Bank of Hawaii - 10-Q quarterly report FY

The accompanying notes are an integral part of the Consolidated Financial Statements (Unaudited).

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The accompanying notes are an integral part of the Consolidated Financial Statements (Unaudited).

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The accompanying notes are an integral part of the Consolidated Financial Statements (Unaudited).

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The accompanying notes are an integral part of the Consolidated Financial Statements (Unaudited).

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Bank of Hawaii Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

Note 1.  Summary of Significant Accounting Policies

Basis of Presentation

Bank of Hawaii Corporation (the “Parent”) is a bank holding company headquartered in Honolulu, Hawaii.  Bank of Hawaii Corporation and its Subsidiaries (the “Company”) provide a broad range of financial products and services to customers in Hawaii and the Pacific Islands (Guam, nearby islands, and American Samoa).  The Parent’s principal subsidiary is Bank of Hawaii (the “Bank”).  All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, the consolidated financial statements reflect normal recurring adjustments necessary for a fair presentation of the results for the interim periods.

Certain prior period amounts have been reclassified to conform to current period classifications.

These statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.  Operating results for the six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

Mortgage Servicing Rights

Effective January 1, 2007, the Company adopted the provisions of SFAS No. 156, “Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140.”  SFAS No. 156 requires all separately recognized servicing assets and liabilities to be initially measured at fair value, if practicable.  In adopting the provisions of SFAS No. 156, the Company recorded an increase in the value of mortgage servicing rights of $8.0 million and a net of tax increase to retained earnings of $5.1 million.  Also, as permitted by SFAS No. 156, the Company reclassified investment securities with a carrying value of $164.2 million (“Designated Securities”) from the available-for-sale portfolio to the trading portfolio.  Concurrently, the Company reclassified unrealized losses of $5.3 million, net of tax, previously recorded as a component of accumulated other comprehensive loss, to retained earnings.  The Designated Securities are carried at fair value on the Company’s statement of condition, with realized and unrealized gains and losses recorded as a component of the change in fair value of Designated Securities in mortgage banking income.  The change in fair value of Designated Securities are intended to offset changes in valuation assumptions affecting the recorded value of the mortgage servicing rights.  The net after-tax cumulative-effect adjustment to adopt the provisions of SFAS No. 156 was to reduce retained earnings by $0.2 million as of January 1, 2007.  The Company also adopted the fair value measurement provisions of SFAS No. 156 in subsequent re-measurements of the mortgage servicing rights.

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Leveraged Leases

Effective January 1, 2007, the Company adopted the provisions of FASB Staff Position (“FSP”) No. 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction,” which amends SFAS No. 13, “Accounting for Leases.”  The timing of cash flows relating to income taxes generated by a leveraged lease is an important assumption that affects the periodic income recognized by the lessor for that lease transaction.  Under the provisions of FSP No. 13-2, a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease transaction requires a recalculation of the total and periodic income related to the leveraged lease transaction.  During the years 1998 through 2002, the Company entered into one leveraged lease transaction known as a Lease In-Lease Out (“LILO”) transaction and five Sale In-Lease Out (“SILO”) transactions.  As of January 1, 2007, the income tax impact of these LILO and SILO transactions was in various stages of review by the Internal Revenue Service (the “IRS”).  Management expected that the outcome of these reviews would change the projected timing of cash flows from these leveraged leases.  As a result, in adopting the provisions of FSP No. 13-2 on January 1, 2007, the Company recorded an after-tax cumulative-effect adjustment to reduce retained earnings by $27.1 million.  This adjustment represented a $42.7 million reduction in the carrying value of lease financing balances and a $15.6 million reduction in deferred income taxes payable.  The provisions of FSP No. 13-2 also provide that subsequent changes in the timing of projected cash flows that results in a change in the net investment of a leveraged lease is to be recorded as a gain or loss in the period in which the assumption is changed.

During the second quarter of 2007, the Company reached an agreement with the IRS as to the terms of settlement of the issues related to the Company’s LILO transaction.  See Note 4 for further discussion on the matter.  There has been no change in the status of the IRS review of the Company’s SILO transactions.

Income Taxes

Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.”  FIN 48 established a recognition threshold and measurement attributes for income tax positions recognized in the Company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.”  In evaluating a tax position for recognition, the Company judgmentally evaluates whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position.  If the tax position meets the more-likely-than-not recognition threshold, the tax position is measured and recognized in the Company’s financial statements as the largest amount of tax benefit that is in management’s judgment greater than 50% likely of being realized upon ultimate settlement.  Effective January 1, 2007, the Company also adopted the provisions of FSP No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48,” which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing a liability for previously unrecognized tax benefits in the statement of condition.  In adopting the provisions of FIN 48 and FSP No. FIN 48-1 on January 1, 2007, the Company recorded an after-tax cumulative-effect adjustment to reduce retained earnings by $7.2 million.

See Note 4 for further discussion on the Company’s FIN 48 tax positions as of January 1, 2007 and June 30, 2007.

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Future Application of Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which is effective for the Company on January 1, 2008.  SFAS No. 157 established a framework for measuring fair value, while expanding fair value measurement disclosures.  SFAS No. 157 established a fair value hierarchy that distinguishes between independent observable inputs and unobservable inputs developed based on the best information available.  SFAS No. 157 expands disclosures about the use of fair value to measure assets and liabilities, the effect of these measurements on earnings for the period, and the inputs used to measure fair value.  Management is currently evaluating the effect that the provisions of SFAS No. 157 will have on the Company’s statements of income and condition.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115,” which is effective for the Company on January 1, 2008.  SFAS No. 159 provides entities with an option to report selected financial assets and financial liabilities, on an instrument by instrument basis, at fair value, with the objective of reducing both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently.  Management is currently evaluating the effect that the provisions of SFAS No. 159 will have on the Company’s statements of income and condition.

Note 2.  Mortgage Banking

The Company’s portfolio of residential mortgage loans serviced for third parties was $2.5 billion as of June 30, 2007 and 2006.  The Company’s mortgage servicing activities includes collecting principal, interest, and escrow payments from borrowers; making tax and insurance payments on behalf of the borrowers; monitoring delinquencies and executing foreclosure proceedings; and accounting for and remitting principal and interest payments to investors.  The Company’s residential mortgage loan servicing portfolio is comprised primarily of fixed rate loans concentrated in Hawaii.

Mortgage servicing rights are recognized as assets when mortgage loans are sold and the rights to service those loans are retained.  As of December 31, 2006, the Company recorded its mortgage servicing rights at their relative fair values on the date the loans were sold and were carried at the lower of the initial recorded value, adjusted for amortization, or fair value.  As of January 1, 2007, the Company adopted the provisions of SFAS No. 156 which requires all separately recognized servicing assets to be initially measured at fair value, if practicable.  As of January 1, 2007, the Company identified its entire balance of mortgage servicing rights as one class of servicing assets for this measurement.  The table below reconciles the balance of the Company’s mortgage servicing rights as of December 31, 2006 and January 1, 2007.

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The changes in the fair value of the Company’s mortgage servicing rights for the three and six months ended June 30, 2007 were as follows:

1 Principally reflects changes in weighted-average constant prepayment rate and weighted-average life assumptions.

2 Principally represents changes due to the pay-off of loans during the period.

The Company estimates the fair value of its mortgage servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income.  The model uses factors such as loan repayment rates, costs to service, ancillary income, impound account balances, and interest rate assumptions in its calculations.  Risks inherent in the valuation of mortgage servicing rights include changes in interest rates, higher than expected loan repayment rates, and the delayed receipt of cash flows, among other factors.  The key assumptions used in estimating the fair value of the Company’s mortgage servicing rights as of June 30, 2007 were as follows:

1 Represents annualized loan repayment rate assumption.

For the three and six months ended June 30, 2007 and 2006, the Company’s mortgage banking income was comprised of the following:

1 On-balance-sheet hedging instruments.

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For the three and six months ended June 30, 2007, the Company’s entire trading portfolio, comprised of mortgage-backed securities, was designated to manage the volatility of the fair value of mortgage servicing rights as an on-balance-sheet hedge.  For the three and six months ended June 30, 2007, realized investment trading gains and losses were not material.

The fair value of the Company’s mortgage servicing rights is sensitive to changes in interest rates and their effect on loan repayment rates.  A sensitivity analysis of the Company’s fair value of mortgage servicing rights to changes in the constant prepayment rate and the discount rate is presented in the following table:

This analysis generally cannot be extrapolated because the relationship of a change in one key assumption to the change in the fair value of the Company’s mortgage servicing rights usually is not linear.  The calculation of the fair value of mortgage servicing rights is dynamic in nature, in that changes in one key assumption may result in changes in other assumptions, which may magnify or counteract the sensitivity analysis presented in the table above.

Note 3.  Pension Plans and Postretirement Benefit Plan

The components of net periodic benefit cost for the Company’s pension plans and the postretirement benefit plan for the three and six months ended June 30, 2007 and 2006 are presented in the following table:

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The net periodic benefit cost for the Company’s pension plans and postretirement benefit plan are recorded as a component of salaries and benefits in the statements of income.  There were no significant changes from the previously reported $7.7 million that the Company expects to contribute to the pension plans and the $1.3 million that it expects to contribute to the postretirement benefit plan for the year ending December 31, 2007.  For the three and six months ended June 30, 2007, the Company contributed $4.6 million and $4.8 million, respectively, to its pension plans.  For the three and six months ended June 30, 2007, the Company contributed $0.2 million and $0.5 million, respectively, to its postretirement benefit plan.

Note 4.  Income Taxes

The following is a reconciliation of the statutory Federal income tax rate to the Company’s effective tax rate for the three and six months ended June 30, 2007 and 2006.

Income earned by the Company is subject to U.S. Federal taxation and to state and territorial taxation in Hawaii and Guam, respectively.  Small amounts of income are subject to taxation by other states and territories as well as some foreign countries.  The Company has effectively settled issues raised during income tax examinations by taxing authorities for years prior to 1998.

As noted in Note 1, the Company reached an agreement with the IRS to effectively settle the matter related to the LILO transaction in June 2007.  The effective settlement with the IRS resulted in a change in the timing of projected cash flows from the LILO transaction.  In January 2007, in adopting the provisions of FSP No. 13-2, the Company recalculated the total and periodic income from the LILO transaction assuming an entire disallowance of income tax deductions taken on previously filed tax returns based on a tax court case which concluded in January 2007.  With the effective settlement of the LILO transaction at a disallowance percentage of less than its original estimate, the Company recalculated the total and periodic income from the LILO transaction from the inception of the lease through June 30, 2007.  In the second quarter of 2007, the Company recorded a $1.5 million credit, which was comprised of a $1.1 million credit to lease financing interest income and a $0.4 million net credit to the provision for income taxes, as a result of the June 2007 change in the disallowance assumption.  The Company is currently appealing issues raised by the IRS in the examination of its income tax returns filed for 1998 through 2002 related to the Company’s five SILO transactions.  There has been no change in the status of the IRS review of the Company’s SILO transactions.  The IRS is currently in the process of examining income tax returns filed for 2003 and 2004.  The State of Hawaii is currently in the process of examining income tax returns filed for 2002 through 2004.

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As noted in Note 1, FIN 48 established a recognition threshold and measurement attributes for income tax positions recognized in the Company’s financial statements in accordance with SFAS No. 109.  FIN 48 requires the Company to record a liability, referred to as an unrecognized tax benefit (“UTB”), for the entire amount of benefit taken in a prior or future income tax return when the Company determines that a tax position has a less than 50% likelihood of being accepted by the taxing authority.  If the Company determines that the likelihood of a tax position being accepted is greater than 50%, but less than 100%, the Company records a liability for UTBs in the amount it believes will be disallowed by the taxing authority.

As of December 31, 2006, prior to adopting the provisions of FIN 48, the Company had recorded the equivalent of $116.4 million of UTBs in its statement of condition.  On January 1, 2007, in adopting the provisions of FIN 48, the Company increased its liability for UTBs to $130.6 million, of which $7.2 million was recorded as a cumulative-effect adjustment to reduce retained earnings, primarily due to the accrual of interest expense.  As of January 1, 2007, of the $130.6 million in the Company’s liability for UTBs, $29.3 million, that if reversed, would have an impact on the Company’s effective tax rate.  As of June 30, 2007, there were no material changes in the Company’s liability for UTBs or in the amount, that if reversed, would have an impact on the Company’s effective tax rate.  With respect to the Company’s appeals of its five SILO transactions, it is reasonably possible that the amount of the liability for UTBs may decrease if facts and circumstances related to the IRS appeals change within the next twelve months.  However, management is currently not able to estimate a range of possible change in the amount of the liability for UTBs recorded as of June 30, 2007.

The Company classifies interest and penalties, if any, related to the liability for UTBs as a component of the provision for income taxes.  As of January 1, 2007, after recording the cumulative-effect adjustment to adopt the provisions of FIN 48, the Company had accrued $21.7 million for the payment of possible interest and penalties.  For the three and six months ended June 30, 2007, the amount recorded by the Company as an estimate of the expected payment of interest and penalties in the provision for income taxes was not material.

Note 5.  Business Segments

The Company’s business segments are Retail Banking, Commercial Banking, Investment Services, and Treasury.  The Company’s internal management accounting process measures the performance of the business segments based on the management structure of the Company.  This process, which is not necessarily comparable with similar information for any other financial institution, uses various techniques to assign balance sheet and income statement amounts to the business segments, including allocations of income, expense, the Provision, and capital.  This process is dynamic and requires certain allocations based on judgment and other subjective factors.  Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to U.S. GAAP.

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Selected financial information for each segment is presented below for the three and six months ended June 30, 2007 and 2006.

1 Certain prior period information has been reclassified to conform to current presentation.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This report may contain, and other statements made by the Company in connection with this report may contain, forward-looking statements concerning, among other things, the Company’s business outlook, the economic and business environment in the Company’s service areas and elsewhere, credit quality and other financial and business matters in future periods.  The Company’s forward-looking statements are based on numerous assumptions, any of which could prove to be inaccurate, and actual results may differ materially from those projected for a variety of reasons, including, but not limited to: 1) general economic conditions are less favorable than expected; 2) competitive pressure among financial services and products; 3) the impact of legislation and the regulatory environment; 4) fiscal and monetary policies of the markets in which the Company serves; 5) changes in accounting standards; 6) changes in tax laws or regulations or the interpretation of such laws and regulations; 7) changes in the Company’s credit quality or risk profile that may increase or decrease the required level of the reserve for credit losses; 8) changes in market interest rates that may affect the Company’s credit markets and ability to maintain its net interest margin; 9) unpredictable costs and other consequences of legal, tax, or regulatory matters; 10) changes to the amount and timing of proposed common stock repurchases; and 11) geopolitical risk, military or terrorist activity, natural disaster, adverse weather, public health and other conditions impacting the Company and its customers’ operations.  For a detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements, refer to the section entitled “Risk Factors” in Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, and subsequent periodic and current reports, filed with the U.S. Securities and Exchange Commission.  Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” and similar expressions are intended to identify forward-looking statements but are not exclusive means of identifying such statements.  The Company does not undertake an obligation to update forward-looking statements to reflect later events or circumstances.

Overview

2007+ Plan

In January 2007, the Company introduced its 2007+ Plan to its shareholders, customers, and employees.  The 2007+ Plan emphasizes growth in revenues, integration of service delivery and business units, development of people, enhancement of the Bank of Hawaii brand, and discipline in managing risk and financial performance.  The 2007+ Plan does not contemplate near-term expansion beyond the Company’s current footprint.

The Company’s 2007+ Plan is based on moderate growth in revenues and consistent positive operating leverage.  Performance objectives include an annual return on assets above 1.7%, return on equity above 25%, and an efficiency ratio approaching 50%, and is based on a stable economy (which continues in Hawaii) and a return to a more traditional interest rate environment (which has not occurred).  The Company’s 2007+ Plan will be reevaluated periodically and updated as market events and business developments dictate.

Earnings Summary

The Company reported strong financial performance for the three and six months ended June 30, 2007 compared to the same periods in 2006.  The Company had strong growth in noninterest income while maintaining discipline in increases to noninterest expense.  These positive factors offset the continued decrease of net interest margin the Company has experienced as a result of the challenging interest rate environment.  Overall credit quality of the Company remains strong and the Hawaii economy remains stable.

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Table 1 presents the Company’s financial highlights and performance ratios for the three and six months ended June 30, 2007 and 2006 and as of June 30, 2007, December 31, 2006, and June 30, 2006.