ITEM 1. BUSINESS
GENERAL
Dime Bancorp, Inc. (the "Holding Company"), a Delaware corporation headquartered in New York, New York, is the holding company for The Dime Savings Bank of New York, FSB, a federally-chartered savings bank (the "Bank" and, together with the Holding Company and its direct and indirect subsidiaries, the "Company"). The principal subsidiary of the Bank is North American Mortgage Company ("NAMC"), a mortgage banking company that was acquired in October 1997 (the "NAMC Acquisition"). At December 31, 1998, the Company operated 90 banking branches located in the greater New York City metropolitan area and conducted its mortgage banking activities nationwide through locations in 43 states. At December 31, 1998, the Company had assets of $22.3 billion, deposits of $13.7 billion and stockholders' equity of $1.4 billion.
For internal management purposes, the Company has four business segments: Retail Banking; Commercial Banking; Mortgage Banking; and Investment Portfolio. Further information regarding these business segments is set forth below and in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Business Segments" and Note 25 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
RETAIL BANKING
General
The Company's Retail Banking segment, which focuses on individuals, includes deposit accounts and related services, securities brokerage services, insurance products, consumer lending activities and maintenance of a portfolio of residential real estate loans receivable. Products and services offered by this business segment, most of which are available 24 hours a day and seven days a week, are delivered through a multi-channel distribution network.
Deposits
The Company's total deposits amounted to $13.7 billion at December 31, 1998, of which $12.2 billion were associated with retail customers. (The remaining balance of total deposits consisted of escrow deposits relating to serviced mortgage loans and commercial banking-related customer deposits.) At that date, the Company operated 42 branches in New York City, 23 branches in Long Island, a total of 8 branches in Westchester and Rockland counties in New York and 17 branches in New Jersey. In addition to its branch system, the Company's deposit gathering network includes its telephone banking center and 190 automated teller machines owned by the Company.
The Company attracts deposits by offering a broad selection of deposit instruments and programs. These include demand accounts, savings accounts, money market accounts, time deposit accounts, individual retirement and Keogh accounts and automatic payroll and Social Security deposit programs. The Company's deposit levels are subject to fluctuations resulting from numerous factors outside the
Company's control, including general economic conditions, market interest rates and competition both from other depository institutions and alternative investments. Depositor behavior is affected by a variety of factors, including risk-related returns on other available investments, the rates paid by the Company compared to other institutions and the Company's ability to satisfy customer needs. These factors may affect the Company's willingness or ability to compete for deposits and, therefore, the level of its deposits.
The Bank is a member of the Bank Insurance Fund ("BIF") of the Federal Deposit Insurance Corporation ("FDIC"), with approximately 65% of its deposits insured by the BIF and the remainder insured by the Savings Association Insurance Fund ("SAIF") of the FDIC, in each case up to applicable limits.
For further information on the Company's deposits, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 9 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
Securities Brokerage Services
Securities brokerage services are provided by the Company through Dime Securities, Inc., a wholly-owned subsidiary that is a registered broker-dealer. The services provided by Dime Securities primarily consist of the execution of securities transactions, on an agency basis, solely upon the order and for the accounts of its customers. In addition, Dime Securities provides standardized and individualized investment and financial planning advice to individuals and business entities. Products sold by Dime Securities, which are not BIF- or SAIF-insured, include: mutual funds; government, corporate and municipal bonds; equity securities and equity options; annuities; and unit investment trusts.
Insurance Activities
The Company's insurance subsidiaries, which include The Dime Agency, Inc., Dime NJ Agency, Inc. and North American Mortgage Insurance Services, currently sell certain tax-deferred annuities and products issued by various insurance companies, including individual and group life, disability and accidental death insurance, as well as hazard, mortgage and automobile insurance. The Company also offers Savings Bank Life Insurance ("SBLI") in New York through its SBLI Department.
Consumer Lending
The Company's consumer loans receivable, which amounted to $973.2 million at the end of 1998, includes adjustable- and fixed-rate home equity loans and lines of credit, manufactured home loans, loans secured by deposits, automobile loans, boat loans, unsecured and secured personal loans, property improvement loans, government-guaranteed student loans and unsecured revolving lines-of-credit and overdraft checking loans. The Company generates consumer loans through its retail branch system, its NAMC loan production network, direct mail and general marketing initiatives.
Home equity loans represented approximately 88% of the Company's total consumer loan portfolio at December 31, 1998. These loans are underwritten following guidelines similar to those for conventional residential real estate loans (see "Mortgage Banking -- Residential Real Estate Loan Production"). During 1998, the loan-to-value ratio on any home equity loan, together with any prior lien, generally did not exceed 90% at the time of origination. Loans made pursuant to home equity lines of credit have adjustable interest rates that, after an introductory period, are based generally on a fixed margin over the prime lending rate.
For a further discussion of the Company's consumer loans receivable, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
Residential Real Estate Loans Receivable Portfolio
At December 31, 1998, the Company maintained a residential real estate loans receivable portfolio of $8.9 billion, consisting of one-to-four family first mortgage loans and cooperative apartment loans. The Company managed the level of this loan portfolio during 1998 consistent with its strategy to reduce the percentage of such loans to total loans receivable.
For a further discussion of the Company's residential real estate loans receivable portfolio, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
COMMERCIAL BANKING
General
The Company's Commercial Banking segment provides both lending and deposit products and services to business customers. This segment includes commercial real estate lending and business banking activities.
Commercial Real Estate Lending
At December 31, 1998, the Company's commercial real estate loans receivable amounted to $2.6 billion, of which approximately $2.0 billion were secured by properties located in the State of New York. During 1998, the Company opened a commercial real estate loan production office in Florida to complement existing offices in the greater New York City metropolitan area, Pennsylvania and Virginia. The Company's underwriting policies with respect to commercial real estate loans are based primarily on the loan-to-value ratio of the property and an assessment as to the adequacy of the underlying project's cash flow and its coverage of operating expenses and debt service payments. The Company's underwriting policies generally also require an appraisal of the underlying property, an engineer's report and a "Phase I" environmental assessment. Loan-to-value ratios at the time of origination are usually not more than 75%.
Business Banking
The Company's business banking activities consist of providing loans (including lease financing and asset-based lending), deposit products and cash management and other services to small- and medium-sized businesses.
The Company originates business loans principally to finance seasonal working capital needs, expansion, renovation and equipment purchases. In general, the ability of the borrower to generate sufficient cash flows from operations to liquidate the debt is a critical component of the credit decision. At December 31, 1998, the Company's business loans receivable amounted to $287.3 million.
For a further discussion of the Company's commercial real estate and business loans receivable, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
MORTGAGE BANKING
General
The Company's Mortgage Banking segment activities, which are conducted principally through NAMC, include the production of residential real estate loans either for the Company's portfolio or for sale into the secondary market and servicing loans for itself and others. During 1998, the Company expanded its mortgage banking operations in continuance of its strategy to strengthen its mortgage banking capabilities and in response to the relatively high level of loan demand.
Residential Real Estate Loan Production
The Company produces fixed-rate and adjustable-rate residential real estate loans through a multi-channel, multi-regional network. Of the Company's total residential real estate loan production during 1998 of $30.5 billion, approximately 48% was originated through approved mortgage brokers (which numbered approximately 8,100 at December 31, 1998, as compared with approximately 6,400 at December 31, 1997), approximately 36% was originated directly by the Company and approximately 16% was purchased through correspondent lenders.
The following table sets forth the geographic distribution of residential real estate loan production during 1998 (in thousands):
- --------------- (1) No other state represented more than 2.7% of the total loan production.
The Company's residential real estate loan production includes loans: (i) that meet the standard underwriting policies and purchase limits (which for single family homes increased to $240,000 by year-end 1998) established by Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") guidelines ("conforming conventional loans"); (ii) in amounts in excess of the FNMA and FHLMC purchase limits ("jumbo loans"); (iii) insured or guaranteed under Federal Housing Administration ("FHA") or Veterans Administration ("VA") programs; (iv) that conform to programs established by various state and local authorities; and (v) exclusively for sale to specified secondary market investors that conform to the requirements of such investors, which may be more or less stringent than those for conforming conventional loans.
Underwriting policies and guidelines for residential real estate loans produced for the Company's portfolio are generally in conformance with those of FNMA and FHLMC. Such policies and guidelines include requiring an appraisal of the value of the collateral for the purpose of determining the loan-to-value ratio (i.e., the ratio that the principal amount of the loan bears to the value of the collateral securing the loan at the time of origination) and the collateral's adequacy as security. The collateral's value is deemed to be the lower of the purchase price or the appraised value, except for refinance loans, where the appraised value is used. With respect to residential first mortgage loans having a loan-to-value ratio in excess of 80% at the date of origination, the Company generally requires private mortgage insurance underwritten by FNMA- and FHLMC-approved insurers in accordance with FNMA and FHLMC coverage levels.
When the Company makes residential real estate loans to borrowers whose creditworthiness does not meet standard FNMA and FHLMC underwriting guidelines ("subprime loans"), it sells the loans, as well as the right to service them, into the secondary market, without recourse to the Company, and receives a fee for their origination.
The Company administers a formal process for approving and monitoring, and conducts annual reviews of, its mortgage brokers and correspondents. Mortgage broker performance is assessed primarily by monitoring loan credit quality. Correspondent-purchased loans are contractually required to be underwritten by the correspondent lenders in accordance with the Company's guidelines and, unless a correspondent lender has been delegated underwriting authority, all loans are re-underwritten by the Company prior to purchase. Correspondent lenders with delegated underwriting status are generally subject to more stringent financial and operational requirements than those without such status and have undergone a comprehensive on-site review conducted by the Company. Mortgage brokers and correspondent lenders demonstrating unacceptable performance or insufficient loan activity are removed from the Company's programs.
Secondary Market Activities
During 1998, the Company continued its strategy of selling into the secondary market substantially all of its fixed-rate residential real estate loan production. Further, the Company opportunistically sells adjustable-rate loans into the secondary market. In total, the Company sold $26.8 billion of residential real estate loans into the secondary market during 1998.
Conforming conventional loans produced by the Company for sale in the secondary market are typically pooled and exchanged for securities backed by such loans (mortgage-backed securities ("MBS")) issued by FNMA or FHLMC, which are sold to investment banking firms. The Company may also sell conforming conventional loans, as whole loans, directly to FNMA or FHLMC or to private investors. Jumbo loans produced for sale in the secondary market are sold to private investors. FHA-insured and VA-guaranteed loans produced for sale in the secondary market are pooled to form Government National Mortgage Association ("GNMA") MBS, issued by the Company, which are sold to investment banking firms.
Loan Servicing
At December 31, 1998, the Company's residential real estate loans serviced for others portfolio (excluding loans being subserviced by the Company) consisted of approximately 274,000 loans with principal balances totaling approximately $27 billion. In return for servicing these loans, the Company earns fees based upon the outstanding principal balances of the loans. Minimum servicing fees for substantially all loans serviced under MBS programs are established by the sponsoring entities. At year-end 1998, the Company was subservicing, for a fee, approximately 60,000 loans with principal balances of approximately $8 billion in connection with bulk sales of loan servicing rights. In addition, at the end of 1998, the Mortgage Banking business segment was servicing approximately 100,000 residential real estate loans owned by the Company with principal balances of approximately $12 billion.
Loan servicing consists of collecting principal and interest payments from borrowers, remitting aggregate principal and interest payments to investors, making loan-related advances when required, accounting for principal and interest, collecting funds for payment of loan-related expense such as taxes and insurance, inspecting the collateral as required, contacting delinquent borrowers, conducting foreclosures and property dispositions in the event of unremedied defaults and generally administering loans.
For a further discussion of the Company's mortgage banking activities, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 8 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
INVESTMENT PORTFOLIO
The Company, pursuant to established policies and guidelines, invests in certain debt and equity securities and money market investments. These investments are made in conjunction with the Company's overall liquidity, interest rate risk and credit risk management processes. In addition, as a member of the Federal Home Loan Bank of New York ("FHLBNY"), the Bank is required to maintain a specified
investment in the capital stock of the FHLBNY (see "Regulation and Supervision -- Federal Home Loan Bank System"). In recent years, the Company's strategy has been to reduce the relative contribution of its investment portfolio, and to increase the relative contributions of other business segments, to overall revenues and profit.
For a further discussion of the Company's investment portfolio, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 3 and 4 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
EMPLOYEES
The Company had 7,437 employees at December 31, 1998. Employees of the Company are not represented by any collective bargaining group. The Company considers its employee relations to be satisfactory.
COMPETITION
The Company experiences substantial competition both in attracting and retaining deposits and in making loans. Its most direct competition for deposits historically has come from other thrift institutions and commercial banks doing business in the greater New York City metropolitan area. The Company also competes for funds with money market mutual funds, corporate and governmental debt securities and other investment alternatives. The Company's competition for loans comes principally from other thrift institutions, commercial banks, mortgage banking companies, consumer finance companies, insurance companies and other institutional investors and lenders. A number of institutions with which the Company competes for deposits and loans have significantly greater assets and capital than the Company.
REGULATION AND SUPERVISION
General
The Bank is a federal savings bank and a member of the FHLBNY and is subject to the regulations, examinations and reporting requirements of the Office of Thrift Supervision (the "OTS"), as the primary regulator of federal savings associations, and of the FDIC, as insurer of the Bank's deposits. Additionally, the Bank is subject to certain limited regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). As a savings and loan holding company, the Holding Company is also subject to the regulations, examinations and reporting requirements of the OTS.
The description of statutory provisions and regulations applicable to savings associations and savings and loan holding companies set forth below does not purport to be a complete description of the statutes and regulations described or of all such statutes and regulations and their effects on the Bank and the Holding Company. The regulatory scheme has been established primarily for the protection of depositors and the financial system generally and is not intended for the protection of stockholders or other creditors.
Deposit Insurance
The FDIC administers two separate deposit insurance funds: the BIF, of which the Bank is a member, and the SAIF. Approximately 65% of the Bank's deposits are BIF-insured and approximately 35% of its deposits are SAIF-insured. Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), the FDIC established a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. Under this system, both BIF-insured and SAIF-insured depository institutions are placed into one of nine confidential assessment risk categories using a two-step process based first on capital ratios and then on other factors. As a result of the enactment of the Deposit Insurance Funds Act of 1996 (the "Funds Act"), SAIF-insured deposit assessment rates currently range
between $0.00 and $0.27 for each $100 of insured deposits, which is identical to BIF-insured deposit assessment rates.
Under the Funds Act, beginning January 1, 1997, insured depository institutions were assessed with respect to BIF-assessable deposits in order to pay for a portion of the debt service of certain bonds issued by the Federal Financing Corporation (the "FICO Bonds"). Prior to January 1, 1997, assessments to pay the debt service on the FICO Bonds were applicable only to SAIF-member institutions. The Funds Act provides that, between January 1, 1997 and the earlier of December 31, 1999 or the date as of which the last savings association ceases to exist, BIF-assessable deposits will be assessed at a rate equal to 20% of the rate applied to SAIF-assessable deposits for purposes of the FICO Bonds debt service assessment. Thereafter, all insured deposits will be assessed on a pro rata basis. The FICO assessment rate is adjusted quarterly to reflect changes in the assessment bases of the BIF and SAIF. The rate for the first quarter of 1999 was set at $0.061 for each $100 of SAIF-assessable deposits and $0.0122 for each $100 of BIF-assessable deposits.
Until the earlier of December 31, 1999 or the date as of which the last savings association ceases to exist, the Funds Act also provides that the federal banking agencies are to take "appropriate action" to prevent insured depository institutions and depository institution holding companies from facilitating or encouraging the shifting of deposits from SAIF-assessable deposits to BIF-assessable deposits for the purpose of evading the assessments imposed on insured depository institutions with respect to SAIF-assessable deposits for deposit insurance and the FICO Bonds debt service.
Capital Requirements
Under federal statute and OTS regulations, savings associations are required to comply with three separate capital adequacy standards. These institutions are required to have core capital equal to 3% of adjusted total assets, tangible capital equal to at least 1.5% of adjusted total assets and total risk-based capital equal to at least 8% of total risk-weighted assets. The OTS is also authorized to establish individual minimum capital requirements for a savings association consistent with these capital standards. The OTS has not established any such individual minimum capital requirements for the Bank. There are potentially severe consequences for failing to meet these regulatory capital requirements.
Core capital includes common stockholders' equity (including common stock, common stock surplus and retained earnings, but excluding any unrealized gains or losses, net of related taxes, on certain securities available for sale), non-cumulative perpetual preferred stock and any related surplus and minority interests in the equity accounts of fully consolidated subsidiaries. Intangible assets, other than servicing assets valued in accordance with applicable regulations and purchased credit card relationships ("PCCRS"), generally must be deducted from core capital. Servicing assets and PCCRS may represent in the aggregate up to 100% of core capital, although the aggregate amount of non-mortgage servicing assets and PCCRS may not exceed 25% of core capital. Servicing assets and PCCRS that are includable in capital are each subject to a limitation equal to the lesser of 90% of fair value or 100% of the remaining unamortized book value. In addition, certain deferred tax assets and investments in and loans to non-includable subsidiaries must be deducted from core capital.
Tangible capital means core capital less any intangible assets (except for mortgage servicing assets includable in core capital and investments in subsidiaries that are not "includable subsidiaries" (except as permitted by regulation).
For purposes of the risk-based capital requirement, total risk-based capital means core capital plus supplementary capital, so long as the amount of supplementary capital that is used to satisfy the requirement does not exceed the amount of core capital. Supplementary capital includes, among other things, subordinated debt issued pursuant to OTS regulations, general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on certain securities available for sale. Risk-weighted assets are determined by multiplying certain categories of the savings association's assets, including off-balance sheet equivalents, by an assigned risk weight of 0% to 100% based on the credit risk associated with those assets as specified in OTS regulations. The OTS
adopted a rule, effective January 1, 1994, incorporating an interest-rate risk component into its existing risk-based capital requirement. In March 1995, the OTS extended a waiver of the interest rate risk capital deduction until it issued a Thrift Bulletin establishing an appeals process and notified thrift institutions of the effective date. Although the OTS issued the Thrift Bulletin on August 21, 1995, it also announced that the automatic interest rate risk capital deduction would not be implemented until the OTS issued a notice otherwise.
Pursuant to FDICIA, the OTS adopted prompt corrective action ("PCA") regulations that established five capital categories for savings associations ("well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized") and require certain mandatory actions and authorize other discretionary actions to be taken by the OTS with respect to institutions in the three undercapitalized categories, with the nature and extent of such actions dependent primarily on the category in which the institution is placed. The OTS has specified by regulation the relevant capital level for each category. Under OTS regulations, an institution is considered well capitalized if its ratio of total risk-based capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets is 5% or greater, and it is not subject to any order or directive by the OTS to meet a specific capital level.
In addition, an institution's primary federal bank regulatory agency is authorized to downgrade the institution's capital category to the next lower category upon a determination that the institution is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice. An unsafe or unsound practice can include receipt by the institution of a less than satisfactory rating on its most recent examination with respect to its asset quality, management, earnings or liquidity.
For information concerning the Bank's regulatory capital status, see Note 16 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
The Federal Deposit Insurance Act (the "FDI Act") generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would be "undercapitalized." "Undercapitalized" depository institutions are subject to limitations on, among other things, asset growth, acquisitions, branching, new business lines, acceptance of brokered deposits and borrowings from the Federal Reserve System and are required to submit a capital restoration plan. The federal bank regulatory agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's holding company, if any, must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the holding company under such guarantee is limited to the lesser of (i) an amount equal to 5% of the depository institution's total assets at the time it became "undercapitalized," or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If the depository institution fails to submit an acceptable plan, it is treated as if it is "significantly undercapitalized." "Significantly undercapitalized" depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become "adequately capitalized," requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. "Critically undercapitalized" institutions are subject to the appointment of a receiver or conservator.
Depositor Preference
The FDI Act provides that, in the event of the "liquidation or other resolution" of an insured depository institution, the claims of depositors of such institution (including claims by the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC, as a receiver, would be afforded a priority over other general unsecured claims against such an institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will be placed ahead of
unsecured, non-deposit creditors, including a holding company for the institution (such as the Holding Company), in order of priority of payment.
Loans-to-One-Borrower Limitations and Loans to Insiders
Savings associations are subject to loans-to-one-borrower limitations under federal law and OTS regulations. At December 31, 1998, the Bank's loans-to-one borrower limitation was approximately $211 million.
Savings associations are also subject to Sections 22(g) and 22(h) of the Federal Reserve Act. These provisions, among other things, limit a savings institution's extension of credit to the principal stockholders, directors and executive officers of the savings institution and its affiliates and to the related interests of these persons.
Liquid Assets
OTS regulations require a saving institution to maintain, for each calendar quarter, an average daily balance of liquid assets (as defined) equal to at least 4% of either (i) its liquidity base (the institution's net withdrawable accounts plus short-term borrowings) at the end of the preceding calendar quarter or (ii) the average daily balance of its liquidity base during the preceding calendar quarter. Monetary penalties may be imposed for failure to meet liquidity ratio requirements.
Restrictions on Dividends and Capital Distributions
The payment of dividends by the Bank to the Holding Company is subject to certain regulatory restrictions. These restrictions may affect the Holding Company's liquidity as well as its ability to pay dividends on its capital stock or principal or interest on its debt. A savings association, such as the Bank, may not make a capital distribution (or pay management fees to its holding company) if, following such distribution (or payment), the institution would be "undercapitalized" as that term is defined for purposes of the PCA provisions described above. In addition, OTS regulations limit the ability of savings associations to pay dividends and make other capital distributions according to the institution's level of capital and income, with the greatest flexibility afforded to institutions that meet or exceed their OTS capital requirements. Capital distributions include cash dividends, payments to repurchase, redeem, retire or otherwise acquire an institution's shares, payments to stockholders of another institution in a cash-out merger, other distributions charged against capital and any other transaction that the OTS determines to entail a payout of capital. To the extent that the OTS regulations described below and the PCA provisions are inconsistent, the PCA provisions take precedence.
Under current OTS regulations, a savings association that exceeds its fully phased-in OTS capital requirements both before and after a proposed distribution (a "Tier 1 Institution") and that has not been advised by the OTS that it is in need of more than normal supervision may, after prior notice to but without the approval of the OTS, make capital distributions during a calendar year up to the higher of (i) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (the percentage by which the institution's ratio of total capital to assets exceeds the ratio of its fully phased-in capital requirement to assets) at the beginning of the calendar year or (ii) 75% of its net income over the most recent four-quarter period. In addition, a Tier 1 Institution may make capital distributions in excess of the foregoing limits if it gives the OTS 30 days' notice of the proposed distribution and the OTS does not object within that period. A Tier 1 Institution that has been notified by the OTS that it is in need of "more than normal supervision" must, under the OTS regulations, be treated as a "Tier 2 Institution" or a "Tier 3 Institution," to which progressively more stringent restrictions on dividends and capital distributions apply. As of December 31, 1998, the Bank was a Tier 1 Institution. The OTS also may prohibit a proposed capital distribution that would otherwise be permitted if it determines that the distribution would constitute an unsafe or unsound practice.
Beginning on April 1, 1999, OTS regulations will dispense with the distinctions between Tier 1, Tier 2 and Tier 3 Institutions and also eliminate the use of the "surplus capital ratio" in determining whether an
application for prior approval of a capital distribution must be filed. A savings association will be required to file an application if: (i) it is not eligible for expedited treatment under the OTS application processing rules; (ii) the total amount of all capital distributions, including the proposed capital distribution, for the applicable calendar year would exceed an amount equal to the savings association's net income for that year to date plus the savings association's retained net income for the preceding two years; (iii) the savings association would not be adequately capitalized under the OTS capital regulation following the distribution; or (iv) the capital distribution would violate a statute, regulation or agreement with the OTS or a condition imposed by the OTS. A savings association that is not required to file an application may be required to file a notice with the OTS under certain conditions, including if it is a subsidiary of a holding company. The OTS may disapprove an application or notice if the proposed capital distribution would: (i) make the association undercapitalized, significantly undercapitalized, or critically undercapitalized; (ii) raise safety or soundness concerns; or (iii) violate a statute, regulation, or agreement with the OTS (or with the FDIC), or a condition imposed in an OTS-approved application or notice.
Also beginning on April 1, 1999, "capital distributions" will include, among other things, payments to repurchase, redeem, retire or acquire the savings association's debt instruments included in total capital or payment of cash or other property to the savings association's owners or affiliates made in connection with a corporate restructuring. Distributions charged against capital will only be included if the savings association would not be "well capitalized" following the distribution.
The Holding Company's ability to pay dividends on its common stock ("Common Stock") is limited by restrictions imposed by Delaware law. In general, dividends may be paid out of the Holding Company's surplus, as defined by Delaware law, or in the absence of such surplus, out of its net profits for the current and/or immediately preceding fiscal year.
Transactions with Affiliates
Under federal law and regulation, transactions between a savings association and its "affiliates," which term includes its holding company and other companies controlled by its holding company, are subject to quantitative and qualitative restrictions. Savings associations are restricted in their ability to engage in certain types of transactions with their affiliates. These "covered transactions" include: (i) purchasing or investing in securities issued by an affiliate; (ii) lending or extending credit to, or guaranteeing credit of, an affiliate; (iii) purchasing assets from an affiliate; and (iv) accepting securities issued by an affiliate as collateral for a loan or extension of credit. Covered transactions are permitted between a savings association and a single affiliate up to 10% of the capital stock and surplus of the association, and between a savings association and all of its affiliates up to 20% of the capital stock and surplus of the institution. The purchase of low-quality assets by a savings association from an affiliate is not permitted. Each loan or extension of credit to an affiliate by a savings association must be secured by collateral with a market value ranging from 100% to 130% (depending on the type of collateral) of the amount of credit extended. Notwithstanding the foregoing, a savings association is not permitted to make a loan or extension of credit to any affiliate unless the affiliate is engaged only in activities that the Federal Reserve Board has determined to be permissible for bank holding companies. Savings associations also are prohibited from purchasing or investing in securities issued by an affiliate, other than shares of a subsidiary. Covered transactions between a savings association and an affiliate, and certain other transactions with or benefiting an affiliate, must be on terms and conditions at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. This arms-length requirement applies to all covered transactions, as well as to: (i) the sale of securities or other assets to an affiliate; (ii) the payment of money or the furnishing of services to an affiliate; (iii) any transaction in which an affiliate acts as agent or broker or receives a fee for its services to the savings association or to any other person; or (iv) any transaction or series of transactions with a third party if any affiliate has a financial interest in the third party or is a participant in the transaction or series of transactions.
Community Reinvestment Act ("CRA")
Under the CRA and the implementing OTS regulations, a savings association has a continuing and affirmative obligation to help meet the credit needs of its local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution.
As part of its CRA activities, the Bank originates loans for affordable housing (which are generally loans to low- or moderate-income borrowers). In order to generate these loans, the Bank's specifically designated staff uses a variety of outreach initiatives, including participation in seminars and housing fairs, such as those targeted to first-time home buyers, loan application materials in a variety of foreign languages and cooperative ventures with not-for-profit groups. The Bank's CRA lending activities also include loans in low- or moderate-income neighborhoods, community development financing for new construction and rehabilitation of affordable multifamily housing and targeted commercial projects. Typically, these project loans are made in partnership with government subsidy programs.
The OTS assigns a CRA rating based upon a Lending Test, Investment Test and Service Test keyed to, respectively, the number of loans, the number of investments and the level of availability of retail banking services in a savings association's assessment area. The Lending Test is the primary component of the assigned composite rating. An "outstanding" rating on the Lending Test automatically results in at least a "satisfactory" rating on the composite, but an institution cannot receive a "satisfactory" or better rating on the composite if it does not receive at least a "low satisfactory" rating on the Lending Test. Alternatively, a savings association may elect to be assessed by complying with a strategic plan approved by the OTS.
Following each of the four most recent CRA examinations of the Bank by the OTS, which were completed in August 1997, June 1995, February 1993 and December 1990, the Bank received an "outstanding" CRA rating, which is the highest rating that an institution may receive.
Savings Association Investment Powers
Federal savings associations are subject to comprehensive regulation governing their investments and activities. Among other things, a federal savings association may invest up to 3% of its assets in service corporations, an unlimited percentage of its assets in operating subsidiaries (which may only engage in activities permissible for the association itself) and under certain conditions may invest in finance subsidiaries. Other than investments in service corporations, operating subsidiaries, finance subsidiaries, stock of government-sponsored agencies such as FHLMC and FNMA and certain "pass-through investments" in entities engaging only in activities that a federal savings association may conduct directly, federal savings associations generally are not permitted to make equity investments. A service corporation in which a federal savings association may invest is permitted to engage in activities reasonably related to the activities of a federal savings association as the OTS may approve on a case-by-case basis and certain activities pre-approved by the OTS.
Under federal law, a savings association may not acquire or retain, directly or through a subsidiary, any corporate debt securities that, when acquired, were not rated in one of the four highest rating categories by at least one nationally recognized rating agency, unless such activity is done through a separately capitalized affiliate (other than a subsidiary or an insured depository institution).
Federal law and regulations empower the Bank to exercise any authority to make investments or engage in activities that the Bank was authorized to exercise or engage in under New York law in effect at the time it converted to a federal mutual charter, whether or not the Bank had utilized such authority as a state-chartered mutual savings bank. These so-called "grandfathered" powers are in addition to the powers the Bank possesses as a federal savings bank. Among these grandfathered powers is the authority to make "leeway" investments. Under this authority, the Bank, subject to certain limitations, may make equity and other investments that do not qualify under any other provision of the grandfathered powers, so long as no one such investment exceeds 1% of the Bank's assets and the total of all such investments does not exceed
5% of its assets. However, certain specific types of investments are prohibited under this provision, including the acquisition of common stock in a commercial bank or life insurance company.
The exercise of these grandfathered powers, or any other activity, is subject to the authority of the FDIC to issue regulations or orders it deems necessary to prevent actions or practices that pose a serious threat to the BIF or the SAIF. The FDIC has authority, upon making such determination, to prohibit a savings association from engaging in that activity.
Acquisition of Control of Savings Associations
The Home Owners Loan Act ("HOLA") prohibits a savings and loan holding company, directly or indirectly, from: (i) acquiring control of a savings association or another savings and loan holding company, without prior OTS approval; (ii) generally acquiring more than 5% of the voting shares of a savings and loan holding company or a savings association which is not a controlled subsidiary; or (iii) acquiring control of an "uninsured institution," as defined in the HOLA. No director or officer of a savings and loan holding company or individual owning, controlling or holding power to vote more than 25% of the holding company's voting shares may: (i) hold, solicit or exercise proxies in respect of any voting rights in a mutual savings association; or (ii) except with the prior approval of the OTS, acquire control of any savings association that is not a subsidiary of such holding company.
Federal Home Loan Bank ("FHLB") System
The Bank is a member of the FHLB system, which consists of 12 regional FHLBs. The FHLB system provides a central credit facility primarily for member institutions. Members are required to hold shares of the capital stock of the regional FHLB in which they are a member in an amount at least equal to the greater of 1% of the member's home mortgage loans or 5% of the member's advances from the FHLB.
Federal Reserve System
The Bank is subject to various regulations promulgated by the Federal Reserve Board, including, but not limited to, Regulation B (Equal Credit Opportunity Act), Regulation D (Federal Reserve Act), Regulation E (Electronic Fund Transfers Act), Regulation Z (Truth in Lending Act), Regulation CC (Expedited Funds Availability Act) and Regulation DD (Truth in Savings Act).
FHLB system members are authorized to borrow from the Federal Reserve "discount window," but Federal Reserve Board regulations require institutions to exhaust all FHLB sources before borrowing from a Federal Reserve Bank.
Legislative and Regulatory Proposals
The operations of a savings association and a savings and loan holding company are affected by the economic, fiscal and monetary policies of the United States and its agencies and regulatory authorities, particularly the Federal Reserve Board. The fiscal and economic policies of various governmental entities and the monetary policies of the Federal Reserve Board have a direct effect on the Company's business operations and the availability, growth and distribution of the Company's investments and deposits.
In addition, proposals to change the laws and regulations governing the operations and taxation of savings associations and other financial institutions and companies that control such institutions are frequently raised in Congress and before the OTS and other bank regulatory authorities. The likelihood of any major changes in the future and the effect such changes might have on the Company are impossible to determine.
Federal Securities Laws
The Holding Company is subject to the periodic reporting, proxy solicitation, tender offer, insider trading and other requirements and restrictions under the Securities Exchange Act of 1934.
TAXATION
The Holding Company files consolidated federal income tax returns with its eligible 80%-or-greater-owned subsidiaries on a calendar year basis. The maximum corporate federal income tax rate applicable to the Holding Company and its subsidiaries currently is 35%, subject to the 20% alternative minimum tax applicable to corporations, as discussed below.
The 20% alternative minimum tax applies generally to taxable income, with certain adjustments, plus items of tax preference ("AMTI") and is imposed to the extent that the alternative minimum tax exceeds the regular income tax for the taxable year. The amount of AMTI that can be offset by net operating loss ("NOL") carryforwards is limited to 90% of AMTI. Therefore, for taxable years in which available NOL carryforwards completely offset taxable income, the Holding Company (and its subsidiaries) would be subject to an effective minimum federal tax rate of 2% of AMTI (as determined before offset by NOL carryforwards). Any alternative minimum tax paid by the Company would be available as a carryforward tax credit, which, subject to certain limitations, could be used to reduce its otherwise determined regular federal tax liability.
For federal income tax purposes, the deduction available to the Bank for bad debts is equal to its actual loss experience. The use of reserves for bad debts is no longer available. Generally, federal bad debt reserve balances in existence on December 31, 1987 will be subject to recapture upon distribution of such reserves to shareholders. For New York State and New York City tax purposes, thrift institutions continue to use the reserve method of tax accounting for bad debts and determine a deduction for bad debts in a manner similar to prior law, including an alternative deduction equal to 32% of the thrift's taxable income as specially determined for this law.
New York State and New York City each imposes an annual franchise tax on banking corporations, based on net income allocable to New York State or New York City, respectively, at a rate of 9%. If, however, the application of an alternative minimum tax (based on taxable assets allocated to New York, "alternative" net income, or a flat minimum fee) results in a greater tax, an alternative minimum tax will be imposed. In addition, New York State imposes a tax surcharge equal to 17% of the New York State franchise tax allocable to business activities carried on in the Metropolitan Commuter Transportation District. NOLs cannot be carried back or forward for New York State or New York City tax purposes. These taxes apply to the Holding Company, the Bank and certain of the Bank's subsidiaries. Certain subsidiaries of a banking corporation may be subject to a general business corporation tax in lieu of the tax on banking corporations. The rules regarding the determination of income allocated to New York and alternative minimum taxes differ for these subsidiaries.
The Holding Company and certain of its subsidiaries are also subject to state and local taxation in states other than New York. Most states provide a statutory apportionment methodology that determines the allocable income subject to tax in those states. In certain cases, the income and activities of the affiliated group are used to determine the tax liability of the entity doing business in that state. Further, the ability to utilize NOL carryovers varies by state. New Jersey imposes a Savings Institution Tax based on net income attributed to New Jersey on the basis of separate accounting, at a rate of 3% and NOLs cannot be carried back or forward. In addition, the Holding Company is subject to an annual franchise tax imposed by Delaware, its state of incorporation. This franchise tax is the higher of an amount determined by reference to authorized shares or assumed capital (asset size), but cannot exceed $150,000.
For additional information regarding income taxes of the Company, see Note 21 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
ITEM 2.
ITEM 2. PROPERTIES
The Company leases its principal executive offices in New York City and its administrative headquarters located in Uniondale, New York. The Company also leases the executive offices for its mortgage banking operations in Tampa, Florida and owns both its residential real estate loan production
headquarters located in Santa Rosa, California and its residential real estate and consumer loan servicing operations center in Albion, New York.
At December 31, 1998, the Bank operated 90 full-service branches in the greater New York City metropolitan area, of which 40 were owned and 50 were leased. At that date, the Company leased approximately 260 residential real estate loan production facilities in 43 states.
For further information regarding the Company's properties and lease obligations, see Notes 7 and 24 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On January 13, 1995, Anchor Savings Bank FSB ("Anchor Savings") filed suit in the United States Court of Federal Claims against the United States for breach of contract and taking of property without compensation in contravention of the Fifth Amendment to the United States Constitution. The action arose because the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") and the regulations adopted by the OTS pursuant to FIRREA deprived Anchor Savings of the ability to include supervisory goodwill and certain other assets for purposes of computing its regulatory capital as the Federal Savings and Loan Insurance Corporation ("FSLIC") had agreed. The direct effect was to cause Anchor Savings to go from an institution that substantially exceeded its regulatory capital requirements to one that was critically undercapitalized upon the effectiveness of the FIRREA-mandated capital requirements.
From 1982 to 1985, Anchor Savings had acquired eight FSLIC-insured institutions that were in danger of failing and causing a loss to the FSLIC. Four institutions were acquired with some financial assistance from the FSLIC and four were unassisted "supervisory" cases. In acquiring the institutions, Anchor Savings assumed liabilities determined to exceed the assets it acquired by over $650 million at the dates of the respective acquisitions. The difference between the fair values of the assets acquired and the liabilities assumed in the transactions were recorded on Anchor Savings' books as goodwill. At the time of these acquisitions, the FSLIC had agreed that this supervisory goodwill was to be amortized over periods of up to 40 years. Without that agreement, Anchor Savings would not have made the acquisitions. When the capital regulations imposed under FIRREA became effective, Anchor Savings still had over $518 million of supervisory goodwill on its books and in excess of 20 years remaining to amortize it under the agreements with FSLIC. The FIRREA-mandated capital requirements excluded all but approximately $124 million of Anchor Savings' supervisory goodwill, over $42 million attributable to the FSLIC contribution in one acquisition, and, until the formation of Anchor Bancorp, Inc., the holding company for Anchor Savings ("Anchor Bancorp"), in 1991, $157 million associated with preferred stock issued to the FSLIC as a result of one of the acquisitions. FIRREA also required the remaining supervisory goodwill to be eliminated by December 31, 1994 for regulatory capital purposes. The elimination of the supervisory goodwill resulted in severe limitations on Anchor Savings' activities and required the disposition of valuable assets under liquidation-like circumstances, as a result of which Anchor Savings was damaged. The complaint asks that the Government make Anchor Savings whole for the effects of the loss, which are estimated to exceed substantially the goodwill remaining at the time FIRREA was enacted.
There are approximately 130 cases involving similar issues pending in the United States Court of Federal Claims, which has entered summary judgment for the plaintiffs as to liability, but not damages, in a small number of the cases. The first three of those cases, referred to as the Winstar cases, were appealed to the United States Supreme Court, which, on July 1, 1996, affirmed the decision that the Government was liable for breach of contract.
All of the Winstar-related cases, including Anchor Savings' lawsuit (which was assumed by the Bank upon consummation of the merger of Anchor Bancorp and Anchor Savings with and into the Holding Company and the Bank, respectively (the "Anchor Merger")), were assigned to the Chief Judge of the Court of Federal Claims. The Chief Judge has issued an Omnibus Case Management Order ("OCMO") that controls the proceedings in all these cases. The OCMO imposes procedures and schedules different
from most cases in the Court of Federal Claims. Under the OCMO, the Bank has moved for partial summary judgment as to the existence of a contract and the inconsistency of the Government's actions with that contract in each of the related transactions. The Government has disputed the existence of a contract in each case and cross-moved for summary judgment. The Government also submitted a filing acknowledging that it is not aware of any affirmative defenses. Briefing on the motions was completed on August 1, 1997. In August 1997, the Court held a hearing on summary judgment motions in four other cases. As part of that hearing, the Court heard argument on eleven issues that the plaintiffs contend are common to many of the pending cases, including the Bank's case. The Court issued its order on December 22, 1997, ruling in favor of the plaintiffs on all eleven "common" issues. The Court's order directed the Government to submit a "show cause" filing by February 20, 1998 asserting why judgment for the plaintiff should not be entered on each of the common issues with respect to each pending summary judgment motion. The Government submitted a filing in response to the "show cause" order, but asserted that it might need further discovery as to certain issues. At a status conference on March 11, 1998, the Court directed each of the plaintiffs to submit a proposed form of order for entry of judgment as to liability on the Winstar contract issues and an accompanying brief by March 31, 1998 and directed the Government to respond by April 30, 1998 with a filing asserting any basis for not entering the order proposed by the plaintiff. On March 31, 1998, the Bank, as directed by the Court, submitted a proposed order imposing liability on the Government as to each of the Bank's claims. On April 30, 1998, the Government served its opposition to the entry of the order. Final submissions were made on May 15, 1998 by the Bank and May 22, 1998 by the Government. No date has been set for argument on the Bank's request to enter judgment. It is not possible to predict whether the Court will grant any of the Bank's motions for partial summary judgment or, if so, when the Chief Judge will schedule a trial on damages and any remaining liability issues.
Commencing in April 1998, the oldest 30 of the pending cases (after excluding certain specific cases) that elected to proceed were allowed to commence full discovery as to liability and damages in their cases. The case-specific discovery will continue through June 1999, unless further extended by the Court. The second 30 cases will start discovery in 1999, and so on. Discovery of damage experts will follow the fact discovery in each case. Cases will not be assigned to trial judges until after the fact discovery is completed. The Bank is among the first 30 plaintiffs and commenced full case-specific discovery on April 1, 1998.
There have been no court decisions determining damages in any of the Winstar-related cases. The trial in the first of the Winstar-related cases to proceed to trial on damages was concluded in April 1998, with closing arguments held in September 1998. A decision in that case is now expected in early April 1999. Trials in two other cases also have recently ended, and decisions are expected in the cases shortly. It also is likely that any determination of damages by the Court of Federal Claims will be appealed. It is impossible, therefore, to predict the measure of damages that will be upheld in cases in which liability is found.
During the summer of 1998, there were settlements in a total of four of the Winstar-related cases in which the Government agreed to make payments to the plaintiffs. The Bank believes that the circumstances of the four settled cases were materially different from the Bank's case, and the Bank does not believe that these settlements will affect the final outcome of its case. The Company is unaware of any other pending settlements in this litigation.
The Company continues to believe that its claim is meritorious, that it is one of the more significant cases before the Court, and that it is entitled to damages, which, as noted, are estimated to exceed substantially the goodwill remaining on Anchor Savings' books at the time FIRREA was enacted.
Certain claims, suits, complaints and investigations involving the Company, arising in the ordinary course of business have been filed or are pending. The Company is of the opinion, after discussion with legal counsel representing the Company in these proceedings, that the aggregate liability or loss, if any, arising from the ultimate disposition of these matters would not have a material adverse effect on the Company's consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to the Holding Company's stockholders during the quarter ended December 31, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock is traded on the New York Stock Exchange ("NYSE") under the symbol "DME." On March 5, 1999, there were approximately 19,751 holders of record of the Common Stock.
The following table sets forth, for the quarters indicated, the high and low sales prices of the Common Stock based on the NYSE Composite Tape and any cash dividends declared per share of Common Stock.
The Holding Company's Board of Directors (the "Board") periodically considers the payment of dividends on the Common Stock, taking into account the Company's financial condition and level of net income, its future prospects, economic conditions, industry practices and other factors, including the dividend restrictions described in "Regulation and Supervision -- Restrictions on Dividends and Capital Distributions" under Item 1, "Business."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
- --------------- (1) For 1995 and 1994, the computation assumes that a warrant to acquire 8.4 million shares of the Common Stock at $0.01 per share (the "Warrant") was exercised. For a further discussion of the Warrant, which was exercised in May 1996 by the FDIC, see Note 15 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
(2) Excludes loans being subserviced by the Company.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
General
The Company's net income for 1998 was $237.1 million, an increase of 94.8% from $121.7 million for 1997, which had increased 16.7% from $104.3 million for 1996. Diluted earnings per common share were $2.06 for 1998, as compared with $1.12 for 1997 and $0.96 for 1996. Net income for 1998 and 1997 was reduced by $4.1 million, or $0.03 per diluted common share, and $1.5 million, or $0.01 per diluted common share, respectively, as a result of after-tax extraordinary losses on the early extinguishment of debt. The Company's returns on average stockholders' equity and average assets for 1998 were 17.84% and 1.11%, respectively, up from 11.04% and 0.60%, respectively, for 1997 and 10.36% and 0.52%, respectively, for 1996.
The $115.4 million increase in net income during 1998, as compared with 1997, was fueled by growth in non-interest income of $379.7 million, or 261%. This growth was principally driven by the Company's
expansion of its mortgage banking operations, largely as a result of the NAMC Acquisition in October 1997. Other factors contributing to the higher level of non-interest income included an aggregate increase of $18.6 million in fees from sales of consumer financial services and products, the recognition of net securities gains of $21.9 million in 1998 as compared with net securities losses of $17.8 million in 1997 (each of which was primarily associated with a balance sheet restructuring initiative implemented in December 1997) and a gain of $9.6 million on the sale of the Bank's sole remaining Florida branch. The Company's net income in 1998, as compared with 1997, also benefited from a $44.2 million increase in net interest income, a reduction in the provision for loan losses of $17.0 million and the effects of tax planning strategies. These factors were partially offset by an increase in non-interest expense of $284.5 million, or 74.6%, which was largely associated with the Company's mortgage banking operations but also reflects, albeit to a much lesser extent, a higher level of expenses incurred by the Company in connection with its plan to prepare its computer systems, software, applications, hardware and facility systems to properly process dates beyond December 31, 1999 (the "Year 2000 Plan").
Contributing to the $17.5 million improvement in net income for 1997, as compared with 1996, were increases in net interest income, fee income, and gains associated with mortgage banking activities, as well as the effect of a $26.3 million charge in 1996 to recapitalize the SAIF (the "SAIF Recapitalization Assessment"). These factors were offset, in part, by an increase in securities-related losses associated with balance sheet restructuring initiatives, a higher provision for loan losses, increases in certain expenses due primarily to business expansion efforts (including the NAMC Acquisition and the acquisition, on April 30, 1997, of BFS Bankorp, Inc. and its wholly-owned subsidiary, Bankers Federal Savings FSB) and the effect of $12.3 million of income tax benefits recognized during 1996 in connection with the final resolution of certain tax filing positions taken in prior years.
Net Interest Income
Net interest income amounted to $527.2 million for 1998, up $44.2 million, or 9.1%, from 1997, largely due to a widening of the net interest margin to 2.68% in 1998 from 2.51% in 1997 and, to a lesser extent, as a result of a $399.1 million increase in average interest-earning assets. The improvement in the net interest margin, which occurred despite the unfavorable interest rate yield curve during 1998, was principally driven by a reduction of 22 basis points in the cost of average interest-bearing liabilities due, in large part, to lower deposit costs. The higher net interest margin also reflects growth in the yield on average interest-earning assets to 7.22% for 1998 from 7.18% for 1997. Contributing to the increase in the yield were favorable changes in the asset mix, as discussed below, and higher yields on securities, the effects of which were partially offset by a 28 basis point reduction in the yield on average loans. The lower yield on loans principally reflects the effects of the lower long-term interest rate environment during 1998, partially offset by sales of certain relatively lower-yielding portfolio loans during the year.
Net interest income for 1997, which amounted to $483.1 million, increased $21.8 million, or 4.7% from 1996, primarily reflecting growth in the net interest margin of 11 basis points. The higher net interest margin was principally due to favorable changes in the mix of interest-earning assets, but also reflects, to a lesser degree, the effect of sales of approximately $126 million of non-performing residential real estate assets in May 1997 (the "1997 NPA Sales"). The improvement in the net interest margin in 1997 was limited by the flattening of the interest rate yield curve during the year.
Part of the Company's strategy in recent years has been to emphasize loans while reducing its reliance on MBS, which have historically provided lower yields than the Company's loans. In connection therewith, during 1998 and 1997, as compared with the respective prior years, the average balance of loans increased $3.7 billion and $1.8 billion, respectively, while the average balance of MBS declined $3.0 billion and $1.7 billion, respectively. For 1998, average loans represented 80.8% of total average interest-earning assets, up from 63.0% for 1997 and 53.9% for 1996. The percentage of average MBS to total average interest-earning assets declined to 15.9% for 1998 from 32.1% for 1997 and 40.9% for 1996. These changes reflect, in part, sales of MBS in connection with balance sheet restructuring initiatives (see "Non-Interest Income -- Net Gains (Losses) on Sales Activities.")
The following table sets forth, for the years indicated, the Company's consolidated average statement of financial condition, net interest income, the average yield on interest-earning assets, and the average cost of interest-bearing liabilities. Average balances are computed on a daily basis. Non-accrual loans are included in average balances in the table below.
- --------------- (1) Includes loans held for sale.
The following table sets forth, for the years indicated, the changes in interest income and expense for each major component of interest-earning assets and interest-bearing liabilities and the amounts attributable to changes in average balances (volume) and average interest rates (rate). The changes in
interest income and interest expense attributable to changes in both volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
- --------------- (1) Includes loans held for sale.
Provision for Loan Losses
The Company's provision for loan losses, which is predicated upon the Company's assessment of the adequacy of its allowance for loan losses (see "Management of Credit Risk -- Allowance for Loan Losses") amounted to $32.0 million for 1998, as compared with $49.0 million for 1997 and $41.0 million for 1996. Included in the provision for loan losses for 1997 was a $14.0 million special provision associated with the 1997 NPA Sales.
Net loan charge-offs amounted to $31.6 million in 1998, $64.0 million in 1997 and $62.8 million in 1996. Net loan charge-offs during 1998 included charge-offs of $9.1 million associated with a bulk sale in December 1998 of approximately $53 million of non-accrual and subperforming loans, substantially all of
which were residential real estate loans (the "1998 NPA Sale"). Net loan charge-offs during 1997 included charge-offs of $35.8 million associated with the 1997 NPA Sales.
Non-Interest Income
General. The Company's non-interest income during 1998 was $525.0 million, or 49.9% of total revenues (net interest income plus non-interest income). In comparison, non-interest income was $145.3 million, or 23.1% of total revenues, in 1997 and $86.0 million, or 15.7% of total revenues, in 1996. The year-to-year increases in non-interest income were predominantly attributable to the Company's expanded mortgage banking operations.
Loan Servicing and Other Fees. Loan servicing and other fees, which includes revenues earned from loan servicing, loan production and certain other loan-related activities, amounted to $199.5 million in 1998, an increase of $125.5 million, or 169.5%, from 1997, which had increased $26.2 million, or 54.7%, from 1996. Of these increases, approximately $74 million and $13 million, respectively, were associated with loan production fees, substantially as a result of growth in residential real estate loan production. A higher average balance of the Company's portfolio of mortgage loans serviced for others also contributed significantly to the increases in loan servicing and other fees in 1998 and 1997, as compared with the respective prior years.
At December 31, 1998, the Company's portfolio of mortgage loans serviced for others, excluding loans being subserviced by the Company, amounted to $27.0 billion, up $5.0 billion, or 22.8%, from one-year earlier. This increase reflects additions during 1998 of $25.0 billion, the effect of which was largely offset by strategic bulk sales of $13.3 billion of mortgage loan servicing rights (see "Net Gains (Losses) on Sales Activities" and "Non-Interest Expense -- Amortization of Mortgage Servicing Assets"), coupled with runoff of $6.7 billion. Excluding loans being subserviced, the weighted average interest rate of the loans underlying the mortgage loans serviced for others portfolio was 7.37% at December 31, 1998, down 51 basis points from year-end 1997. In connection with its bulk sales of mortgage loan servicing rights, the Company was subservicing $7.9 billion of loans at the end of 1998. The Company receives fees for subservicing loans until the transfer of the servicing responsibility to the purchasers of the servicing rights.
Banking Service Fees. Banking service fees totaled $41.4 million for 1998, an increase of $9.6 million, or 30.3%, from 1997. During 1997, banking service fees were $31.8 million, up 13.3% from $28.1 million in 1996. The growth in banking service fees in 1998 and 1997, as compared with the respective prior years, was reflective of changes in the Company's fee structure, coupled with volume increases in certain underlying transactions due, in part, to an expanded network of automated teller machines.
Securities and Insurance Brokerage Fees. Securities and insurance brokerage fees for 1998 amounted to $32.7 million, up $9.0 million, or 37.9%, as compared with 1997. This growth was largely driven by an $8.5 million increase in insurance fees, principally due to the expansion of the Company's insurance product line and the number of states in which the products are sold as a result of the NAMC Acquisition (pursuant to which the Company also acquired NAMC's insurance subsidiaries). In 1997, securities and insurance brokerage fees totaled $23.7 million, an increase of $2.7 million as compared with 1996, which was attributable to relatively equal growth in securities brokerage fees and insurance fees.
Net Gains (Losses) on Sales Activities. During 1998, the Company recognized net gains on sales activities of $244.5 million, as compared with net gains of $12.0 million in 1997 and net losses of $12.7 million in 1996. The following table summarizes net gains (losses) on sales activities for the year ended December 31 (in thousands):
Net gains on sales of loans held for sale increased $194.1 million in 1998 and $20.6 million in 1997 as compared with the respective prior years, reflective of increased sales of mortgage loans into the secondary market. During 1998, the Company sold $26.8 billion of mortgage loans into the secondary market, up from $4.7 billion during 1997 and $1.1 billion during 1996. The relatively high level of loan sales during 1998, while largely attributable to the Company's expanded mortgage banking operations, also reflects the significant loan refinancing activity that resulted, in large part, from the relatively lower long-term interest rate environment during the year.
The securities-related net gains during 1998 of $21.9 million were substantially associated with sales of $1.9 billion of securities, including virtually all of the $1.4 billion of MBS that had been designated for sale in connection with the transfer of the Company's entire securities held to maturity portfolio to its securities available for sale portfolio as part of a balance sheet restructuring initiative implemented in December 1997. At that time, the Company recognized a loss of $25.2 million associated with the write-down to estimated fair value of those MBS designated for sale with unrealized losses (which contributed substantially to the securities-related net losses of $17.8 million in 1997), but subsequent movements in interest rates resulted in higher than initially anticipated sales prices. The securities-related net losses during 1996 were substantially associated with sales of $2.0 billion of MBS in connection with a balance sheet restructuring initiative implemented in December 1995 and the recognition of other than temporary impairment in value on certain MBS (see "Management of Credit Risk -- MBS").
During each of the first, third and fourth quarters of 1998 and the fourth quarter of 1997, the Company consummated a bulk sale of mortgage loan servicing rights (see "Amortization of Mortgage Servicing Assets"). These sales, the net gains on which amounted to $2.0 million in 1998 and $6.9 million in 1997, were associated with the Company's mortgage banking risk management activities and were intended to reduce the impact of a declining long-term interest rate environment on the value of the Company's mortgage servicing assets. The Company did not consummate any bulk sales of mortgage loan servicing rights during 1996.
In August 1998, the Bank sold its sole remaining Florida branch and recognized a gain of $9.6 million. At the time of sale, this branch had deposits of $207.2 million.
The net losses of $6.2 million in 1998 and $4.1 million in 1996 reflected in the above table under the caption "Other" were largely associated with the termination of certain derivative financial instrument agreements and losses on the write-down of certain non-interest earning assets, respectively.
Other. Other non-interest income was $6.9 million in 1998, as compared with $3.7 million in 1997 and $1.7 million in 1996, which included $1.0 million associated with the settlement of certain litigation. The higher levels of other non-interest income in 1998 and 1997, as compared with the respective prior years, were largely associated with the Company's investment of $150.0 million during the third quarter of 1997 in a bank-owned life insurance program. In general, under this program, the Company purchases,
owns, and is the beneficiary of insurance policies on the lives of certain employees who consent to being covered under the program in order to help defray certain costs associated with the Company's employee benefit plans.
Non-Interest Expense
General. Non-interest expense was $665.6 million in 1998, up $284.5 million, or 74.6%, from 1997. This increase was largely the result of the full year effect of the NAMC Acquisition, which was accounted for under the purchase method of accounting, coupled with the Company's continued expansion of its mortgage banking operations during 1998 in furtherance of its strategy in this area and in response to the relatively high level of loan demand during the year.
During 1997, non-interest expense amounted to $381.1 million, as compared with $352.0 million in 1996. The $29.1 million increase was principally associated with the NAMC Acquisition, the effect of which was partially offset by the $26.3 million SAIF Recapitalization Assessment and certain non-recurring personnel expenses recognized in 1996, as well as legislation which reduced the Bank's federal deposit insurance premiums.
General and Administrative ("G&A") Expense. Virtually all components of G&A expense increased in 1998 from 1997, largely as a result of the NAMC Acquisition.
Compensation and employee benefits expense amounted to $270.1 million for 1998, as compared with $157.9 million for 1997 and $139.4 million for 1996. The higher expense levels in 1998 and 1997 were largely reflective of the Company's expansion of its mortgage banking operations, but also reflect, among other factors, higher levels of commissions and incentives and normal merit increases. With respect to 1997 as compared with 1996, the impact of such factors was partially limited by charges of $5.6 million recognized during 1996 in connection with the retirement, on December 31, 1996, of the Company's former Chief Executive Officer and severance benefits incurred during 1996 in connection with the relocation of the headquarters of the Company's mortgage banking operations from Uniondale, New York to Tampa, Florida. At December 31, 1998, the Company had 7,123 full-time equivalent employees, up from 6,000 one-year earlier and 2,872 at year-end 1996.
Occupancy and equipment expense was $92.5 million in 1998, up $28.9 million, or 45.4%, from 1997, which had increased $10.9 million, or 20.7%, as compared with 1996. These increases were principally associated with the growth in the Company's mortgage banking operations, particularly the NAMC Acquisition, but also reflect, among other factors, the effect of technology-related expenditures.
Other G&A expense increased $93.6 million, or 80.9%, in 1998 and $14.9 million, or 14.8%, in 1997, as compared with the respective prior years, largely due to the Company's business expansion efforts. The following table provides details of other G&A expense for the year ended December 31 (in thousands):
Amortization of Mortgage Servicing Assets. Amortization of mortgage servicing assets amounted to $92.3 million in 1998, an increase of $62.5 million from 1997. This increase was largely attributable to a higher level of mortgage servicing assets but, to a lesser extent, also reflects the impact of accelerated loan prepayments as a result of the relatively lower long-term interest rate environment during 1998. Despite the interest rate environment during 1998, the Company was not required to recognize impairment of its mortgage servicing assets during the year. Amortization of mortgage servicing assets had increased to $29.8 million for 1997 from $19.4 million for 1996, substantially due to the NAMC Acquisition.
The Company's mortgage servicing assets (including related derivative financial instruments hedging such assets) had a carrying value of $692.5 million at the end of 1998, as compared with $341.9 million at the end of 1997 and $127.7 million at the end of 1996. At December 31, 1998, the estimated fair value of the Company's mortgage servicing assets was $724.4 million.
In a declining long-term interest rate environment, actual or expected prepayments of the loans underlying the Company's mortgage servicing assets portfolio may increase, which would have an adverse impact on the value of such assets. In connection therewith, the Company uses certain derivative financial instruments to hedge its mortgage servicing assets (see "Asset/Liability Management -- Derivative Financial Instruments"). In addition, in an effort to reduce the prepayment risk associated with its mortgage servicing assets portfolio, the Company consummated three bulk sales totaling $13.3 billion of mortgage loan servicing rights during 1998 and a bulk sale of $3.0 billion of mortgage loan servicing rights during the fourth quarter of 1997. As a result of these bulk sales, the carrying value of mortgage servicing assets (excluding the effect of derivative financial instruments hedging such assets) was reduced by approximately $278 million during 1998 and $57 million during 1997.
Other Real Estate Owned ("ORE") Expense, Net. The following table summarizes ORE expense, net, for the year ended December 31 (in thousands):
- --------------- (1) The provision for 1997 includes $0.6 million associated with the 1997 NPA Sales.
Contributing to the decline in ORE expense, net, in 1997, as compared with 1996, were the sales of approximately $13 million of residential ORE in connection with the 1997 NPA Sales.
SAIF Recapitalization Assessment. The FDIC implemented portions of the Funds Act in a final regulation that became effective in the fourth quarter of 1996. The FDIC regulation mandated the SAIF Recapitalization Assessment of $0.657 per $100 of SAIF-insured deposits as of March 31, 1995 in order to recapitalize the SAIF and bring it to its statutorily-required level of $1.25 of reserves for each $100 of insured deposits. However, the Funds Act provided for certain adjustments for purposes of computing the SAIF Recapitalization Assessment, including a 20% reduction for certain BIF-member institutions having SAIF-insured deposits, such as the Bank. The Bank's SAIF Recapitalization Assessment of $26.3 million was expensed during 1996.
Restructuring and Related Expense. The Company incurred restructuring and related expense of $9.9 million during 1997 in connection with the NAMC Acquisition and $3.5 million during 1996 in connection with the Anchor Merger. No such expense was incurred during 1998.
Income Tax Expense
Income tax expense for 1998 was $113.5 million, as compared with $75.0 million for 1997 and $50.0 million for 1996. The year-to-year increases reflect higher pre-tax income and, with respect to 1997 as
compared with 1996, the impact of $12.3 million of tax benefits realized during 1996 as a result of the final resolution of certain federal, state and local tax filing positions taken in prior years. The Company's effective income tax rate was 32.0% in 1998, as compared with 37.9% in 1997 and 32.4% in 1996. The effective income tax rate in 1998 was favorably affected by the restructuring of assets within corporate entities. The Company believes that its effective income tax rate will increase in 1999.
Extraordinary Items
During 1998 and 1997, the Company recognized after-tax extraordinary losses of $4.1 million and $1.5 million, respectively, on the early extinguishment of $157.2 million and $55.6 million, respectively, of long-term debt (see "Financial Condition -- Borrowed Funds").
BUSINESS SEGMENTS
General
The Company manages its operations in a manner to focus on two strategic objectives: fulfilling its role as a banking institution for both individuals and businesses and as a national provider of residential mortgage products and services. Accordingly, the Company aligns its various business objectives in support of these goals. As described in Item 1, "Business," the Company has four business segments.
The Company views its segments' performance on an operating earnings basis, which represent net income adjusted for the effects of certain non-recurring or unusual items. Such items, after tax, aggregated $20.0 million, ($35.4) million and ($16.5) million for 1998, 1997 and 1996, respectively (see Note 25 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data").
The following table summarizes operating earnings results for the Company's business segments as derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company for the year ended December 31 (in thousands):
- --------------- (1) Intersegment transactions, the most significant of which are described in the text below, have been eliminated in consolidation. In addition, this line includes the Company's funding center, which reflects the effects of intersegment match-funding of all assets and liabilities, and transacts external borrowings on behalf of the Company.
Retail Banking
Retail Banking's profit for 1998 totaled $120.2 million, an increase of 12.4% from $107.0 million in 1997, which had increased 19.2% from $89.7 million in 1996. In recent years, the Company has sought to grow its Retail Banking business with particular focus on the retention and selective growth of its retail deposit base and expanded consumer lending activities.
Average retail deposits (which does not include escrow deposits associated with mortgage servicing activities) amounted to $12.4 billion in 1998, as compared with $12.7 billion in 1997 and $12.3 billion in 1996. The decline from 1997 to 1998 was primarily attributable to the sale of the Company's sole remaining Florida branch and reductions in relatively more costly time deposits. Retail banking fees
increased annually over this time frame, contributing to the profit growth. The Company also generates fee income by providing additional financial services, including securities and insurance brokerage services.
The average portfolio of consumer loans, the largest component of which is home equity loans, increased to approximately $861 million in 1998 from $730 million in 1997 and $724 million in 1996. The growth in 1998, which occurred despite significant run-off related to the mortgage refinance boom of 1998, was due primarily to management's expanded focus on this business, and such was assisted in part by the NAMC Acquisition, which has provided a nationwide distribution capability.
In addition, the average balance of the Company's residential real estate loans receivable portfolio increased in size by over $900 million in each of 1998 and 1997, as compared with the respective prior year period. Substantially all of these loans are serviced by the Company's Mortgage Banking segment for an internal fee, which is eliminated in consolidation.
Commercial Banking
Commercial Banking's profit totaled $37.4 million in 1998, a 13.3% increase from 1997. This segment's profit for 1997 of $33.0 million represented an increase of 54.2% from $21.4 million in 1996. During these years, the Company has both increased its commercial real estate lending activities and developed a business banking group, which operates principally through its branch distribution network. As a result, the aggregate average balance of commercial real estate and business loans outstanding increased by over $275 million in 1998 and $375 million in 1997, as compared with the corresponding prior year period. Average Commercial Banking-related deposits increased by over $50 million per year in each of 1998 and 1997, as compared with the respective prior year, averaging $254 million in 1998, with growth attributable to both areas within this segment. Virtually all such deposits are relatively lower costing deposit products.
Mortgage Banking
Mortgage Banking's profit increased to $79.4 million in 1998 from $17.9 million in 1997 and $0.2 million in 1996. The Company believes the NAMC Acquisition in October 1997 provided it with the scale necessary in both loan production and servicing to compete effectively in the mortgage banking business nationwide. In addition, the record mortgage market during 1998 enabled the Company to leverage its new capability, generating record loan production and developing a sizeable and more geographically diverse loan servicing portfolio. The fact that NAMC's operations were included for the full year 1998, coupled with the strength of the mortgage market in 1998, were the primary reasons for the significantly increased profitability of this segment year-to-year. In addition, for internal purposes, this segment recognizes gains on sales of portfolio loans to the Retail Banking segment and is credited with recurring fee income for servicing these loans. Such intersegment income is eliminated in consolidation.
Investment Portfolio
Historically, the Company maintained a significant proportion of its assets in MBS and other investments. Commencing in late 1995, management took steps to reduce the relative size of this portfolio, investing instead in its various business activities. These steps included the transfer, in 1997, of all securities out of its held to maturity portfolio and into its available for sale portfolio and sales of certain relatively lower-yielding securities. As a result, the average securities balance in 1998 was approximately half that of 1996, and the relative contribution of this segment to the Company's earnings has been reduced significantly. For 1998, profit from the Investment Portfolio segment was $19.2 million, representing only 7.5% of the Company's total reportable segments' profit, compared with $19.8 million in 1997 and $13.9 million in 1996, each of which represented approximately 11% of the total reportable segments' profit.
For further financial information on the Company's business segments, see Note 25 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
YEAR 2000 ISSUE
The Company acknowledges the challenges posed worldwide due to the current inability of certain computer systems to properly recognize the date change from December 31, 1999 to January 1, 2000. Failure to adequately meet these challenges could have a material adverse effect on the operations of a financial institution, such as the Company. The Company has adopted its Year 2000 Plan to prepare its computer systems, software, applications, hardware and facility systems to properly process dates beyond December 31, 1999. The Year 2000 Plan requires modifications to be made to certain of the Company's existing systems and, in other cases, conversions to new systems or software.
In accordance with guidelines established by the Federal Financial Institutions Examinations Council and the OTS, the Company has completed both the assessment and analysis phase and the remediation phase of its Year 2000 Plan with respect to its mission-critical systems. The Company has substantially completed the testing phase of the Year 2000 Plan, including user acceptance, unit, and interface testing, with respect to its internal mission-critical systems. The Company has commenced external interface testing with mission-critical and other material third parties and currently anticipates that such testing will be substantially completed by June 30, 1999.
Further, the Company has established remediation contingency plans and business resumption contingency plans for its mission-critical systems. The Company's remediation contingency plans focus on mitigating the risks associated with the failure to remediate its mission-critical systems prior to the year 2000 and the business resumption contingency plans focus on mitigating the operational risks to the Company and its customers should the Company's core business processes fail, regardless of whether its mission-critical systems are remediated by the year 2000.
The Company has developed a campaign designed to educate and reassure its customers regarding the impact of the year 2000 issue and the readiness of the Company to face the challenges posed by the approach of the new millennium. As part of this process, the Company is preparing a training program to provide employees with comprehensive information about the Company's efforts so that they can answer questions posed by individual customers and others.
In addition, the Company is involved in ongoing communications with its significant third-party contractors, such as vendors and service providers, for the purpose of evaluating their readiness to meet the challenges of the year 2000 and the extent to which the Company may be affected by the remediation efforts connected with their systems, software, and applications. The Company cannot guarantee that the computer systems of such third-parties will be remediated on a timely basis or that the failure of any such party to remediate, or a remediation that is incompatible with the Company's systems, would not have a material adverse effect on the Company.
The estimated total pre-tax cost of the Year 2000 Plan is approximately $20 million, of which $17.5 million has been incurred through December 31, 1998. The estimated total cost substantially reflects consulting fees associated with software modification, project management and programming, as well as ancillary items, but does not include such items as the cost of Company personnel involved in the Year 2000 Plan or capital expenditures that would have been made to systems regardless of the issues associated with the impending year 2000.
The preceding discussion includes forward-looking statements that involve inherent risks and uncertainties. A number of factors could cause the actual impact of the year 2000 issue to differ materially from Company estimates. Those factors include, but are not limited to, uncertainties in the cost of remediation of hardware and software, inaccurate or incomplete testing results, and the ineffective remediation of computer codes of internal mission-critical systems or external system interfaces. The Company cannot guarantee that its efforts will be accomplished in a timely manner or that the failure thereof will not have a material adverse effect on the Company. Failure of the Company or its significant third-party contractors to effectively remedy year 2000 issues could cause disruption of the Company's operations resulting in increased operating costs and other adverse effects. In addition, to the extent
significant customers' financial positions are weakened as a result of year 2000 issues, credit quality could be adversely impacted.
ASSET/LIABILITY MANAGEMENT
General
The Company's asset/liability management is governed by policies that are reviewed and approved annually by the Boards of Directors of the Holding Company and the Bank, which oversee the development and execution of risk management strategies in furtherance of these polices. The Asset/ Liability Management Committee, which is comprised of members of the Company's senior management, monitors the Company's interest rate risk position and related strategies.
Market Risk
In general, market risk is the sensitivity of income to variations in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices, such as prices of equities. The Company's market rate sensitive instruments include interest-earning assets, interest-bearing liabilities, and derivative financial instruments.
During 1998, the Company used, to a limited degree, market rate sensitive instruments for trading purposes.
The Company enters into market rate sensitive instruments in connection with its various business operations, particularly its mortgage banking activities. Loans originated, and the related commitments to originate loans that will be sold, represent market risk that is realized in a short period of time, generally two to three months.
The Company's primary source of market risk exposure arises from changes in United States interest rates and the effects thereof on mortgage prepayment and closing behavior, as well as depositors' choices ("interest rate risk"). Changes in these interest rates will result in changes in the Company's earnings and the market value of its assets and liabilities. The Company does not have any material exposure to foreign exchange rate risk or commodity price risk. Movements in equity prices may have an indirect, but limited, effect on certain of the Company's business activities or the value of credit sensitive loans and securities.
Interest Rate Risk Management
The Company manages its interest rate risk through strategies designed to maintain acceptable levels of interest rate exposure throughout a range of interest rate environments. These strategies are intended not only to protect the Company from significant long-term declines in net interest income as a result of certain changes in the interest rate environment, but also to mitigate the negative effect of certain interest rate changes upon the Company's mortgage banking operating results. The Company seeks to contain its interest rate risk within a band that it believes is manageable and prudent given its capital and income generating capacity. As a component of its interest rate risk management process, the Company employs various derivative financial instruments.
The Company's sensitivity to interest rates is driven primarily by the mismatch between the term to maturity or repricing of its interest-earning assets and that of its interest-bearing liabilities. Historically, the Company's interest-bearing liabilities have repriced or matured, on average, sooner than its interest-earning assets.
The Company is also exposed to interest rate risk arising from the "option risk" embedded in many of the Company's interest-earning assets. For example, mortgages and the mortgages underlying MBS may contain prepayment options, interim and lifetime interest rate caps and other such features affected by changes in interest rates. Prepayment option risk affects mortgage-related assets in both rising and falling interest rate environments as the financial incentive to refinance a mortgage loan is directly related to the level of the existing interest rate on the loan relative to current market interest rates.
Extension risk on mortgage-related assets is the risk that the duration of such assets may increase as a result of declining prepayments due to rising interest rates. Certain mortgage-related assets are more sensitive to changes in interest rates than others, resulting in a higher risk profile. Because the Company's interest-bearing liabilities are not similarly affected, the gap between the duration of the Company's interest-earning assets and interest-bearing liabilities generally increases as interest rates rise. In addition, in a rising interest rate environment, adjustable-rate assets may reach interim or lifetime interest rate caps, thereby limiting the amount of their upward adjustment, which effectively lengthens the duration of such assets.
Lower interest rate environments may also present interest rate risk exposure. In general, lower interest rate environments tend to accelerate loan prepayment rates, thus reducing the duration of mortgage-related assets and accelerating the amortization of any premiums paid in the acquisition of these assets. The amortization of any premiums over a shorter than expected term causes yields on the related assets to decline from anticipated levels. In addition, unanticipated accelerated prepayment rates increase the likelihood of potential losses of net future servicing revenues associated with the Company's mortgage servicing assets.
The Company is also exposed to interest rate risk resulting from certain changes in the shape of the yield curve (particularly a flattening or inversion -- also called "yield curve twist risk" -- of the yield curve) and to differing indices upon which the yield on the Company's interest-earning assets and the cost of its interest-bearing liabilities are based ("basis risk").
As further described below, in evaluating and managing its interest rate risk, the Company employs simulation models to help assess its interest rate risk exposure and the impact of alternate interest rate scenarios, which consider the effects of adjustable-rate loan indices, periodic and lifetime interest rate adjustment caps, estimated loan prepayments, anticipated deposit retention rates, and other dynamics of the Company's portfolios of interest-earning assets and interest-bearing liabilities.
Derivative Financial Instruments
The Company currently uses a variety of derivative financial instruments to assist in managing its interest rate risk exposures and, on a very limited basis, for trading purposes. While the Company's use of derivative financial instruments in managing its interest rate exposures has served to mitigate the unfavorable effects that changes in interest rates may have on its results of operations, the Company continues to be subject to interest rate risk.
Interest Rate Risk-Management Instruments. The Company's assets have historically repriced or matured at a longer term than the liabilities used to fund those assets. Consequently, the Company uses derivative financial instruments in its efforts to reduce the repricing risk.
At December 31, 1998, the Company used four major classes of derivative financial instruments to manage interest rate risk: (i) interest rate swaps, where the Company pays a fixed rate and receives a floating rate; (ii) interest rate caps, where the Company receives the excess, if any, of a designated floating rate, all of which were tied to the weekly average yield of the one-year constant maturity Treasury index, over a specified rate (the "Cap Strike Rate"); (iii) interest rate swaptions, where, in exchange for the payment of a premium, the Company has the right to enter into interest rate swaps at a future date; and (iv) interest rate futures in money market instruments.
Interest rate swaps are used to modify specific fixed-rate assets and adjustable-rate borrowings and thereby improve the stability of the Company's net interest margin. Interest rate caps are used to hedge the periodic and lifetime rate caps embedded in specific adjustable-rate loans and securities. Interest rate swaptions are used to hedge the repricing risk on certain assets with high prepayment risk. Interest rate futures are used to hedge the repricing risk of certain short-term borrowed funds.
The following table sets forth the characteristics of derivative financial instruments used by the Company at December 31, 1998 for interest rate risk-management purposes, segregated by the activities that they hedge (dollars in thousands):
- --------------- (1) The weighted average Cap Strike Rate was 8.00%.
(2) The weighted average strike rate was 6.75%.
The use of derivative financial instruments for interest rate risk-management purposes resulted in decreases in net interest income during 1998, 1997 and 1996 of $19.6 million, $17.6 million and $17.2 million, respectively.
Mortgage Banking Risk-Management Instruments. At December 31, 1998, the Company used three major classes of derivative financial instruments to protect against the impact of substantial declines in long-term interest rates and the consequent increase in mortgage prepayment rates: (i) interest rate swaps, where the Company receives a fixed rate and pays a floating rate, although, in certain cases, the Company pays a floating rate for a set period of time; (ii) interest rate floors, where the Company receives the difference, if any, between a designated average long-term interest rate (generally the constant maturity Treasury or swap indices) and a specified strike rate (the "Floor Strike Rate"); and (iii) interest rate caps, where the Company receives the excess, if any, of a designated floating rate over a specified rate. The designated floating rates at December 31, 1998 were all tied to the one-month London Interbank Offered Rate ("LIBOR").
Two major classes of derivative financial instruments were used by the Company at December 31, 1998 to hedge the risk in its loans held for sale and related commitment pipeline. To the extent that the Company estimates that it will have loans to sell, the Company sells loans into the forward MBS market. Such short sales are similar in composition as to term and coupon with the loans held in, or expected to be funded into, the loans held for sale portfolio. In addition, because the amount of loans that the Company will fund, as compared with the total amount of loans that it has committed to fund, is uncertain, the Company purchased put options on MBS.
The following table sets forth the characteristics of derivative financial instruments used by the Company at December 31, 1998 in connection with its mortgage banking activities, segregated by the activities that they hedge (dollars in thousands):
- --------------- (1) The variable-rate payable will be tied to one-month LIBOR.
(2) The weighted average Floor Strike Rate was 5.27%.
(3) The weighted average Cap Strike Rate was 6.09%.
Trading Instruments. At December 31, 1998, the derivative financial instruments used by the Company for trading purposes consisted of interest rate caps with a notional amount of $165.0 million (the estimated fair value of these interest rate caps at year-end 1998 was not material). These interest rate caps had a weighted average strike rate of 6.91% at the end of 1998.
For additional information concerning the Company's derivative financial instruments, see Notes 1 and 23 of Notes to Consolidated Financial Statements in Item 8, "Financial Statements and Supplementary Data."
Asset/Liability Repricing
The measurement of differences (or "gaps") between the Company's interest-earning assets and interest-bearing liabilities that mature or reprice within a period of time is one indication of the Company's sensitivity to changes in interest rates. A negative gap generally indicates that, in a period of rising interest rates, deposit and borrowing costs will increase more rapidly than the yield on loans and securities and, therefore, reduce the Company's net interest margin and net interest income. The opposite effect will generally occur in a declining interest rate environment. Although the Company has a large portfolio of adjustable-rate assets, the protection afforded by such assets in the event of substantial rises in interest rates for extended time periods is limited due to interest rate reset delays, periodic and lifetime interest rate caps, payment caps and the fact that indices used to reprice a portion of the Company's adjustable-rate assets lag changes in market rates. Moreover, in declining interest rate environments or certain shifts in the shape of the yield curve, these assets may prepay at significantly faster rates than otherwise anticipated. It should also be noted that the Company's gap measurement reflects broad judgmental assumptions with regard to repricing intervals for certain assets and liabilities.
The following table reflects the repricing of the Company's interest-earning assets, interest-bearing liabilities and related derivative financial instruments at December 31, 1998. The amount of each asset, liability or derivative financial instrument is included in the table at the earlier of the next repricing date or maturity. Prepayment assumptions for loans and MBS used in preparing the table are based upon industry standards as well as the Company's experience and estimates. Non-accrual loans have been included in the "Over One Through Three Years" category. Demand deposits, money market deposits and
savings accounts are allocated to the various repricing intervals in the table based on the Company's experience and estimates.
The Company also utilizes complex simulation models to perform a sensitivity analysis by which it estimates the potential change in its net interest income over selected time periods resulting from hypothetical changes in interest rates. This analysis evaluates the interest rate sensitivity of all of the Company's interest-earning assets, interest-bearing liabilities and derivative financial instruments by measuring the impact of changing rates on 12-month projected interest income and interest expense. The Company estimates that, over a 12-month period, its net interest income would increase by approximately 3% and be virtually unchanged in the event of an instantaneous and sustained 100 basis point increase and decrease in interest rates, respectively.
This analysis requires the Company to make certain assumptions regarding prepayments of loans and securities, reinvestment of cash flow, deposit retention, availability of external funding, and the spread between market rates on interest-earning assets and interest-bearing liabilities. The Company relies upon industry data, as well as its own experience, in developing the estimates required for this interest rate sensitivity analysis.
The Company has developed policies addressing limits on changes in 12-month projected net interest income for specific instantaneous and sustained shocks in interest rates. The Company also utilizes market value of portfolio equity and duration of equity analyses in the management of its interest rate risk.
MANAGEMENT OF CREDIT RISK
General
The Company's credit risk arises from the possibility that borrowers, issuers, or counterparties will not perform in accordance with contractual terms. The Company has a process of credit risk controls and management procedures by which it monitors and manages its level of credit risk.
Non-Performing Assets
The Company's non-performing assets, which consist of non-accrual loans and ORE, net, amounted to $83.3 million at December 31, 1998, down $63.4 million, or 43.2%, from $146.7 million at year-end 1997. Non-accrual loans are all loans 90 days or more delinquent, as well as loans less than 90 days past due for which the full collectability of contractual principal or interest payments is doubtful. When a loan is placed on non-accrual status, any accrued but unpaid interest income on the loan is reversed and future interest income on the loan is recognized only if actually received by the Company and full collection of principal is not in doubt. Loans are generally returned to accrual status when principal and interest payments are current, full collectability of principal and interest is reasonably assured, and a consistent record of performance has been demonstrated. Loans modified in a troubled debt restructuring ("TDR") that have demonstrated a sufficient payment history to warrant return to performing status are not included within non-accrual loans (see "Loans Modified in a TDR").
The Company generally has pursued a loan-by-loan/property-by-property disposition strategy with respect to its non-performing assets, while also considering the appropriateness of alternate disposition strategies, including bulk sales of non-performing assets. As part of the 1998 NPA Sale, the Company sold approximately $48 million of non-performing residential real estate loans. The Company had sold approximately $126 million of non-performing residential real estate assets in the 1997 NPA Sales.
The following table presents the components of the Company's non-performing assets at December 31 (dollars in thousands):
The Company continues to expand its lending activities and product mix. The Company intends to continue to monitor closely the effects of these efforts on the overall risk profile of its loans receivable portfolio, which the Company expects will continue to change over time.
The level of loans delinquent less than 90 days may, to some degree, be an indicator of future levels of non-performing assets. The following table sets forth, at December 31, 1998, such delinquent loans of the Company, net of those already in non-performing status (in thousands):
Loans Modified in a TDR
When borrowers encounter financial hardship but are able to demonstrate to the Company's satisfaction an ability and willingness to resume regular monthly payments, the Company may provide them with an opportunity to restructure the terms of their loans. These arrangements, which are negotiated individually, generally provide for interest rates that are lower than those initially contracted for, but which may be higher or lower than current market interest rates for loans with comparable risk, and may, in some instances, include a reduction in the principal amount of the loan. The Company evaluates the costs associated with any particular restructuring arrangement and may enter into such an arrangement if it believes it is economically beneficial for the Company to do so.
The following table sets forth the Company's loans that have been modified in a TDR, excluding those classified as non-accrual loans, at December 31 (in thousands):
Allowance for Loan Losses
The Company's allowance for loan losses, which amounted to $105.1 million at December 31, 1998, is intended to be maintained at a level sufficient to absorb all estimable and probable losses inherent in the loans receivable portfolio. In determining the appropriate level of the allowance for loan losses and, accordingly, the level of the provision for loan losses, the Company reviews its loans receivable portfolio on at least a quarterly basis, taking into account its impaired loans, the size, composition and risk profile of the portfolio, delinquency levels, historical loss experience, cure rates on delinquent loans, economic conditions and other pertinent factors, such as assumptions and projections of future conditions. While the Company believes that the allowance for loan losses is adequate, additions to the allowance for loan losses may be necessary in the event of future adverse changes in economic and other conditions that the Company is unable to predict.
The following table sets forth the activity in the Company's allowance for loan losses for the year ended December 31 (dollars in thousands):
- --------------- (1) The provision for loan losses for 1997 included $14.0 million associated with the 1997 NPA Sales.
(2) Loan charge-offs for 1998 and 1997 included $9.1 million associated with the 1998 NPA Sale and $35.8 million associated with the 1997 NPA Sales, respectively.
The following table sets forth, at December 31 for the years indicated, the Company's allocation of the allowance for loan losses by category of loans receivable and the percentage of each category of loans receivable to total loans receivable (dollars in thousands).
- --------------- (1) The unallocated portion of the allowance for loan losses, as well the portions allocated to the listed loan categories, are available to absorb losses for any of the listed loan categories.
The Company has developed models and other analytic tools to assist in the assessment of estimable and probable losses inherent in both the non-performing and performing residential real estate loan portfolios. The Company periodically reviews and refines these models, analyzing the continuing validity of the assumptions used, comparing actual experience to that projected in the models and modifying those assumptions as may, in the Company's judgment, be appropriate. The Company also regularly analyzes economic trends and underlying portfolio trends, such as changes in geographic and property type mix and loan seasoning. The results of these reviews and analyses, which may yield a range of values, are evaluated in determining the need during any period for additions to the allowance for loan losses for residential real estate loans. However, it should be noted that these various models and analyses depend upon a large number of estimates and assumptions, especially with respect to future economic and market conditions and borrower behavior, that are subject to change, and it is entirely likely that future events will vary in some respects from those predicted by any particular model or analysis.
The adequacy of the allowance for loan losses for the Company's commercial real estate loan portfolio is based in part on a loan-by-loan analysis that includes a risk-rating system. The Company's Asset Quality Review Department ("AQRD") provides an independent review of the analyses performed by management with respect to commercial real estate loans, including the respective risk ratings assigned to such loans. Pursuant to the Company's policy, the AQRD conducts an annual review of all commercial real estate loans that have been assigned certain risk ratings, with the balance of the portfolio reviewed on a test basis.
MBS
Of the $3.0 billion carrying value of the Company's MBS portfolio at December 31, 1998, $2.0 billion were issued by entities other than FHLMC, GNMA and FNMA. These privately-issued MBS have generally been underwritten by large investment banking firms, with the timely payment of principal and interest on these securities supported ("credit enhanced") in varying degrees by either insurance issued by a financial guarantee insurer, letters of credit or subordination techniques. Privately-issued MBS are subject to certain credit-related risks normally not associated with MBS issued by FHLMC, GNMA and
FNMA, including the limited loss protection generally provided by the various forms of credit enhancements, as losses in excess of certain levels are not protected. Furthermore, the credit enhancement itself is subject to the creditworthiness of the provider. Thus, in the event that a provider of a credit enhancement does not fulfill its obligations, the MBS holder could be subject to risk of loss similar to a purchaser of a whole loan pool. While substantially all of the privately-issued MBS held by the Company at December 31, 1998 were rated "AA" or better by one or more of the nationally recognized securities rating agencies, no assurance can be given that such ratings will be maintained.
During 1998, 1997 and 1996, the Company recognized losses of $0.6 million, $1.5 million and $4.7 million, respectively, associated with other than temporary impairment in value of certain privately-issued MBS, the carrying value of which amounted to approximately $58 million at year-end 1998. These losses were necessitated by the depletion of the underlying credit enhancements as a result of losses incurred on the loans underlying the securities, coupled with the Company's projections of estimated future losses on the securities.
The following table sets forth, by issuer, the aggregate amortized cost and estimated fair value of the Company's privately-issued MBS that exceeded 10% of stockholders' equity at December 31, 1998 (in thousands):
Derivative Financial Instruments
The level of credit risk associated with derivative financial instruments depends on a variety of factors, including the estimated fair value of the instrument, the collateral maintained, the use of master netting arrangements and the ability of the counterparty to comply with its contractual obligations. In the event of default by a counterparty, the Company would be subject to an economic loss that corresponds to the cost to replace the agreement. There were no past due amounts related to the Company's derivative financial instruments at December 31, 1998 or 1997.
FINANCIAL CONDITION
General
The Company's total assets amounted to $22.3 billion at December 31, 1998, as compared with $21.8 billion at the end of 1997. The most significant factor contributing to the growth in total assets was an increase in loans held for sale, the effect of which was largely offset by a reduction in securities available for sale.
Securities
Securities available for sale declined to $3.3 billion, or 16.3% of total interest-earning assets, at December 31, 1998 from $5.0 billion, or 24.6% of total interest-earning assets, at year-end 1997. Contributing to this decline were the sales of substantially all of the $1.4 billion of MBS that had been designated for sale in connection with the balance sheet restructuring initiative implemented in December 1997. In total, during 1998, the Company sold $1.9 billion of securities, purchased $1.7 billion of securities, and received principal payments on securities of $1.5 billion. At December 31, 1998, 89.0% of the securities available for sale portfolio consisted of MBS, down from 98.2% at the end of 1997.
The following table sets forth the carrying value of the Company's securities available for sale and securities held to maturity at December 31 for the years indicated (in thousands):
At December 31, 1998, the Company's securities available for sale portfolio had gross unrealized gains of $25.8 million and gross unrealized losses of $31.5 million. These gross unrealized gains and losses reflect normal market conditions and vary, either positively or negatively, based primarily on changes in general levels of market interest rates relative to the yields on the portfolios.
Loans
In connection with its mortgage banking activities, the Company maintains a portfolio of loans held for sale into the secondary market. At December 31, 1998, loans held for sale amounted to $3.9 billion, up from $1.8 billion at the end of 1997.
The Company's loans receivable (exclusive of the allowance for loan losses) declined slightly to $12.7 billion at December 31, 1998 from $13.0 billion at year-end 1997. This decline was attributable to a reduction in residential real estate loans receivable, the effect of which was partially offset by growth in the Company's commercial real estate, consumer and business loans receivable. In the aggregate, commercial real estate, consumer and business loans receivable represented 30.0% of total loans receivable at December 31, 1998, up from 24.2% one-year earlier, reflecting the results of the Company's strategy to increase the percentage of such loans to total loans receivable.
Residential real estate loans receivable amounted to $8.9 billion at the end of 1998, a 9.4% decline from $9.8 billion at the end of 1997. In 1998, the Company produced $2.7 billion of loans for this portfolio, which substantially offset principal repayments during the year. In connection with the Company's balance sheet restructuring activities, approximately $780 million of relatively lower-yielding loans were transferred to loans held for sale in the first quarter of 1998 and sold during the second and third quarters of 1998.
Commercial real estate loans receivable increased $304.7 million, or 13.5%, during 1998 and amounted to $2.6 billion at December 31, 1998. At that date, this portfolio consisted primarily of loans secured by multifamily properties (57%), shopping centers (19%) and office buildings (11%).
Consumer loans receivable amounted to $973.2 million at December 31, 1998, an increase of $199.4 million, or 25.8%, from the end of 1997. This increase was largely attributable to growth in home equity loans, the Company's primary focus in this lending area. During 1998, the Company began offering its home equity loans through NAMC's loan production network, which contributed to an increase in home equity loan principal balances during 1998 of $220.8 million, or 35.8%. At December 31, 1998, home equity loans represented approximately 88% of the consumer loans receivable portfolio, up from approximately 82% at December 31, 1997.
The Company's business loans receivable increased to $287.3 million at year-end 1998 from $99.1 million at the end of 1997. This increase reflects the Company's heightened focus in this area as well as the diversification of loan products offered, including the introduction during 1998 of lease financing.
The following table summarizes the Company's loans receivable (exclusive of the allowance for loan losses) at December 31 (in thousands):
The following table presents the contractual maturities of the principal balances of the Company's real estate construction loans receivable and business loans receivable (excluding lease financing receivables) at December 31, 1998 (in thousands):
Loan production, which includes originations and purchases for portfolio and for sale in the secondary market, amounted to $32.7 billion for 1998, representing an increase of $22.9 billion as compared with 1997. While this increase was substantially associated with growth in residential real estate loan production to $30.5 billion for 1998 from $8.6 billion for 1997, the Company also experienced growth in commercial real estate loan production of $588.4 million, or 109.0%, consumer loan production of $238.3 million, or 48.1%, and business loan production of $231.6 million, or 184.4%.
The increase in residential real estate loan production in 1998, as compared with 1997, reflects the Company's expansion of its mortgage banking activities, largely due to the NAMC Acquisition, as well as a relatively high level of loan refinancings, which resulted principally from the lower long-term interest rate environment during 1998 as compared with 1997. Of the total residential real estate loan production during 1998, approximately 56% were refinanced loans. The relatively lower long-term interest rate environment during 1998 also resulted in significant production of fixed-rate residential real estate loans. Fixed-rate residential real estate loan production, substantially all of which is sold by the Company into the secondary market, represented approximately 90% of total residential real estate loan production during 1998.
The following table summarizes the Company's loan production for the year ended December 31 (in thousands):
Deposits
Total deposits amounted to $13.7 billion at year-end 1998, down $195.8 million from December 31, 1997. In August 1998, the Bank sold its remaining Florida branch which, at the time of sale, had deposits of $207.2 million. During 1998, time deposits declined $1.1 billion, reflecting the Company's strategy to decrease the percentage of such deposits to total deposits. The effect of this decline was largely offset by an overall $0.9 billion increase in non-interest bearing and relatively lower-costing deposit products.
The following table sets forth a summary of the Company's deposits at December 31 (dollars in thousands):
Borrowed Funds
The following table sets forth a summary of the Company's borrowed funds at December 31 (dollars in thousands):
In July 1998, the Holding Company redeemed the remaining $44.4 million of its outstanding 8.9375% senior notes due July 2003, which resulted in a pre-tax extraordinary loss of $1.9 million. (During 1997, the Holding Company had purchased $55.6 million of such senior notes and, in connection therewith, recognized a pre-tax extraordinary loss of $2.4 million.) In addition, all of the Bank's $78.0 million of Collateralized Real Yield Securities were repaid, at the option of the holders thereof, in August 1998, which resulted in a pre-tax extraordinary loss of $0.6 million. Further, in September 1998, the Holding Company purchased $34.8 million of the then-outstanding $200.0 million of guaranteed preferred beneficial interests in its 9.33% junior subordinated deferrable interest debentures, which resulted in a pre-tax extraordinary loss of $4.6 million.
During September 1998, the Holding Company, in a private offering, issued $100.0 million of senior notes due March 1999 with a stated interest rate of 6.12%.
At December 31, 1998, the Holding Company had an effective shelf registration in place pursuant to which it could issue, from time to time, debentures, notes or other unsecured evidences of indebtedness. These debt securities, which may be unsubordinated or subordinated to certain other obligations of the
Holding Company, may be offered separately or together in one or more series, up to an aggregate amount of $300.0 million. No securities had been issued pursuant to this shelf registration as of year-end 1998.
Stockholders' Equity
At December 31, 1998, stockholders' equity amounted to $1.4 billion, or 6.21% of total assets. In comparison, stockholders' equity at year-end 1997 amounted to $1.3 billion, or 6.02% of total assets. The growth in stockholders' equity during the year was limited principally by the effect of treasury stock purchases and dividends declared on the Common Stock. Book value per common share of $12.42 at December 31, 1998 increased 9.9% from $11.30 one-year earlier.
During 1998, the Holding Company repurchased 6.4 million shares of Common Stock at a cost of $178.0 million. At December 31, 1998, the Holding Company had one Common Stock repurchase program in effect. Under this program, which was announced in September 1998, the Holding Company is authorized to repurchase up to approximately 5.6 million shares of its outstanding Common Stock. During 1998, 0.3 million shares of Common Stock were acquired under this program. No time limit was established to complete this program.
Dividends declared and paid on the Common Stock for 1998 amounted to $21.6 million, or $0.19 per share, up from $12.9 million, or $0.12 per share, for 1997. The Holding Company's Common Stock dividend payout ratio was 9.1% for 1998, as compared with 10.5% for 1997.
LIQUIDITY
The Company's liquidity management process focuses on ensuring that sufficient funds exist to meet withdrawals from deposit accounts, loan funding commitments, the repayment of borrowed funds, and other financial obligations and expenditures, as well as ensuring the Bank's compliance with regulatory liquidity requirements. The liquidity position of the Company, which is monitored on a daily basis, is managed pursuant to established policies and guidelines.
The Company's sources of liquidity include principal repayments on loans and MBS, borrowings, deposits, sales of loans in connection with mortgage banking activities, sales of securities available for sale, and net cash provided by operations. Additionally, the Company has access to the capital markets for issuing debt or equity securities, as well as access to the discount window of the Federal Reserve Bank of New York, if necessary, for the purpose of borrowing to meet temporary liquidity needs, although it has not utilized this funding source in the past.
Excluding funds raised through the capital markets, the primary source of funds of the Holding Company, on an unconsolidated basis, has been dividends from the Bank, whose ability to pay dividends is subject to regulations of the OTS (see "Regulation and Supervision -- Restrictions on Dividends and Capital Distributions" in Item 1, "Business").
Under existing OTS regulations, the Bank must maintain, for each calendar quarter, an average daily balance of liquid assets (as defined) equal to at least 4.0% of either (i) its liquidity base (the Bank's net withdrawable accounts plus short-term borrowings) at the end of the preceding calendar quarter or (ii) the average daily balance of its liquidity base during the preceding quarter. For the fourth quarter of 1998, the Bank's liquidity ratio was 15.9%.
REGULATORY CAPITAL
Pursuant to OTS regulations, the Bank is required to maintain tangible capital of at least 1.50% of adjusted total assets, core capital of at least 3.00% of adjusted total assets, and total risk-based capital of at least 8.00% of risk-weighted assets. The Bank exceeded these capital requirements at December 31, 1998.
Under the PCA regulations adopted by the OTS pursuant to FDICIA, an institution is considered well capitalized, the highest of five categories, if it has a leverage ratio of at least 5.00%, a Tier 1 risk-based capital ratio (core capital to risk-weighted assets) of at least 6.00%, and a total risk-based capital
ratio of at least 10.00%, and it is not subject to an order, written agreement, capital directive, or PCA directive to meet and maintain a specific capital level for any capital measure. At December 31, 1998, the Bank met the published standards for a well capitalized designation under these regulations.
The following table sets forth the Bank's regulatory capital position at December 31 (dollars in thousands):
The declines in the Bank's risk-based capital and Tier 1 risk-based capital ratios during 1998 reflect an increase in risk-based assets to $13.4 billion at December 31, 1998 from $11.8 billion at the end of 1997. Contributing to the higher level of risk-based assets was a change in the mix of the Bank's assets.
OTHER MATTERS
On December 16, 1998, the Holding Company announced that it had entered into a definitive agreement to acquire Lakeview Financial Corp. ("Lakeview"), headquartered in West Paterson, New Jersey. Lakeview is the holding company for Lakeview Savings Bank, which operates eleven offices in northern New Jersey. On a consolidated basis at October 31, 1998, Lakeview had assets of approximately $573 million and deposits of approximately $454 million. Under the terms of the agreement, holders of Lakeview's common stock may elect to receive either 0.9 of a share of Common Stock or $24.26 in cash for each outstanding share of Lakeview common stock, subject to a requirement that, in the aggregate, 65% of Lakeview's outstanding shares of common stock will be exchanged for Common Stock and the remaining shares will be exchanged for cash. This transaction, which is expected to close during the second quarter of 1999, remains subject to regulatory approvals and the approval of Lakeview's shareholders.
RECENT ACCOUNTING DEVELOPMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 requires that an entity recognize all derivative instruments as either assets or liabilities in statements of financial position and measure those instruments at fair value. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. Earlier adoption of SFAS No. 133 is encouraged, but is permitted only as of the beginning of any fiscal quarter that begins after its issuance. SFAS No. 133 may not be applied retroactively to financial statements of prior periods. The Company intends to adopt SFAS No. 133 on January 1, 2000. The Company has not completed its evaluation of the effect that the adoption of SFAS No. 133 will have upon its financial condition and results of operations.
In October 1998, the FASB issued SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." SFAS No. 134, which amends SFAS No. 65, "Accounting for Certain Mortgage Banking Activities," requires that, after the securitization of a mortgage loan held for sale, any retained MBS should be classified in accordance with the provisions of SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." However, SFAS No. 134 requires that a mortgage banking enterprise classify as trading any retained MBS that it commits to sell before or during the securitization process. SFAS No. 134 is effective for the first fiscal quarter beginning after December 15, 1998. The Company does not believe that SFAS No. 134, when adopted, will materially impact its financial condition or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required by this Item is contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset/Liability Management," incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth the name, age, and position of each executive officer of the Company as of March 1, 1999 and the year in which such person joined the Company:
Mr. Daras has been employed by the Company in the positions stated above for more than five years. The principal occupation for at least the last five years of each other executive officer who is not a member of the Board is set forth below:
Mr. Brooks, who joined Anchor Savings in July 1987, served as Vice President and General Counsel of Anchor Bancorp from its formation until the Anchor Merger and as Secretary of Anchor Bancorp from March 1993 until the Anchor Merger. He was General Counsel of the Company from April 1995 to January 1998, at which time he assumed his present position.
Mr. Burriesci joined the Company in July 1997 as Chief Financial Officer. From 1990 until he joined the Company, he held various finance-related positions with First Fidelity Bancorporation, the most recent
of which was Executive Vice President and Corporate Controller, until it was acquired by First Union Corporation in 1996, where he served as Executive Vice President-Finance and Administration and Chief Financial Officer-Northern Region.
Mr. Kelly has served in various legal and business positions with the Company since joining the Bank in January 1987, including as assistant to the President from February 1992 to March 1995 and thereafter as Deputy General Counsel until he assumed his present position in January 1998.
Mr. Munoz joined the Company in April 1995 as Chief Credit Officer. Prior to joining the Company, he served in various positions with Citibank, N.A., where he was most recently Senior Vice President and a member of the Credit Policy Committee. In that position, he had been responsible at various times for credit management and oversight of part or all of Citibank's worldwide consumer banking activities, as well as Private Banking and Global Finance in Latin America.
Ms. Patterson joined the Company in May 1996 as General Manager, Consumer Lending and assumed her present position in June 1997. From 1989 until she joined the Company, Ms. Patterson held several positions with Chemical Bank, including most recently as General Manager of its Consumer Asset Group, until the merger of that institution with Chase Manhattan Bank in 1996, when she became the Director of Marketing for its National Consumer Services Division.
Information required by this Item regarding members of the Board is contained in the Holding Company's definitive Proxy Statement for its 1999 Annual Meeting of Stockholders (the "Proxy Statement"), which is expected to be filed with the Securities and Exchange Commission (the "Commission") within 120 days from December 31, 1998, incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this Item is contained in the Proxy Statement, incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this Item is contained in the Proxy Statement, incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this Item is contained in the Proxy Statement, incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
See Item 8, "Financial Statements and Supplementary Data."
(a)(2) FINANCIAL STATEMENT SCHEDULES
All financial statement schedules for the Holding Company and its subsidiaries have been included in the consolidated financial statements or the related notes or they are either inapplicable or not required.
(a)(3) EXHIBITS
- --------------- * Management Contract or Compensatory Plan or Arrangement.
(b) REPORTS ON FORM 8-K
During the three-month period ended December 31, 1998, the Holding Company filed with the Commission one Current Report on Form 8-K, dated December 16, 1998, which reported that, on December 15, 1998, the Holding Company had entered into a definitive agreement to acquire Lakeview.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DIME BANCORP, INC.
By: /s/ LAWRENCE J. TOAL ------------------------------------ Lawrence J. Toal Chairman of the Board, Chief Executive Officer, President, and Chief Operating Officer
March 31, 1999 -------------- Date
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 31, 1999 by the following persons on behalf of the registrant and in the capacities indicated.
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders Dime Bancorp, Inc.:
We have audited the accompanying consolidated statements of financial condition of Dime Bancorp, Inc. and subsidiaries (Dime) as of December 31, 1998 and 1997, and the related consolidated statements of income, changes in stockholders' equity, cash flows and comprehensive income for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of Dime's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dime Bancorp, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles.
/s/ KPMG LLP New York, New York January 21, 1999
DIME BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes to consolidated financial statements.
DIME BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements.
DIME BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
DIME BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
DIME BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
DIME BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Dime Bancorp, Inc. (the "Holding Company") is a unitary savings and loan holding company organized under the laws of the State of Delaware in 1994. The principal subsidiary of the Holding Company is The Dime Savings Bank of New York, FSB (the "Bank"). The accounting policies applied by the Holding Company and its subsidiaries (collectively, the "Company") conform with generally accepted accounting principles and prevailing practices within the financial services industry.
At December 31, 1998, the Company operated 90 banking branches located in the greater New York City metropolitan area and conducted its mortgage banking operations nationwide through offices located in 43 states.
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated statement of financial condition and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The following is a description of the Company's significant accounting policies.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Holding Company and its subsidiaries, all of which are wholly-owned, after the elimination of all significant intercompany balances and transactions. Certain amounts in prior years have been reclassified to conform with the current year presentation.
Securities
Securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and are carried at amortized cost. Securities purchased for the objective of selling them in the near term and mortgage-backed securities ("MBS") held for sale in connection with mortgage banking activities are classified as trading securities and are carried at estimated fair value with unrealized gains and losses recognized in operations. The Company did not maintain a securities held to maturity portfolio or trading securities portfolio at December 31, 1998 or 1997. Securities not otherwise classified as held to maturity or trading are classified as available for sale and are carried at estimated fair value with unrealized gains and losses, net of the related income tax effect, reported in a separate component of stockholders' equity.
The amortization of premiums and accretion of discounts on securities is recognized in income using the interest method over the lives of the securities, adjusted, in the case of MBS, for actual prepayments. Gains and losses on sales of securities are recognized using the specific identification method.
The carrying value of a security is reduced through a write-down charged to income in the event the Company determines that an other than temporary impairment in value has occurred.
Loans
Loans held for sale are carried at the lower of cost or market value, as determined on an aggregate basis. Net unrealized losses are recognized in a valuation allowance by charges to income. Premiums, discounts and certain origination fees and costs on loans held for sale are deferred and recognized as a component of the gain or loss on sale. Gains and losses on sales of loans held for sale are recognized at the settlement dates and are determined by the difference between the sales proceeds and the carrying value of the loans.
DIME BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Loans receivable are generally carried at unpaid principal balances adjusted for unamortized premiums, unearned discounts and deferred loan origination fees and costs, which are recognized as yield adjustments over the lives of the loans using the interest method.
Loans are placed on non-accrual status upon becoming 90 days contractually past due as to principal or interest, or at an earlier date if the full collectability of principal or interest is doubtful. Interest income previously accrued but not collected at the date a loan is placed on non-accrual status is reversed against interest income. Cash receipts on a non-accrual loan are applied to principal and interest in accordance with its contractual terms unless full payment of principal is not expected, in which case cash receipts, whether designated as principal or interest, are applied as a reduction of the carrying value of the loan. A non-accrual loan is generally returned to accrual status when principal and interest payments are current, full collectability of principal and interest is reasonably assured and a consistent record of performance has been demonstrated.
A loan is deemed a troubled debt restructuring ("TDR") by the Company when modifications of a concessionary nature are made to the loan's original contractual terms due to a deterioration in the borrower's financial condition.
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan," as amended, the Company considers a loan falling within its scope impaired when, based upon current information and events, it is probable that it will be unable to collect all amounts due, both principal and interest, according to the contractual terms of the loan agreement. SFAS No. 114 does not apply to loans held for sale or those large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. Loans reviewed by the Company for impairment are limited to residential real estate loans receivable modified in a TDR since January 1, 1995, business loans receivable, and commercial real estate loans receivable. Specific factors used in the impaired loan identification process include, but are not limited to, delinquency status, loan-to-value ratio, the condition of the underlying collateral, credit history, and debt coverage. At a minimum, loans reviewed for impairment by the Company are classified as impaired when delinquent more than six months. Impaired loans are principally measured using the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral for collateral dependent loans. For impaired loans on non-accrual status, cash receipts are applied, and interest income recognized, pursuant to the discussion above for non-accrual loans. For all other impaired loans, cash receipts are applied to principal and interest in accordance with the contractual terms of the loan and interest income is recognized on the accrual basis.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level the Company believes is sufficient to provide for losses inherent in its loans receivable portfolio. The allowance for loan losses is increased by loss provisions charged to operations and decreased by charge-offs (net of recoveries). In determining the appropriate level of the allowance for loan losses, the Company reviews its loans receivable portfolio on at least a quarterly basis, taking into account its impaired loans, the size, composition and risk profile of the portfolio, delinquency levels, historical loss experience, cure rates on delinquent loans, economic conditions and other pertinent factors, such as assumptions and projections of future conditions.
Premises and Equipment
Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the lesser of the terms of their respective leases or estimated useful lives.
DIME BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Mortgage Servicing Assets
The Company recognizes, as separate assets, the rights to service mortgage loans, whether those rights are acquired through loan purchase or loan origination activities. The initial recognition of originated mortgage servicing assets is predicated upon an allocation of the total cost of the related loans between the loans and the loan servicing rights based on their relative estimated fair values. Purchased mortgage servicing assets are recorded at cost. Mortgage servicing assets are amortized in proportion to and over the period of estimated net servicing income.
On a quarterly basis, mortgage servicing assets are assessed for impairment based upon their estimated fair value. For purposes of such assessments, the Company stratifies its mortgage servicing assets by underlying loan type (i.e., adjustable-rate, fixed-rate and balloon) and interest rate. Impairment of mortgage servicing assets is recognized through a valuation allowance for each impaired stratum with the individual allowances adjusted in subsequent periods to reflect changes in the measurement of impairment. The estimated fair value of each strata is determined through a discounted cash flow analysis of future cash flows incorporating numerous assumptions including servicing income, servicing costs, market discount rates, prepayment speeds, and default rates.
Other Real Estate Owned ("ORE")
ORE, which consists of real estate acquired in satisfaction of loans, is carried at the lower of cost or estimated fair value less estimated selling costs. Write-downs required at time of acquisition are charged to the allowance for loan losses. Subsequent to acquisition, the Company maintains an allowance for actual and potential future declines in value.
Goodwill
Goodwill is generally amortized using the straight-line method over periods ranging from 15 to 25 years. Goodwill is reviewed for possible impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If necessary, deferred tax assets are reduced to the amount that, based on available evidence, will more than likely be realized.
Earnings Per Common Share
Basic earnings per common share have been computed by dividing net income by the weighted average number of shares of the Holding Company's common stock ("Common Stock") outstanding during the period. Diluted earnings per common share have been computed by dividing net income by the sum of the weighted average number of shares of Common Stock and dilutive Common Stock equivalents outstanding (using the treasury stock method) during the period.
Consolidated Statements of Cash Flows
For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include cash and due from banks and money market investments.
DIME BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Cash flows associated with derivative financial instruments used by the Company for risk-management purposes are classified in the accompanying Consolidated Statements of Cash Flows in the same category as the cash flows from the asset or liability being hedged.
Derivative Financial Instruments
Risk-Management Instruments. The Company uses a variety of derivative financial instruments as part of its interest rate risk-management strategy and to manage certain risks associated with its mortgage banking activities. Derivative financial instruments used for these purposes must be designated as a hedge at their inception and must remain effective as a hedge throughout their contractual terms. If the effectiveness of the derivative financial instrument as a hedge is not maintained, the instrument is accounted for as a trading instrument. Derivative financial instruments used by the Company for risk- management purposes principally include interest rate swaps, interest rate caps, interest rate floors, interest rate futures, forward contracts and options.
For those derivative financial instruments used to modify the interest rate characteristics of designated interest-earning assets or interest-bearing liabilities, net amounts payable or receivable on the instruments are accrued as an adjustment to interest income or interest expense of the designated assets or liabilities. The estimated fair values of such derivative financial instruments are not reflected in the Company's consolidated financial statements unless designated to securities available for sale, in which case the derivative financial instruments are carried at estimated fair value with unrealized gains and losses, net of related income taxes, reported in a separate component of stockholders' equity.
For forward contracts and options used in connection with the Company's mortgage banking activities, realized gains and losses are recognized in operations in the period settlement occurs. Unrealized gains and losses on such derivative financial instruments are included in the computation of the lower of cost or market valuation of loans held for sale.
Unrealized gains and losses on derivative financial instruments used to hedge mortgage servicing assets are considered in the determination of the estimated fair value of such assets.
Premiums paid on derivative financial instruments used for risk-management purposes are deferred as a component of the carrying value of the designated assets or liabilities and amortized against income over the terms of the contracts.
In the event of the early termination of a derivative financial instrument contract used for risk-management purposes, any resulting gain or loss is deferred, as an adjustment of the carrying value of the designated assets or liabilities, and recognized in operations over the shorter of the remaining life of the designated assets or liabilities or the derivative financial instrument agreement. If the designated assets or liabilities are subsequently sold or otherwise disposed of, any remaining deferred gains or losses are recognized in operations.
If the balance of a hedged asset or liability declines below the notional value of the related derivative financial instrument, the Company may redesignate, at fair value, the derivative financial instrument to other assets or liabilities or discontinue hedge accounting with respect to the portion of the notional amount that exceeds the balance. When hedge accounting is discontinued, derivative financial instruments are accounted for as trading instruments.
Trading Instruments. The Company, to a limited degree, also uses derivative financial instruments for trading purposes. Realized and unrealized gains and losses on these instruments are recognized in operations. The fair value of trading derivative financial instruments in gain positions is reported in the Consolidated Statements of Financial Condition in "Other assets," whereas the fair value of such instruments in loss positions is reported in "Other liabilities."
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Comprehensive Income
Effective as of January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and displaying comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income, which includes net income and other comprehensive income, is defined as the change in equity during a period from all transactions and other events and circumstances from non-owner sources.
NOTE 2 -- ACQUISITIONS
On October 15, 1997, prior to its opening for business, North American Mortgage Company ("NAMC"), a mortgage banking company headquartered in Santa Rosa, California, was acquired by the Company (the "NAMC Acquisition"). At the date of acquisition, NAMC serviced approximately $12 billion of loans for others and operated in 30 states. NAMC, subsequent to the acquisition, is operating under that name as a subsidiary of the Bank. In connection with the NAMC Acquisition, each share of NAMC's common stock outstanding immediately prior to the closing of the NAMC Acquisition was converted into 1.37 shares of Common Stock (the "NAMC Exchange Ratio"), and each outstanding option issued by NAMC to acquire NAMC's common stock was converted, after giving effect to the NAMC Exchange Ratio, into an option to purchase Common Stock. As a result, the Holding Company issued 19,437,741 shares of Common Stock (of which 7,479,664 were issued from treasury) and options to purchase 1,862,087 shares of Common Stock at an average exercise price of $14.18 per share. The purchase price of NAMC was approximately $351 million based on an assigned price per share of the Common Stock of $18.06. The NAMC Acquisition was accounted for under the purchase method of accounting. Accordingly, its impact is only reflected in the Company's consolidated financial statements beginning on October 15, 1997. Goodwill arising from the NAMC Acquisition is being amortized on a straight-line basis over 25 years.
The allocation of the purchase price of NAMC included a restructuring liability of $10.0 million for personnel-related costs, primarily severance benefits, of which $4.7 million and $5.3 million were paid during 1998 and 1997, respectively. In addition, the allocation of the purchase price of NAMC included a restructuring liability for transaction fees and other costs in the amount of $9.6 million, including a $2.5 million liability recognized during 1998. The balance in this restructuring liability was $1.1 million at the end of 1998. Cash payments and non-cash reductions charged to this restructuring liability amounted to $2.2 million and $1.8 million, respectively, in 1998 and $4.0 million and $0.5 million, respectively, in 1997.
In connection with the NAMC Acquisition, the Company incurred expenses during 1997 of $9.9 million associated with its employees and operations. Such expenses are reflected in the accompanying Consolidated Statements of Income under the caption "Restructuring and related expense."
After the close of business on April 30, 1997, the Company acquired BFS Bankorp, Inc. and its wholly-owned subsidiary, Bankers Federal Savings FSB (collectively, the "BFS Acquisition") for $93.3 million in cash. At that time, BFS Bankorp, Inc. was liquidated and Bankers Federal Savings FSB was merged with and into the Bank. The purchase price of the BFS Acquisition was funded from the normal cash flows of the Company. Goodwill arising from the BFS Acquisition is being amortized over 15 years using the straight-line method. In connection with the BFS Acquisition, the Company acquired loans receivable, net, of $574.5 million and assumed deposits in five New York City branches of $447.1 million. As this acquisition was accounted for under the purchase method of accounting, its impact is only reflected in the Company's consolidated financial statements beginning on May 1, 1997.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Summaries of the NAMC Acquisition and the BFS Acquisition are as follows (in thousands):
- --------------- (1) Includes adjustments during 1998 which resulted in a decrease of $0.1 million in the fair value of assets acquired, excluding cash and cash equivalents received, an increase of $2.8 million in the fair value of liabilities assumed and an increase of $2.9 million in goodwill.
On December 16, 1998, the Holding Company announced that it had entered into a definitive agreement to acquire Lakeview Financial Corp. ("Lakeview"), headquartered in West Paterson, New Jersey. Lakeview is the holding company for Lakeview Savings Bank, which operates eleven offices in northern New Jersey. On a consolidated basis at October 31, 1998, Lakeview had assets of approximately $573 million and deposits of approximately $454 million. Under the terms of the agreement, holders of Lakeview's common stock may elect to receive either 0.9 of a share of Common Stock or $24.26 in cash for each outstanding share of Lakeview common stock, subject to a requirement that, in the aggregate, 65% of Lakeview's outstanding shares of common stock will be exchanged for Common Stock and the remaining shares will be exchanged for cash. This transaction, which is expected to close during the second quarter of 1999, remains subject to regulatory approvals and the approval of Lakeview's shareholders.
NOTE 3 -- CASH AND CASH EQUIVALENTS
Cash and cash equivalents were comprised of the following at December 31 (in thousands):
Federal Reserve Board regulations require the Bank to maintain specified minimum reserve balances against certain deposits. These reserves, which may consist of vault cash and non-interest earning deposits at the Federal Reserve Bank of New York, were $39.1 million and $36.7 million for the calculation periods including December 31, 1998 and 1997, respectively.
It is the Company's policy to take possession of securities purchased under agreements to resell. The average balance of securities purchased under agreements to resell during 1998 and 1997 was $0.5 million
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and $34.5 million, respectively. The maximum month-end balance of securities purchased under agreements to resell was $2.1 million during 1998 and $284.3 million during 1997.
NOTE 4 -- SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of securities available for sale, as well as related gross unrealized gains and losses, are summarized as follows at December 31 (in thousands):
At December 31, 1998, $2.2 billion of securities available for sale were pledged as collateral for borrowed funds and other purposes.
During December 1997, the Company, primarily as a result of a reassessment of its asset/liability management strategy, transferred its entire portfolio of securities held to maturity to its portfolio of securities available for sale. At the date of transfer, the securities held to maturity portfolio had an amortized cost of $3.6 billion and net unrealized pre-tax losses of approximately $51 million. In connection with a decision made at the time of transfer to sell $1.4 billion of the transferred securities, the Company, during December 1997, wrote-down those securities with unrealized losses to estimated fair value and recognized a pre-tax loss of $25.2 million. Substantially all of the securities designated for sale were sold during 1998.
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Information concerning sales of securities available for sale is summarized below for the year ended December 31 (in thousands):
The following table sets forth, at December 31, 1998, the amortized cost, estimated fair value and weighted average yield of debt securities available for sale by period to contractual maturity (dollars in thousands):
- --------------- (1) The weighted average yield is based on amortized cost.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 5 -- LOANS RECEIVABLE, NET
A summary of loans receivable, net, is as follows at December 31 (in thousands):
Loans receivable totaling $6.4 billion were pledged as collateral for borrowed funds at December 31, 1998.
At December 31, 1998, the Company's residential real estate loans receivable were principally concentrated in the states of New York (30.3%), Connecticut (12.4%), New Jersey (6.9%), California (6.6%) and Illinois (6.4%). At that date, the Company's commercial real estate loans receivable were largely concentrated in the states of New York (77.0%) and New Jersey (9.2%). Home equity loans at the end of 1998 were primarily concentrated in the states of New York (51.7%), California (10.9%) and New Jersey (9.7%). Business loans at year-end 1998 were largely concentrated in the states of New York (56.6%), New Jersey (9.9%) and Maryland (6.7%).
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Activity in the allowance for loan losses is summarized as follows for the year ended December 31 (in thousands):
- --------------- (1) The provision for loan losses and loan charge-offs for 1997 included $14.0 million and $35.8 million, respectively, associated with bulk sales of approximately $113 million of non-accrual residential real estate loans receivable in May 1997.
(2) Loan charge-offs for 1998 included $9.1 million associated with a bulk sale of approximately $53 million of non-accrual and subperforming loans in December 1998, substantially all of which were residential real estate loans.
NOTE 6 -- NON-PERFORMING ASSETS, LOANS MODIFIED IN A TDR, AND IMPAIRED LOANS
Non-performing assets were comprised of the following at December 31 (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Activity in the allowance for losses on ORE is summarized as follows for the year ended December 31 (in thousands):
The following table sets forth loans that have been modified in a TDR, excluding those classified as non-accrual loans, at December 31 (in thousands):
The amount of interest income that would have been recorded on non-accrual loans and loans modified in a TDR, if such loans had been current in accordance with their original terms, was $5.9 million, $18.7 million and $34.1 million for 1998, 1997 and 1996, respectively. The amount of interest income that was recorded on these loans was $2.9 million, $11.5 million and $18.9 million for 1998, 1997 and 1996, respectively.
The following table sets forth information regarding the Company's impaired loans at December 31 (in thousands):
The Company's average recorded investment in impaired loans for 1998, 1997 and 1996 was $28.1 million, $46.7 million and $76.8 million, respectively. Interest income recognized on such loans for 1998, 1997 and 1996 amounted to $1.3 million, $4.2 million and $3.9 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 7 -- PREMISES AND EQUIPMENT, NET
Premises and equipment, net, consisted of the following at December 31 (in thousands):
Depreciation and amortization of premises and equipment charged to expense amounted to $28.3 million, $20.2 million and $16.7 million for 1998, 1997 and 1996, respectively.
NOTE 8 -- LOAN SERVICING
Mortgage loans serviced by the Company for others are not included in the accompanying Consolidated Statements of Financial Condition. The balance of such loans amounted to $34.9 billion, $25.0 billion and $11.0 billion at December 31, 1998, 1997 and 1996, respectively. The balances at December 31, 1998 and 1997 include $7.9 billion and $3.0 billion, respectively, of loans being subserviced by the Company in connection with sales of loan servicing rights.
A summary of activity in mortgage servicing assets is summarized in the table below for the year ended December 31 (in thousands):
- --------------- (1) Includes amortization associated with derivative financial instruments hedging mortgage servicing assets.
The estimated fair value of the Company's mortgage servicing assets at December 31, 1998 was $724.4 million.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 9 -- DEPOSITS
Deposits were comprised of the following at December 31 (in thousands):
- --------------- (1) Includes brokered deposits of $238.5 million at December 31, 1998 and $193.0 million at December 31, 1997.
Scheduled maturities of time deposits at December 31, 1998 are set forth in the table which follows (dollars in thousands):
The following table sets forth the scheduled maturities of time deposits with balances of $100,000 or more at December 31, 1998 (in thousands):
At December 31, 1997, time deposits with balances of $100,000 or more amounted to $1.0 billion.
In August 1998, the Bank sold its sole remaining Florida branch, which had deposits of $207.2 million at the time of sale.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 10 -- FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Information concerning federal funds purchased and securities sold under agreements to repurchase is summarized in the table below at or for the year ended December 31 (dollars in thousands):
The federal funds purchased and securities sold under agreements to repurchase outstanding at December 31, 1998 matured in January 1999.
Accrued interest payable on securities sold under agreements to repurchase, which is included under the caption "Other liabilities" in the accompanying Consolidated Statements of Financial Condition, amounted to $4.8 million, $21.0 million and $15.2 million at December 31, 1998, 1997 and 1996, respectively.
The MBS pledged as collateral for securities sold under agreements to repurchase were delivered to the broker-dealers who arranged the transactions. The broker-dealers may have loaned these MBS to other parties in the normal course of their operations and agreed to resell to the Company the identical MBS sold.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 11 -- FEDERAL HOME LOAN BANK OF NEW YORK ("FHLBNY") ADVANCES
Information concerning short-term FHLBNY advances is summarized in the table below at or for the year ended December 31 (dollars in thousands):
Of the $3.6 billion of short-term FHLBNY advances outstanding at December 31, 1998, $3.2 billion matures in January 1999, $300.0 million matures in July 1999 and $150.0 million matures in August 1999.
Long-term FHLBNY advances consisted of the following at December 31 (dollars in thousands):
The weighted average effective interest rate on long-term FHLBNY advances was 5.85% at December 31, 1998 and 6.30% at December 31, 1997. Scheduled principal repayments of long-term FHLBNY advances for the five years subsequent to December 31, 1998 were $125.1 million in 1999, $160.1 million in 2000, $10.2 million in 2001, $20.1 million in 2002, and $10.1 million in 2003.
At December 31, 1998, FHLBNY advances were collateralized by the Bank's investment in FHLBNY stock and by certain MBS and residential real estate loans receivable.
NOTE 12 -- SENIOR NOTES
Senior notes, which are unsecured obligations of the Holding Company and are not subordinated to any other indebtedness of the Holding Company, were comprised of the following at December 31 (dollars in thousands):
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The 6.12% senior notes due March 1999 (the "6.12% Senior Notes") were issued in September 1998 and are not redeemable prior to their maturity. Interest on the 6.12% Senior Notes is payable at maturity. The average balance of the 6.12% Senior Notes during 1998 was $30.9 million.
In July 1998, the Holding Company, at its option, redeemed the remaining $44.4 million of its outstanding 8.9375% senior notes due July 2003 (the "8.9375% Senior Notes"). In November 1997, the Holding Company had purchased $55.6 million of such senior notes. In connection with these transactions, after-tax extraordinary losses of $1.1 million and $1.5 million were recognized during 1998 and 1997, respectively. The 8.9375% Senior Notes had been issued in 1993 and interest thereon was payable semi-annually.
The 10.50% senior notes due November 2005 (the "10.50% Senior Notes"), interest on which is payable quarterly, were issued in 1994. Effective November 15, 1998, the 10.50% Senior Notes became redeemable, at the option of the Holding Company, in whole or in part at specified redemption prices.
NOTE 13 -- GUARANTEED PREFERRED BENEFICIAL INTERESTS IN DIME BANCORP, INC.'S JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES ("TRUST PREFERRED SECURITIES")
On May 6, 1997, Dime Capital Trust I ("Dime Capital"), a Delaware statutory business trust that was formed by the Holding Company, issued $200.0 million aggregate liquidation amount of 9.33% Capital Securities, Series A (the "Series A Capital Securities"), representing preferred beneficial interests in Dime Capital, in an underwritten public offering and $6.2 million aggregate liquidation amount of common beneficial interests represented by its common securities to the Holding Company (the "Dime Capital Common Securities," and together with the Series A Capital Securities, the "Dime Capital Securities"). In connection therewith, Dime Capital purchased $206.2 million aggregate principal amount of 9.33% Junior Subordinated Deferrable Interest Debentures, Series A, due May 6, 2027 (the "Series A Subordinated Debentures") issued by the Holding Company, which amount is equal to the aggregate liquidation amount of the Dime Capital Securities. Dime Capital is wholly-owned by the Holding Company and exists for the sole purpose of issuing the Dime Capital Securities and investing the proceeds thereof in the Series A Subordinated Debentures. The Series A Subordinated Debentures, which are, and will be, the sole assets of Dime Capital, are subordinate and junior in right of payment to all present and future senior indebtedness of the Holding Company. The Holding Company, through: (i) a guarantee agreement, between the Holding Company and The Chase Manhattan Bank ("Chase"), as trustee; (ii) a trust agreement, among the Holding Company, as depositor, Chase, as property trustee, Chase Manhattan Bank Delaware, as Delaware trustee, certain employees or officers of the Holding Company, as administrative trustees, and the holders from time to time of the Dime Capital Securities; (iii) an expense agreement, between the Holding Company and Dime Capital; (iv) the Series A Subordinated Debentures; and (v) an indenture regarding the Series A Subordinated Debentures, between the Holding Company and Chase, as trustee, when taken in the aggregate, has fully and unconditionally guaranteed all of Dime Capital's obligations under the Series A Capital Securities. The Series A Capital Securities are subject to mandatory redemption, in whole or in part, upon the repayment of the Series A Subordinated Debentures at their stated maturity or earlier redemption. Distributions on the Series A Capital Securities are payable semi-annually and are reflected in the Company's Consolidated Statements of Income under the caption "Interest expense on borrowed funds."
The carrying value and outstanding principal amount of the Trust Preferred Securities was $162.0 million and $165.2 million, respectively, at December 31, 1998 and $196.1 million and $200.0 million, respectively, at December 31, 1997. In September 1998, the Holding Company purchased $34.8 million of the outstanding Series A Capital Securities, which resulted in an after-tax extraordinary loss of $2.7 million. The Trust Preferred Securities have an effective interest rate of 9.53%.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 14 -- OTHER BORROWED FUNDS
Information concerning short-term Treasury tax and loan notes included in other borrowed funds is summarized in the table below at or for the year ended December 31 (dollars in thousands):
Long-term debt of the Company included in other borrowed funds consisted of the following at December 31 (dollars in thousands):
The weighted average effective interest rate on the long-term debt included in the above table was 6.68% at December 31, 1998 and 6.08% at December 31, 1997. The scheduled principal payments due on the long-term debt included in the above table for the five years subsequent to December 31, 1998 were $0.6 million in 1999, $26.4 million in 2000, $0.7 million in 2001, $1.6 million in 2002, and $26.8 million in 2003.
The medium term notes, all of which were assumed in connection with the NAMC Acquisition, are unsecured. The terms of these notes provide for semi-annual fixed-rate interest payments and a single principal payment at maturity.
From 1983 to 1985, the Bank had entered into various borrowing agreements under which it transferred certain tax-exempt bonds, preferred stocks and tax-exempt loans to certain unit investment trusts and others, accompanied by put options. During the terms of the agreements, the holders are entitled to return the assets to the Bank under various circumstances at specified prices. The underlying bonds, preferred stocks and loans transferred in the put transactions had carrying values of $8.6 million, $3.3 million and $8.4 million, respectively, at December 31, 1998. At that date, these borrowing agreements were further collateralized by designated MBS.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Collateralized Real Yield Securities, which were issued in August 1988 and were obligations of the Bank, were repaid, at the option of the holders thereof, in August 1998. Upon their repayment, a $0.3 million after-tax extraordinary loss was recognized. Interest on these borrowings was payable quarterly at a rate reset quarterly based on the sum of 3.00% plus the percentage change, if any, in the Consumer Price Index for all Urban Consumers during the preceding twelve-month period.
NOTE 15 -- STOCKHOLDERS' EQUITY
Preferred Stock
At December 31, 1998 and 1997, the Holding Company was authorized to issue, in one or more series, 40 million shares of preferred stock with a par value of $0.01 per share (the "Preferred Stock"). The powers, designations, preferences and relative, participating, optional or other rights, if any, and the qualifications, limitations or restrictions thereof, including, but not limited to, the number of shares of any series of Preferred Stock, the dividend rights, redemption rights, liquidation preferences, voting rights and conversion rights of any series is determined by the board of directors of the Holding Company (the "Board"). As of December 31, 1998, no shares of the Preferred Stock have ever been issued.
Common and Treasury Stock
In April 1998, the stockholders of the Holding Company authorized an increase in the number of authorized shares of Common Stock to 350 million from 200 million. At December 31, 1998, 13.2 million shares of Common Stock were reserved for future issuance under the Company's stock-based employee benefit plans.
The following table sets forth the Holding Company's common share activity during the years indicated.
In May 1996, the Federal Deposit Insurance Corporation ("FDIC") exercised its warrant to acquire 8,407,500 shares of Common Stock at $0.01 per share (the "FDIC Warrant") and sold the underlying shares in a secondary public offering. This warrant had been issued originally in July 1993 in accordance with the terms of an agreement between Anchor Bancorp, Inc. ("Anchor Bancorp") and the FDIC. (On January 13, 1995, Anchor Bancorp and its wholly-owned savings bank subsidiary, Anchor Savings Bank FSB ( "Anchor Savings" and, together with Anchor Bancorp, "Anchor") merged with and into the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Holding Company and the Bank, respectively, which were the surviving entities. These mergers are collectively referred to as the "Anchor Merger.")) Pursuant to this agreement, Anchor Bancorp exchanged $157.0 million of its Class A cumulative preferred stock for $71.0 million of its newly-issued 8.9375% Senior Notes and a warrant to acquire, at an exercise price of $0.01 per share, 4,750,000 shares of Anchor Bancorp's common stock (which was converted to a warrant to acquire 8,407,500 shares of Common Stock at $0.01 per share upon consummation of the Anchor Merger). In this exchange, the FDIC also relinquished its claim to $47.2 million of accumulated but undeclared and unpaid dividends with respect to the Class A cumulative preferred stock.
At December 31, 1998, the Holding Company had one Common Stock repurchase program in effect. Under this program, which was announced in September 1998, the Holding Company is authorized to repurchase up to approximately 5.6 million shares of its outstanding Common Stock. During 1998, 335,000 shares of Common Stock were acquired under this program.
Dividend Restrictions
The Holding Company's ability to pay dividends on the Common Stock is limited by restrictions imposed by Delaware law. In general, dividends may be paid out of the Holding Company's surplus, as defined by Delaware law, or in the absence of such surplus, out of its net profits for the current and/or immediately preceding fiscal year.
The funding of any future dividend payments on the Common Stock by the Holding Company may be dependent on dividends it receives from the Bank. The ability of the Bank to pay dividends to the Holding Company is subject to federal regulations.
Generally, the Bank may not make a capital distribution, which includes cash dividends, at any time when, after such distribution, its regulatory capital would be below the regulatory capital requirements of the Office of Thrift Supervision ("OTS") or below the standards established by the prompt corrective action ("PCA") provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") for an institution to be deemed adequately capitalized.
Under OTS regulations, a savings institution that exceeds its fully phased-in capital requirements, both before and after a proposed distribution, and that has not been advised by the OTS that it is in need of more than normal supervision, may, after prior notice to, but without the approval of the OTS, make capital distributions during a calendar year up to the higher of (i) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its surplus capital ratio (the percentage by which an institution's ratio of total capital to assets exceeds the ratio of its fully phased-in capital requirement to assets) at the beginning of the calendar year or (ii) 75% of its net income over the most recent four-quarter period.
Stockholder Protection Rights Plan
In October 1995, the Board adopted a Stockholder Protection Rights Plan (the "Rights Plan"). Under the Rights Plan, which expires in November 2005, the Board declared a dividend of one right on each outstanding share of Common Stock, which was paid on November 6, 1995 to stockholders of record on that date (the "Rights"). Until it is announced that a person or group has acquired 20% or more of the outstanding Common Stock (an "Acquiring Person") or has commenced a tender offer that could result in their owning 20% or more of Common Stock, the Rights will be evidenced solely by the Holding Company's common stock certificates, will automatically trade with the Common Stock and will not be exercisable. Following any such announcement, separate Rights would be distributed, with each Right entitling its owner to purchase participating preferred stock of the Holding Company having economic and voting terms similar to those of one share of Common Stock for an exercise price of $50.
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Upon announcement that any person or group has become an Acquiring Person and unless the Board acts to redeem the Rights, then ten business days thereafter (or such earlier or later date, not beyond 30 days, as the Board may decide) (the "Flip-in Date"), each Right (other than Rights beneficially owned by any Acquiring Person or transferee thereof, which become void) will entitle the holder to purchase, for the $50 exercise price, a number of shares of Common Stock having a market value of $100. In addition, if, after an Acquiring Person gains control of the Board, the Holding Company is involved in a merger or sells more than 50% of its assets or assets generating more than 50% of its operating income or cash flow, or has entered into an agreement to do any of the foregoing (or an Acquiring Person is to receive different treatment than all other stockholders), each Right will entitle its holder to purchase, for the $50 exercise price, a number of shares of common stock of the Acquiring Person having a market value of $100. If any person or group acquires between 20% and 50% of the outstanding Common Stock the Board may, at its option, exchange one share of such Common Stock for each Right. The Rights may also be redeemed by the Board for $0.01 per Right prior to the Flip-in Date.
NOTE 16 -- REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory -- and possibly additional discretionary -- actions by regulators that, if undertaken, could have a direct material effect on the Bank's and the Company's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for PCA, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's regulatory capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings and other factors.
Quantitative measures established by regulation by the OTS to ensure capital adequacy (the "Capital Adequacy Regulations") require the Bank to maintain, as set forth in the table below, specified minimum amounts of and ratios of tangible and core ("tier 1") capital to adjusted total assets and of total risk-based capital to total risk-weighted assets. Management believes that, as of December 31, 1998, the Bank was in compliance with the Capital Adequacy Regulations.
Pursuant to FDICIA, the OTS adopted PCA regulations (the "PCA Regulations") which established five capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." To be categorized as well capitalized, the Bank must maintain the minimum capital ratios set forth in the table below. As of December 31, 1998, the most recent notification from the OTS categorized the Bank as well capitalized under the regulatory framework for PCA. There are no conditions or events since that notification that the Bank believes have changed its category.
The following table summarizes, at December 31 for the years shown, the Bank's actual regulatory capital amounts and ratios, as well as its minimum capital requirements under the Capital Adequacy Regulations and under the PCA Regulations for it to be deemed well capitalized (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 17 -- NET GAINS (LOSSES) ON SALES ACTIVITIES
Net gains (losses) on sales activities were comprised of the following for the year ended December 31 (in thousands):
NOTE 18 -- EMPLOYEE BENEFIT PLANS
Pension and Postretirement Health Care and Life Insurance Plans
The Company currently maintains a non-contributory, qualified, defined benefit pension plan (the "Qualified Pension Plan") covering, except as noted, substantially all salaried employees of the Company who meet certain age and length of service requirements. The Qualified Pension Plan assets primarily consist of equity and debt securities. NAMC personnel are generally covered by a plan maintained by NAMC (see "Other Plans"). The Company also maintains various non-contributory, non-qualified, defined benefit pension plans (the "Non-Qualified Pension Plans"). Benefits under these plans have not been prefunded by the Company.
In addition, the Company currently sponsors unfunded postretirement health care and life insurance plans covering, except as noted, substantially all salaried employees of the Company who meet certain age and length of service requirements. Employees of NAMC, with certain exceptions, are not covered under these plans. In general, the Company's postretirement health care plan requires contributions from participants. Benefits under the Company's postretirement life insurance plan are provided to participants on a non-contributory basis.
Effective January 1, 1998, the Company adopted SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132 standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and
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eliminates certain disclosures no longer deemed useful. The following disclosures have been prepared in accordance with SFAS No. 132.
The following table provides details of the changes in the benefit obligation and fair value of plan assets for the above plans for each of the years shown and a reconciliation, at the end of each year shown, of the funded status of the plans with the net amount recognized in the consolidated statement of financial condition (in thousands):
The components of the net amounts recognized in the Company's Consolidated Statements of Financial Condition in connection with its pension plans and postretirement health care and life insurance plans were as follows at December 31 (in thousands):
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Weighted average assumptions used by the Company in accounting for its pension plans and postretirement health care and life insurance plans were as follows at December 31:
Net periodic expense associated with the Company's pension plans and postretirement health care and insurance plans included the following components for the year ended December 31 (in thousands):
Pension plans with accumulated benefit obligations in excess of plan assets at December 31, 1998 and 1997 consisted of the Non-Qualified Pension Plans. The aggregate projected benefit obligation and accumulated benefit obligation of these plans amounted to $20.6 million and $19.5 million, respectively, at December 31, 1998 and $18.3 million and $17.9 million, respectively, at December 31, 1997.
As of December 31, 1998, the average annual rate of increase in the per capita cost of covered health care benefits for 1999 was assumed to be 9.00% for participants less than 65 years old and 6.00% for all other participants and was assumed to decline gradually until a floor of 5.00% was reached in 2003 and 2000, respectively. Increasing the assumed health care cost trend rates by 1.0% in each year would increase the related accumulated benefit obligation at December 31, 1998 by $0.9 million and the aggregate of the related service and interest cost components by $0.1 million. A 1.0% decrease in the assumed health care cost trend rates in each year would decrease the related accumulated benefit obligation by $0.8 million and the aggregate of the related service and interest cost components by $0.1 million.
Other Plans
The Company maintains a savings plan, the Retirement 401(k) Investment Plan, which covers substantially all employees of the Company, other than those eligible to participate in a defined contribution benefit plan assumed by the Company in connection with the NAMC Acquisition. Under the Retirement 401(k) Investment Plan, participants may contribute up to 15% of their base pay on a before-or after-tax basis, up to legal limits. The Company currently makes matching contributions equal to 100% of the first 6% of participant contributions. Participants vest immediately in their own contributions and over a period of five years for the Company's contributions. Each member's contributions and matching
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contributions are invested, in accordance with the member's directions, in one or any combination of available investment options.
In connection with the NAMC Acquisition, the Company assumed NAMC's 401(k) Savings and Retirement Plan. This plan covers substantially all NAMC personnel, except those employees of NAMC covered under the Qualified Pension Plan or the Retirement 401(k) Investment Plan. The provisions of the 401(k) savings component of this plan provide for contributions by participants of up to 15% of their total pay on a before-tax basis, up to legal limits, and matching contributions by the Company of up to 1.5% of a participant's eligible compensation. Participants vest immediately in their own contributions and over a period of four years for the Company's contributions. Under the provisions of the retirement benefit component of the 401(k) Savings and Retirement Plan, contributions are made by the Company equal to 4% of the participant's eligible pay. Participants vest in such contributions over a period of seven years. Contributions to the 401(k) Savings and Retirement Plan are invested, in accordance with the participant's direction, in one or any combination of available investment options.
The Company also maintains non-qualified arrangements under which supplemental amounts in excess of those allocated under the Retirement 401(k) Investment Plan are allocated with respect to certain employees and upon which earnings are credited. These amounts include supplemental allocations based upon the amounts that would otherwise be contributed as matching contributions under the Retirement 401(k) Investment Plan on base pay that exceeds the amount for which matching contributions are permitted to be made under the Retirement 401(k) Investment Plan.
The aggregate expense recognized by the Company in connection with the above plans was $8.7 million, $4.9 million and $4.3 million for 1998, 1997 and 1996, respectively.
NOTE 19 -- STOCK PLANS
Stock Option and Incentive Plans
As further described below, at December 31, 1998, the Company had a total of four stock option and stock incentive plans in effect under which shares of Common Stock were available for future grants and a total of four terminated stock option and stock incentive plans under which stock-based awards remained outstanding. Awards granted under the terminated plans prior to their termination remain in effect in accordance with their terms.
During 1997, the Company adopted its Pride Shares Program, a broad-based stock option plan under which there was a grant in each of May 1997 and March 1998 of an option to each eligible full-time employee and each eligible part-time employee to purchase 150 shares and 75 shares, respectively, of Common Stock. During 1999, the Company expects to make a final grant under the Pride Shares Program of an option to each eligible full-time employee and each eligible part-time employee to purchase 200 shares and 100 shares, respectively, of Common Stock. Options awarded under the Pride Shares Program have an exercise price equal to the grant date market price of the Common Stock and expire 11 years from the grant date. Vesting of options awarded under this plan generally occurs at the earlier of five years after the date of grant or the date the Common Stock price reaches a specified target price (as established at the date of grant) and its closing price stays at, or rises above, that target price for five consecutive trading days. The options granted under the Pride Shares Program during 1997, all of which vested during that year, had a target price of $20.00, whereas the options granted during 1998, which have not vested as of December 31, 1998, have a target price of $36.00. At December 31, 1998, a total of 2,000,000 shares of Common Stock had been reserved for issuance under the Pride Shares Program, of which 860,600 shares were available for future grants.
Also in 1997, the Company adopted a broad-based stock incentive plan (the "1997 Stock Incentive Plan"), under which all employees, excluding certain officers, are eligible to receive options to purchase
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Common Stock at an exercise price equal to the market price of the Common Stock at the date of grant. An aggregate of 600,000 shares of Common Stock have been reserved for issuance under this plan (including 300,000 shares during 1998), of which 30,105 shares remained available for future grants as of December 31, 1998. The 1997 Stock Incentive Plan does not have an established termination date, but may be terminated at any time by the Board. The options to purchase Common Stock that have been awarded under the 1997 Stock Incentive Plan generally vest in three equal annual installments beginning one year from the date of grant and may be exercised over a period not in excess of eleven years.
A stock incentive plan for outside directors ("the 1997 Stock Incentive Plan for Outside Directors") was approved by the Holding Company's stockholders during 1997, replacing a predecessor plan that had been adopted in 1987 (the "1987 Stock Incentive Plan for Outside Directors") and that terminated by its terms during 1996. Under the 1997 Stock Incentive Plan for Outside Directors, which terminates in May 2007, 350,000 shares of Common Stock have been reserved for future issuance. As amended during 1998, this plan provides for discretionary grants by the Board to outside directors of the Holding Company and its eligible direct and indirect subsidiaries of stock options, stock appreciation rights ("SARs"), restricted Common Stock, and deferred Common Stock. The terms of such grants are established by the Board. Options that have been awarded under the 1997 Stock Incentive Plan for Outside Directors have a term of 11 years, an exercise price equal to the market price of the Common Stock on the date granted and generally vest in three equal annual installments beginning one year from the date of grant. At year-end 1998, 308,500 shares of Common Stock remained available to be awarded under the 1997 Stock Incentive Plan for Outside Directors.
The 1987 Stock Incentive Plan for Outside Directors, prior to its termination, provided for a one-time only grant to each outside director of the Holding Company of an option to purchase 3,000 shares of Common Stock, a tandem SAR, which only become exercisable upon a change in control of the Company, and the right to purchase 1,000 shares of restricted Common Stock at $1.00 per share. This plan also provided for similar discretionary stock-based awards to directors of eligible direct and indirect subsidiaries of the Holding Company. Stock options and SARs granted under the 1987 Stock Incentive Plan for Outside Directors have an exercise price equal to the market price of the Common Stock at the date of grant, generally vested in three equal annual installments beginning one year from the date of grant and may be exercised over a period not in excess of eleven years.
The Company also adopted stock incentive plans in 1986 and 1991 (the "1986 Stock Incentive Plan" and the "1991 Stock Incentive Plan," respectively). The 1986 Stock Incentive Plan, which terminated by its terms during 1996, provided for grants to key employees of Common Stock-based awards, including stock options, SARs, and restricted Common Stock. The 1991 Stock Incentive Plan provides for grants to all employees of Common Stock-based awards including stock options, SARs, restricted Common Stock, deferred Common Stock, certain loans, and tax offset payments. The 1991 Stock Incentive Plan was amended during 1998 to, among other things, extend its termination date to March 2008 from February 2004, increase the number of shares of Common Stock reserved for future issuance by 5,000,000 and provide that the exercise price of options granted on or after the date of amendment will not be less than the market price of the Common Stock at the date of grant. At December 31, 1998, 5,123,955 shares of Common Stock remained available to be awarded under the 1991 Stock Incentive Plan. All SARs granted under the 1986 and 1991 Stock Incentive Plans have been awarded in tandem with stock options and become exercisable upon a change in control of the Company. Stock options and SARs that have been granted under these plans have an exercise price equal to the market price of the Common Stock at the date of grant, generally vest in three equal annual installments beginning one year from the date of grant and may be exercised over a period not in excess of eleven years.
In connection with the Anchor Merger, the Holding Company assumed stock option plans that had previously been adopted by Anchor Bancorp in 1990 and 1992 (the "1990 Stock Option Plan" and the
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"1992 Stock Option Plan," respectively). Upon consummation of the Anchor Merger, the number of outstanding options under these plans was multiplied by, and the per share exercise price divided by, 1.77, which was the ratio at which each share of Common Stock was exchanged for each share of Anchor Bancorp common stock outstanding at the date of the Anchor Merger (the "Anchor Exchange Ratio"). The 1990 Stock Option Plan, which terminated by its terms during 1996, provided for options to key employees, while the 1992 Stock Option Plan, which was terminated by the Board during 1998, provided for options to all employees to purchase shares of Common Stock over a period not in excess of ten years, or in certain circumstances, ten years and one day, with vesting generally occurring in three equal annual installments beginning one year from the date of grant. All options granted under these plans have, as applicable, an exercise price equal to the market price of the Common Stock at the date of grant or the market price of Anchor Bancorp's common stock at the date of grant as adjusted for the Anchor Exchange Ratio.
The following table provides a summary of the Company's stock option activity for the years ended December 31, 1998, 1997 and 1996 and stock options exercisable at the end of each of those years (number of options in thousands):
- --------------- (1) The weighted average grant-date fair value was $11.54 in 1998, $7.09 in 1997 and $6.02 in 1996.
The following table summarizes information about stock options outstanding at December 31, 1998 (number of options in thousands):
During 1998, 1997 and 1996, shares of restricted Common Stock issued amounted to 341,500, 95,640 and 40,000, respectively. The weighted average grant price and weighted average grant-date fair value of
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these shares was $0.84 and $28.05, respectively, in 1998, $1.00 and $16.76, respectively, in 1997, and $1.00 and $11.66, respectively, in 1996. At December 31, 1998, there were 430,668 outstanding shares of non-vested restricted Common Stock. Restrictions generally lapse in installments over the restriction period, which is generally three to five years. Compensation expense recognized in operations in connection with restricted Common Stock awards was $2.8 million in 1998, $0.7 million in 1997 and $0.2 million in 1996.
Employee Stock Purchase Plan
In 1993, the Company adopted an employee stock purchase plan (the "Employee Stock Purchase Plan"), reserving 1,000,000 shares of Common Stock for purchase by eligible employees of the Company. This plan permits a per share purchase price of between 85% and 100%, as established by the Compensation Committee of the Board (the "Compensation Committee"), of the market price of the Common Stock on the first date of the relevant purchase period. The Compensation Committee also establishes the purchase period and number of shares made available to each eligible participant during a specified purchase period. During 1998 and 1997, 79,812 and 60,602 shares, respectively, of Common Stock were purchased by employees under the Employee Stock Purchase Plan at a per share price of $15.38 and $12.13, respectively, which, in both cases, was equal to the Common Stock market price on the first date of the purchase period. No shares of Common Stock were purchased during 1996 under the Employee Stock Purchase Plan. During 1998, shares of Common Stock were made available for purchase in March 1999 under the Employee Stock Purchase Plan at a per share price of $30.13, which was equal to the Common Stock market price on the first date of the purchase period. The number of such shares subscribed to amounted to 366,431 at December 31, 1998. Shares of Common Stock available for future purchase under the Employee Stock Purchase Plan amounted to 635,441 at December 31, 1998. The grant-date fair value of each purchase right granted in 1998, 1997 and 1996 under the Employee Stock Purchase Plan was $4.34, $2.16 and $1.51, respectively.
Pro Forma Data
The Company, as permitted under SFAS No. 123, "Accounting for Stock-Based Compensation," accounts for its stock-based compensation awards using the intrinsic value-based method prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Under this method, compensation cost is measured by the excess, if any, of the quoted market price of the Common Stock at date of grant, or other measurement date, over the amount an employee is required to pay to acquire the Common Stock. Had compensation expense for the Company's stock-based compensation plans been recognized consistent with the fair value-based method of SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below for the year ended December 31 (in thousands, except per share data):
In preparing the pro forma information, the grant-date fair value of each stock option granted under the Company's stock option and stock incentive plans and each purchase right granted under the Employee Stock Purchase Plan was estimated on the date of grant using the Black-Scholes option-pricing model. For stock options, the following weighted-average assumptions were used for the years ended December 31, 1998, 1997 and 1996, respectively: risk-free interest rates of 5.16%, 6.30% and 5.97%; expected life of 5.6 years, 5.4 years and 6.0 years; volatility of 37%, 32% and 45%; and dividend yields of
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0.69%, 0.83% and 0.00%. For the Employee Stock Purchase Plan, the following assumptions were used for the years ended December 31, 1998, 1997 and 1996, respectively: risk-free interest rates of 5.54%, 6.12% and 5.44%; expected life of one year for each year; volatility of 31%, 30% and 25%; and dividend yields of 0.66%, 1.04% and 0.00%.
NOTE 20 -- OTHER GENERAL AND ADMINISTRATIVE EXPENSE
The following table provides details of other general and administrative expense for the year ended December 31 (in thousands):
NOTE 21 -- INCOME TAXES
Income tax expense attributable to income before extraordinary items consisted of the following for the year ended December 31 (in thousands):
Excluded from the preceding table were income tax benefits of $3.0 million in 1998 and $0.9 million in 1997 associated with the recognition of extraordinary losses on the early extinguishment of debt. The preceding table also excludes the tax effects recorded directly to stockholders' equity in connection with unrealized gains and losses on securities available for sale and certain tax benefits associated with the Company's stock option and stock incentive plans. In the aggregate, these tax effects increased (decreased) stockholders' equity by $3.7 million, $8.1 million and $(4.1) million in 1998, 1997 and 1996, respectively.
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The following is a reconciliation of federal income tax expense attributable to income before extraordinary items computed at the statutory rate of 35.0% to the actual income tax expense attributable to income before extraordinary items for the year ended December 31 (in thousands):
The Company's effective income tax rate on income before extraordinary items was 32.0% for 1998, 37.9% for 1997 and 32.4% for 1996.
The combined federal, state and local income tax effects of temporary differences that gave rise to significant portions of the Company's deferred tax assets and deferred tax liabilities were as follows at December 31 (in thousands):
At December 31, 1998, the Company had net operating loss carryforwards for federal income tax purposes of $65.0 million, substantially all of which are available to reduce future federal income taxes through the year 2009. In addition, at that date, the Company had general business tax credit carryforwards of $7.7 million which are available to reduce future federal income taxes, of which $1.0 million expire in 2009, $1.5 million expire in 2010, $1.6 million expire in 2011, $1.8 million expire in 2012,
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and $1.8 million expire in 2013. The Company, at December 31, 1998, also had federal alternative minimum tax credit carryforwards of $4.1 million, which are available to reduce future federal income taxes without expiration. As a result of the issuance of Common Stock in connection with the NAMC Acquisition, the Holding Company underwent an "ownership change," as defined in section 382 of the Internal Revenue Code of 1986, as amended, which limits the Company's utilization of its net operating loss carryforwards and equivalent tax credit carryforwards to no more than $143 million per calendar year.
During 1996, federal legislation was enacted that generally eliminates the potential recapture of federal income tax deductions arising from commonly used methods of calculating bad debt reserves for periods prior to 1988 if an institution with a thrift charter (such as the Bank) were to change to a commercial bank charter. In addition, this legislation repealed the reserve method of tax accounting for bad debts used by the Bank and other "large" thrift institutions, effective for taxable years beginning after 1995. The legislation also contains provisions that require the recapture in future periods of tax reserves for periods after 1987, but such provisions have not and are not expected to have a material impact on the Company's consolidated financial statements. Further, New York State legislation was enacted during 1996, and New York City legislation was enacted in March 1997, allowing thrift institutions to continue to use the reserve method of tax accounting for bad debts and to determine a deduction for bad debts in a manner similar to prior law.
At December 31, 1998, the Bank had approximately $209 million of bad debt reserves for New York income tax purposes for which no provision for income tax had been made, of which approximately $98 million are subject to recapture upon distribution to the Holding Company of these tax reserves. Any charge to a bad debt reserve for other than bad debts on loans would create income for tax purposes only, which would be subject to the then current corporate tax rate. For federal tax purposes, approximately $176 million of the Bank's previously accumulated bad debt deductions are subject to recapture upon its distribution to the Holding Company. It is not the Bank's intention to make any distributions to the Holding Company, or use the reserve in any manner, that would create income tax liabilities for the Bank.
In order for the Bank to be permitted to maintain a New York tax bad debt reserve for thrifts, certain thrift definitional tests must be met, including maintaining at least 60% of its assets in qualifying assets, as defined for tax purposes, and maintaining a thrift charter. If the Bank failed to meet these definitional tests, the transition to the reserve method permitted commercial banks would result in an increase in the New York tax provision because a deferred tax liability would be established to reflect the eventual recapture of some or all of the New York bad debt reserve. The Bank's percentage of qualifying assets at December 31, 1998 was in excess of the minimum threshold. The Bank does not anticipate failing the thrift definitional tests for New York tax purposes.
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NOTE 22 -- EARNINGS PER COMMON SHARE
The following table sets forth the computations of basic and diluted earnings per common share for the year ended December 31 (in thousands, except per share data):
NOTE 23 -- DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses various derivative financial instruments as part of its overall interest rate risk-management strategy, to manage certain risks associated with its mortgage banking activities and, to a limited extent, for trading purposes.
The Company's exposure to credit risk in connection with its use of derivative financial instruments is represented by the positive fair value of the instruments. For a further discussion of the credit risk associated with the Company's derivative financial instruments, reference is made to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Management of Credit Risk -- Derivative Financial Instruments."
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Certain of the Company's derivative financial instruments at December 31, 1998 require that the Company or its counterparty, to the extent that the market value of the position for that party is negative, maintain collateral, subject to a minimum call, with the other party. If the Company is subject to an initial collateral requirement, the amount of the initial collateral modifies the collateral maintenance level.
Interest Rate Risk-Management Derivative Financial Instruments
The following table summarizes the notional amounts and estimated fair values of derivative financial instruments used by the Company for interest rate risk-management purposes at December 31 (in thousands):
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Activity in derivative financial instruments used for interest rate risk-management purposes is summarized in the following table for the years shown (in thousands):
The interest rate swap agreements used by the Company at December 31, 1998 for purposes of interest rate risk management are in the form where, based on an agreed-upon notional amount, the Company agrees to make periodic fixed-rate payments, while the counterparty agrees to make periodic variable-rate payments. The use of these derivative financial instruments allows the Company to achieve interest income or expense similar to what would exist if it had changed the interest rate of the hedged assets from a fixed-rate to a variable-rate and had changed the interest rate of the hedged liabilities from a variable-rate to a fixed-rate.
The following table sets forth the contractual maturities of interest rate swap agreements used for interest rate risk-management purposes at December 31, 1998, as well as the related weighted average interest rates payable and receivable at that date (dollars in thousands):
- --------------- (1) Variable rates, substantially all of which are tied to the one-month London Interbank Offered Rate ("LIBOR"), are presented on the basis of rates in effect at December 31, 1998; however, actual repricings of the interest rate swaps will be based on the applicable interest rates in effect at the actual repricing dates.
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Interest rate caps purchased by the Company represent agreements where, in return for a premium paid to the counterparty at inception, the counterparty agrees to pay the Company the excess, if any, of a designated floating market interest rate over a specified strike interest rate (the "Cap Strike Rate"), as applied to the notional amount. The interest rate cap agreements used by the Company for interest rate risk-management purposes at December 31, 1998, all of which mature in 2000, had a weighted average Cap Strike Rate of 8.00%. The designated floating market interest rates specified in these agreements were tied to the weekly average yield of the one-year constant maturity Treasury index ("CMT").
Under the Company's outstanding interest rate swaptions at December 31, 1998, the Company, in exchange for the payment of a premium to the counterparty, has the right to enter into interest rate swaps at a future date. These interest rate swaptions, all of which are used to hedge the repricing risk on certain loans receivable with high prepayment risk, mature during 1999 and have a weighted average strike rate of 6.75%.
At December 31, 1998, the Company used interest rate futures to hedge the repricing risk of certain short-term borrowed funds. During 1998, the Company used short sales of generic MBS to hedge its exposure to changes in the value of non-generic MBS that it had decided to sell.
Mortgage Banking Risk-Management Derivative Financial Instruments
The following table summarizes the notional amounts and estimated fair values of derivative financial instruments used by the Company for mortgage banking risk-management purposes at December 31 (in thousands):
The Company uses forward contracts to hedge its exposure to interest rate risk associated with loans held for sale origination activities. These contracts represent firm commitments to deliver MBS or loans at a specified price at a specified future date. The Company must deliver the MBS or loans in accordance with the requirements of the contracts or, if it cannot fulfill its contractual obligations, pair-off the commitments and recognize the gain or loss based on the change in the price of the underlying contract
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(i.e., the specified price minus the repurchase price multiplied by the notional amount). The outstanding forward contracts at year-end 1998 mature at various dates through March 1999.
The Company's outstanding put options at December 31, 1998 give it the right, but not the obligation, to sell to the counterparty a designated financial instrument at a specified price during an agreed upon period of time or on a specific date. The Company pays a premium for this right. Under these put options, the Company generally benefits if the price of the underlying financial instrument declines. The outstanding put options at December 31, 1998 mature at various dates through June 1999.
At December 31, 1998, the Company used interest rate floors, interest rate caps and interest rate swaps in order to minimize the impact of the potential loss of net future servicing revenues associated with certain of the Company's mortgage servicing assets as a result of an increase in loan prepayments, which is generally triggered by declining interest rates.
Interest rate floors purchased by the Company for the purpose of hedging its mortgage servicing assets represent agreements where, in return for a premium paid to the counterparty at inception, the counterparty agrees to pay the Company the amount, if any, by which a designated market interest rate (primarily CMT or swap indices) is less than a specified strike interest rate (the "Floor Strike Rate"), as applied to the notional amount. The weighted average Floor Strike Rate on the outstanding agreements at December 31, 1998 was 5.27%. The expected maturities of the notional amounts of the Company's outstanding interest rate floor agreements at December 31, 1998 were $0.4 billion in 1999, $1.7 billion in 2003, and $0.3 billion in 2005.
The interest rate cap agreements used by the Company to hedge mortgage servicing assets at December 31, 1998, all of which mature in 2008, had a weighted average Cap Strike Rate of 6.09%. The designated floating market interest rates specified in these agreements were tied to one-month LIBOR.
The following table sets forth, at December 31, 1998, the contractual maturities of interest rate swap agreements (excluding those agreements that are forward starting) hedging mortgage servicing assets, as well as the related weighted average interest rates payable and receivable at that date (dollars in thousands):
- --------------- (1) These interest rate swaps are structured so that the Company both receives and makes fixed-rate payments for the initial two years of the agreements. Thereafter, the Company will begin making variable-rate payments tied to one-month LIBOR.
(2) Variable rates, all of which are tied to one-month LIBOR, are presented on the basis of rates in effect at December 31, 1998; however, actual repricings of the interest rate swaps will be based on the applicable interest rates in effect at the actual repricing dates.
At December 31, 1998, the Company had an interest rate swap hedging mortgage servicing assets for which the accrual of interest does not begin until November 1999. This forward starting interest rate swap
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matures in 2007 and has a notional amount of $100.0 million, a fixed-rate receivable of 6.38% and a variable-rate payable tied to one-month LIBOR.
Activity in derivative financial instruments used to hedge mortgage servicing assets is summarized in the following table for the years shown (in thousands):
Trading Derivative Financial Instruments
At December 31, 1998, the derivative financial instruments used by the Company for trading purposes consisted of interest rate caps with a notional amount of $165.0 million. The estimated fair value of these interest rate caps at year-end 1998 was not material. The derivative financial instruments used for trading purposes during 1998 had an average positive estimated fair value of $0.1 million during the year. The Company did not use derivative financial instruments for trading purposes during 1997 or 1996.
The interest rate cap agreements used by the Company at December 31, 1998 for trading purposes mature in 1999. These instruments had a weighted average Cap Strike Rate of 6.91% at year-end 1998. The designated floating market interest rates specified in these agreements were tied to one-month LIBOR.
NOTE 24 -- COMMITMENTS AND CONTINGENT LIABILITIES
The Company has entered into non-cancelable lease agreements with respect to Company premises and equipment that expire at various dates through the year 2013. Certain leases contain escalation clauses, which correspond with increased real estate taxes and other operating expenses, and renewal options calling for increased rents. Net rent expense was $39.2 million, $23.7 million, and $17.7 million for 1998, 1997 and 1996, respectively. At December 31, 1998, the projected minimum future rental payments required under the terms of non-cancelable leases were $32.2 million in 1999, $29.2 million in 2000, $26.2 million in 2001, $23.4 million in 2002, $19.9 million in 2003, and $71.1 million in years thereafter. The projected minimum future rental payments have not been reduced by projected sublease rentals of $3.2 million.
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The Company had the following commitments to extend credit and purchase loans at December 31 (in thousands):
Commitments to extend credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Such commitments generally have fixed expiration dates or termination clauses and may require payment of a fee. Since certain of the commitments are expected to expire without being drawn upon, the total commitment amounts may not represent future cash requirements. The Company evaluates the creditworthiness of these transactions through its lending policies. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on the Company's credit evaluation of the borrower. The Company's maximum exposure to credit loss for commitments to extend credit as a result of non-performance by the counterparty is the contractual notional amount.
The Company had letters of credit outstanding at December 31, 1998 and 1997 of $62.0 million and $23.7 million, respectively. Letters of credit represent agreements whereby the Company guarantees the performance of a customer to a third party. The Company requires collateral to support such agreements based on the Company's evaluation of the creditworthiness of the customer. The credit risk associated with letters of credit is similar to that incurred by the Company in its lending activities.
The Company is obligated under various limited recourse provisions associated with certain residential and commercial real estate loans sold in past years. The principal balance of loans sold with limited recourse amounted to approximately $523 million and $648 million at December 31, 1998 and 1997, respectively. The Company's exposure to credit loss on loans sold with recourse is similar to the credit risk associated with the Company's on-balance sheet loans receivable.
Certain claims, suits, complaints and investigations involving the Company, arising in the ordinary course of business, have been filed or are pending. The Company is of the opinion, after discussion with legal counsel representing the Company in these proceedings, that the aggregate liability or loss, if any, arising from the ultimate disposition of these matters would not have a material adverse effect on the Company's consolidated financial position or results of operations.
NOTE 25 -- BUSINESS SEGMENTS
On January 1, 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements, requires that selected information about operating segments be reported in interim financial statements issued to stockholders, and establishes standards for related disclosures about an enterprise's products and services, geographic areas, and major customers.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company manages its operations in a manner to focus on two strategic goals: fulfilling its role as a banking institution for both individuals and businesses and as a national provider of residential mortgage products and services. Accordingly, the Company aligns its various business objectives in support of these goals. For purposes of disclosures in accordance with SFAS No. 131, the Company has four reportable business segments: Retail Banking; Commercial Banking; Mortgage Banking; and Investment Portfolio.
The financial information provided below has been derived from the internal profitability system used by management to monitor and manage the financial performance of the Company. The accounting policies employed for each unit are largely the same as those described in Note 1, "Summary of Significant Accounting Policies," in all material respects, and as such, numerous intersegment transactions are recorded to appropriately reflect each segment's performance. The Company reflects its internal results on interest-earning assets and interest-bearing liabilities on a matched funded basis and accounts for intersegment revenue and transfer costs and credits based upon estimated fair market values at the time of the transaction. Certain indirect or overhead costs are allocated to the segments based on total assets and other appropriate criteria. The Company views its segments' performance on an operating earnings basis, which represent net income adjusted for the effects of certain non-recurring or unusual items.
The following table sets forth certain information regarding the Company's business segments for the years ended December 31 (in thousands):
For purposes of this presentation, segment revenues reflect net interest income, less provision for loan losses, plus non-interest income. Segment profit reflects tax-effected operating results. The segment revenues and profit above incorporate certain intersegment transactions that the Company views as appropriate for purposes of reflecting the performance of certain segments, which are eliminated in the preparation of the consolidated financial statements in accordance with generally accepted accounting principles. To the extent practicable, the results for 1997 and 1996 have been restated to be comparable with management's preparation of the 1998 results.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company's management views each of its business segments as if they were stand-alone operations. As such, the results of operations for each segment reflect entries that would be recorded for an independent enterprise, such as charges for services rendered on their behalf by other segments or support units, and entries relating to the allocation of capital and to the purchase or sale of funds as needed. The capital allocated to the segment generates intersegment net interest income. Funds sold or purchased are distributed via the Company's funding center and are provided on a matched maturity basis. These intersegment entries are subsequently eliminated in consolidation.
The other primary adjustments between the internal management reports and the consolidated operating earnings relate to the production and servicing of loans in the Company's portfolio. Loans produced that are placed in the residential real estate loans receivable portfolio are sold to the Retail Banking segment with an imputed market gain or loss recognized by the Mortgage Banking segment. As a result, the impact of these transactions, and resultant ongoing adjustments from prior periods, must be reversed as an intersegment elimination. Mortgage Banking also receives revenue for servicing the loan portfolio and Retail Banking is charged for this function as a reduction of its net yield. There are no other material intersegment adjustments.
The following table sets forth reconciliations of reportable segment revenues and profit to the Company's consolidated totals for the year ended December 31 (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Additional information regarding the Company's business segments, including a description of the products and services from which each business segment derives its revenues, is disclosed in Item 1, "Business" and Item 8, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
NOTE 26 -- FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires the disclosure, where practicable, of the fair value of on- and off-balance sheet financial instruments. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any possible tax ramifications, estimated transaction costs, or any premium or discount that could result from offering for sale at any one time the Company's entire holdings of a particular financial instrument. Because no active market exists for a certain portion of the Company's financial instruments, the fair value estimates for such financial instruments are based on judgments regarding, among other factors, future cash flows, future loss experience, current economic conditions and risk characteristics. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect these estimates. The Company has not included certain material items in its disclosure as such items, which the Company believes have significant value, are not considered financial instruments under SFAS No. 107.
The following table sets forth the carrying values and estimated fair values of the Company's on-balance sheet financial instruments at December 31 (in thousands):
- --------------- (1) Excludes the net book value of business lease financing receivables which are not considered financial instruments under SFAS No. 107.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table sets forth the carrying values and estimated fair values of the derivative financial instruments used by the Company for risk-management purposes at December 31 (in thousands):
The methodologies and assumptions used by the Company in estimating the fair values of its financial instruments are described below.
The carrying value of cash and cash equivalents was deemed to be a reasonable estimate of their fair value due to the short-term nature of these items and because they do not present significant credit concerns.
The estimated fair value of securities available for sale was determined by use of quoted market prices or dealer quotes.
The fair value of FHLBNY stock was estimated to be its carrying value, which is indicative of its redemption price.
The estimated fair value of loans held for sale was estimated using the quoted market prices for securities backed by similar types of loans and current dealer commitments to purchase loans.
The estimated fair value of certain loans receivable was deemed to be equal to their carrying value due to the repricing characteristics of the loans. For other loans receivable, the Company grouped performing loans with similar characteristics and applied prices available in the secondary market as a reference and adjusted for differences in servicing and credit quality. When a secondary market rate was not available, and for non-performing loans, fair value was estimated using a discounted cash flow analysis that utilized a discount rate commensurate with the credit and interest rate risk inherent in the loans.
The estimated fair values of accrued interest receivable and payable have been determined to equal their carrying amounts as these amounts are generally due or payable within 90 days.
The estimated fair value of deposits without a specified maturity, which includes demand, savings and money market deposits, was the amount payable on the valuation date. For fixed-maturity time deposits, fair value was estimated based on the discounted value of contractual cash flows using current market interest rates offered for deposits with similar remaining maturities.
The estimated fair values of borrowed funds maturing within 90 days were deemed to be equal to their carrying values. The estimated fair values of all other borrowed funds were based on quoted market prices or on the discounted value of contractual cash flows using current market interest rates for borrowings with similar terms and remaining maturities.
The estimated fair values of the Company's derivative financial instruments were based upon quoted market prices, dealer quotes or pricing models. The estimated fair value of off-balance sheet financial
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
instruments has not been considered in determining the estimated fair value of on-balance sheet financial instruments.
The Company has reviewed its outstanding commitments to extend credit, commitments to purchase loans, letters of credit and loans sold with recourse at December 31, 1998 and 1997 and has determined that their estimated fair values were not material.
NOTE 27 -- FINANCIAL STATEMENTS OF THE HOLDING COMPANY
STATEMENTS OF FINANCIAL CONDITION (IN THOUSANDS)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STATEMENTS OF INCOME (IN THOUSANDS)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STATEMENTS OF CASH FLOWS (IN THOUSANDS)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 28 -- CONDENSED QUARTERLY CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)