UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
OR
Commission file number 0-7949
BANCWEST CORPORATION
Registrant’s telephone number, including area code: (808) 525-7000
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed bySection 13 or l5(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 o Noo
Indicate by check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes o No þ
As of August 1, 2003 the number of outstanding shares of each of the issuer’s classes ofcommon stock (all of which were beneficially owned by BNP Paribas) was:
TABLE OF CONTENTS
FORM 10-QJune 30, 2003
INDEX
The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with BancWest Corporation’s 2002 Annual Report on Form 10-K.
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
BancWest Corporation and SubsidiariesCONSOLIDATED STATEMENTS OF INCOME (Unaudited)
The accompanying notes are an integral part of these consolidated financial statements.
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BancWest Corporation and SubsidiariesCONSOLIDATED BALANCE SHEETS (Unaudited)
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BancWest Corporation and SubsidiariesCONSOLIDATED BALANCE SHEETS, Continued (Unaudited)
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BancWest Corporation and SubsidiariesCONSOLIDATED STATEMENTS OFCHANGES IN STOCKHOLDER’S EQUITY AND COMPREHENSIVE INCOME (Unaudited)
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BancWest Corporation and SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
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BancWest Corporation and SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. Summary of Significant Accounting Policies
Descriptions of the significant accounting policies of BancWest Corporation and Subsidiaries (BancWest, the Company or we/our) are included in Note 1 (Summary of Significant Accounting Policies) to the audited consolidated financial statements included in the Company’s 2002 Annual Report on Form 10-K. There have been no significant changes to these policies.
Reclassifications
The 2002 Consolidated Financial Statements were reclassified in certain respects to conform to the 2003 presentation. Such reclassifications did not have a material effect on the Consolidated Financial Statements.
2. Mergers and Acquisitions
United California Bank Acquisition
On March 15, 2002, BancWest completed its acquisition of all outstanding common stock of United California Bank (UCB) from UFJ Bank Ltd. of Japan (UFJ). UCB was subsequently merged with and into Bank of the West in April 2002 and its branches were integrated into the Company’s branch network system in the third quarter of 2002. On the date of acquisition by BancWest, UCB had 115 branches (located exclusively in California), total assets of $10.1 billion, net loans of $8.5 billion and total deposits of $8.2 billion. The preceding amounts do not include purchase price adjustments. UCB’s strong presence in Southern California complements BancWest’s existing network in Northern California, Nevada, New Mexico and the Pacific Northwest. Results of operations of UCB are included in our Consolidated Financial Statements beginning on March 15, 2002. The purchase price of approximately $2.4 billion was paid in cash and accounted for as a purchase. BNP Paribas funded BancWest’s acquisition of UCB by providing $1.6 billion of additional capital and lending the Company $800 million. We expect to achieve cost savings for the combined company of approximately $75 million per year beginning in 2003. These anticipated cost savings primarily involve compensation and occupancy-related expenses.
The following table provides an allocation of the purchase price:
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BancWest Corporation and SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Continued)
BancWest incurred expenses associated with exiting certain branches, operational centers and technology platforms of the pre-merged Bank of the West, as well as certain other conversion and restructuring expenses, totaling approximately $18 million. Exit costs associated with UCB were considered as part of the purchase accounting for the acquisition. BancWest established a severance reserve of approximately $40.5 million. Approximately 750 employees throughout the combined organization have been or will be displaced in conjunction with the acquisition. As of June 30, 2003, this initiative was substantially complete. In addition to the severance reserve, we recorded the following accruals: $34.5 million for losses on subleases, $8.0 million for contract cancellations, $1.3 million for relocation and other. From the date of acquisition to June 30, 2003, we made the following adjustments to the reserves: $6.9 million increase for severance, $7.5 million decrease for losses on subleases, $4.9 million increase for contract cancellations and $0.2 million decrease for relocation. In addition, the reserves were decreased as follows: $36.6 million for severance payments, $7.9 million for sublease loss amortization, $7.9 million for contract cancellation payments and $0.9 million for relocation and other payments.
The following unaudited pro forma financial information for the three and six months ended June 30, 2002, assumes that the UCB acquisition occurred as of January 1, 2002, after giving effect to certain adjustments. The pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the results of operations which may occur in the future or which would have occurred had the UCB acquisition been consummated as of January 1, 2002:
In conjunction with the purchase of UCB from UFJ Bank Ltd. of Japan, there were certain items that were in dispute. The disputed items were related to UCB’s loan charge-offs and its deferred tax liability. In March 2003, an arbitrator decided in favor of BancWest on both matters. Interest on the disputed amounts totaled $0.8 million, which was recognized in other income during the first quarter of 2003. The resolution of the loan charge-off issue was a receivable due from UFJ of $8.9 million, an increase to our allowance for credit losses of $13.6 million, representing recoveries of loans charged off by BancWest, and a related decrease to our deferred tax liability of $4.7 million. Upon resolution of the deferred tax issue during the first quarter of 2003, we reassessed the adequacy of UCB’s deferred tax liability and reduced the related goodwill by $14.9 million. All cash due from UFJ as a result of the arbitrator’s decision was received in April 2003.
3. Derivative Financial Instruments
Any portion of the changes in the fair value of a derivative designated as a hedge that is deemed ineffective is recorded in current period earnings; this amount was not material in the three and six months ended June 30, 2003.
Fair Value Hedges
The Company has various derivative instruments that hedge the fair values of recognized assets or liabilities or of unrecognized firm commitments (fair value hedges). At June 30, 2003, the Company carried an interest rate swap of $2.8 million with a fair market value loss of $0.9 million that was categorized as a fair value hedge for a commercial loan. The Company receives 1-month LIBOR and pays a fixed rate of 8.32%.
At June 30, 2003, we carried a $150 million interest rate swap with BNP Paribas to hedge obligations under the 9.5% BancWest Capital I Quarterly Income Preferred Securities. We pay 3-month LIBOR plus 3.69% and receive fixed payments at 9.5%. The fair market value gain of the swap at June 30, 2003 was $5.3 million.
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Cash Flow Hedges
At June 30, 2003, the Company carried interest rate swaps of $600 million with a fair market value gain of $64.6 million which were categorized as cash flow hedges, to hedge our LIBOR-based commercial loans. The interest rate swaps were entered into during 2001 by UCB and mature in 2006. We pay 3-month LIBOR and receive fixed rates ranging from 5.64% to 5.87%. The net settlement on the $600 million swaps has increased commercial loan interest income by $11.7 million from January 1, 2003 through June 30, 2003. The Company estimates net settlement gains, recorded as commercial loan interest income, of $25.4 million over the next twelve months resulting from these hedges.
During June 2003, the Company entered into interest rate swaps totaling $50 million in order to reduce exposure to interest rate increases associated with short-term fixed rate liabilities. The swaps hedge forecasted transactions associated with short-term fixed rate liabilities. The swaps mature as follows: $20 million in 2013, $20 million in 2018 and $10 million in 2023. We pay fixed rates ranging from 3.64% to 4.47% and receive 3 month LIBOR. There has been no effect on net income from these swaps year-to-date 2003. The Company estimates a net increase to interest expense of $1.4 million over the next twelve months resulting from these hedges.
Free-standing Derivative Instruments
Free-standing derivative instruments include derivative transactions entered into for risk management purposes that do not otherwise qualify for hedge accounting. Interest rate lock commitments issued on residential mortgage loans intended to be held for resale are considered free-standing derivative instruments. The interest rate exposure on these commitments is economically hedged primarily with best efforts forward sale contracts. The commitments and free-standing derivative instruments are marked to market and recorded as a component of noninterest income in the consolidated statement of income. Once a loan commitment is funded, the same forward sale contract is designated as a fair value hedge of the loan held for sale, as described above. Trading activities primarily involve providing various free-standing interest rate and foreign exchange derivative products to customers. Interest rate derivative instruments utilized by the Company in its trading operations include interest rate swaps, caps, floors and collars.
The following table summarizes derivatives held by the Company as of June 30, 2003 and 2002:
4. Operating Segments
Our reportable segments are the ones we use in our internal reporting at Bank of the West and First Hawaiian Bank (First Hawaiian). Bank of the West’s segments operate primarily in California, Oregon, Washington, Idaho, New Mexico and Nevada. As discussed below, certain Bank of the West segments conduct business nationwide. Although First Hawaiian’s segments operate primarily in Hawaii, First Hawaiian also has significant operations outside the state, such as leveraged leases, international banking and branches in Guam and Saipan.
The results of each segment are determined by our management accounting process, which assigns balance sheet and income statement items to each reporting segment. The net interest income of each segment includes the results of the Bank’s transfer pricing process, which assesses an internal funds charge on all segment assets and a funds credit on all segment liabilities. The internal charges and credits assigned to each asset and liability are intended to match the maturity, repayment and interest rate characteristics of that asset or liability. With the exception of goodwill, assets are allocated to each business segment on the basis of assumed benefit to their business operations. Goodwill is assigned on the basis of projected future earnings of the segments. The process of management accounting is dynamic and subjective. There is no comprehensive or authoritative guidance which can be followed.
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Bank of the West
Bank of the West manages its operations through three business segments: Regional Banking, Commercial Banking and Consumer Finance.
Regional Banking:
Regional Banking seeks to serve a broad customer base by furnishing a wide range of retail and commercial banking products. Deposit products offered by this segment include checking accounts, savings deposits, market rate accounts, Individual Retirement Accounts and time deposits. Regional Banking utilizes its branch network as its principal funding source. Bank of the West’s telephone banking service, a network of automated teller machines and the online eTimeBanker service provide retail customers with other means of accessing and managing their accounts.
Through its branch network, this business segment originates a variety of consumer loans, including direct vehicle loans, lines of credit and second mortgages. In addition, Regional Banking originates and holds a portfolio of first mortgage loans on one- to four-family residences. Through its commercial banking operations conducted from its branch network, Regional Banking offers a wide range of commercial banking products intended to serve the needs of smaller community-based businesses. These include in-branch originations of standardized loan and deposit products for businesses with relatively simple banking and financing needs. More complex and customized commercial banking services are offered through Bank of the West’s regional banking centers, which serve clusters of branches and provide lending, deposit and cash management services to companies operating in the relevant market areas. Regional Banking also provides a number of fee-based products and services such as annuities, insurance and securities brokerage.
The Regional Banking Segment includes a Business Banking Division which supports commercial lending activities for middle market business customers through Business Banking centers located throughout California, as well as Portland, Oregon, Reno and Las Vegas, Nevada and Albuquerque, New Mexico. The Regional Banking Segment also includes a Pacific Rim Division which offers multilingual services through a branch network in predominately Asian American communities in California, with specialized domestic and international products and services for both individuals and companies.
Commercial Banking:
The Commercial Banking Segment supports business clients with revenues between $25 million and $350 million. This segment’s clients include those engaged in agribusiness, real estate industries, as well as, churches, Small Business Administration (SBA) and equipment leasing clients. Equipment leasing is available through the Bank’s commercial offices, branches, brokers across the nation and its subsidiary, Trinity Capital. Trinity specializes in nationwide vendor leasing and servicing programs for manufacturers in specific markets.
Services offered include cash management, trade finance, correspondent banking services and syndication of commercial credits exceeding $30 million.
Consumer Finance:
The Consumer Finance Segment targets the origination of auto loans and leases in the western United States, and recreational vehicle and marine loans nationwide, with emphasis on originating credits at the high end of the credit spectrum. These loans and leases are originated through a network of auto dealers and recreational vehicle and marine dealers serviced by sales representatives located throughout the country. This segment also includes Bank of the West’s wholly-owned subsidiary, Essex Credit Corporation, which focuses on the origination of marine and recreational vehicle loans directly with customers. Essex has office locations throughout the United States and sells substantially all of its loans to investors servicing released for a fee.
First Hawaiian Bank
First Hawaiian manages its operations through the following business segments: Retail Banking, Consumer Banking, Commercial Banking and Financial Management.
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Retail Banking:
First Hawaiian’s Retail Banking Segment operates its main banking office in Honolulu, Hawaii, and 55 other banking offices located throughout Hawaii. First Hawaiian also operates three branches in Guam and two branches in Saipan.
The focus of First Hawaiian’s retail/community banking strategy is primarily in Hawaii, where it has a 40% market share of the domestic bank deposits of individuals, corporations and partnerships in the state as of June 30, 2003. Thanks to its significant market share in Hawaii, First Hawaiian already has product or service relationships with a majority of the households in the state. Therefore, a key goal of its retail community banking strategy is to build those relationships by cross-selling additional products and services to existing individual and business customers.
In pursuing the community banking markets in Hawaii, Guam and Saipan, First Hawaiian seeks to serve a broad customer base by furnishing a range of retail and commercial banking products. Through its branch network, First Hawaiian generates first-mortgage loans on residences and a variety of consumer loans, consumer lines of credit and second mortgages. Through commercial banking operations conducted from its branch network, First Hawaiian offers a wide range of banking products intended to serve the needs of smaller, community-based businesses. First Hawaiian also provides a number of fee-based products and services such as annuities and mutual funds, insurance and securities brokerage.
To complement its branch network and serve these customers, First Hawaiian operates a system of automated teller machines, a 24-hour phone center in Honolulu and a full-service Internet banking system.
Consumer Banking:
Consumer Lending: First Hawaiian offers many types of loans and credits to consumers, including lines of credit (uncollateralized or collateralized) and various types of personal and automobile loans. First Hawaiian also provides indirect consumer automobile financing on new and used autos by purchasing finance contracts from dealers. First Hawaiian’s Dealer Center is one of the largest commercial bank automobile lenders in the State of Hawaii. First Hawaiian is the largest issuer of MasterCard® credit cards and VISA® credit cards in Hawaii.
Real Estate Lending-Residential: First Hawaiian makes residential real estate loans, including home-equity loans, to enable borrowers to purchase, refinance, improve or construct residential real property. The loans are collateralized by mortgage liens on the related property, substantially all located in Hawaii. First Hawaiian also originates residential real estate loans for sale on the secondary market.
Commercial Lending: First Hawaiian is a major lender to small and medium-sized businesses in Hawaii and Guam. Lending services include receivable and inventory financing, equipment term loans, letters of credit, dealer vehicle flooring financing and trade financing. To support the cash management needs of both commercial banking customers and large private and public deposit relationships maintained with the bank, First Hawaiian operates a Cash Management Department which provides a full range of innovative and relationship-focused cash management services.
Real Estate Lending-Commercial: First Hawaiian provides permanent financing for a variety of commercial developments, such as retail facilities, warehouses and office buildings.
International Banking Services: First Hawaiian maintains an International Banking Division which provides international banking products and services through First Hawaiian’s branch system, its international banking headquarters in Honolulu, a Grand Cayman branch, three Guam branches, two branches in Saipan and a representative office in Tokyo, Japan. First Hawaiian maintains a network of correspondent banking relationships throughout the world.
First Hawaiian’s international banking activities are primarily trade-related and are concentrated in the Asia-Pacific area.
Financial Management:
Trust and Investment Services: First Hawaiian’s Financial Management Segment offers a full range of trust and investment management services, and also seeks to reinforce customer relationships developed by or in conjunction with the Retail Banking
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Segment. The Financial Management Segment provides asset management, advisory and administrative services for estates, trusts and individuals. It also acts as trustee and custodian of retirement and other employee benefit plans. At June 30, 2003, the Trust and Investments Division had approximately 4,000 accounts with a market value of $8.2 billion. Of this total, $6.0 billion represented assets in nonmanaged accounts and $2.2 billion were managed assets.
Securities and Insurance Services: First Hawaiian, through a wholly-owned subsidiary, First Hawaiian Insurance, Inc., provides insurance brokerage services for personal, business or estate insurance to its customers. First Hawaiian Insurance offers insurance needs analysis for individuals, families and businesses, as well as life, disability and long-term care insurance products. In association with an independent registered broker-dealer, First Hawaiian offers mutual funds, annuities and other securities in its branches.
Private Banking Services: The Private Banking Department within First Hawaiian’s Financial Management Segment provides a wide range of products to high-net-worth individuals.
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BancWest Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Continued)
The tables below present information about the Company’s operating segments as of or for the periods indicated:
[Additional columns below]
[Continued from above table, first column(s) repeated]
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(1) The material net interest income and noninterest income items in the Other column relate to Treasury activities of $21.3 million and $38.1 million and unallocated other income of $3.6 million and $7.9 million for the three and six months ended June 30, 2003, respectively. The material net interest income and noninterest income items in the Other column for the three and six months ended June 30, 2002 resulted substantially from Treasury activities of $12.9 million and $18.1 million and unallocated other income of $12.9 million and $16.6 million, respectively.
The material noninterest expense items in the Other column for the three and six months ended June 30, 2003, are substantially derived from Treasury activities and unallocated administrative items. The noninterest expense items in the Other column for the three months ended June 30, 2002 are mostly the result of unallocated merger-related costs of $2.7 million, Treasury activities of $4.4 million and unallocated administrative items of $3.0 million. The material noninterest expense items in the Other column for the six months ended June 30, 2002 resulted primarily from Treasury activities of $7.1 million, unallocated merger-related costs of $8.8 million and unallocated administrative items of $3.9 million.
The material average asset items in the Other column relate to unallocated Treasury securities for the periods presented.
The material average deposit items in the Other column relate to unallocated Treasury balances for the three and six months ended June 30, 2003 and 2002.
(2) Other is composed of Administrative and Syndicated and Media Lending. Administrative represents administrative support areas including Information Management and Operations and Finance and Investment.
The material items in Other were related to the following for the periods presented:
The material items in noninterest income were primarily from unallocated Treasury activities.
The material items in noninterest expense consist primarily of unallocated costs.
The material items in the Other column relate to average assets that are unallocated Treasury securities for the periods presented. The material items in the Other column relate to average deposits that are unallocated balances for the three and six months ended June 30, 2003 and 2002.
(3) The Other BancWest category in the table above consists primarily of BancWest Corporation (Parent Company), FHL Lease Holding Company, Inc., BancWest Capital I and First Hawaiian Capital I.
(4) The reconciling items in the above table are principally intercompany eliminations.
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The Company adopted SFAS 142 on January 1, 2002. The most significant changes made by SFAS 142 are that goodwill and other indefinite-lived intangible assets are no longer amortized and will be tested for impairment at least annually. As of June 30, 2003, the Company had goodwill of $3.2 billion. The table below provides the breakdown of goodwill by reportable segment and the change during the year.
The estimated annual amortization expense for finite-lived intangible assets, primarily core deposit intangibles arising from the BNP Paribas merger and the acquisition of UCB, is approximately $23 million (pre-tax) for each of the years from 2003 to 2007. The details of our intangible assets are depicted below:
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BancWest Corporation and SubsidiariesMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Headquartered in Honolulu, Hawaii, with offices in San Francisco, BancWest is a financial holding company with assets in excess of $36 billion at June 30, 2003. BancWest, through its subsidiaries, operates a general commercial banking business and other businesses related to banking. Its principal assets are its investments in Bank of the West, a State of California-chartered bank; and First Hawaiian, a State of Hawaii-chartered bank. We provide a wide range of general commercial banking services, providing retail and corporate banking, trust and insurance services to individuals, institutions, businesses and governments.
Net income for the second quarter of 2003 was $107.7 million, compared with $96.6 million for the second quarter of 2002. Net income for the first six months of 2003 was $209.7 million compared with $162.0 million for the same period in 2002. Net interest income was $321.3 million for the second quarter of 2003 and $636.6 million for the first six months of 2003 compared with $321.9 million and $546.4 million for the same periods of 2002. Noninterest income was $100.6 million and $195.4 million for the second quarter and first half of 2003, respectively, compared with $88.4 million and $151.1 million for the same periods in 2002. Noninterest expense totaled $229.8 million and $450.4 million for the second quarter and first half of 2003, respectively, compared with $228.8 million and $387.9 million for the same periods of 2002.
BancWest had total assets of $36.4 billion at June 30, 2003, up 7.3% from a year earlier. Investment Securities totaled $5.1 billion, an increase of 49.8% as compared to the same period in 2002. Loans and leases totaled $25.0 billion, an increase of 3.7% compared to the same period in 2002. Deposits were $25.0 billion, up 3.8%.
BancWest’s nonperforming assets were reduced significantly to 0.75% of loans and foreclosed properties at June 30, 2003, an improvement from 1.04% at June 30, 2002. The provision for credit losses was $18.9 million for the second quarter of 2003 compared to $22.9 million for the same period in 2002. BancWest’s allowance for credit losses was 1.57% of total loans and leases at June 30, 2003, compared to 1.59% at December 31, 2002 and 1.61% at June 30, 2002.
NEW PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board (FASB) issued Financial Interpretation 46, Consolidation of Variable Interest Entities (FIN 46). Previously, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN 46 changes that by requiring a variable interest entity (VIE) to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE’s activities or entitled to receive a majority of the VIE’s residual returns or both. The company that consolidates the VIE is its primary beneficiary. The consolidation requirements of FIN 46 apply immediately to VIEs created after January 31, 2003 and to all VIEs for interim periods beginning after June 15, 2003. We have not been party to the creation of any VIEs since January 31, 2003. However, we are party to three VIEs that were created prior to January 2003.
REFIRST, Inc. is a VIE that was created by a nonrelated third party to construct, finance and hold title to our administrative headquarters building in Honolulu, First Hawaiian Center (FHC). We entered into a noncancelable operating lease for FHC with REFIRST, Inc. that terminates on December 1, 2003. Our intention is to purchase FHC at the end of the lease term. Prior to July 1, 2003, we were not required to consolidate REFIRST, Inc. into our Consolidated Financial Statements. However, upon our implementation of FIN 46, REFIRST, Inc. was consolidated into BancWest effective July 1, 2003 and will be included in our future Consolidated Financial Statements. In addition, the depreciation expense of FHC and interest expense on the financing will be included on our Consolidated Statements of Income and Consolidated Statements of Cash Flows on a prospective basis. The provisions of FIN 46 require us to record a cumulative effect of an accounting change upon its implementation. The amount of such cumulative effect, (essentially, a retrospective depreciation charge for an 18- month period covering the time in which the building was last revalued for purchase-accounting purposes) as it relates to the consolidation of REFIRST, Inc., recognized in July 2003 was an after-tax charge to earnings of approximately $2.4 million. Additionally, we increased the total assets by approximately $160 million (principally due to the addition of the FHC building), increased debt by approximately $193.9 million, reduced the deferred tax liability by approximately $1.7 million and decreased the reserve for the guaranteed residual value upon lease termination of $30 million.
As of June 30, 2003, BancWest Capital I (BWE Trust) and First Hawaiian Capital I (FH Trust) (the Trusts) were fully consolidated subsidiaries of BancWest Corporation. The Trusts issued preferred and common capital securities. The preferred capital securities
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BancWest Corporation and SubsidiariesMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS (Continued)
were sold to the public; BWE owns the common securities. The purpose of these entities is to allow for the issuance of preferred capital securities that qualify for inclusion in Tier 1 regulatory capital. At the Trusts’ inception, we issued junior subordinated deferrable interest debentures to the Trusts in return for either capital securities, in the case of BWE Trust, or the proceeds from capital securities that were issued from FH Trust. In the attached Consolidated Financial Statements, we report the preferred securities sold to the public on our Consolidated Balance Sheets as “Guaranteed preferred beneficial interests in Company’s junior subordinated debentures,” and we include the interest payments related to these securities on our Consolidated Statements of Income and Consolidated Statements of Cash Flows as interest expense on long-term debt. As we are not the primary beneficiary of the Trusts, effective July 1, 2003 these Trusts will be deconsolidated and will not be included in future Consolidated Financial Statements. The $263 million of “Guaranteed preferred beneficial interests in Company’s junior subordinated debentures” will no longer be presented on the Company’s balance sheet. Instead, the junior subordinated debentures issued by BWE to the Trusts will be included as part of long-term debt on the balance sheet. The deconsolidation will not have a material impact on our consolidated financial position, cash flows or, subject to further guidance from the Federal Reserve Board, Tier 1 capital. There will be no cumulative effect on income as a result of the deconsolidation.
In April 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting. SFAS 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. This statement will be applied prospectively and is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.
In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). SFAS 150 establishes standards for the classification and measurement of financial instruments with characteristics of both liabilities and equity. This standard is effective beginning in the third quarter of 2003. We do not expect the adoption of this standard to have a material impact on our consolidated financial position, results of operations or cash flows.
FORWARD-LOOKING STATEMENTS
Certain matters contained in this filing are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Our forward-looking statements (such as those concerning our plans, expectations, estimates, strategies, projections and goals) involve risks and uncertainties that could cause actual results to differ materially from those discussed in the statements. Readers should carefully consider those risks and uncertainties in reading this report. Factors that could cause or contribute to such differences include, but are not limited to: (1) global, national and local economic and market conditions, specifically with respect to changes in the United States economy and geopolitical uncertainties; (2) the level and volatility of interest rates and currency values; (3) government fiscal and monetary policies; (4) credit risks inherent in the lending process; (5) loan and deposit demand in the geographic regions where we conduct business; (6) the impact of intense competition in the rapidly evolving banking and financial services business; (7) extensive federal and state regulation of our business, including the effect of current and pending legislation and regulations; (8) whether expected revenue enhancements and cost savings are realized within expected time frames; (9) matters relating to the integration of our business with that of past and future merger partners, including the impact of combining these businesses on revenues, expenses, deposit attrition, customer retention and financial performance; (10) our reliance on third parties to provide certain critical services, including data processing; (11) the proposal or adoption of changes in accounting standards by the FASB, the Securities and Exchange Commission (SEC) or other standard setting bodies; (12) technological changes; (13) other risks and uncertainties discussed in this document or detailed from time to time in other SEC filings that we make; and (14) management’s ability to manage risks that result from these and other factors. Our forward-looking statements are based on management’s current views about future events. Those statements speak only as of the date on which they are made. We do not intend to update forward- looking statements, and, except as required by law, we disclaim any obligation or undertaking to update or revise any such statements to reflect any change in our expectations or any change in events, conditions, circumstances or assumptions on which forward-looking statements are based.
MONETARY POLICY AND ECONOMIC CONDITIONS
Our earnings and businesses are affected not only by general economic conditions (both domestic and international), but also by the monetary policies of various governmental regulatory authorities of (i) the United States and foreign governments and (ii)
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international agencies. In particular, our earnings and growth may be affected by actions of the Federal Reserve Board in connection with its implementation of national monetary policy through its open market operations in United States Government securities, control of the discount rate and establishment of reserve requirements against both member and non-member financial institutions’ deposits. These actions have a significant effect on the overall growth and distribution of loans and leases, investments and deposits, as well as on the rates earned on loans and leases or paid on deposits. It is difficult to predict future changes in monetary policies.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of June 30, 2003. We have established policies and procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. However, given the sensitivity of our Consolidated Financial Statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition.
Our accounting policies are discussed in detail in the notes to the Consolidated Financial Statements, Note 1 of our 2002 Annual Report on Form 10-K. Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified two policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our Consolidated Financial Statements.
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CONSOLIDATED FINANCIAL HIGHLIGHTS (Unaudited)
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NET INTEREST INCOME
Net interest income decreased 0.2% in the three months ended June 30, 2003 to $321.3 million from $321.9 million in the corresponding period last year. Net interest income increased to $636.6 million, a growth of 16.5% in the six months ending June 30, 2003 from $546.4 million in the same six-month period last year. The margins in the three and six-month periods ending June 30, 2003 decreased in a record low interest rate environment in which the yields on our earning assets declined faster than the rates on our funding sources, resulting in a negative impact to net interest income that is presented in our three-month comparison. The increase in the six-month period was primarily due to changes in our earning assets portfolio and shifts in our deposits.
Average earning assets increased by $1.6 billion and $5.1 billion or 5.8% and 21.4%, respectively, in the three and six months ended June 30, 2003 from the corresponding periods last year. These increases were primarily driven by purchases of investment securities, residential real estate loans and originations of consumer loans. In addition, our March 2002 acquisition of United California Bank (UCB) increased both our investment securities and loans and leases. We significantly increased our purchasing of investment securities in the three months ended June 30, 2003 from the comparable period last year. Average investment securities increased $1.4 billion and $1.4 billion or 42.6% and 47.5%, respectively, in the three and six-month periods ended June 30, 2003 compared to the corresponding periods last year. Average loans and leases outstanding grew slightly during the three-month period ended June 30, 2003 and 17.9% or $3.7 billion during the six-month period ended June 30, 2003 compared to the same periods last year.
For the three and six months ended June 30, 2003 interest-bearing demand deposits decreased 29.3% and 25.3% or $112.6 million and $91.1 million. Savings deposits increased $753.8 million and $2.3 billion or 8.1% and 31.1%, respectively for the three and six months ended June 30, 2003 compared to last year. Short-term borrowing decreased 20.9% and 7.5% or $505.7 million and $140.7 million, respectively, offset by a significant increase in long-term borrowing of 55.8% and 53.1% or $1.3 billion and $1.2 billion in the three and six-month periods, respectively, ending June 30, 2003 from the same periods in 2002. The shift from short-term to long-term debt was primarily a result of finalizing the long-term financing for the portion of the UCB acquisition ($800 million) that had been financed during the interim with short-term debt.
In addition to a falling interest rate environment, our cost of funds was lowered by an increase in average noninterest-bearing deposits in the three and six months ended June 30, 2003 as compared to the same periods in 2002. The percentage of average noninterest-bearing deposits to total average deposits for the three and six months ended June 30, 2003 increased to 28.4% and 28.1%, respectively, from 24.5% and 23.7% for the same periods in 2002.
The following table sets forth consolidated average balance sheets, as well as an analysis of interest income/expense and yield/rate for each major category of interest-earning assets and interest-bearing liabilities for the periods indicated on a taxable equivalent basis. The tax equivalent adjustment is made for items exempt from federal income taxes (assuming a 35% tax rate for 2003 and 2002) to make them comparable with taxable items before any income taxes are applied.
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NONINTEREST INCOME
The following table reflects the key components of the change in noninterest income for the three and six months ended June 30, 2003, as compared to the same periods in 2002:
As the table above shows in detail, noninterest income increased by 13.7% and 29.4% for the three and six months ended June 30, 2003, respectively, compared to the same periods in 2002. The increase in service charges on deposit accounts for the three months ended June 30, 2003 is primarily due to an increase in the average deposits and modest repricing within the California market. The increase in other service charges and fees compared to the same period last year is primarily due to higher income from prepayment and penalty fees on commercial loans, higher lease servicing income from the acquisition of Trinity Capital in November 2002 higher account analysis fees and increased debit card usage. The increase in other noninterest income is primarily due to increased income from the sale of a lease.
Much of the increase in noninterest income for the six months ended June 30, 2003 from June 30, 2002 is attributable to the acquisition of UCB, which did not take place until March 15, 2002. In large part due to this acquisition, year-to-date average deposit balances increased approximately 18.6% for the six months ended June 30, 2003 as compared to the same period in the prior year. This increase in average deposits is the primary cause for the increase in service charges on deposit accounts. The increase in other service charges and fees is also partially attributable to the UCB acquisition, but other factors explaining the increase include higher debit card income and higher income from prepayment and penalty fees on commercial loans. Other noninterest income increased for the six months ended June 30, 2003 compared to the six months ended June 30, 2002 due to the UCB acquisition and a gain on the sale of a lease.
Approximately $1.5 million and $3.4 million in gains on the sale of investment securities were recognized in the three and six months ended June 30, 2003, respectively.
NONINTEREST EXPENSE
The following table reflects the key components of the change in noninterest expense for the three and six months ended June 30, 2003 as compared to the same periods in 2002:
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As the table above shows in detail, the change in noninterest expense from the previous year was not material in the second quarter. The increase in benefits is primarily attributable to higher workers’ compensation insurance, higher group healthcare insurance and increased retirement plan expense. The increase in other expense is primarily attributable to higher depreciation expense on software, higher general liability and property insurance, increased charitable contributions and a $4.7 million charge in the second quarter of 2003 for restructuring a leveraged lease in FHL Lease Holding Company, Inc.
In the six months ended June 30, 2003 noninterest expense increased 16.1% compared to the same period in 2002. The increase in noninterest expense is predominately due to the UCB acquisition, which was finalized on March 15, 2002. The increase in workers’ compensation insurance, group healthcare insurance and retirement plan expenses also contributed to the increase in employee benefits. Increases in other expenses include certain fees and software depreciation that we incurred this year that were not incurred in 2002 as well as the leveraged lease restructuring charge mentioned above.
OPERATING SEGMENT RESULTS
Regional Banking segment’s net income was $29.4 million in the second quarter, compared with $34.7 million for the same period in 2002, a decrease of 15.3%. Net interest income decreased 9.4% from $133.2 million in the three months ended June 30, 2002 to $120.7 million this year. Noninterest income increased 5.6% in the three months ended June 30, 2003 from the same period last year. Noninterest expense decreased 2.1%. The provision for credit allowances increased 65.4% from $2.6 million to $4.3 million.
Charges on deposit accounts increased 6% in the three months ended June 30, 2003 compared to the same quarter last year primarily due to a 3.8% increase in the number of personal and business demand deposit accounts as well as some modest repricing efforts in the
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California markets. Other service charges increased $1.9 million or 34% in the three months ended June 30, 2003 from the same period last year due to interchange revenue and increased volume in debit card usage with the addition of the MasterCard® product and the former UCB customer base. Occupancy expenses decreased in the second quarter of 2003 compared to the corresponding period last year due to the consolidation of 15 branch sites. Marketing expenses increased $1.4 million or 34% in the three months ended June 30, 2003 compared to last year due to increased spending on name recognition, promotions and campaign efforts to penetrate Southern California geographical markets and retain the acquired UCB customer base. Increases in other expenses for this period were due to accounting process changes for acquired UCB branch activities, such as the recording of certain losses and legal expenses.
Average loans outstanding decreased 10.8% from the second quarter of 2002 while average assets and deposits remained relatively flat from the same quarter last year. The decline in average loans was due to a $292 million decline in installment loans and a $240 million decline in commercial loans.
Net income for the first half of 2003 was $59.8 million compared to $58.8 million for the six months ended June 30, 2002, an increase of 1.7%. Net interest income increased 10.0% from $220.6 million in the six months ended June 30, 2002 to $242.6 million year-to-date this year, primarily due to the acquisition of UCB branches on March 15, 2002. Noninterest income increased 23.9% compared to the corresponding period last year. Noninterest expense increased $33.6 million or 18.4% in the six months ended June 30, 2003 from the same period last year. The provision for credit losses increased $3.4 million primarily from the UCB merger and the significant increase in the size of our loan portfolio.
Noninterest income categories, including service charges on deposit accounts and trust and investment income, increased during the six months ended June 30, 2003 over the same period last year due, in part to the UCB acquisition. Other service charges increased $6.8 million or 62% in the six months ended June 30, 2003 from the corresponding period last year, $3.4 million was due to debit interchange income, reflecting the combined VISA® and acquired MasterCard® accounts. Noninterest expense increased in the six months ended June 30, 2003 over this period last year primarily due to the acquisition of UCB and in part to a 22% rise in group insurance costs.
Average deposit balances in the six months ended June 30, 2003 grew approximately 19.0% over last year. Deposit margins have decreased from 2.65% to 2.21% in the six months ended June 30, 2003 from the same period in the prior year due to the record low interest rate environment which has significantly reduced the value of core-deposit products. Although the record low interest rate environment has also significantly increased early loan prepayments as retail customers sought to refinance their borrowings with lower rate loans, loan margins have increased slightly from 2.48% to 2.66%.
Commercial Banking segment’s net income increased 22.3% in the three months ended June 30, 2003 from $32.8 million in the three months ended June 30, 2002 to $40.1 million this year. Net interest income increased 3.6%. Noninterest income increased $4.3 million or 44.3% in this quarter compared to the second quarter of 2002. Noninterest expense increased 6.8% and the provision for credit losses decreased significantly.
Net interest income increased in the three months ended June 30, 2003 despite a declining interest rate environment that eroded margins on deposits. Net interest income increased in the second quarter due to a 41 basis point increase over the prior quarter in the margin on loans and leases, while yields on deposits dropped 141 basis points due to lower transfer pricing rates from the second quarter of 2002. The increase in loan and lease margins reflects a change in portfolio mix between loans and leases, with higher yielding leases obtained through the Trinity Capital acquisition replacing lower yielding loans. The increase in the three months ended June 30, 2003 from the same period in the previous year in noninterest income was primarily due to a $1.7 million increase to portfolio servicing revenue in Trinity Capital. Prepayment penalty fees and increased loan fees associated with portfolio growth in Small Business Administration (SBA), Church Lending, and Healthcare also contributed to the increase. Noninterest expense increased in the second quarter compared to the corresponding period last year due to the acquisition of Trinity Capital.
Net income for the six months ended June 30, 2003 increased $28.7 million or 61.2% from $46.9 million in the first half of 2002 to $75.6 million this year. Noninterest income also increased significantly from $11.6 million last year to $25.4 million in the six months ended June 30, 2003. Noninterest expense increased $21.3 million or 55.2% and the provision for credit losses decreased significantly.
The Commercial Banking Segment achieved growth in loans and growth in net income due to strong performance in SBA, Church Lending, Healthcare, and Business Services in the six months ended June 30, 2003. Other areas, primarily commercial, agribusiness and real estate lending, declined in the first half of 2003, compared to 2002. The decline was largely due to lower net interest margins
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on deposits. Careful management of asset quality resulted in a decline in average loans and leases from the six months ended June 30, 2002 to the corresponding period in 2003. Noninterest income increased 119.0% in the six months ended June 30, 2003 from the same period a year ago due to loan fees (an increase of $3.0 million) and deposit services (an increase of $3.2 million) resulting from the UCB acquisition, portfolio servicing and other leasing fees due to the Trinity Capital acquisition (an increase of $3.0 million) and loan fees driven by loan growth in SBA, Church Lending and Healthcare (an increase of $1.8 million).
Acquisitions of UCB in April 2002 and Trinity Capital in November 2002 resulted in increases of 34.9% in average loans and 98.4% in average deposits in the six months ended June 30, 2003. The Commercial Banking Segment continues to pursue a strategy of leveraging efficiencies gained through the expanded resources resulting from the UCB acquisition, while focusing on niche markets where there is competitive advantage, such as equipment leasing, SBA loans and religious lending.
Consumer Finance segment’s net income for the three months ended June 30, 2003 was $13.2 million compared to $11.0 million a year ago. Net interest income in the second quarter 2003 was $50.7 million, compared with $43.3 million for the same period in 2002, an increase of 17.1%. Noninterest income increased $0.6 million or 20.7%. Noninterest expense increased from $14.1 million in the three months ended June 30, 2003 to $15.6 million this year. Our provision for credit allowances also increased 22.6% in the second quarter of this year compared to the second quarter of 2002.
The Consumer Finance Segment remains very competitively priced in the indirect lending market. Noninterest income in the three months ended June 30, 2003 was $3.5 million, compared with $2.9 million for the same period in 2002. This increase was primarily due to gains on sales of loans through our Essex subsidiary and an increase in loan servicing related fees. Noninterest expense for the second quarter 2003 increased by 10.6% over the same period in 2002. This increase was primarily due to an increase in the cost of employee benefits and an increase in the use of outside services related to higher production volumes. Other expense categories experienced a decrease due to efficiency gains.
Net income for the six months ended June 30, 2003 was $27.8 million compared to $22.3 million in the same period a year ago. Net interest income for the six months ended June 30, 2003 was $100.4 million, compared to $85.1 million for the same period in 2002, an increase of 18.0%. Noninterest income increased 14.8% and noninterest expense increased 9.2% in the first half of 2003 compared to the corresponding period in 2002. The provision for credit losses increased $4.8 million from $24.8 million in the first half of 2002 to $29.6 million in 2003.
Noninterest income for the six months ended June 30, 2003 was $6.2 million, compared with $5.4 million for the same period in 2002. This increase was primarily due to gains on sales of loans through our Essex subsidiary which has experienced an 8% increase in production and a 35% increase in income from other loan servicing related fees. Noninterest expense for the six months ended June 30, 2003 increased by $2.6 million from the same period in 2002. This increase was primarily due to higher staff and occupancy requirements associated with growth and the UCB acquisition. Additionally, increases in the cost of employee benefits and increases in the use of outside services related to higher production volumes contributed to the higher expenses in 2003.
Average assets for the six months ended June 30, 2003 were $7.3 billion, compared to $6.4 billion, an increase of $0.9 billion, or 14.1% in the six months ended June 30, 2002. This increase is due to both the UCB acquisition that took place in 2002 and increased indirect loan production.
Retail Banking segment’s net income for the second quarter ending June 30, 2003 decreased $0.3 million, or 1.4%. Net interest income increased by $1.1 million, or 1.7% for the second quarter of 2003 compared to the same period in 2002. Noninterest income for the second quarter increased by $0.1 million, or 0.6%. Noninterest expense for the second quarter increased by $1.8 million, or 4.1% compared to the prior year. The provision for credit losses for the three months ended June 30, 2003 decreased by $0.1 million, or 5.3%, compared to the prior year.
Retail Banking segment’s net income for the six months ended June 30, 2003 decreased $0.1 million, or 0.2% compared to the same period in 2002. Net interest income for the six months ended June 30, 2003 decreased $1.2 million, or 0.9% compared to the same period in the prior
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year. The decrease was primarily due to the transfer of loans to the Commercial Banking Segment in April 2002. Noninterest income for the six months ended June 30, 2003 increased $1.6 million, or 5.0%, compared to the prior year. The increase was due to higher account analysis fees. Noninterest expense for the six months ended June 30, 2003 increased $1.9 million or 2.2% compared to the prior year. The increase was primarily due to higher retirement plan expenses. The provision for credit losses for the first half of 2003 decreased $0.6 million, or 14.6% compared to the prior year.
Consumer segment’s net income for the three months ended June 30, 2003 increased $3.4 million, or 52.3% compared to the prior year. Net interest income for the second quarter increased by $3.7 million, or 21.0%, compared to the prior year. Noninterest income for the three months ended June 30, 2003 increased $2.9 million, or 51.8%, compared to the prior year. Noninterest expense for the second quarter ending June 30, 2003 increased $1.2 million, or 11.7%, compared to the same period in the prior year. There was no change in the provision for credit losses in the second quarter of 2003 compared to the prior year.
Consumer segment’s net income for the six months ended June 30, 2003 increased $6.2 million, or 46.6%, compared to the prior year. Net interest income for the six months ended June 30, 2003 increased by $6.2 million or 17.7% compared to the prior year. The increase was primarily due to higher loan volume and a wider margin. Noninterest income for the first half of 2003 increased $5.9 million, or 51.3%, compared to the same period in the prior year. The increase was primarily due to higher merchant service income and higher gains on sales of loans. Noninterest expense for the six months ended June 30, 2003 increased $2.3 million, or 11.2%, compared to the corresponding period last year. The increase was primarily due to increases in incentive compensation, temporary help salaries and higher retirement plan expense. Provision for credit losses in the first six months of 2003 compared to the same period in the prior year increased $0.1 million, or 2.2%.
Commercial Banking segment’s net income for the three months ended June 30, 2003 increased $0.2 million, or 4.3%, compared to the same period in the prior year. Net interest income for the second quarter increased $0.1 million, or 1.3% compared to the corresponding period last year. Noninterest income for the second quarter of 2003 compared to the prior year decreased $0.1 million, or 5.9%. Noninterest expense for the three months ended June 30, 2003 increased $0.3 million, or 15%, compared to the same period in the prior year.
Commercial Banking segment’s net income for the six months ended June 30, 2003 increased $1.3 million, or 14.9%, compared to the same period in the prior year. Net interest income for the first half of 2003 increased $1.9 million, or 14.1%, compared to the same period last year. The increase was primarily due to the transfer of loans from the Retail Banking Segment, higher volume and a wider margin. Noninterest income for the six months ended June 30, 2003 compared to the prior year did not change. Noninterest expense for the six months ended June 30, 2003 increased $0.8 million, or 22.2%, compared to the same period in the prior year.
Financial Management segment’s net income was $1.1 million for the second quarter of 2003, compared to $0.5 million for the same period in 2002, an increase of 120.0%. Net interest income for the three months of 2003 increased $0.1 million compared to the same period in the prior year. Noninterest income increased $1.2 million, or 17.9%, for the second quarter of 2003 compared to the same period in the prior year. Noninterest expense for the second quarter ending June 30, 2003 increased $1 million, or 16.9%, compared to the corresponding quarter last year.
Net income for the six months ended June 30, 2003 was $1.5 million, an increase of $0.2 million, or 15.4%, for the same period in 2002. Net interest income for the six months ended June 30, 2003 increased $0.1 million compared to the same period in the prior year. Noninterest income for the first six months of 2003 increased $0.8 million, or 5.7%, compared to the same period in 2002. Noninterest expense for the six months ended June 30, 2003 increased $1.3 million, or 10.9%, compared to the same period last year. The increase was primarily due to higher salaries and retirement plan expense.
INVESTMENT SECURITIES
Available-for-Sale
The fair value of available-for-sale securities at June 30, 2003 increased by approximately $1.7 billion, or 49.8%, compared to the value at June 30, 2002 and increased by approximately $1.2 billion, or 30.5%, compared to December 31, 2002. While we still continue to originate and purchase loans, we have increased our purchases of investment securities as the slow economy has not been conducive to significant loan originations.
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The following table presents the amortized cost, unrealized gains and losses and fair values of available-for-sale investment securities as of the dates indicated:
Gains and losses realized on the sales of available-for-sale investment securities are determined using the specific identification method. Gross realized gains and losses on available-for-sale investment securities for the three and six months ended June 30, 2003 and 2002 were as follows:
LOANS AND LEASES
The following table sets forth the loan and lease portfolio by major categories and loan and lease mix at June 30, 2003, December 31, 2002 and June 30, 2002:
The loan and lease portfolio is the largest component of earning assets and accounts for the greatest portion of total interest income. There was a 3.7% increase in total loans and leases from June 30, 2002 and a 3.6% increase compared to December 31, 2002.
When comparing the current period to December 31, 2002 there was a decrease of $158.1 million or 3.3%, in commercial lending, offset by increases of $344.5 million, or 3.3% in real estate loans and $743.7 million, or 12.4% in consumer loans. When comparing the current period to June 30, 2002 the decrease in construction real estate loans of $169.7 million, or 15.7% was substantially offset
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by increases of $441.1 million, or 4.3%, in total real estate loans and $660.2 million, or 10.8% in consumer loans. Consumer loans consist primarily of direct and indirect automobile, recreational vehicle, marine, credit card and unsecured financing.
Our foreign loans are principally in Guam and Saipan. Foreign loans as of June 30, 2003 decreased $40.7 million, or 10.3%, from December 31, 2002 and decreased $29.9 million, or 7.8%, from June 30, 2002.
Loan concentrations are considered to exist when there are amounts loaned to multiple borrowers engaged in similar activities, which would cause them to be similarly impacted by economic or other conditions. At June 30, 2003, we did not have a concentration of loans greater than 10% of total loans which is not otherwise disclosed as a category of loans as shown in the table above.
Off-balance-sheet commitments were as follows at June 30, for the years indicated:
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NONPERFORMING ASSETS
Nonperforming assets at June 30, 2003, December 31, 2002 and June 30, 2002 were as follows:
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Nonperforming assets at June 30, 2003 were $188.1 million, or 0.75%, of total loans and leases and other real estate owned and repossessed personal property (“OREO”), compared to 1.02% at December 31, 2002 and 1.04% at June 30, 2002. Nonperforming assets at June 30, 2003 were 0.52% of total assets, compared to 0.71% at December 31, 2002 and 0.74% at June 30, 2002.
Nonperforming assets at June 30, 2003 decreased by $57.4 million, or 23.4%, from December 31, 2002 and decreased by $63.3 million, or 25.2%, from June 30, 2002. These decreases were primarily due to substantial decreases in nonaccrual loans for commercial lending resulting from resolution of problem relationships. The decrease from December 31, 2002 was slightly offset by an increase in nonaccrual residential real estate loans. Those nonaccrual loans increased $2.4 million, or 44.9% since December 31, 2002 but decreased $2.6 million, or 25.0% since June 30, 2002.
Foreign nonperforming assets decreased at June 30, 2003 by $2.0 million, or 20.0% from December 31, 2002 and by $0.3 million, or 3.9% from June 30, 2002 primarily due to loans in Guam. However, our overall foreign loan portfolio, composed primarily of loans in Guam and Saipan, represents a relatively small component (1.4%) of our total loan portfolio at June 30, 2003.
We generally place a loan or lease on nonaccrual status when we believe that collection of principal or interest has become doubtful or when loans and leases are 90 days past due as to principal or interest, unless they are well secured and in the process of collection. We may make an exception to the general 90-day-past-due rule when the fair value of the collateral exceeds our recorded investment in the loan or when other factors indicate that the borrower will shortly bring the loan current.
While the majority of consumer loans and leases are subject to our general policies regarding nonaccrual loans, certain past-due consumer loans and leases are not placed on nonaccrual status because they are charged off upon reaching a predetermined delinquency status varying from 120 to 180 days, depending on product type.
When we place a loan or lease on nonaccrual status, previously accrued and uncollected interest is reversed against interest income of the current period. When we receive a cash interest payment on a nonaccrual loan, we apply it as a reduction of the principal balance when we have doubts about the ultimate collection of the principal. Otherwise, we record such payments as income.
Nonaccrual loans and leases are generally returned to accrual status when they: (1) become current as to principal and interest and have demonstrated a sustained period of payment performance or (2) become both well secured and in the process of collection.
Other than the loans listed, we were not aware of any significant potential problem loans where possible credit problems of the borrower caused us to seriously question the borrower’s ability to repay the loan under existing terms. Loans past due 90 days or more and still accruing interest totaled $20.7 million at June 30, 2003 a decrease of $0.4 million, or 2.0%, from December 31, 2002 and a decrease of $7.5 million, or 26.6%, from June 30, 2002. The decrease at June 30, 2003 compared to December 31, 2002 was primarily due to real estate-commercial and commercial, financial and agricultural loans. The decrease at June 30, 2003 compared to June 30, 2002 was primarily due to commercial, financial and agricultural loans, partially offset by real estate-commercial loans. All of the loans that are past due 90 days or more and still accruing interest are, in our judgment, adequately collateralized and in the process of collection.
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PROVISION AND ALLOWANCE FOR CREDIT LOSSES
The following table sets forth the activity in the allowance for credit losses for the periods indicated:
(1) Annualized.
The allowance for credit losses for the first six months of 2003 was $391.5 million, an increase of $4.2 million, or 1.1%, compared to the same period in 2002. The provision for credit losses is based upon our judgment as to the adequacy of the allowance for credit losses to absorb probable losses inherent in the portfolio as of the balance sheet date. The Company uses a systematic methodology to determine the adequacy of the Allowance and related provision for credit losses to be reported for financial statement purposes. The determination of the adequacy of the Allowance is ultimately one of judgment, which includes consideration of many factors, including, among other things, the amount of problem and potential problem loans and leases, net charge-off experience, changes in the composition of the loan and lease portfolio by type and location of loans and leases and in overall loan and lease risk profile and quality, general economic factors and the fair value of collateral.
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Our approach to managing exposure to credit risk involves an integrated program of setting appropriate standards for credit underwriting and diversification, monitoring trends that may affect the risk profile of the credit portfolio and making appropriate adjustments to reflect changes in economic and financial conditions that could affect the quality of the portfolio and loss probability. The components of this integrated program include:
Net charge-offs were $34.1 million for the six months ended June 30, 2003, a decrease of $26.2 million, or 43.4%, from the same period in 2002. Charge-offs were higher in the six months ended June 30, 2002 primarily due to charge-offs required in late March on the UCB portfolio. These charge-offs were contested with UFJ and settlement, resulting in $13.6 million of recoveries, was reached in the first quarter, as discussed in note 2.
For the six months ended June 30, 2003, recoveries increased by $18.4 million, or 145.6%, compared to the same period in 2002. The increase in recoveries was primarily in commercial, financial and agricultural loans, due to the settlement with UFJ discussed above.
Net charge-offs for the six months ended June 30, 2003 were 0.3% of average loans and leases (annualized) compared to 0.6% (annualized) for the same period in 2002.
The Allowance increased to 2.3 times nonperforming loans and leases (excluding 90 days or more past due accruing loans and leases) at June 30, 2003 from 1.69 times at June 30, 2002. The increase in the ratio is principally due to a decrease in nonperforming loans and leases and the higher allowance resulting from $13.6 million of recoveries recognized from the UFJ settlement.
In our judgment, the Allowance was adequate to absorb losses inherent in the loan and lease portfolio at June 30, 2003. However, changes in prevailing economic conditions in our markets could result in changes in the level of nonperforming assets and charge-offs in the future and, accordingly, changes in the Allowance. We will continue to closely monitor economic developments and make necessary adjustments to the Allowance accordingly.
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DEPOSITS
Deposits are the largest component of our total liabilities and account for a significant portion of total interest expense. At June 30, 2003, total deposits were $25.0 billion, an increase of 1.9% from December 31, 2002, and an increase of 3.8% over June 30, 2002. The increase was primarily due to the growth in our customer deposit base and various deposit product programs that we initiated.
During the 12-month period from July 1, 2002 to June 30, 2003, the benchmark federal funds rate was decreased by 50 basis points contributing to lower interest rates on deposits.
LIQUIDITY MANAGEMENT
Liquidity refers to our ability to provide sufficient short- and long-term cash flows to fund operations and to meet obligations and commitments, including depositor withdrawals and debt service, on a timely basis at reasonable costs. We achieve our liquidity objectives with both assets and liabilities. We obtain short-term asset-based liquidity through our investment securities portfolio and short-term investments that can be readily converted to cash. These liquid assets consist of cash and due from banks, interest-bearing deposits in other banks, federal funds sold, securities purchased under agreements to resell and investment securities. Such assets represented 19.3% of total assets at June 30, 2003, compared to 17.8% at December 31, 2002.
Intermediate and longer-term asset liquidity is primarily provided by regularly scheduled maturities and cash flows from our loans and investment securities. Additional liquidity is available from certain assets that can be sold or securitized, such as consumer and mortgage loans. We obtain short-term liability-based liquidity primarily from deposits. Average total deposits for the three months ended June 30, 2003 were $24.3 billion, compared to $22.3 billion for the year ended December 31, 2002. Average total deposits funded 69.7% of average total assets for the six months ended June 30, 2003 and 71.0% for the year ended December 31, 2002.
We also obtain short-term liquidity from ready access to regional and national wholesale funding sources, including issuing our own certificates of deposit, purchasing federal funds, selling securities under agreements to repurchase, arranging lines of credit from other banks and obtaining credit facilities from the Federal Home Loan Banks. Additional information on short-term borrowings is provided in Note 10 to the Consolidated Financial Statements on pages 55 and 56 of our 2002 Annual Report on Form 10-K. Offshore deposits in the international market provide another available source of funds.
Funds taken in the intermediate and longer-term markets are structured to avoid concentration of maturities and to reduce refinancing risk. We also attempt to diversify the types of instruments issued to avoid undue reliance on any one market.
Liquidity for the parent company is primarily provided by dividend and interest income from its subsidiaries. Short-term cash requirements are met through liquidation of short-term investments. Longer-term liquidity is provided by access to the capital markets and the ability to obtain resources from BNP Paribas.
CAPITAL
Stockholder’s equity increased to $4,088 million at June 30, 2003 from $3,867 million at December 31, 2002, an increase of $221 million, or 5.7%. Stockholder’s equity at June 30, 2003 increased as compared to June 30, 2002 by $288 million, or 7.6%. The increase between June 30, 2003 and December 31, 2002 was primarily due to net income earned by the Company during the six-month period. The increase between June 30, 2003 and June 30, 2002 was primarily due to net income earned during the twelve month period and unrealized gains on investment securities and cash flow hedge derivatives partially offset by a $167 million adjustment to properly reflect BNP Paribas’ accounting basis in BancWest following its purchase on December 19, 2001 of the remaining 55% of outstanding voting stock it did not already own. This adjustment, recognized in the fourth quarter of 2002, was recorded as a decrease in the “surplus” category of the Company’s stockholder’s equity.
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Capital adequacy regulations require the Company’s depository institution subsidiaries to maintain minimum ratios of Tier 1 Capital and Total Capital to risk-weighted assets and of Tier 1 Capital to average assets (leverage). These amounts and ratios as of June 30, 2003 are set forth below:
We elected to become a financial holding company concurrent with the BNP Paribas acquisition. Because of this election, only our depository institution subsidiaries are subject to various regulatory capital requirements administered by the Federal banking agencies. If these subsidiaries fail to meet minimum capital requirements, the Federal agencies can initiate certain mandatory actions. Such regulatory actions could have a material effect on the Company’s financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt corrective action, our depository institution subsidiaries must each meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. These capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
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BancWest Corporation and SubsidiariesQUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 3. Quantitative and Qualitative Disclosures About Market Risk
INTEREST RATE RISK MEASUREMENT AND MANAGEMENT
The Company’s net interest income is subject to interest rate risk to the extent our interest-bearing liabilities (primarily deposits and borrowings) mature or reprice on a different basis than our interest-earning assets (primarily loans and leases and investment securities). When interest-bearing liabilities mature or reprice more quickly than interest-earning assets during a given period, an increase in interest rates could reduce net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, a decrease in interest rates could have a negative impact on net interest income. In addition, the impact of interest rate swings may be exacerbated by factors such as our customers’ propensity to manage their demand deposit balances more or less aggressively or to refinance mortgage and other consumer loans depending on the interest rate environment.
The Asset/Liability Committees of the Company and our major subsidiaries are responsible for managing interest rate risk. The Asset/Liability Committees generally meet monthly or quarterly. The committees may recommend changes to a particular subsidiary’s interest rate profile to their respective Board of Directors, should changes be necessary and depart significantly from established policies. Derivatives entered into for trading purposes include commitments to purchase and sell foreign currencies and mortgage backed securities as well as certain interest rate swaps and options.
We also enter into customer accommodation interest rate swaps and foreign exchange spot and forward contracts as well as contracts to offset either the customer’s counter-position or our foreign currency denominated deposits. These contracts basically offset each other and they do not expose us to material losses resulting from interest rate or foreign currency fluctuations.
The Company models our net interest income in order to quantify our exposure to changes in interest rates. Generally, the size of the balance sheet is held relatively constant and then subjected to interest rate shocks up in 100 basis-point increments and down in a 50 basis-point increment. Each account-level item is repriced according to its respective contractual characteristics, including any embedded options which might exist (e.g., periodic interest rate caps or floors on loans and leases which permit the borrower to prepay the principal balance of the loan or lease prior to maturity without penalty). Derivative financial instruments such as interest rate swaps, swaptions, caps or floors are included as part of the modeling process. For each interest rate shock scenario, net interest income over a 12-month horizon is compared against the results of a scenario in which no interest rate change occurs (flat rate scenario) to determine the level of interest rate risk at that time.
The projected impact of incremental increases and a 50 basis-point decrease in interest rates on the Company’s consolidated net interest income over the 12 months beginning July 1, 2003 and January 1, 2003 is shown below:
The changes in the models are due to differences in interest rate environments which include the absolute level of interest rates, the shape of the yield curve and spreads between benchmark rates.
Significant Assumptions Utilized And Inherent Limitations
The net interest income changes for each interest rate scenario presented above include assumptions based on accelerating or decelerating mortgage and installment loan prepayments in declining or rising scenarios, respectively, and adjusting deposit levels and mix in the different interest rate scenarios. The magnitude of changes to both areas in turn is based upon analyses of customers’ historic behavior in differing rate environments. However, these analyses may differ from actual future customer behavior. For example, actual prepayments may differ from current assumptions as prepayments are affected by many variables which cannot be predicted with certainty (e.g., prepayments of mortgages may differ on fixed and adjustable loans depending upon current interest
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BancWest Corporation and SubsidiariesQUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (continued)
rates, expectations of future interest rates, availability of refinancing, economic benefit to borrower, financial viability of borrower, etc.).
As with any model for analyzing interest rate risk, certain limitations are inherent in the method of analysis presented above. For example, the actual impact on net interest income due to certain interest rate shocks may differ from those projections presented should market conditions vary from assumptions used in the analysis. Furthermore, the analysis does not consider the effects of a changed level of overall economic activity that could exist in certain interest rate environments. Moreover, the method of analysis used does not take into account the actions that management might take to respond to changes in interest rates because of inherent difficulties in determining the likelihood or impact of any such response.
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BancWest Corporation and SubsidiariesCONTROLS AND PROCEDURES
Item 4. Controls and Procedures
As of the end of the period covered by the filing date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s chairman and chief executive officer and its chief financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, its chairman and chief executive officer and its chief financial officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings.
There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation.
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
The Exhibits listed below are filed or incorporated by reference as part of this Report.
(a) Exhibits
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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EXHIBIT INDEX
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