UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Mark One
For the quarterly period ended March 31, 2002or
For the transition period from to .
Commission file number 000-24939
EAST WEST BANCORP, INC.
(Exact name of registrant as specified in its charter)
Registrant's telephone number, including area code: (626) 799-5700
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 Par Value
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Number of shares of common stock of the registrant outstanding as of April 30, 2002: 23,598,675 shares
TABLE OF CONTENTS
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PART I—FINANCIAL INFORMATION ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS
EAST WEST BANCORP, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data)(unaudited)
See accompanying notes to interim consolidated financial statements.
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EAST WEST BANCORP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data)(Unaudited)
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EAST WEST BANCORP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Dollars in thousands)(Unaudited)
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EAST WEST BANCORP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)(Unaudited)
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EAST WEST BANCORP, INC. AND SUBSIDIARIESNOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTSFor the Three Months Ended March 31, 2002 and 2001 (Unaudited)
1. BASIS OF PRESENTATION
The consolidated financial statements include the accounts of East West Bancorp, Inc. (the "Company") and its wholly owned subsidiaries, East West Bank and subsidiaries (the "Bank") and East West Insurance Agency, Inc. Intercompany transactions and accounts have been eliminated in consolidation.
The interim consolidated financial statements, presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"), are unaudited and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of financial condition and results of operations for the interim periods. All adjustments are of a normal and recurring nature. Results for the period ended March 31, 2002 are not necessarily indicative of results which may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company's annual report on Form 10K for the year ended December 31, 2001.
Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation.
2. ACCOUNTING CHANGES
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires companies to cease amortizing goodwill that existed at June 30, 2001. The amortization of existing goodwill ceased on December 31, 2001. Any goodwill resulting from acquisitions completed after June 30, 2001 will not be amortized. SFAS No. 142 also establishes a new method of testing goodwill for impairment on an annual basis or on an interim basis if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying value. The adoption of SFAS No. 142 on January 1, 2002 resulted in a cumulative pre-tax income of $1.4 million ($788 thousand after-tax) representing the remaining balance of negative goodwill at December 31, 2001. Positive goodwill will continue to be reviewed for impairment on an annual basis. Pursuant to the goodwill impairment test provisions of SFAS No. 142, the Company has identified its reporting units and has allocated assets, liabilities, and goodwill accordingly to those reporting units. The Company expects to complete its initial impairment test of positive goodwill in the next few weeks. Although the Company has not completed its initial impairment test of positive goodwill, management does not believe that any material impairment exists at March 31, 2002.
Effective January 1, 2001, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income ("OCI") and
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are recognized in the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings.
The adoption of SFAS No. 133 on January 1, 2001 resulted in a cumulative pre-tax reduction to income of $149 thousand ($87 thousand after-tax) as a result of the fair valuation of two interest rate swap agreements with a combined notional amount of $30.0 million. These swap agreements were used to hedge fixed rate brokered certificates of deposit totaling $30.0 million. Pursuant to the adoption of SFAS No. 133, the Company records these interest rate swap agreements at their estimated fair values, with resulting gains or losses recorded in current earnings. No interest rate swap agreements were outstanding at March 31, 2002 and December 31, 2001.
3. OTHER INTANGIBLES
The Company also has premiums on acquired deposits which represent the intangible value of depositor relationships resulting from deposit liabilities assumed in various acquisitions. The Company amortizes premiums on acquired deposits using the straightline method over 7 to 10 years. At March 31, 2002, the balance of deposit premiums totaled $8.8 million. Estimated future amortization expense of premiums on acquired deposits is as follows: $1.3 million for the remaining three quarters of 2002, $1.8 million in 2003, 2004, and 2005, and $1.3 million in 2006.
4. COMMITMENTS AND CONTINGENCIES
Credit Extensions—In the normal course of business, there are various outstanding commitments to extend credit which are not reflected in the accompanying interim consolidated financial statements. As of March 31, 2002, undisbursed loan commitments, commercial and standby letters of credit, and commitments to fund mortgage loan applications in process amounted to $399.3 million, $238.1 million, and $176.0 million, respectively.
Litigation—The Company is a party to various legal proceedings arising in the normal course of business. While it is difficult to predict the outcome of such litigation, the Company does not expect that such litigation will have a material adverse effect on its financial position and results of operations.
Regulated Investment Company—On February 21, 2002, Senate Bill No. 1660 was introduced to the California State Senate. This legislative proposal, which contained provisions affecting registered investment companies, would have adversely affected past and future state tax benefits generated through East West Securities, Inc., the Company's registered investment company subsidiary. Further, this proposed legislation would have had a negative impact on the Company's effective income tax rate in future periods. However, on April 3, 2002, an amendment to Senate Bill No. 1660 removed the proposed California tax law changes related to registered investment companies. Management cannot predict if other legislation affecting registered investment companies will be proposed this year or at any other time in the future. The Company continues to assess its long-term plans for East West Securities, Inc.
5. STOCKHOLDERS' EQUITY
Earnings Per Share—The actual number of shares outstanding at March 31, 2002, was 23,546,303. Basic earnings per share are calculated on the basis of the weighted average number of shares outstanding during the period. Diluted earnings per share are calculated on the basis of the weighted average number of shares outstanding during the period plus shares issuable upon the assumed exercise of outstanding common stock options and warrants.
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The following tables set forth the Company's earnings per share calculations for the three months ended March 31, 2002 and 2001:
Quarterly Dividends—The Company's Board of Directors declared and paid a quarterly common stock cash dividend of $0.0675 per share payable on or about February 22, 2002 to shareholders of record on February 8, 2002. For the first quarter of 2002, cash dividends totaling $1.6 million have been paid to the Company's shareholders.
6. BUSINESS SEGMENTS
Management utilizes an internal reporting system to measure the performance of various operating segments within the Company and the Company overall. Four principal operating segments have been identified by the Company for purposes of management reporting: retail banking, commercial lending, treasury, and residential lending. Information related to the Company's remaining centralized functions and eliminations of intersegment amounts have been aggregated and included in "Other." Although all four operating segments offer financial products and services, they are managed separately based on each segment's strategic focus. While the retail banking segment focuses primarily on retail operations through the Company's branch network, certain designated branches have responsibility for generating commercial deposits and loans. The commercial lending segment primarily generates commercial loans and deposits through the efforts of commercial lending officers located in the Company's northern and southern California production offices. The treasury department's primary focus is managing the Company's investments, liquidity, and interest rate risk; the residential lending segment is mainly responsible for the Company's portfolio of single family and multifamily residential loans.
Operating segment results are based on the Company's internal management reporting process, which reflects assignments and allocations of capital, certain operating and administrative costs and the provision for loan losses. Net interest income is based on the Company's internal funds transfer pricing system which assigns a cost of funds or a credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and noninterest expense, including depreciation and amortization, directly attributable to a segment are assigned to that business. Indirect costs, including overhead expense, are allocated to the segments based on several factors, including, but not limited to, full-time equivalent employees, loan volume and deposit volume. The provision for credit losses is allocated based on new loan originations for the period. The Company evaluates overall performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses.
Future changes in the Company's management structure or reporting methodologies may result in changes in the measurement of operating segment results. Results for prior periods have been restated for comparability for changes in management structure or reporting methodologies.
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The following tables present the operating results and other key financial measures for the individual operating segments for the three months ended March 31, 2002 and 2001:
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of East West Bancorp, Inc. and its subsidiaries (the "Company"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to the financial condition of the Company and the results of its operations. This discussion and analysis should be read in conjunction with the Company's 2001 annual report on Form 10-K for the year ended December 31, 2001, and the accompanying interim unaudited consolidated financial statements and notes thereto.
In addition to historical information, this discussion includes certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 which involve inherent risks and uncertainties. A number of important factors could cause the Company's actual results and performance in future periods to differ materially from those discussed in such forward-looking statements. These factors include, but are not limited to, the effect of interest rate and currency exchange fluctuations; competition in the financial services market for both deposits and loans; the Company's ability to efficiently incorporate acquisitions into its operations; the ability of the Company to increase its customer base; and regional and general economic conditions. Given these uncertainties, the reader is cautioned not to place undue reliance on such forward-looking statements. The Company expressly disclaims any obligation to update or revise any forward-looking statements contained herein to reflect any changes in the Company's expectations of results or any change in events.
Results of Operations
The Company reported net income of $11.7 million, or $0.48 per diluted share for the first quarter of 2002, compared with $9.8 million, or $0.41 per diluted share, reported during the first quarter of 2001. The 19% increase in net earnings is primarily attributable to higher net interest income and the cumulative effect of a change in accounting principle due to the adoption of SFAS 142, partially offset by a higher provision for loan losses and lower non-interest related revenues. Excluding the impact of the cumulative effect of changes in accounting principle, net income for the first quarter of 2002 increased 10% to $10.9 million, from $9.9 million for the first quarter of 2001.
The Company's annualized return on average total assets increased to 1.66% for the quarter ended March 31, 2002, from 1.55% for the same period in 2001. The annualized return on average stockholders' equity decreased to 18.78% for the first quarter of 2002, compared with 19.50% for the first quarter of 2001.
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Components of Net Income
Net Interest Income
The Bank's primary source of revenue is net interest income, which is the difference between interest income on earning assets and interest expense on interest-bearing liabilities. Net interest income for the first quarter of 2002 totaled $27.6 million, a 17% increase over net interest income of $23.5 million for the same period in 2001.
Total interest and dividend income during the quarter ended March 31, 2002 decreased 19% to $40.1 million compared with $49.4 million during the same period in 2001, primarily due to lower yields on all categories of earning assets and reduced volume of the Bank's investment securities portfolio. Despite a 12% growth in average earning assets during the first quarter of 2002, particularly in loans and short-term investments, it was insufficient to mitigate the negative impact of several progressive cuts in interest rates during the year. Growth in the Bank's average loan portfolio of 18%, partially offset by decreases in investment securities and FHLB stock, triggered the growth in average earning assets. The net growth in average earning assets was funded largely by increases in noninterest-bearing demand deposits and interest-bearing checking accounts.
Total interest expense during the first quarter of 2002 decreased 51% to $12.5 million compared with $25.9 million for the same period a year ago. The decrease in interest expense is also primarily attributable to lower rates paid on substantially all categories of interest-bearing liabilities compounded by a lower volume of short-term borrowings and FHLB advances.
Net interest margin, defined as taxable equivalent net interest income divided by average earning assets, increased 20 basis points to 4.15% during the first quarter of 2002, compared with 3.95% for the first quarter of 2001. As a result of several progressive declines in interest rates since March 31, 2001, the overall yield on average earning assets decreased 225 basis points to 6.03% during the first quarter of 2002, compared to 8.28% for the first quarter of 2001. Similarly, the Company's overall cost of funds decreased 262 basis points to 2.44% during the first quarter of 2002, from 5.06% for the same period last year, in response to the declining interest rate environment. During the first quarter of 2002, the increase in the net interest margin reflects the Company's continued reliance on noninterest-bearing demand deposits as a considerable funding source. Average noninterest-bearing demand deposits increased 93% to $485.7 million during the quarter ended March 31, 2002, compared to $251.3 million for the same period a year ago. Furthermore, as the Company's substantial portfolio of time deposits continue to reprice in line with the downward trend in interest rates, the disproportional effect of lower interest rates on asset yields and cost of funds that caused a contraction in the Company's net interest margin in previous quarters was significantly reduced in the first quarter of 2002.
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The following table presents the net interest spread, net interest margin, average balances, interest income and expense, and the average yields and rates by asset and liability component for the three months ended March 31, 2002 and 2001:
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Analysis of Changes in Net Interest Margin
Changes in the Bank's net interest income are a function of changes in rates and volumes of both interest-earning assets and interest-bearing liabilities. The following table sets forth information regarding changes in interest income and interest expense for the years indicated. The total change for each category of interest-earning asset and interest-bearing liability is segmented into the change attributable to variations in volume (changes in volume multiplied by old rate) and the change attributable to variations in interest rates (changes in rates multiplied by old volume). Nonaccrual loans are included in average loans used to compute this table.
Provision for Loan Losses
The provision for loan losses amounted to $2.6 million for the first quarter of 2002 compared to $717 thousand for the same period in 2001. Provisions for loan losses are charged to income to bring the allowance for credit losses to a level deemed appropriate by management based on the factors discussed under the "Allowance for Loan Losses" section of this report.
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Noninterest Income
Components of Noninterest Income
Noninterest income includes revenues earned from sources other than interest income. These sources include: service charges and fees on deposit accounts, ancillary fees on loans, fees and commissions generated from trade finance activities and the issuance of letters of credit, net gains on sales of investment securities available for sale, loans, and affordable housing investments, and net gains on trading securities.
Noninterest income decreased 18% to $5.3 million during the three months ended March 31, 2002, from $6.4 million during the three months ended March 31, 2001. Included in noninterest income for the first quarter of 2001 were $1.5 million in net gains on sales of available for sale securities, $327 thousand in net gains on sales of loans and $415 thousand in net gains on trading securities. There were no such gains recorded during the first quarter of 2002. Further, as a consequence of adopting SFAS No. 142, the Company recorded the remaining balance of negative goodwill amounting to $1.4 million as a cumulative effect of a change in accounting principle effective January 1, 2002. As such, there was no amortization of negative goodwill during the first quarter of 2002. This compares to $104 thousand in amortization expense recorded during the first quarter of 2001.
Partially offsetting these decreases to noninterest income were increases in branch service revenues, ancillary loan fees, and letters of credit fees and commissions and other operating income. Branch fees, which represent revenues derived from branch operations, amounted to $1.5 million during the three months ended March 31, 2002, an 17% increase from the $1.2 million earned in the first quarter of 2001. The increase in branch fees is primarily due to sustained growth in revenues from analysis charges on commercial deposit accounts, increased commissions from sales of alternative investment products, including mutual funds and annuities, and higher revenues from wire transfer transactions due to increased volume.
Ancillary fees on loans include fees and service charges related to appraisal services, loan documentation, processing and underwriting, and secondary market-related activities. Ancillary loan fees increased 93% to $1.4 million during the first quarter of 2002, compared to $741 thousand during the first quarter of 2001. This is primarily attributable to a sustained increase in secondary marketing activities resulting from lower interest rates. Further, a 143% increase in residential mortgage loan originations during the first quarter of 2002, predominantly refinance activity prompted by lower interest rates, also contributed to higher loan fees during the period.
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Other noninterest income, which include insurance commissions and insurance-related service fees, interest earned on officer life insurance policies, branch rental income, and income from operating leases increased 10% to $1.1 million. The increase is primarily attributable to a substantial increase in insurance commissions and other insurance-related service fee income generated through the Company's subsidiary, East West Insurance Agency, Inc.
Noninterest Expense
Components of Noninterest Expense
Noninterest expense, which is comprised primarily of compensation and employee benefits, occupancy and other operating expenses, decreased 2% to $15.1 million during three months ended March 31, 2002. The decrease is primarily attributable to the absence of amortization expense related to positive goodwill due to the adoption of SFAS No. 142 effective January 1, 2002. Total amortization expense of intangible assets decreased 56% to $478 thousand during the first quarter of 2002, compared to $1.1 million during the first quarter of 2001.
Compensation and employee benefits decreased 2% to $6.3 million during the three months ended March 31, 2002, compared to $6.4 million for the same period a year ago. The decrease in compensation expense is primarily due to operating efficiencies gained through restructuring and streamlining efforts of certain areas of the Bank.
Occupancy expenses increased 9% to $2.6 million during the first quarter of 2002. The increase is primarily due to adjusted monthly lease payments for a branch location to coincide with current market terms. Prior to April 2001, contractual rent payments for this particular location were significantly below market terms. Additionally, the opening of two Ranch 99 in-store branches in February 2002 further contributed to the increase in occupancy expenses during the three months ended March 31, 2002. These are overhead factors that were not present during the first quarter of 2001.
The amortization of investments in affordable housing partnerships decreased marginally by 2% to $1.0 million during the first quarter of 2002, compared with $1.1 million for the first quarter of 2001. Total investments in affordable housing partnerships amounted to $21.4 million at March 31, 2002, compared to $20.7 million at March 31, 2001.
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Deposit insurance premiums and regulatory assessments increased 14% to $153 thousand for the three months ended March 31, 2002, compared with $134 thousand for the same period in 2001. Although there was a decrease in the Savings Association Insurance Fund ("SAIF") annualized Financing Corporation ("FICO") assessment rate to 1.76 basis points for the first quarter of 2002, from 1.96 basis points for the same period in 2001, deposit insurance premiums increased during the three months ended March 31, 2002 as a result of the significant growth in the Bank's assessable deposit base.
Other operating expenses include advertising and public relations, telephone and postage, stationery and supplies, bank and item processing charges, insurance, legal and other professional fees. Other operating expenses increased 6% to $4.1 million during the three months ended March 31, 2002, compared with $3.8 million for the same period in 2001. The increase in other operating expenses is due primarily to the Company's continued organic growth.
The Company's efficiency ratio, which represents noninterest expense (excluding the amortization of intangibles and investments in affordable housing partnerships) divided by the aggregate of net interest income before provision for loan losses and noninterest income (excluding the amortization of intangibles), decreased to 41% for the quarter ended March 31, 2002, compared to 44% for the corresponding period in 2001. The decrease reflects efficiencies realized in the Company's operations from infrastructure investments made in the past two years as well as a general company-wide effort to carefully monitor overall operating expenses.
Provision for Income Taxes
The provision for income taxes increased 8% to $4.2 million for the first quarter of 2002, compared with $3.9 million for the same period in 2001. The increase in the tax provision is primarily attributable to a 10% increase in pretax earnings during the three months ended March 31, 2002, compared to the corresponding period in 2001.
The provision for income taxes reflects state tax benefits achieved through East West Securities Company, Inc., a regulated investment company formed and funded in July 2000. The Company offers no assurance as to the continued realization of state tax benefits through this regulated investment company in the foreseeable future. The provision for income taxes for the first quarter of 2002 also reflects the utilization of tax credits totaling $1.0 million, compared to $775 thousand utilized during the same period in 2001. The first quarter 2002 provision reflects an effective tax rate of 27.8%, compared with 28.4% for the first quarter of 2001.
Balance Sheet Analysis
The Company's total assets increased $77.9 million, or 3%, to $2.90 billion, as of March 31, 2002, relative to total assets at December 31, 2001. The increase in total assets was due primarily to a $99.6 million growth in loans receivable, partially offset by a decrease in cash and cash equivalents of $19.8 million. The increase in total assets was funded largely by an increase of $124.2 million in deposits, partially offset by a decrease in FHLB advances of $40.0 million.
Investment Securities Available for Sale
Total investment securities available for sale decreased 1% to $320.4 million as of March 31, 2002, compared to total available for sale securities of $323.1 million at December 31, 2001. Investment securities with a net carrying value of $132.6 million were purchased during the first quarter of 2002. Total repayments of available for sale securities amounted to $133.3 million during the quarter ended March 31, 2002. Proceeds from repayments were applied towards additional investment securities purchases, repayments of FHLB advances, and funding a portion of the loan originations and loan purchases made during the first quarter of 2002. There were no sales of available for sale securities
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during the three months ended March 31, 2002. This compares with $1.5 million in net gains on sales of investment securities recorded during the same period in 2001.
The following table sets forth the amortized cost and the estimated fair values of investment securities available for sale as of March 31, 2002 and December 31, 2001:
Loans
The Company experienced moderate loan demand during the first quarter of 2002. Net loans receivable increased $99.6 million, or 5%, to $2.23 billion at March 31, 2002. The increase in loans was funded primarily through deposit growth and through repayments of investment securities available for sale.
The growth in loans is comprised primarily of net increases in residential single family loans of $15.3 million or 5%, multifamily loans of $60.2 million or 16%, commercial real estate loans of $58.5 million or 7%, and consumer loans of $11.2 million or 16%. Partially offsetting the growth in these loan categories was a net decrease in construction loans of $4.7 million or 3% and commercial loans of $40.3 million or 11%. The net decrease in construction loans is primarily attributable to net loan payoffs and the conversion of one large loan to a permanent loan. The net decrease in commercial business loans is primarily due to loan payoffs and reduced usage of commercial and trade finance lines.
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The following table sets forth the composition of the loan portfolio as of the dates indicated:
Nonperforming Assets
Nonperforming assets are comprised of nonaccrual loans, loans past due 90 days or more but not on nonaccrual, restructured loans and other real estate owned, net. Nonperforming assets as a percentage of total assets were 0.33% and 0.20% at March 31, 2002 and December 31, 2001, respectively. Nonaccrual loans, which include loans 90 days or more past due, totaled $5.2 million at March 31, 2002, compared with $3.7 million at year-end 2001. Loans totaling $2.6 million were placed on nonaccrual status during the first quarter of 2002. These additions to nonaccrual loans were offset by $171 thousand in payoffs and principal paydowns, $890 thousand in gross chargeoffs, and $21 thousand in loans brought current. Additions to nonaccrual loans during the first quarter of 2002 were comprised of a $639 thousand in residential single family loans, an $18 thousand residential multifamily loan, $1.9 million in commercial business loans, $45 thousand in finance leases, and $64 thousand in automobile loans.
Restructured loans and loans that have had their original terms modified totaled $4.3 million at March 31, 2002, compared with $2.1 million at year-end 2001. The increase in restructured loans at March 31, 2002 is due to the addition of two commercial real estate loans totaling $2.2 million, slightly offset by principal payments received during the first quarter of 2002 amounting to $11 thousand.
Other real estate owned ("OREO") includes properties acquired through foreclosure or through full or partial satisfaction of loans. There were no additions to OREO during the first quarter of 2002.
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The following table sets forth information regarding nonaccrual loans, loans past due 90 days or more but not on nonaccrual, restructured loans and other real estate owned as of the dates indicated:
The Company evaluates impairment of loans according to the provisions of SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended. Under SFAS No. 114, loans are considered impaired when it is probable that the Company will be unable to collect all amounts due according the contractual terms of the loan agreement, including scheduled interest payments. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as an expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent, less costs to sell.
At March 31, 2002, the Bank had classified $10.4 million of its loans as impaired, compared with $7.3 million at December 31, 2001. Specific reserves on impaired loans totaled $462 thousand at March 31, 2002 and $1.1 million at December 31, 2001. The Bank's average recorded investment in impaired loans for the three months ended March 31, 2002 and 2001 were $10.8 and $11.7 million, respectively. During the three months ended March 31, 2002 and 2001, gross interest income that would have been recorded on impaired loans, had they performed in accordance with their original terms, totaled $262 thousand and $325 thousand, respectively. Of this amount, actual interest recognized on impaired loans, on a cash basis, was $109 and $241 thousand, respectively.
Allowance for Loan Losses
Management of the Bank is committed to maintaining the allowance for loan losses at a level that is considered to be commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, management performs an ongoing assessment of the risks inherent in the portfolio. While management believes that the allowance for loan losses is adequate at March 31, 2001, future additions to the allowance will be subject to continuing evaluation of estimated and known, as well as inherent, risks in the loan portfolio.
The allowance for loan losses is increased by the provision for loan losses which is charged against current period operating results, and is decreased by the amount of net chargeoffs during the period. At March 31, 2002, the allowance for loan losses amounted to $29.2 million, or 1.29% of total loans, compared with $27.6 million, or 1.28% of total loans, at December 31, 2001, and $25.6 million, or 1.35% of total loans, at March 31, 2001. The $1.6 million increase in the allowance for loan losses at March 31, 2002, from year-end 2001, is comprised of $2.6 million in additional loss provisions and $952 thousand in net chargeoffs recorded during the period.
The provision for loan losses of $2.6 million for the first quarter of 2002 represents a 256% increase from the $717 thousand in loss provisions recorded during the first quarter of 2001. First quarter 2002 net chargeoffs amounting to $952 thousand represent 0.17% of average loans outstanding
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for the three months ended March 31, 2002. This compares to net chargeoffs of $559 thousand, or 0.12% of average loans outstanding for the same period in 2001. The Bank continues to record loss provisions to compensate for both the continued growth of the Bank's loan portfolio, which grew 5% during the first quarter of 2002, and the changing composition of the overall loan portfolio, reflecting a shift toward commercial real estate and commercial business loans. Further, increases in nonperforming assets and net chargeoffs during the first quarter of 2002 are factors that contributed to the increase in loan loss provisions during the three months ended March 31, 2002.
The following table summarizes activity in the allowance for loan losses for the three months ended March 31, 2002 and 2001:
The Bank's total allowance for loan losses is comprised of two components—allocated and unallocated. The Bank utilizes several methodologies to determine the allocated portion of the allowance and to test overall adequacy. The two primary methodologies, the classification migration model and the individual loan review analysis methodology, provide the basis for determining allocations between the various loan categories as well as the overall adequacy of the allowance. These methodologies are augmented by ancillary analyses, which include historical loss analyses, peer group comparisons, and analyses based on the federal regulatory interagency policy for loan and lease losses.
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The following table reflects management's allocation of the allowance for loan losses by loan category and the ratio of each loan category to total loans as of the dates indicated:
Allocated reserves on single family loans decreased $43 thousand, or 23%, to $141 thousand at March 31, 2002 primarily due to a decrease in the loss factor for single family loans that are not classified (i.e. rated "pass"). The loss factor for single family loans rated "pass" declined to 1 basis point at March 31, 2002 compared to 2 basis points at December 31, 2001. At March 31, 2002, approximately 98% of the loans within this category were rated "pass."
Allocated reserves on multifamily loans increased $143 thousand, or 7%, to $2.1 million as of March 31, 2002 primarily due to a 16% increase in the volume of loans in this loan category from year-end 2001 levels. Partially offsetting the impact of loan growth in this category is a decline in the loss factor for multifamily loans rated "pass." At March 31, 2002, the loss factor for multifamily loans rated "pass" was 2 basis points, compared with 4 basis points at December 31, 2001. Approximately 99% of the loans within this category were rated "pass."
Allocated reserves on commercial real estate loans increased $530 thousand, or 6%, to $8.8 million as of March 31, 2002 primarily due to a 7% increase in the volume of loans in this category from year-end 2001 levels.
Allocated reserves on construction loans decreased $249 thousand, or 8%, to $2.8 million at March 31, 2002 due to the payoff of an $8.2 million hotel loan which had a 3% hotel industry concentration risk allocation associated with it. In addition, a 3% decline in the volume of construction loans since year-end 2001 further contributed to the decrease in allocated reserves in this loan category.
Allocated reserves on commercial business loans increased $980 thousand, or 10%, to $11.2 million at March 31, 2002 primarily due to an increase in the minimum loss rate for commercial business loans rated "pass." Based on the increasing size and rate of recent losses experienced by the Company in this loan category, management has deemed it prudent to raise the minimum loss rate on such loans to 2%, compared to 1% at December 31, 2001.
The allowance for loan losses of $29.2 million at March 31, 2002 exceeded the Bank's allocated allowance by $4.1 million, or 14% of the total allowance. This compares to an unallocated allowance of $3.9 million, or 14%, as of December 31, 2001. The $4.1 million unallocated allowance at March 31, 2002 is comprised of three elements. First, the Bank has set aside $311 thousand for foreign transaction risk associated with credit lines totaling $85.7 million extended to financial institutions in foreign countries. Loss factors, ranging from 0.1% to 5.0% of the total credit facility, are multiplied by anticipated usage volumes to determine the loss exposure on this type of credit offering. These loss factors are internally determined based on the sovereign risk ratings of the various countries which range from BBB+ to AAA. The second element, which accounts for approximately $1.3 million of the
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unallocated allowance, represents a 5% economic risk factor to compensate for the continued slowdown of the national economy, as evidenced by rising unemployment rates and energy costs, eroding consumer confidence, and substantial shortfalls in sales and earnings. Management of the Bank has deemed it prudent to set aside a portion of the unallocated allowance to compensate for this current economic risk. The third and final element, which accounts for approximately $2.5 million, or approximately 10% of the allocated allowance amount of $25.0 million at March 31, 2002, was established to compensate for the modeling risk associated with the classification migration and individual loan review analysis methodologies.
Deposits
Deposits increased $124.2 million, or 5%, to $2.54 billion at March 31, 2002. The deposit growth was comprised primarily of increases in non-interest bearing demand accounts of $40.4 million or 8%, interest-bearing checking accounts of $17.1 million or 9%, savings accounts of $8.5 million or 4%, and time deposits of $56.1 million, or 4%. The increases can be attributed to momentum from various retail promotions as well as continued carryover benefits from the Prime Bank acquisition.
Although the Company occasionally promotes certain time deposit products, its efforts are largely concentrated in increasing the volume of low-cost transaction accounts which generate higher fee income and are a less costly source of funds in comparison to time deposits.
Borrowings
The Bank regularly uses short-term borrowings and FHLB advances to manage its liquidity position. Short-term borrowings, which consist of federal funds purchased and securities sold under agreements to repurchase. FHLB advances decreased 39% to $64.0 million as of March 31, 2002, a decrease of $40.0 million from December 31, 2001. Growth in core deposits and runoffs on short-term investments and investment securities available for sale can be attributed to the decrease in FHLB advances as of March 31, 2002. There were no outstanding short-term borrowings at March 31, 2002 and December 31, 2001.
Capital Resources
The primary source of capital for the Company is the retention of net after tax earnings. At March 31, 2002, stockholders' equity totaled $256.6 million, a 5% increase from $244.4 million as of December 31, 2001. The increase is due primarily to: (1) net income of $11.7 million during the first quarter of 2002; (2) net issuance of common stock totaling $1.8 million, representing 170,324 shares, from the exercise of stock options; (3) stock compensation costs amounting to $81 thousand related to the Company's Restricted Stock Award Program; and (4) tax benefits of $1.7 million resulting from the exercise of nonqualified stock options. These transactions were offset by: (1) payment of first quarter 2002 cash dividends totaling $1.6 million; (2) an increase of $1.4 million in unrealized losses on available for sale securities; and (3) repurchases of $1 thousand or 100 shares of common stock resulting from forfeitures of restricted stock awards.
Management is committed to maintaining capital at a level sufficient to assure shareholders, customers and regulators that the Company and its bank subsidiary are financially sound. The Company and its bank subsidiary are subject to risk-based capital regulations adopted by the federal banking regulators in January 1990. These guidelines are used to evaluate capital adequacy and are based on an institution's asset risk profile and off-balance sheet exposures. According to the regulations, institutions whose Tier 1 and total capital ratios meet or exceed 6% and 10%, respectively, are deemed to be "well-capitalized." At March 31, 2002, the Bank's Tier 1 and total capital ratios were 9.9% and 11.1%, respectively, compared to 9.8% and 11.0%, respectively, at December 31, 2001.
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The following table compares the Company's and the Bank's actual capital ratios at March 31, 2002, to those required by regulatory agencies for capital adequacy and well-capitalized classification purposes:
ASSET LIABILITY AND MARKET RISK MANAGEMENT
Liquidity
Liquidity management involves the Bank's ability to meet cash flow requirements arising from fluctuations in deposit levels and demands of daily operations, which include funding of securities purchases, providing for customers' credit needs and ongoing repayment of borrowings. The Bank's liquidity is actively managed on a daily basis and reviewed periodically by the Asset/Liability Committee and the Board of Directors. This process is intended to ensure the maintenance of sufficient funds to meet the needs of the Bank, including adequate cash flow for off-balance sheet instruments.
The Bank's primary sources of liquidity are derived from financing activities which include the acceptance of customer and broker deposits, federal funds facilities, repurchase agreement facilities and advances from the Federal Home Loan Bank of San Francisco. These funding sources are augmented by payments of principal and interest on loans, the routine liquidation of securities from the available-for-sale portfolio and securitizations of eligible loans. Primary uses of funds include withdrawal of and interest payments on deposits, originations and purchases of loans, purchases of investment securities, and payment of operating expenses.
During the three months ended March 31, 2002, the Company experienced net cash outflows from operating activities of $6.4 million, compared to net cash inflows of $19.2 million for the three months ended March 31, 2001. Net cash outflows from operating activities for the first quarter of 2002 were primarily due to the payment of accrued federal income taxes related to the 2001 fiscal year and the origination of loans held for sale. For the first quarter of 2001, net cash inflows from operating activities were due primarily to proceeds from the sale of securitized loans. Net cash outflows from investing activities totaled $97.1 million for the first quarter of 2002 primarily due to loan growth. For the three months ended March 31, 2001, net cash inflows from investing activities totaled $73.0 million which can be attributed to net proceeds from the sale of loans receivable and investment securities available for sale, as well as cash acquired through the purchase of Prime Bank in January 2001. The Company experienced net cash inflows from financing activities of $83.7 million for the first quarter of 2002 primarily due to deposit growth partially offset by net repayments on FHLB advances. For the first quarter of 2001, net cash outflows from financing activities of $39.6 million can be attributed to net repayments of FHLB advances partially offset by deposit growth.
As a means of augmenting its liquidity, the Bank has established federal funds lines with four correspondent banks and several master repurchase agreements with major brokerage companies. At March 31, 2002, the Bank's available borrowing capacity includes approximately $59.4 million in repurchase arrangements, $92.0 million in federal funds line facilities, and $141.0 million in unused FHLB advances. Management believes its liquidity sources to be stable and adequate. At March 31, 2002, management was not aware of any information that was reasonably likely to have a material effect on the Bank's liquidity position.
The liquidity of the parent company, East West Bancorp, Inc. is primarily dependent on the payment of cash dividends by its subsidiary, East West Bank, subject to limitations imposed by the
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Financial Code of the State of California. During the three months ended March 31, 2002, total dividends paid by the Bank to East West Bancorp, Inc. totaled $1.7 million, compared with $8.2 million for the same period in 2001. As of March 31, 2002, approximately $70.9 million of undivided profits of the Bank were available for dividends to the Company.
Interest Rate Sensitivity Management
The Bank's success is largely dependent upon its ability to manage interest rate risk, which is the impact of adverse fluctuations in interest rates on the Bank's net interest income and net portfolio value. Although in the normal course of business the Bank manages other risks, such as credit and liquidity risk, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Bank's financial condition and results of operations.
The fundamental objective of the asset liability management process is to manage the Bank's exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. The Bank's strategy is formulated by the Asset/Liability Committee, which coordinates with the Board of Directors to monitor the Bank's overall asset and liability composition. The Committee meets regularly to evaluate, among other things, the sensitivity of the Bank's assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses on its available-for-sale portfolio (including those attributable to hedging transactions), purchase and securitization activity, and maturities of investments and borrowings.
The Bank's overall strategy is to minimize the adverse impact of immediate incremental changes in market interest rates (rate shock) on net interest income and net portfolio value. Net portfolio value is defined as the present value of assets, minus the present value of liabilities and off-balance sheet instruments. The attainment of this goal requires a balance between profitability, liquidity and interest rate risk exposure. To minimize the adverse impact of changes in market interest rates, the Bank simulates the effect of instantaneous interest rate changes on net interest income and net portfolio value on a monthly basis. The table below shows the estimated impact of changes in interest rates on net interest income and market value of equity as of March 31, 2002 and December 31, 2001, assuming a parallel shift of 100 to 200 basis points in both directions:
All interest-earning assets, interest-bearing liabilities and related derivative contracts are included in the interest rate sensitivity analysis at March 31, 2002 and December 31, 2001. At March 31, 2002 and December 31, 2001, the Bank's estimated changes in net interest income and net portfolio value were within the ranges established by the Board of Directors.
The primary analytical tool used by the Bank to gauge interest rate sensitivity is a simulation model used by many major banks and bank regulators, and is based on the actual maturity and repricing characteristics of interest-rate sensitive assets and liabilities. The model attempts to predict
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changes in the yields earned on assets and the rates paid on liabilities in relation to changes in market interest rates. As an enhancement to the primary simulation model, prepayment assumptions and market rates of interest provided by independent broker/dealer quotations, an independent pricing model and other available public sources are incorporated into the model. Adjustments are made to reflect the shift in the Treasury and other appropriate yield curves. The model also factors in projections of anticipated activity levels by Bank product line and takes into account the Bank's increased ability to control rates offered on deposit products in comparison to its ability to control rates on adjustable-rate loans tied to published indices.
The following tables provide the outstanding principal balances and the weighted average interest rates of the Bank's non-derivative financial instruments as of March 31, 2002. The Bank does not consider these financial instruments to be materially sensitive to interest rate fluctuations. Historically, the balances of these financial instruments have remained fairly constant over various economic conditions. The information presented below is based on the repricing date for variable rate instruments and the expected maturity date for fixed rate instruments.
Expected maturities of assets are contractual maturities adjusted for projected payment based on contractual amortization and unscheduled prepayments of principal as well as repricing frequency. Expected maturities for deposits are based on contractual maturities adjusted for projected rollover rates and changes in pricing for deposits with no stated maturity dates. The Bank utilizes assumptions supported by documented analyses for the expected maturities of its loans and repricing of its deposits. It also relies on third party data providers for prepayment projections for amortizing securities. The actual maturities of these instruments could vary significantly if future prepayments and repricing differ from the Bank's expectations based on historical experience.
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The fair values of short-term investments approximate their book values due to their short maturities. The fair values of available for sale securities are based on bid quotations from third party data providers. The fair values of loans are estimated for portfolios with similar financial characteristics and takes into consideration discounted cash flows based on expected maturities or repricing dates utilizing estimated market discount rates as projected by third party data providers.
Transaction deposit accounts, which include checking, money market and savings accounts, are presumed to have equal book and fair values because the interest rates paid on these accounts are based on prevailing market rates. The fair value of time deposits is based upon the discounted value of contractual cash flows, which is estimated using current rates offered for deposits of similar remaining terms. The fair value of short-term borrowings approximates book value due to their short maturities. The fair value of FHLB advances is estimated by discounting the cash flows through maturity or the next repricing date based on current rates offered by the FHLB for borrowings with similar maturities. The fair value of junior subordinated debt securities is estimated by discounting the cash flows through maturity based on current rates offered on the 30-year Treasury bond.
The Asset/Liability Committee is authorized to utilize a wide variety of off-balance sheet financial techniques to assist in the management of interest rate risk. The Bank has sometimes used derivative instruments, primarily interest rate swap and cap agreements, as part of its management of asset and liability positions in connection with its overall goal of minimizing the impact of interest rate fluctuations on the Bank's net interest margin or its stockholders' equity. These contracts are entered into for purposes of reducing the Bank's interest rate risk and not for trading purposes. At March 31, 2002, the Bank has one remaining interest rate cap agreement with a notional amount of $18 million and a fair value, based on quoted market price, of approximately zero. This interest cap agreement is tied to the three-month LIBOR and will mature in October 2002.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES OF MARKET RISKS
For quantitative and qualitative disclosures regarding market risks in the Bank's portfolio, see, "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations—Asset Liability and Market Risk Management."
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Neither the Bank nor the Company is involved in any material legal proceedings. The Bank, from time to time is party to litigation which arises in the ordinary course of business, such as claims to enforce liens, claims involving the origination and servicing of loans, and other issues related to the business of the Bank. In the opinion of management, based upon the advice of legal counsel, the resolution of any such issues would not have a material adverse impact on the financial position, results of operations, or liquidity of the Bank or the Company.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
No events have transpired which would make response to this item appropriate.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. ITEM EXHIBITS AND REPORTS ON FORM 8-K
All other material referenced in this report which is required to be filed as an exhibit hereto has previously been submitted.
The Company filed no reports on Form 8-K during the first quarter of 2002.
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SIGNATURE
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.
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