IOs expire in 2022. Any IO amortization in excess of all legal entities’ taxable income would become an NOL subject to the 7 or 10 year carry-over period. Upon a business combination, which is not
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
structured as a purchase of assets, the IOs should survive and be available to be used by the group’s legal entities.
During the first quarter of 2008, the Company entered into an agreement with the Puerto Rico Treasury Department with respect to the allocation method (and period) of expenses incurred related to a settlement agreement (“Settlement Expenses”) that resulted from litigation related to the Company’s restatement. This agreement was effective as of December 31, 2007 and permits the total expense related to the settlement of the lawsuit ($96.0 million) to be allocated to any entity within the Company over a period of three years.
NOLs generated between 2005 and 2011 can be carried forward for a period of 10 years (there is no carry-back allowed in Puerto Rico). The NOLs creating deferred tax assets as of December 31, 2010, expire beginning in 2016 until 2020 for Puerto Rico entities and 2025 through 2028 for United States entities. Since each legal entity files a separate income tax return, the NOLs can only be used to offset future taxable income of the entity that incurred it. In case of a business combination, which is not structured as an asset sale, the NOLs should survive and be available to offset future taxable income of the originating entity. Following a business combination, and under certain circumstances, the entity having the NOLs could utilize these NOLs relative to some business activities that created the NOLs and may be precluded from using the NOLs to offset income from new business activities.
The Company evaluates its deferred tax asset for realizability, and are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.
In assessing the realization of deferred tax assets, the Company considers the expected reversal of its deferred tax assets and liabilities, projected future taxable income, cumulative losses in recent years, and tax planning strategies. The determination of a valuation allowance on deferred tax assets requires judgment based on the weight of all available evidence and considering the relative impact of negative and positive evidence.
As of December 31, 2010, the Company had two Puerto Rico entities which were in a cumulative loss position. For purposes of assessing the realization of the DTAs, the cumulative taxable loss position for these two entities is considered significant negative evidence that has caused management to conclude that the Company will not be able to fully realize the deferred tax assets related to these two entities in the future. Accordingly, as of December 31, 2010 and 2009, the Company determined that it was more likely than not that $462.7 million and $385.9 million, respectively, of its gross deferred tax asset would not be realized and maintained a valuation allowance for those amounts. As of December 31, 2010 and 2009, the Company’s deferred tax assets were as follows:
Components of the Company’s DTAs at December 31, were as follow:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Net operating loss carry-forwards outstanding at December 31, 2010 expire as follows:
The decrease in the DTA is primarily due to the tax effect of the sale of non-agency CMO’s that did not have a valuation allowance.
As of December 31, 2010 and 2009, the deferred tax asset valuation allowance off-set the following deferred tax assets:
For Puerto Rico taxable entities with positive core earnings, a valuation allowance on deferred tax assets was not recorded since they are expected to continue to be profitable. At December 31, 2010, the net deferred tax asset associated with these two companies was $9.0 million, compared to $14.4 million at December 31, 2009. In addition, approximately, $94.4 million of the IO tax asset maintained at the holding company would be realized through these entities. In management’s opinion, for these companies, the positive evidence of profitable core earnings outweighs any negative evidence.
The valuation allowance also includes $1.3 million and $3.0 million related to deferred taxes on unrealized losses on cash flow hedges as of December 31, 2010 and 2009, respectively.
Management did not establish a valuation allowance on the deferred tax assets generated on the unrealized gains and losses of its securities available for sale as of December 31, 2010 and 2009, because the Company had the positive intent and the ability to hold the securities until maturity or recovery of value. In April 2010, the Company sold non-agency CMOs with a market value of $253.5 million as of March 31, 2010, and recognized a loss of $138.3 million. As of March 31, 2010, these securities reflected an unrealized pre-tax loss of $129.4 million and had a DTA of $19.5 million.
Failure to achieve sufficient projected taxable income in the entities and deferred tax assets where a valuation allowance has not been established, might affect the ultimate realization of the net deferred tax assets.
Management assesses the realization of its deferred tax assets at each reporting period. To the extent that earnings improve and the deferred tax assets become realizable, the Company may be able to reduce the valuation allowance through earnings.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Accounting for Uncertainty in Income Taxes
As of December 31, 2010, the Company did not have unrecognized tax benefits and had accrued interest of $0.8 million on previously unrecognized tax benefits. As of December 31, 2009 and 2008, the Company had unrecognized tax benefits of $3.5 million and $13.7 million, respectively, and accrued interest of $0.6 million and $5.2 million, respectively. The Company classifies all interest related to tax uncertainties as income tax expense. For the years ended December 31, 2010, 2009 and 2008, the Company recognized interest and penalties of $0.2 million, $0.6 million and $1.4 million, respectively.
The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to the expiration of statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examinations, litigation and legislative activity, and the addition or elimination of uncertain tax positions. During the third quarter of 2010, the Company settled its uncertain tax positions. As of December 31, 2010, the following years remain subject to examination: U.S. Federal jurisdictions - 2004 through 2008 and Puerto Rico - 2005 through 2008.
The following presents the beginning and ending amounts of accruals for uncertain income tax positions:
29.
Guarantees
In the ordinary course of the business, Doral Financial makes certain representations and warranties to purchasers and insurers of mortgage loans at the time of the loan sales to third parties regarding the characteristics of the loans sold, and in certain circumstances, such as in the event of early or first payment default. To the extent the loans do not meet specified characteristics, if there is a breach of contract of a representation or warranty or if there is an early payment default, Doral Financial may be required to repurchase the mortgage loan and bear any subsequent loss related to the loan. For the year ended December 31, 2010, repurchases amounted to $1.0 million, compared to $13.7 million for the corresponding 2009 period. These repurchases were at fair value and no significant losses were incurred.
In the past, in relation to its asset securitizations and loan sale activities, the Company sold pools of delinquent FHA, VA and conventional mortgage loans on a servicing retained basis. Following these transactions, the loans are not reflected on Doral Financial’s Consolidated Statement of Financial Condition. Under these arrangements, as part of its servicing responsibilities, Doral Financial is required to advance the scheduled payments of principal, interest and taxes whether or not collected from the underlying borrower. While Doral Financial expects to recover a significant portion of the amounts advanced through foreclosure or, in the case of FHA and VA loans, under the applicable FHA and VA insurance and guarantee programs, the amounts advanced tend to be greater than normal arrangements because of the delinquent status of the loans. As of December 31, 2010 and 2009, the outstanding principal balance of such delinquent loans was $139.6 million and $154.2 million, respectively.
In addition, Doral Financial’s loan sale activities in the past included certain mortgage loan sale and securitization transactions subject to recourse arrangements that require Doral Financial to repurchase or
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
substitute the loan if the loans are 90 - 120 days or more past due or otherwise in default. The Company is also required to pay interest on delinquent loans in the form of servicing advances. Under certain of these arrangements, the recourse obligation is terminated upon compliance with certain conditions, which generally involve: (i) the lapse of time (normally from four to seven years), (ii) the lapse of time combined with certain other conditions such as the unpaid principal balance of the mortgage loans falling below a specific percentage (normally less than 80%) of the appraised value of the underlying property, or (iii) the amount of loans repurchased pursuant to recourse provisions reaching a specific percentage of the original principal amount of loans sold (generally from 10% to 15%). As of December 31, 2010 and 2009, the Company’s records reflected that the outstanding principal balance of loans sold subject to full or partial recourse was $0.8 billion and $0.9 billion, respectively. As of such dates, the Company’s records also reflected that the maximum contractual exposure to Doral Financial if it were required to repurchase all loans subject to recourse was $0.7 billion and $0.8 billion, respectively. Doral Financial’s contingent obligation with respect to its recourse provision is not reflected on the Company’s Consolidated Financial Statements, except for a liability of estimated losses from such recourse agreements, which is included in “Accrued expenses and other liabilities”. The Company discontinued the practice of selling loans with recourse obligations in 2005. Doral Financial’s current strategy is to sell loans on a non-recourse basis, except recourse for certain early payment defaults and industry standard representations and warranties. For the years ended December 31, 2010 and 2009, the Company repurchased at fair value $28.6 million and $27.3 million, respectively, pursuant to recourse provisions.
Doral Financial’s reserve for its exposure to recourse amounted to $10.3 million and $9.4 million and the reserve for other credit-enhanced transactions explained above amounted to $9.0 million and $8.8 million as of December 31, 2010 and 2009, respectively.
The following table shows the changes in the Company’s liability for estimated losses from recourse agreements, included in the Statement of Financial Condition, for each of the periods shown:
30.
Unused lines of credit
At December 31, 2010 and 2009, the Company had an uncommitted line of credit of up to 30% of the assets reflected in the Consolidated Statement of Financial Condition of Doral Bank Puerto Rico and Doral Bank US. As of December 31, 2010 and 2009, the Company could draw an additional $2.4 billion and $2.2 billion, respectively. As a condition of drawing these additional amounts, the Company is required to pledge collateral for the amount of the draw plus a required over-collateralization amount. As of December 31, 2010 and 2009, the Company had pledgeable excess collateral of $0.7 billion and $0.3 billion, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
31.
Financial Instruments with Off-Balance Sheet Risk
The following tables summarize Doral Financial’s commitments to extend credit, commercial and performance standby letters of credit and commitments to sell loans.
The Company enters into financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments may include commitments to extend credit and sell loans. The contractual amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long as the conditions established in the contract are met. Commitments generally have fixed expiration dates or other termination clauses. Generally, the Company does not enter into interest rate lock agreements with borrowers.
The Company purchases mortgage loans and simultaneously enters into a sale and securitization agreement with the same counterparty, essentially a forward contract that meets the definition of a derivative during the period between trade and settlement date.
A letter of credit is an arrangement that represents an obligation on the part of the Company to a designated third party, contingent upon the failure of the Company’s customer to perform under the terms of the underlying contract with a third party. The amount of the letter of credit represents the maximum amount of credit risk in the event of non-performance by these customers. Under the terms of a letter of credit, an obligation arises only when the underlying event fails to occur as intended, and the obligation is generally up to a stipulated amount and with specified terms and conditions. Letters of credit are used by the customer as a credit enhancement and typically expire without having been drawn upon.
The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty.
32.
Commitments and Contingencies
Total minimum rental and operating commitments for leases in effect at December 31, 2010, were as follow:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Total rent expense for the years ended December 31, 2010, 2009 and 2008 amounted to approximately $7.7 million, $7.2 million and $7.4 million, respectively.
Doral Financial and its subsidiaries are defendants in various lawsuits or arbitration proceedings arising in the ordinary course of business, including employment related matters. Management believes, based on the opinion of legal counsel, that the aggregated liabilities, if any, arising from such actions will not have a material adverse effect on the financial statements of Doral Financial.
Since 2005, Doral Financial became a party to various legal proceedings, including regulatory and judicial investigations and civil litigation, arising as a result of the Company’s restatement.
Legal Matters
On August 24, 2005, the U.S. Attorney’s Office for the Southern District of New York served Doral Financial with a grand jury subpoena seeking the production of certain documents relating to issues arising from the restatement, including financial statements and corporate, auditing and accounting records prepared during the period from January 1, 2000 to the date of the subpoena. Doral Financial is cooperating with the U.S. Attorney’s Office in this matter. Doral Financial cannot predict the outcome of this matter and is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact to Doral Financial of this matter.
On August 13, 2009, Mario S. Levis, the former Treasurer of Doral, filed a complaint against the Company in the Supreme Court of the State of New York. The complaint alleges that the Company breached a contract with the plaintiff and the Company’s by-laws by failing to advance payment of certain legal fees and expenses that Mr. Levis has incurred in connection with a criminal indictment filed against him in the U.S. District Court for the Southern District of New York. Further, the complaint claims that Doral Financial fraudulently induced the plaintiff to enter into agreements concerning the settlement of a civil litigation arising from the restatement of the Company’s financial statements for fiscal years 2000 through 2004. The complaint seeks declaratory relief, damages, costs and expenses. On December 18, 2009, the parties entered into a Settlement Agreement. On December 17, 2009, Mr. Levis’ motion for a preliminary injunction was denied as moot, and all further proceedings were stayed, but the procedures for future disputes between the parties and outlined in the Settlement Agreement were not affected by the stay.
Banking Regulatory Matters
On March 16, 2006, Doral Financial entered into a consent cease and desist order with the Federal Reserve. The mutually agreed upon order required Doral Financial to conduct reviews of its mortgage portfolio, and to submit plans regarding the maintenance of capital adequacy and liquidity. The consent order contains restrictions on Doral Financial from obtaining extensions of credit from, or entering into certain asset purchase and sale transactions with its banking subsidiaries, without the prior approval of the Federal Reserve. The consent order restricts Doral Financial from receiving dividends from the banking subsidiaries without the approval of the respective primary banking regulatory agency. Doral Financial is also required to request permission from the Federal Reserve for the payment of dividends on its common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date and requires Doral Financial and Doral Bank PR to submit plans regarding the maintenance of minimum levels of capital and liquidity. Doral Financial has complied with these requirements and no fines or civil money penalties were assessed against the Company under the order.
As a result of an examination conducted during the third quarter of 2008, on July 8, 2009, Doral Bank PR consented with the FDIC and paid civil monetary penalties of $38,030 related to deficiencies in compliance with the National Flood Insurance Act as a result of flood insurance coverage, failure to maintain continuous flood insurance protection and failure to ensure that borrowers obtain flood insurance in a timely manner.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
On February 19, 2008, Doral Bank PR entered into a consent order with the FDIC relating to failure to comply with certain requirements of the Bank Secrecy Act (“BSA”). The regulatory findings that resulted in the order were based on an examination conducted for the period ended December 31, 2006, and were related to findings that had initially occurred in 2005 prior to the Company’s change in management and the Recapitalization. The order replaced the Memorandum of Understanding with the FDIC and the Office of the Commissioner dated August 23, 2006. Doral Bank PR was not required to pay any civil monetary penalties in connection with this order. The order required Doral Bank PR to correct certain violations of law, within the timeframes set forth in the order (generally 120 days) including certain violations regarding the BSA, failure to maintain an adequate BSA/Anti-Money Laundering Compliance Program (a “BSA/AML Compliance Program”) and failure to operate with an effective compliance program to ensure compliance with the regulations promulgated by the United States Department of Treasury’s Office of Foreign Asset Control (“OFAC”). The order further required Doral Bank PR to, among other things, amend its policies, procedures and processes and training programs to ensure full compliance with the BSA and OFAC; conduct an expanded BSA/AML risk assessment of its operations, enhance its due diligence and account monitoring procedures, review its BSA/AML staffing and resource needs, amend its policies and procedures for internal and external audits to include periodic reviews for BSA/AML compliance, OFAC compliance and perform annual independent testing programs for BSA/AML and OFAC requirements. The order also required Doral Bank PR to engage an independent consultant to review account and transaction activity from April 1, 2006 through March 31, 2007 to determine compliance with suspicious activity reporting requirements (the “Look Back Review”). On September 15, 2008, the FDIC terminated this consent order. As the Look Back Review was in process, Doral Bank PR and the FDIC agreed to a Memorandum of Understanding that covered the remaining portion of the Look Back Review. On June 30, 2009, the FDIC terminated this Memorandum of Understanding because the Look Back Review had been completed.
Doral Financial and Doral Bank PR have undertaken specific corrective actions to comply with the requirements of the terminated enforcement actions and the single remaining enforcement action, but cannot give assurance that such actions are sufficient to prevent further enforcement actions by the banking regulatory agencies.
33.
Retirement and compensation plans
The Company maintains a profit-sharing plan with a cash or deferred arrangement named the Doral Financial Corporation Retirement Savings and Incentive Plan (“the Plan”). The Plan is available to all employees of Doral Financial who have attained age 18 and complete one year of service with the Company. Participants in the Plan have the option of making pre-tax or after-tax contributions. The Company makes a matching contribution equal to $0.50 for every dollar of pre-tax contribution made by participants to the Plan with an annual compensation exceeding $30,000, up to 3% of the participant’s basic compensation, as defined. For those participants in the Plan with an annual compensation up to $30,000, the Company makes a matching contribution equal to $1.00 for every dollar of pre-tax contribution, up to 3% of the participant’s basic compensation, as defined. Company matching contributions are invested following the employees investment direction for their own money. The Company is also able to make fully discretionary profit-sharing contributions to the Plan. The Company’s expense related to its retirement plan during the years ended December 31, 2010, 2009 and 2008, amounted to approximately $436,000, $459,000 and $294,000, respectively.
As of December 31, 2010, 2009 and 2008 the Company had no defined benefit or post-employment benefit plans.
34.
Capital Stock and Additional Paid-In Capital
On September 29, 2003, and October 8, 2003, the Company issued 1,200,000 shares and 180,000 shares, respectively, of its 4.75% perpetual cumulative convertible preferred stock (the “convertible preferred stock”)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
having a liquidation preference of $250 per share in a private offering to qualified institutional buyers pursuant to Rule 144A. Each share of convertible preferred stock is currently convertible into 0.31428 shares of common stock, subject to adjustment under specific conditions. As of December 31, 2010 and 2009, there were 813,526 and 872,160 shares issued and outstanding, respectively. The convertible preferred stock ranks on parity with the Company’s 7.00% non-cumulative non-convertible monthly income preferred stock, Series A (the “7% preferred stock”), 8.35% non-cumulative non-convertible monthly income preferred stock, Series B (the “8.35% preferred stock”) and 7.25% non-cumulative non-convertible monthly income preferred stock, Series C (the “7.25% preferred stock”), with respect to dividend rights and rights upon liquidation, winding up or dissolution (see description below).
On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of convertible and non-convertible preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-convertible preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of convertible preferred stock.
During 2008, the Company paid dividends of $11.875 per share (an aggregate of $16.4 million), on the convertible preferred stock.
During the second quarter of 2002, the Company issued 4,140,000 shares of its 7.25% preferred stock at a price of $25.00 per share, its liquidation preference. As of December 31, 2010 and 2009, there were 2,716,005 and 3,579,202 shares issued and outstanding, respectively. The 7.25% preferred stock may be redeemed at the option of the Company beginning on May 31, 2007, at varying redemption prices starting at $25.50 per share.
On August 31, 2000, the Company issued 2,000,000 shares of its 8.35% preferred stock at a price of $25.00 per share, its liquidation preference. As of December 31, 2010 and 2009, there were 1,331,694 and 1,782,661 shares issued and outstanding, respectively. The 8.35% preferred stock may be redeemed at the option of the Company beginning on September 30, 2005, at varying redemption prices that start at $25.50 per share.
On February 22, 1999, the Company issued 1,495,000 shares of its 7% preferred stock at a price of $50.00 per share, its liquidation preference. As of December 31, 2010 and 2009, there were 950,166 and 1,266,827 shares issued and outstanding, respectively. The 7% preferred stock may be redeemed at the option of the Company beginning February 28, 2004, at varying redemption prices that start at $51.00 per share.
On May 7, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock and a cash payment in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on May 7, 2009 and expired on June 8, 2009. Each of the series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement that was filed with the SEC on May 7, 2009, as amended. The transaction was settled on June 11, 2009.
On October 20, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock for a limited number of its Convertible Preferred Stock. The offer to exchange commenced on October 20, 2009 and expired on December 9, 2009. The transaction was settled on December 14, 2009.
On March 15, 2010, the Company filed a registration statement on Form S-4 announcing its offer to exchange a stated amount of common stock for a limited number of its Convertible and Non-convertible Preferred Stocks. The transaction commenced on February 10, 2010 and expired on March 19, 2010. The transaction was settled on March 24, 2010.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The exchange by holders of shares of the non-convertible preferred stock for shares of common stock and payment of a cash premium resulted in the extinguishment and retirement of such shares of non-convertible preferred stock and an issuance of common stock. The carrying (liquidation) value of each share of non-convertible preferred stock retired was reduced and common stock and additional paid-in-capital increased in the amount of the fair value of the common stock issued. Upon the cancellation of such shares of non-convertible preferred stock acquired by the Company pursuant to the offer to exchange, the difference between the carrying (liquidation) value of shares of non-convertible preferred stock retired and the fair value of the exchange offer consideration exchanged (cash plus fair value of common stock) was treated as an increase to retained earnings and income available to common shareholders for earnings per share purposes.
The exchange by holders of convertible preferred stock for common stock and a cash premium was accounted for as an induced conversion. Common stock and additional paid-in-capital was increased by the carrying (liquidation) value of the amount of convertible preferred stock exchanged. The fair value of common stock issued and the cash premium in excess of the fair value of securities issuable pursuant to the original exchange terms was treated as a reduction to retained earnings and net income available to common shareholders for earnings per share purposes.
On April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers of the Company’s common stock, including certain direct and indirect investors in Doral Holdings Delaware LLC (“Doral Holdings”), the Company’s parent company, to raise up to $600.0 million of new equity capital for the Company through a private placement. Shares were sold in two tranches: (i) a $180.0 million non-contingent tranche consisting of approximately 180,000 shares of the Company’s Mandatorily Convertible Non-Cumulative Non-Voting Preferred Stock (the “Preferred Stock”), $1.00 par value and $1,000 liquidation preference per share and (ii) a $420.0 million contingent tranche consisting of approximately 13.0 million shares of the Company’s common stock and approximately 359,000 shares of non-voting Preferred Stock. In addition, as part of the non-contingent tranche, the Company issued into escrow 105,002 shares of Preferred Stock with a liquidation value of $105.0 million, to be released to purchasers if the Company did not complete an FDIC assisted transaction.
Doral used the net proceeds from the placement of the shares in the Non-Contingent Tranche to provide additional capital to the Company to facilitate the Company (through its wholly owned subsidiary, Doral Bank PR) qualifying as a bidder for the acquisition of certain assets and assumption of certain liabilities of one or more banks from the FDIC, as receiver.
On April 30, 2010, the Company announced that it had not been selected to acquire the assets and liabilities of any Puerto Rico bank in an FDIC-assisted transaction. As a result, pursuant to the Stock Purchase Agreement and the related escrow agreement, the 105,002 shares of Preferred Stock and the $420.0 million of contingent funds were released from escrow to the purchasers and the contingent tranche of securities was not issued. After giving effect to the release of the 105,002 shares of Preferred Stock from escrow, the shares of Preferred Stock issued in the capital raise had an effective sale price of $3.00 per common share equivalent.
In connection with the Stock Purchase Agreement, the Company also entered into a Cooperation Agreement with Doral Holdings, Doral Holdings L.P. and Doral GP Ltd. pursuant to which Doral Holdings made certain commitments including the commitment to vote in favor of converting the Preferred Stock to common stock and registering the shares issued pursuant to this capital raise and other previously issued unregistered shares of common stock and to dissolve Doral Holdings pursuant to certain terms and conditions.
Accordingly, during the third quarter of 2010, the Company converted 285,002 shares of Preferred Stock into 60,000,386 shares of common stock. In addition, during the third quarter of 2010, Doral Holdings LLC, previously the controlling shareholder of Doral Financial, distributed its shares in Doral Financial to its investors and was dissolved. The Company is no longer a controlled company as a result of this conversion and the dissolution of Doral Holdings LLC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company had the following series of preferred stock prior to the settlement of the exchange offers:
Results of the 2009 preferred stock exchange offers were as follows:
Results of the 2010 preferred stock exchange offers were as follows:
The ability of the Company to pay dividends in the future is limited by the consent order entered into with the Federal Reserve and by various restrictive covenants contained in the debt agreements of the Company, the earnings, cash position and capital needs of the Company, general business conditions and other factors deemed relevant by the Company’s Board of Directors.
Current regulations limit the amount in dividends that Doral Bank PR and Doral Bank US may pay. Payment of such dividends is prohibited if, among other things, the effect of such payment would cause the capital of Doral Bank PR or Doral Bank US to fall below the regulatory capital requirements. The Federal Reserve Board has issued a policy statement that provides that insured banks and financial holding companies should generally pay dividends only out of current operating earnings. In addition, the Company’s consent order with the Federal Reserve does not permit the Company to receive dividends from Doral Bank PR unless the payment of such dividends has been approved by the FDIC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Dividends paid from a U.S. subsidiary to certain qualifying corporations such as the Company are generally subject to a 10% withholding tax under the provisions of the U.S. Internal Revenue Code.
35.
Stock Option and Other Incentive Plans
Since 2003 Doral Financial commenced expensing the fair value of stock options granted to employees using the “modified prospective” method. Using this method, the Company has expensed the fair value of all employee stock options and restricted stock granted after January 1, 2003, as well as the unvested portions of previously granted stock options. The Company estimates the pre-vesting forfeiture rate, for grants that are forfeited prior to vesting, beginning on the grant date and to true-up forfeiture estimates through the vesting date so that compensation expense is recognized only for grants that vest. When unvested grants are forfeited, any compensation expense previously recognized on the forfeited grants is reversed in the period of the forfeiture. Accordingly, periodic compensation expense will include adjustments for actual and estimated pre-vesting forfeitures and changes in the estimated pre-vesting forfeiture rate. The Company did not change its adjustment for actual and estimated pre-vesting forfeitures and changes in the estimated pre-vesting forfeiture rate.
On April 8, 2008, the Company’s Board of Directors approved the 2008 Stock Incentive Plan (the “Plan”) subject to shareholder approval, which was obtained at the annual shareholders’ meeting held on May 7, 2008. The Plan replaced the 2004 Omnibus Incentive Plan. Stock options granted are expensed over the stock option vesting period based on fair value which is determined using the Black-Scholes option-pricing method at the date the options are granted.
The Omnibus Plan was in effect from April 21, 2004 throughout 2008, and provided for equity-based compensation incentives (the “awards”) through the grant of stock options, stock appreciation rights, restricted stock, restricted stock units and dividend equivalents, as well as cash and equity-based performance awards. The Compensation Committee had full authority and absolute discretion to determine those eligible to receive awards and to establish the terms and conditions of any awards; however, the Omnibus Plan had various limits and vesting restrictions that applied to individual and aggregate awards.
The aggregate number of shares of common stock which the Company may issue under the Plan is limited to 6,750,000. No options were granted by the Company for the year ended December 31, 2010 and 2009.
On July 22, 2008, four independent directors were each granted 2,000 shares of restricted stock and stock options to purchase 20,000 shares of common stock at an exercise price equal to the closing price of the stock on the grant date. The restricted stock became 100% vested during the third quarter of 2009. The stock options vest ratably over a five year period commencing with the grant date.
On June 25, 2010, the Board of Directors of Doral Financial Corporation approved and adopted a retention program for six of the Company’s officers (the “Retention Program”). Pursuant to the Retention Program, the Company granted 3,000,000 shares of the Company’s common stock as restricted stock to such officers. The restricted stock will vest in installments as long as at the time of vesting the employee has been continuously employed by the Company from the date of grant, as follows: 33% will vest 12 calendar months after the grant date, an additional 33% will vest 24 calendar months after the grant date, and the remaining 33% will vest 36 calendar months after the grant date. Notwithstanding the foregoing, 100% of the restricted stock will vest (i) upon the occurrence of a change of control of the Company; (ii) if the Company terminates the employee’s employment without cause or the employee terminates his or her employment for good reason (as defined in the agreement); or (iii) upon such employee’s death.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Stock-based compensation recognized was as follows:
Changes in stock options for 2010, 2009 and 2008 are as follows:
The fair value of the options granted in 2008 was estimated using the Black-Scholes option-pricing model, with the following assumptions:
Expected volatility is based on the historical volatility of the Company’s common stock over a ten-year period. The Company uses empirical research data to estimate options exercise and employee termination within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The expected dividend yield is based on management’s expectation that the Company will not resume dividend payments on its Common Stock for the foreseeable future.
Doral Financial’s nonvested restricted shares activity for the year ended December 31, 2010 are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
During 2010, 2009 and 2008, no options were exercised.
As of December 31, 2010, the total amount of unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan was approximately $7.0 million related to stock options and restricted stock granted. That cost is expected to be recognized over a period of 3 years for the stock options and the restricted stock. As of December 31, 2010, the total fair value of shares and restricted stock was $8.8 million.
36.
Losses Per Share Data
The reconciliation of the numerator and denominator of the losses per share follows:
(1)
The carrying value of the non-convertible preferred stock exceeded the fair value of consideration transferred and, accordingly, the difference between the liquidation preference of the preferred stock retired and the market value of the common stock issued and the cash tendered (in 2009) amounted to $31.6 million and $23.9 million for the years ended December 31, 2010 and 2009, respectively, and was credited to retained earnings. In the case of the convertible preferred stock, the fair value of stock exchanged for the preferred stock converted exceeded the fair value of the stock issuable pursuant to the original conversion terms and, accordingly, this excess or inducement amounted to $5.1 million and $32.5 million for the years ended December 31, 2010 and 2009, respectively, was charged to retained earnings. As a result, both transactions impacted the net loss attributable to common shareholders.
(2)
Potential common shares consist of common stock issuable under the assumed exercise of stock options and unvested shares of restricted stock using the treasury stock method. This method assumes that the potential common shares are issued and the proceeds from exercise in addition to the amount of compensation cost attributed to future services are used to purchase common stock at the exercise date. The difference between the number of potential shares issued and the shares purchased is added as incremental shares to the actual number of shares outstanding to compute diluted earnings per share. Stock options and unvested shares of restricted stock that result in lower potential shares issued than shares purchased under the treasury stock method are not included in the computation of dilutive (loss) earnings per share since their inclusion would have an antidilutive effect in earnings per share. As of December 31, 2010, there were granted 60,000 stock options and 3,000,000 shares of restricted stock that were also excluded from this computation for its antidilutive effect.
(3)
For the years ended December 31, 2010, 2009 and 2008, net loss per common share represents both the basic and diluted loss per common share, respectively, for each of the periods presented.
On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of convertible and non-convertible preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-convertible preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of convertible preferred stock.
For the year ended December 31, 2010, there were 813,526 shares of the Company’s 4.75% perpetual cumulative convertible preferred stock that were excluded from the computation of diluted earnings per share because their effect would have been antidilutive, compared to 872,160 for the corresponding 2009 period. Each share of convertible preferred stock is currently convertible into 0.31428 shares of common stock, subject
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
to adjustment under specific conditions. The option of the purchasers to convert the convertible preferred stock into shares of the Company’s common stock is exercisable only (a) if during any fiscal quarter after September 30, 2003, the closing sale price of the Company’s common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading date of the preceding fiscal quarter exceeds 120% of the conversion price of the convertible preferred stock (currently 120% of $795.47, or $954.56); (b) upon the occurrence of certain corporate transactions; or (c) upon the delisting of the Company’s common stock. On or after September 30, 2008, the Company may, at its option, cause the convertible preferred stock to be converted into the number of shares of common stock that are issuable at the conversion price. The Company may only exercise its conversion right if the closing sale price of the Company’s common stock exceeds 130% of the conversion price of the convertible preferred stock (currently 130% of $795.47, or $1,034.11) in effect for 20 trading days within any period of 30 consecutive trading days ending on a trading day not more than two trading days prior to the date the Company gives notice of conversion.
37.
Regulatory Requirements
Holding Company Requirements
Doral Financial is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956 (the “BHC Act”), as amended by the Gramm-Leach-Bliley Act of 1999 (the “Gramm-Leach-Bliley Act”). As a bank holding company, Doral Financial’s activities and those of its banking and non-banking subsidiaries are limited to banking activities and such other activities the Federal Reserve has determined to be closely related to the business of banking.
Banking Charters
Doral Bank PR is a commercial bank chartered under the laws of the Commonwealth of Puerto Rico regulated by the Office of the Commissioner of Financial Institutions (the “Office of the Commissioner”), pursuant to the Puerto Rico Banking Act of 1933, as amended, and subject to supervision and examination by the Federal Deposit Insurance Corporation (“FDIC”). Its deposits are insured by the FDIC.
Doral Bank US is a federally chartered savings bank regulated by the Office of Thrift Supervision (“OTS”). Its deposit accounts are also insured by the FDIC.
Regulatory Capital Requirements
The Company’s banking subsidiaries are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory actions against Doral Financial’s banking subsidiaries, as well as additional discretionary actions, by regulators that, if undertaken, could have a direct material effect on the Company. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and its banking subsidiaries must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items. The Company’s and its banking subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures, established by regulation to ensure capital adequacy, require the Company’s banking subsidiaries to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined).
As of December 31, 2010, Doral Bank PR and Doral Bank US exceeded the thresholds for well-capitalized banks as set forth in the prompt corrective action regulations adopted by the FDIC pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991. The thresholds for a well capitalized
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
institution prescribed by the FDIC’s regulations are, a Leverage Ratio of at least 5%, a Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and the institution must not be subject to any written agreement or directive to meet a specific capital ratio.
Failure to meet minimum regulatory capital requirements could result in the initiation of certain mandatory and additional discretionary actions by banking regulators against Doral Financial and its banking subsidiaries that, if undertaken, could have a material adverse effect on the Company.
On March 17, 2006, the Company entered into a consent order with the Federal Reserve. Pursuant to the requirements of the existing cease and desist order, the Company submitted a capital plan to the Federal Reserve in which it has agreed to maintain minimum leverage ratios of at least 5.5% and 6.0% for Doral Financial and Doral Bank PR, respectively. While the Tier 1 and Total capital ratios have risk weighting components that take into account the low level of risk associated with the Company’s mortgage and securities portfolios, the Leverage Ratio is significantly lower because it is based on total average assets without any risk weighting.
As of December 31, 2010, Doral Bank PR exceeded the “well-capitalized” threshold under the regulatory framework for prompt corrective action. To exceed the “well-capitalized” threshold, Doral Bank PR must maintain Total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table.
Doral Bank US is subject to substantially the same regulatory capital requirements of Doral Bank PR as set forth above. As of December 31, 2010, Doral Bank US was in compliance with the capital threshold for a “well-capitalized” institution.
On March 19, 2009, the Board of Directors of Doral Financial approved a capital infusion of up to $75.0 million to Doral Bank PR, of which $19.8 million was made during the first quarter of 2009. On November 20, 2009, the Board of Directors approved an additional capital contribution of up to $100.0 million to Doral Bank PR, which was made during November and December 2009. During the second and third quarter of 2010, the Board of Directors of Doral Financial approved capital contributions to Doral Bank PR totaling $194.0 million.
Doral Financial’s, Doral Bank PR’s and Doral Bank US’s actual capital amounts and ratios are presented in the following table. Approximately $117.6 million (2009 - $124.1 million), $21.5 million (2009 - $24.1 million), and $1.7 million (2009 - $1.9 million) representing non-qualifying perpetual preferred stock
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
and non-allowable assets such as deferred tax asset, goodwill and other intangible assets, were deducted from the capital of Doral Financial, Doral Bank PR and Doral Bank US, respectively.
(1)
Tier 1 capital to average assets in the case of Doral Financial and Doral Bank PR, and Tier 1 capital to adjusted total assets in the case of Doral Bank US.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Housing and Urban Development Requirements
The Company’s mortgage operation is a U.S. Department of Housing and Urban Development (“HUD”) approved non-supervised mortgagee and is required to maintain an excess of current assets over current liabilities and minimum net worth, as defined by the various regulatory agencies. Such equity requirement is tied to the size of the Company’s servicing portfolio and ranged up to $1.0 million. The Company is also required to maintain fidelity bonds and errors and omissions insurance coverage based on the balance of its servicing portfolio. Non-compliance with these requirements could derive in actions from the regulatory agencies such as monetary penalties, the suspension of the license to originate loans, among others.
As of December 31, 2010 and December 31, 2009, Doral Mortgage maintained $27.2 million and $24.4 million, respectively, in excess of the required minimum level for adjusted net worth required by HUD.
Registered Broker-Dealer Requirements
During the third quarter of 2007, Doral Securities voluntarily withdrew its license as broker dealer with the SEC and its membership with FINRA. As a result of this decision, Doral Securities’ operations during 2008 were limited to acting as a co-investment manager to a local fixed-income investment company. Doral Securities provided notice to the investment company in December 2008 of its intent to assign its rights and obligations under the investment advisory agreement to Doral Bank PR. The assignment was completed in January 2009 and Doral Securities did not conduct any other operations in 2009. During the third quarter of 2009, this investment advisory agreement was terminated by the investment company. Effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial Corporation.
38.
Fair Value of Assets and Liabilities
The Company uses fair value measurements to state certain assets and liabilities at fair value and to support fair value disclosures. Securities held for trading, securities available for sale, derivatives and servicing assets are recorded at fair value on a recurring basis. Additionally, from time to time, Doral may be required to record other financial assets at fair value on a nonrecurring basis, such as loans held for sale, loans receivable and certain other assets. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.
The Company discloses for interim and annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not in the statement of financial position.
Fair Value Hierarchy
The Company categorizes its financial instruments based on the priority of inputs to the valuation technique into a three level hierarchy described below.
•
Level 1 - Valuation is based upon unadjusted quoted prices for identical instruments traded in active markets.
•
Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market, or are derived principally from or corroborated by observable market data, by correlation or by other means.
•
Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Determination of Fair Value
The Company bases fair values on the price that would be received upon sale of an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. It is Doral Financial’s intent to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy.
Fair value measurements for assets and liabilities where there is limited or no observable market data are based primarily upon the Company’s estimates, and are generally calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the fair values represent management’s estimates and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.
The Company relies on appraisals for valuation of collateral dependent impaired loans and other real estate owned. An appraisal of value is obtained at the time the loan is originated. New estimates of collateral value are obtained when a loan that has been performing becomes delinquent and is determined to be collateral dependent, and at the time an asset is acquired through foreclosure. Updated reappraisals are requested at least every two years for collateral dependent loans and other real estate owned.
Residential mortgage loans are considered collateral dependent when they are 180 days past due (collateral dependent residential mortgage loans are those past due loans whose borrowers’ financial condition has deteriorated to the point that Doral considers only the collateral when determining its allowance for loan loss estimate). An updated estimate of the property’s value is obtained when the loan in 180 days past due, and a second assessment of value is obtained when the loan is 360 days past due. The Company generally uses broker price opinions (“BPOs”) as an assessment of value of collateral dependent residential mortgage loans.
As it takes a period of time for commercial loan appraisals to be completed once they are ordered, Doral must at times estimate its allowance for loan and lease losses for an impaired loan using a dated, or stale, appraisal. As Puerto Rico has experienced some decrease in property values during its extended recession, the reported values of the stale appraisals must be adjusted to recognize the “fade” in market value. In order to estimate the value of collateral with stale appraisals, Doral has developed separate collateral price indices for small commercial loans and large commercial loans that are used to measure the market value fade in appraisals completed in one year to the current year. The indices provide a measure of how much the property value has changed from the year in which the most recent appraisal was received to the current year. In estimating its allowance for loan and lease losses on collateral dependent loans using outdated appraisals, Doral uses the original appraisal as adjusted for the estimated fade in property value less selling costs to estimate the current fair value of the collateral. That current adjusted estimated fair value is then compared to the reported investment, and if the adjusted fair value is less than reported investment, that amount is included in the allowance for loan and lease loss estimate.
Residential development construction loans that are collateral dependent present unique challenges to estimating the fair value of the underlying collateral. Residential development construction loans are partially completed with additional construction costs to be incurred, have units being sold and released from the construction loan, and may have additional land collateralizing the loan on which the developer hopes or expects to build additional units. Therefore, the value of the collateral is regularly changing and any appraisal has a limited useful life. Doral uses an internally developed estimate of value that considers Doral’s exit strategy of foreclosing and completing the construction started and selling the individual units constructed for residential buildings, and separately uses the most recent appraised value for any remnant land adjusted for the fade in value since the appraisal date as described above. This internally developed estimate is prepared in conjunction with a third party servicer of the portfolio who validates and determines the inputs used to arrive at the estimate of value (e.g. units sold, expected sales, cost to complete, etc.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Once third party appraisals are obtained the previously estimated property values are updated with the actual values reflected in the appraisal and any additional loss incurred is recognized in the period when the appraisal is received. The internally developed collateral price index is also updated and any changes resulting from the update in the index are also recognized in the period.
Following is a description of valuation methodologies used for financial instruments recorded at fair value, including the general classification of such instruments pursuant to the valuation hierarchy.
Securities held for trading: Securities held for trading are reported at fair value and consist primarily of securities and derivatives held for trading purposes. The valuation method for trading securities is the same as the methodology used for securities classified as Available for Sale. The valuation methodology for IOs (Level 3) and derivatives (Level 2) are described in the Servicing assets and interest-only strips, and Derivatives sections, respectively.
For residual CMO certificates included in trading securities, the Company uses a cash flow model to value the securities. Doral utilizes the collateral’s statistics available on Bloomberg such as forecasted prepayment speed, weighted-average remaining maturity, weighted-average coupon and age. Based on Bloomberg information, the Company forecasts the cash flows and then discounts it at the discount rate used for the period. For purposes of discounting, the Company uses the same Z-spread methodology used for the valuations of Doral’s floating rate IOs.
Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions, expected defaults and loss severity. Level 1 securities (held for trading) include those securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 securities include agency CMOs, municipal bonds, and agency MBS. Level 3 securities include non-agency and agency CMOs for which quoted market prices are not available. For determining the fair value of Level 3 securities available for sale, the Company uses a valuation model that calculates the present value of estimated future cash flows. The model incorporates the Company’s own estimates of assumptions market participants use in determining the fair value, including prepayment speeds, loss assumptions and discount rates.
Loans held for sale: Loans held for sale are carried at the lower of net cost or market value on an aggregate portfolio basis. The amount, by which cost exceeds market value, if any, is accounted for as a loss through a valuation allowance. Loans held for sale consist primarily of mortgage loans held for sale. The market value of mortgage loans held for sale is generally based on quoted market prices for MBS adjusted to reflect particular characteristics of the asset such as guarantee fees, servicing fees, actual delinquency and credit risk. Loans held for sale are classified as Level 2, except for loans where management makes certain adjustments to the model based on unobservable inputs that are significant. These loans are classified as Level 3. Loans held for sale were carried at cost as of December 31, 2010.
Loans receivable: Loans receivable are those held principally for investment purposes. These consist of construction loans for new housing development, certain residential mortgage loans which the Company does not expect to sell in the near future, commercial real estate, commercial and industrial, leases, land, and consumer loans. Loans receivable are carried at their unpaid principal balance, less unearned interest, net of deferred loan fees or costs (including premiums and discounts), undisbursed portion of construction loans and an allowance for loan and lease losses. Loans receivable include collateral dependent loans for which the repayment of the loan is expected to be provided solely by the underlying collateral. The Company does not record loans receivable at fair value on a recurring basis. However, from time to time, the Company records nonrecurring fair value adjustments to collateral dependent loans to reflect (i) partial write-downs that are based on the fair value of the collateral, or (ii) the full charge-off of the loan carrying value. The fair value of the collateral is mainly derived from appraisals that take into consideration prices in observed transactions
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
involving similar assets in similar locations. The Company classifies loans receivable subject to nonrecurring fair value adjustments as Level 3.
For the fair value of loans receivable, not reported at fair value, loans are classified by type such as residential mortgage loans, commercial real estate, commercial and industrial, leases, land, and consumer loans. The fair value of residential mortgage loans is based on quoted market prices for MBS adjusted by particular characteristics like guarantee fees, servicing fees, actual delinquency and the credit risk associated to the individual loans. For the syndicated commercial loans, the Company engages a third party specialist to assist with its valuation. The fair value of syndicated commercial loans is determined based on market information on trading activity. For all other loans, the fair value is estimated using discounted cash flow analyses, based on LIBOR and with adjustments that the Company believes a market participant would consider in determining fair value for like assets.
Servicing assets and interest-only strips: The Company routinely originates, securitizes and sells mortgage loans into the secondary market. As a result of this process, the Company typically retains the servicing rights and, in the past, also retained IOs. Servicing assets retained in a sale or securitization arise from contractual agreements between the Company and investors in mortgage securities and mortgage loans. Since 2007, the Company records mortgage servicing assets at fair value on a recurring basis. Considerable judgment is required to determine the fair value of the Company’s servicing assets. Unlike highly liquid investments, the market value of servicing assets cannot be readily determined because these assets are not actively traded in securities markets. The fair value of the servicing assets is determined based on a combination of market information on trading activity (servicing asset trades and broker valuations), benchmarking of servicing assets (valuation surveys) and cash flow modeling. The valuation of the Company’s servicing assets incorporates two sets of assumptions: (i) market derived assumptions for discount rates, servicing costs, escrow earnings rate, float earnings rate and cost of funds and (ii) market derived assumptions adjusted for the Company’s loan characteristics and portfolio behavior for escrow balances, delinquencies and foreclosures, late fees, prepayments and prepayment penalties. For IOs the Company uses a valuation model that calculates the present value of estimated future cash flows. The model incorporates the Company’s own estimates of assumptions market participants use in determining the fair value, including estimates of prepayment speeds, discount rates, defaults and contractual fee income. IOs are recorded as securities held for trading. Fair value measurements of servicing assets and IOs use significant unobservable inputs and, accordingly, are classified as Level 3.
Real estate held for sale: The Company acquires real estate through foreclosure proceedings. These properties are held for sale and are stated at the lower of cost or fair value (after deduction of estimated disposition costs). A loss is recognized for any initial write down to fair value less costs to sell. The fair value of the properties is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the properties, which are not market observable. The Company records nonrecurring fair value adjustments to reflect any losses in the carrying value arising from periodic appraisals of the properties charged to expense in the period incurred. The Company classifies real estate held for sale subject to nonrecurring fair value adjustments as Level 3.
Other assets: The Company may be required to record certain assets at fair value on a nonrecurring basis. These assets include premises and equipment, goodwill, and certain assets that are part of CB, LLC. CB, LLC is an entity formed to manage a residential real estate project that Doral Bank PR received in lieu of foreclosure. Fair value measurements of these assets use significant unobservable inputs and, accordingly, are classified as Level 3.
Premises and equipment: Premises and equipment are carried at cost. However, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, the Company recognizes an impairment loss based on the fair value of the property, which is generally obtained from
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
appraisals. Property impairment losses are recorded as part of occupancy expenses in the Consolidated Statement of Operations.
Goodwill: Goodwill is not amortized, but is tested for impairment at least annually or more frequently if events or circumstances indicate possible impairment. In determining the fair value of a reporting unit the Company uses discounted cash flow analysis. Goodwill impairment losses are recorded as part of other expenses in the Consolidated Statement of Operations.
CB, LLC: Events or changes in circumstances may indicate that the carrying amount of certain assets may not be recoverable, such as for land and the remaining housing units. Impairment losses are recorded as part of occupancy expenses in the Consolidated Statement of Operations.
Derivatives: Substantially all of the Company’s derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, Doral Financial measures fair value using internally developed models that use primarily market observable inputs, such as yield curves and volatility surfaces.
The non-performance risk is evaluated internally considering collateral held, remaining term and the creditworthiness of the entity that bears the risk. These derivatives are classified as Level 2. Level 2 derivatives consist of interest rate swaps and interest rate caps.
Following is a description of valuation methodologies used for instruments not recorded at fair value.
Cash and due from banks and other interest-earning assets: Valued at the carrying amounts in the Consolidated Statements of Financial Condition. The carrying amounts are reasonable estimates of fair value due to the relatively short period to maturity.
Deposits: Fair value is calculated considering the discounted cash flows based on brokered certificates of deposit curve and internally generated decay assumptions.
Loans payable: These loans represent secured lending arrangements with local financial institutions that are generally floating rate instruments, and therefore their fair value has been determined to be par.
Notes payable, advances from FHLB, other short-term borrowings and securities sold under agreements to repurchase: Valued utilizing discounted cash flow analysis over the remaining term of the obligation using market rates for similar instruments.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Financial Assets and Liabilities Recorded at Fair Value on a Recurring Basis
The tables below present the balance of assets and liabilities measured at fair value on a recurring basis.
(1)
Included as part of accrued expenses and other liabilities in the Consolidated Statement of Financial Condition
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The changes in Level 3 of assets for the years ended December 31, 2010 and 2009, measured at fair value on a recurring basis are summarized as follows:
(1)
Securities held for trading classified as Level 3 include IOs and residual CMO certificates. Change in fair value is recognized as part of non-interest income in the Company’s Consolidated Statement of Operations as net gain (loss) on trading activities, which includes
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
$8.8 million and $2.8 million of changes in fair value of IOs and $0.1 million of changes in fair value of residual CMO certificates for the years ended December 31, 2010 and 2009, respectively. Amortization of IO is recognized as part of interest income on interest-only strips and includes $10.3 million and $9.3 million for the years ended December 31, 2010 and 2009, respectively.
(2)
Level 3 securities available for sale include non-agency and agency CMOs, certain agency mortgage-backed securities and other securities not actively traded. OTTI is recognized as part of non-interest income in the Company’s Consolidated Statement of Operations. Amortization of premium and discount is recognized as part of interest income as mortgage-backed securities, which includes $1.3 million and $0.3 million for the years ended December 31, 2010 and 2009, respectively.
(3)
Change in fair value of servicing assets is recognized as part of non-interest income in the Company’s Consolidated Statement of Operations as servicing income for the periods presented. The change in fair value is net of the adjustment related to the repurchase of $102.8 million and $178.7 million in principal balance of mortgage loans serviced for others for the years ended December 31, 2010 and 2009, respectively. Capitalization of servicing assets is recognized as part of non-interest income (loss) as net gain on mortgage loan sales and fees, which includes $8.2 million and $7.4 million for the years ended December 31, 2010 and 2009, respectively.
(4)
Other adjustments include purchases, sales, principal repayments, amortization of premium and discount, and transfers from Level 3 of securities available for sale. Other adjustments also include the capitalization of servicing assets.
Assets Recorded at Fair Value on a Nonrecurring Basis
The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described above. The following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at period end.
(1)
Represents the carrying value of collateral dependent loans for which adjustments are based on the appraised value of the collateral.
(2)
Represents the carrying value of real estate held for sale for which adjustments are based on the appraised value of the properties.
(3)
Represents the carrying value of CB, LLC assets for which adjustments are based on the appraised value of land and the remaining housing units.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The following table summarizes total losses relating to assets (classified as level 3) held at the reporting periods.
Disclosures about Fair Value of Financial Instruments
The following table discloses the carrying amounts of financial instruments and their estimated fair values as of December 31, 2010 and 2009. The amounts in the disclosure have not been updated since year end, therefore, the valuations may have changed significantly since that point in time. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methods may have a material effect on the estimated fair value amounts.
For assets measured at fair value on a nonrecurring basis during 2010 that were still hold on the balance sheet at December 31, 2010, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets of portfolios at period end.
(1)
Includes derivatives of $13,000 and $1.1 million for December 31, 2010 and 2009, respectively.
(2)
Includes $153.4 million and $128.6 million for December 31, 2010 and 2009, respectively, related to GNMA defaulted loans for which the Company has an unconditional buy-back option.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
(3)
Includes $0.7 million and $1.9 million of derivatives held for trading purposes and $4.7 million and $10.7 million of derivatives held for purposes other than trading, for December 31, 2010 and 2009, respectively, as part of accrued expenses and other liabilities in the Consolidated Statement of Financial Condition.
39.
Derivatives
Doral Financial uses derivatives to manage its exposure to interest rate risk. The Company maintains an overall interest rate risk-management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate changes. Derivatives include interest rate swaps, interest rate caps and forward contracts. The Company’s goal is to manage interest rate sensitivity by modifying the repricing or maturity characteristics of certain balance sheet assets and liabilities so that net interest margin is not, on a material basis, adversely affected by movements in interest rates.
Doral Financial accounts for derivatives on a mark-to-market basis with gains or losses charged to operations as they occur. The fair value of derivatives is generally reported net by counterparty. The fair value of derivatives accounted as hedges is also reported net of accrued interest and included in other liabilities in the Consolidated Statement of Financial Position. Derivatives not accounted as hedges in a net asset position are recorded as securities held for trading and derivatives in a net liability position as other liabilities in the Consolidated Statement of Financial Position.
As of December 31, 2010 and 2009, the Company had the following derivative financial instruments outstanding:
(1)
Fair value included as part of “Securities held for trading” in the Company’s Statement of Financial Condition.
(2)
Fair value included as part of “Accrued expenses and other liabilities” in the Company’s Statement of Financial Condition.
Cash Flow Hedges
As of December 31, 2010 and 2009, the Company had $74.0 million and $305.0 million, respectively, outstanding pay fixed interest rate swaps designated as cash flow hedges with maturities between September 2011 and November 2012 (2009 - July 2010 - November 2012). The Company designated the pay fixed interest rate swaps to hedge the variability of future interest cash flows of adjustable rate advances from FHLB. For the year ended December 31, 2010, the Company recognized $0.3 million of ineffectiveness for the interest rate swaps designated as cash flow hedges. For the year ended December 31, 2009 no inefectiveness was recognized. As of December 31, 2010 and 2009, accumulated other comprehensive income (loss) included unrealized losses on cash flow hedges of $3.2 million and $7.6 million, respectively, of which the Company expects to reclassify approximately $3.0 million and $7.2 million, respectively, against earnings during the next twelve months.
Doral Financial’s interest rate swaps had weighted average receive rates of 0.29% and 0.25% and weighted average pay rates of 4.60% and 3.53% at December 31, 2010 and 2009, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The table below presents the location and effect of cash flow derivatives on the Company’s results of operations and financial condition for the years ended December 31, 2010 and 2009.
Trading and Non-Hedging Activities
The following table summarizes the total derivatives positions at December 31, 2010 and 2009, respectively, and their different designations. It also includes net gains (losses) on derivative positions for the periods indicated.
Doral Financial held $310.0 million and $480.0 million in notional value of derivatives not designated as hedges at December 31, 2010 and 2009, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company purchases interest rate caps to manage its interest rate exposure. Interest rate cap agreements generally involve purchases of out of the money caps to protect the Company from adverse effects from rising interest rates. These products are not linked to specific assets and liabilities that appear on the balance sheet or to a forecasted transaction and, therefore, do not qualify for hedge accounting. As of December 31, 2010 and 2009, the Company had outstanding interest rate caps with a notional amount of $210.0 million and $270.0 million, respectively.
The Company enters into forward contracts to create an economic hedge on its mortgage warehouse line. During the second quarter of 2009, the Company entered into an additional forward contract to create an economic hedge on its MSR. The notional amount of this additional forward contract as of December 31, 2010 and 2009 was $50.0 million and $165.0 million, respectively. As of December 31, 2010 and 2009, the Company had forwards hedging its warehousing line with a notional amount of $50.0 million and $45.0 million, respectively. For the years ended December 31, 2010 and 2009, the Company recorded gains of $5.6 million and $2.8 million, respectively, on forward contracts which included gains of $7.5 million and $5.2 million, respectively, related to the economic hedge on the MSR.
Credit risk related to derivatives arises when amounts receivable from a counterparty exceed those payable. Because the notional amount of the instruments only serves as a basis for calculating amounts receivable or payable, the risk of loss with any counterparty is limited to a small fraction of the notional amount. Doral Financial’s maximum loss related to credit risk is equal to the gross fair value of its derivative instruments. Doral Financial deals only with derivative dealers that are national market makers with strong credit ratings in their derivatives activities. The Company further controls the risk of loss by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. In addition, counterparties are required to provide cash collateral to Doral Financial when their unsecured loss positions exceed certain negotiated limits.
All derivative contracts to which Doral Financial is a party settle monthly, quarterly or semiannually. Further, Doral Financial has netting agreements with the dealers and only does business with creditworthy dealers. Because of these factors, Doral Financial’s credit risk exposure related to derivatives contracts at December 31, 2010 and 2009 was not considered material.
40.
Variable Interest Entities
In June 2009, the FASB revised authoritative guidance for determining the primary beneficiary of a variable interest entity (“VIE”). A variable interest entity is an entity that by design possesses the following characteristics:
•
The equity investment at risk is not sufficient for the entity to finance its activities without additional subordinated financial support.
•
As a group, the holders of equity investment at risk do not possess: (i) the power, through voting rights or similar rights, to direct the activities that most significantly impact the entity’s economic performance; or (ii) the obligation to absorb expected losses or the right to receive the expected residual returns of the entity; or (iii) symmetry between voting rights and economic interests and where substantially all of the entity’s activities either involve or are conducted on behalf of an investor with disproportionately fewer voting rights (e.g., structures with nonsubstantive voting rights).
The Company is required to consolidate any VIEs in which it is deemed to be the primary beneficiary through having (i) power over the significant activities of the entity and (ii) having an obligation to absorb losses or the right to receive benefits from the VIE which are potentially significant to the VIE.
The Company identified four potential sources of variable interests: (i) the servicing portfolio, (ii) the investment portfolio, (iii) the lending portfolio and (iv) special purpose entities with which the Company is involved, and performed and assessed each for the existence of VIEs and determination of possible
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
consolidation requirements. In all instances where the Company identified a variable interest in a VIE, a primary beneficiary analysis was performed.
Servicing Assets: In the ordinary course of business, the Company transfers financial assets (whole loan sale/securitizations) in which it has retained the right to service the assets. The servicing portfolio was considered a potential source of variable interest and was analyzed to determine if any VIEs required consolidation. The servicing portfolio was grouped into three segments: government sponsored entities (“GSEs”), governmental agencies and private investors. Except for two private investors (further analyzed as investment securities below), the Company concluded that the servicing fee received from providing this service did not represent a variable interest as defined by this guidance. The Company determined that its involvement with these entities is in the ordinary course of business and the criteria established to consider the servicing activities as those of a service provider (fiduciary in nature) and not a decision maker, were met.
Investment Securities: The Company analyzed its investment portfolio and determined that it had several residual interests in non-agency CMOs that required full analysis to determine the primary beneficiary. For trading assets and insignificant residual interests as well as investments in non-profit vehicles, the Company determined that it was not the primary beneficiary since it does not have power over the significant activities of the entity. For two residual interests in non-agency CMOs where the Company is also the servicer of the underlying assets it was determined that due to: (i) the unilateral ability of the issuers to remove the Company from its role as servicer, or role of servicer for loans more than 90 days past due; (ii) the issuer’s right to object to commencement of the foreclosure procedures; and (iii) the requirement for issuer authorization of the sales price of all foreclosed property; the Company did not have power over the significant activities of the entity and therefore consolidation was not appropriate.
Loans: Through its construction portfolio, the Company provides financing to legal entities created with the limited purpose of developing and selling residential or commercial properties. Often these entities do not have sufficient equity investment at risk to finance its activities, and the Company could potentially have a variable interest in the entities since it may absorb losses related to the loans granted. In situations where the loan defaults or is re-structured by the Company, the loan could result in the Company’s potential absorption of losses of the entity. However, the Company is not involved in the design or operations of these entities and it has therefore been concluded that the Company does not have the power over the activities that most significantly impact the economic performance of the VIEs and is not considered the primary beneficiary in any of these entities. The Company will continue to assess this portfolio on an ongoing basis to determine if there are any changes in its involvement with these VIEs that could potentially lead to consolidation treatment.
Special Purpose Entities: The Company is involved with two special purpose entities that are deemed to be VIEs:
•
The Company sold an asset portfolio to a third party on July 29, 2010, consisting of performing and non-performing late-stage residential construction and development loans and real estate, with carrying amounts at the transfer date of $33.8 million, $63.4 million and $4.8 million, respectively. As consideration for the transferred assets, the Company received a $5.1 million cash payment and a $96.9 million note receivable which has a 10-year maturity and a fixed interest rate of 8.0% per annum and permits interest capitalization for the first 18 months. This financing provided by the Company is secured by a general pledge of all of the acquiring entity’s assets. As of December 31, 2010, the carrying amount of the note receivable was $96.9 million and is classified in loans receivable in the Consolidated Statement of Financial Condition.
Concurrent with this transaction, the Company provided the acquirer with a $28.0 million construction line of credit which has a 10- year maturity and a fixed interest rate of 8.0% per annum. The line of credit will be used by the acquirer of the assets to provide construction advances on the transferred loans or to fund construction on foreclosed properties. As of December 31, 2010, the carrying amount of the line of credit is $0.8 million and is classified in loans receivable in the Consolidated Statement of Financial Condition.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The Company has determined that the acquirer is a VIE and that the Company is not its primary beneficiary. The assets of the acquirer are comprised of the transferred asset portfolio in addition to $10.2 million of in-kind capital contribution provided by a single third party. The sole equity holder has unconditionally committed to contribute an additional $7.0 million of capital over the next six years.
The primary beneficiary of a VIE is an enterprise that has a controlling financial interest in the VIE which exists when an enterprise has both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. The rights provided to the Company as creditor are protective in nature. As the Company does not have the right to manage the loan portfolio, impact foreclosure proceedings, or manage the construction and sale of the property, the Company does not have power over the activities that most significantly impact the economic performance of the acquirer. The Company’s maximum exposure to loss from the variable interest entity is limited to the interest and principal outstanding on the note receivable and the line of credit. Therefore, the Company is not the primary beneficiary of the variable interest entity.
The transfer of the portfolio, consisting of construction loans and real estate assets, was accounted for as a sale. The note receivable was recognized at its initial fair value of $96.9 million. The initial fair value measurement of the note receivable was determined using discount rate adjustment techniques with significant unobservable (Level 3) inputs. Management based its fair value estimate using cash flows forecasted considering the initial and future loan advances, when the various construction project units would be complete, current absorption rates of new housing in Puerto Rico, and a market interest rate that reflects the estimated credit risk of the acquirer and the nature of the loan collateral. Doral considered the loans to be construction loans for the purposes of determining a market rate.
•
During the third quarter of 2010, the Company, through one of its subsidiaries, Doral Money, entered into a CLO arrangement with a third party in which up to $450.0 million of largely U.S. mainland based commercial loans are pledged to collateralize AAA rated debt of $250.0 million paying three month LIBOR plus 1.85 percent issued by Doral CLO I, Ltd. Doral CLO I, Ltd. is a variable interest entity created to hold the commercial loans and issue the previously noted debt and $200.0 million of subordinated notes to the Company whereby the Company receives any excess proceeds after payment of the senior debt interest and other fees and charges specified in the indenture agreement. The Company also serves as collateral manager of the assets of Doral CLO I, Ltd. Doral CLO I, Ltd. is consolidated with the Company in these financial statements.
A CLO is a securitization where a special purpose entity purchases a pool of assets consisting of loans and issues multiple tranches of equity or notes to investors. Typically, the asset manager has the power over the significant decisions of the VIE through its discretion to manage the assets of the CLO.
Doral CLO I, Ltd. is a VIE because it does not have sufficient equity investment at risk and the subordinated notes provide additional financial support to the structure. Management has determined that the Company is the primary beneficiary of Doral CLO I, Ltd. because it has a variable interest in Doral CLO I, Ltd. through both its collateral manager fee and its obligation to absorb potentially significant losses and the right to receive potentially significant benefits of the CLO through the subordinated securities held. The most significant activities of Doral CLO I, Ltd. are those associated with managing the collateral obligations on a day-to-day basis and, as collateral manager, the Company controls the significant activities of the VIE.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
The classifications of assets and liabilities on the Company’s Statement of Financial Condition associated with our consolidated VIE follows:
The following table summarizes the Company’s unconsolidated VIEs and presents the maximum exposure to loss that would be incurred under severe, hypothetical circumstances, for which the possibility of occurrence is remote, for the periods indicated.
(1)
Maximum exposure to loss is a required disclosure under GAAP and represents estimated loss that would be incurred under severe, hypothetical circumstances, for which the possibility of occurrence is remote, such as where the value of our interests and any associated collateral declines to zero, without any consideration of recovery or offset from any economic hedges. Accordingly, this required disclosure is not an indication of expected loss.
(2)
Refers to book value of residual interest from two private placements (Refer to Note 7 for additional information). These transactions are structured without recourse, so as servicers our exposure is limited to standard representations and warranties as seller of the loans and responsibilities as servicer of the SPE’s assets.
41.
Segment Information
The Company operates in three reportable segments: mortgage banking activities, banking (including thrift operations) and insurance agency activities. The Company’s segment reporting is organized by legal entity and aggregated by line of business. Legal entities that do not meet the threshold for separate disclosure
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
are aggregated with other legal entities with similar lines of business. Management made this determination based on operating decisions particular to each business line and because each one targets different customers and requires different strategies. The majority of the Company’s operations are conducted in Puerto Rico. The Company also operates in the mainland United States, principally in the New York City metropolitan area and since the third quarter of 2010 in the north west area of Florida.
In the past, the Company operated an institutional securities business through Doral Securities. During the third quarter of 2007, Doral Securities voluntarily withdrew its license as a broker dealer with the SEC and its membership with the FINRA. As a result of this decision, Doral Securities’ operations during 2008 were limited to acting as a co-investment manager to a local fixed-income investment company. Doral Securities provided notice to the investment company in December 2008 of its intent to assign its rights and obligations under the investment advisory agreement to Doral Bank PR. The assignment was completed in January 2009 and Doral Securities did not conduct any other operations in 2009. During the third quarter of 2009, this investment advisory agreement was terminated by the investment company. Effective on December 31, 2009, Doral Securities was merged with and into its holding company, Doral Financial Corporation.
On July 1, 2008, Doral International, an IBE, subject to supervision, examination and regulation by the Commissioner of Financial Institutions under the IBC Act, was merged with and into Doral Bank PR, Doral International’s parent company, with Doral Bank PR being the surviving corporation, in a transaction structured as a tax free reorganization.
On December 16, 2008, Doral Investment was organized to become a new subsidiary of Doral Bank PR. On February 2, 2010, Doral Investment was granted license to operate as an international banking entity under the IBC Act. Doral Investment is not currently operational.
The accounting policies followed by the segments are the same as those described in Note 2.
The following tables present net interest income, provision for loan and lease losses, non-interest income (loss), (loss) income before income taxes, net income (loss) and identifiable assets for each of the Company’s reportable segments for the periods presented.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
(1)
The intersegment eliminations in the tables above include servicing fees paid by the banking subsidiaries to the mortgage banking subsidiary recognized as a reduction of the non interest income, direct intersegment loan origination costs amortized as yield adjustment or offset against net gains on mortgage loan sales and fees (mainly related with origination costs paid by the banking segment to the mortgage banking segment) and other income derived from intercompany transactions, related principally to rental income paid to Doral Properties, the Company’s subsidiary that owns the corporate headquarters facilities. Assets include internal funding and investments in subsidiaries accounted for at cost.
The following table summarizes the financial results for the Company’s Puerto Rico and mainland U.S. operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
42. Quarterly Results of Operations
Financial data showing results for each of the quarters in 2010, 2009 and 2008 are presented below. These results are unaudited. In the opinion of management all adjustments necessary (consisting only of normal recurring adjustments) for a fair statement have been included:
(1)
For each of the quarters in 2010, 2009 and 2008, (loss) earnings per common share represents the basic and diluted (loss) earnings per common share.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
43. Doral Financial Corporation (Holding Company Only) Financial Information
The following condensed financial information presents the financial position of the holding company only as of December 31, 2010 and 2009, and the results of its operations and cash flows for the years ended December 31, 2010, 2009 and 2008.
Doral Financial Corporation
(Parent Company Only)
Statement of Financial Condition
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Doral Financial Corporation
(Parent Company Only)
Statement of Operations
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
Doral Financial Corporation
(Parent Company Only)
Statement of Cash Flows
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR
DORAL FINANCIAL CORPORATION - (Continued)
During 2010, 2009 and 2008, the parent company contributed capital amounting to $193.9 million, $119.8 million and $182.9 million, respectively, to Doral Bank PR. This capital infusion was approved by the Board of Directors of Doral Financial.
During 2010 and 2009, the parent company received dividends amounting to $11.9 million and $18.0 million from Doral Insurance.
As a state non-member bank, Doral Bank PR’s ability to pay dividends is limited by the Puerto Rico Banking Law which requires that a reserve fund be maintained in an amount equal to at least 20% of the outstanding capital of the institution. The payment of dividends by Doral Bank PR may also be affected by other regulatory requirements and policies, such as the maintenance of certain minimum capital levels described in Note 37, above.
Savings banks, such as Doral Bank US, that meet all applicable capital requirements may make distributions in an amount equal to the sum of (i) the current year’s net income, and (ii) the retained net income from the preceding two years, without an application to the OTS. See Note 34, for additional information regarding restrictions to pay dividends.
44. Subsequent Events
New Puerto Rico Tax Code. On January 31, 2011, the Governor signed into law the Internal Revenue Code of 2011 (“2011 Code”) making the PR Code ineffective, for the most part, for years commenced after December 31, 2010. The most significant impact on Corporations of the 2011 Code is the reduction in the maximum statutory corporate income tax rate from 39% to 30% for years commenced after December 31, 2010 and ending before January 1, 2014; if the Government meets its income generation and expense control goals, for years commenced after December 31, 2013, the maximum corporate tax rate will be 25%. The 2011 Code eliminated the special 5% surtax on corporations for tax year 2011. The Company is evaluating the impact of the tax reform on its results of operations, however the change in the statutory tax rate will result in a reduction in the net deferred tax asset with a corresponding charge to deferred tax expense during the first quarter of 2011. A corporation may elect to be subject to the provisions of the PR Code by the time it files its income tax return for the first year commenced after December 31, 2010 and ending before January 1, 2012. Once the election is made, it will be effective for such year and the next 4 succeeding years.
Advances from FHLB restructure. In January 2011, the Company entered into an agreement with the FHLB to restructure $555.4 million of its non-callable term advances, reducing the average interest rate on those restructured advances to 1.7% from 4.1% and extending the average maturities to 39 months from 14 months. This transaction resulted in a $22.0 million fee paid to the FHLB.