ITEM 1. BUSINESS
General
Quaker City Bancorp, Inc., incorporated in Delaware, is primarily engaged in the savings and loan business through its wholly owned subsidiary Quaker City Bank (the "Bank"). The Company was organized on September 13, 1993, for the purpose of acquiring all of the capital stock of the Bank issued in the conversion of the Bank from mutual to stock form effective December 30, 1993. The Bank was originally founded in 1920 as the Mutual Building and Loan Association of Whittier, and in 1938 became a federally chartered mutual savings and loan association. The Company's principal business is serving as the holding company for the Bank. The executive offices of the Company are located at 7021 Greenleaf Avenue, Whittier, California 90602, telephone number (562) 907-2200.
The Bank currently operates fifteen retail full service branches in the southern California communities of Whittier (2), La Habra (2), Brea, Fullerton, La Mirada, Hacienda Heights, Anaheim Hills, Rowland Heights, Lakewood, Los Angeles, Corona, Foothill Ranch and Placentia. Four of these branches were opened in calendar year 2000 inside Wal-Mart stores. The Bank also has plans to open at least two additional Wal-Mart "in-store" branches in southern California during fiscal 2001.
The Company is a savings and loan holding company and as such is subject to examination and regulation by the Office of Thrift Supervision ("OTS"). The deposits of the Bank are insured by the Savings Association Insurance Fund ("SAIF") of the Federal Deposit Insurance Corporation (the "FDIC"). The Bank is regulated by the Director of the OTS and the FDIC. The Bank is a member of the Federal Home Loan Bank ("FHLB") of San Francisco, which is one of the 12 regional banks comprising the Federal Home Loan Bank System. The Bank is also subject to certain regulations of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") with respect to
reserves required to be maintained against deposits and certain other matters. See "--Regulation and Supervision--General."
The Bank's principal business has been and continues to be attracting retail deposits from the general public in its primary deposit market area surrounding its offices and investing those deposits, together with funds generated from operations and borrowings. Through its wholly owned subsidiary, Quaker City Financial Corporation ("QCFC"), the Company also engages in the sale of insurance and investment products on an agency basis. See "-- Subsidiary Activities." The Company originates predominantly multifamily, commercial real estate and one-to-four family loans and emphasizes multifamily lending in low and moderate income communities, primarily in southern California metropolitan areas. To a lesser extent, loans are also originated and purchased in Central and Northern California. Under certain circumstances, one-to-four family loans are purchased on loans secured by properties outside the state of California.
Historically, the Company's principal business was the making of one-to-four family and multifamily (five or more units) loans. In every year for which data is presented in this report, i.e., 1996 through 2000, the Company's multifamily loan portfolio has increased in total dollar amount and has represented a significant portion of the Company's total loan portfolio. See "--Lending Activities--Loan and MBS Portfolio Composition." Beginning principally with the hiring announced in January 1998 of the income property lending staff of another southern California financial institution, the Company has increased its focus on commercial real estate lending. The Company currently intends to continue its emphasis on multifamily and commercial real estate lending, with their higher risk-adjusted rates of return, rather than on lower yielding one-to-four family lending. At June 30, 2000, the Company's gross loan portfolio (including loans held for sale) totaled $1.0 billion, 68.33% of which was secured by multifamily properties (approximately $505.4 million) and commercial real estate (approximately $196.5 million).
Both the multifamily and the commercial real estate loan portfolios have grown at a significant rate during fiscal 2000. From June 30, 1999 to June 30, 2000 the net increase in the Company's multifamily portfolio was $113.8 million representing a 29.07% increase in the size of the portfolio. From June 30, 1999 to June 30, 2000, the net increase in the Company's commercial real estate loan portfolio was $56.1 million, representing a 39.92% increase in the size of the portfolio. At June 30, 2000, however, the $505.4 million multifamily portfolio represented 49.20% of the Company's gross loans and the $196.5 million commercial real estate portfolio represented 19.13% of the Company's gross loans. As a percentage of gross loans, the multifamily portfolio increased in size by 3.27% and the commercial real estate portfolio increased in size by 2.65% from June 30, 1999 to June 30, 2000. See "--Lending Activities--Multifamily Lending--Commercial Real Estate Lending."
In addition to originating loans to hold in portfolio, the Company also originates loans for sale. The Company sold $48.9 million of loans in fiscal 2000. The Company also purchases loans for investment and for sale. During fiscal 2000, the Company purchased $85.8 million in loans of which, $45.6 million were one-to-four family. Loans sold come from loans held in the Company's portfolio designated as being held for sale or originated during the most recent period and designated as held for sale. Historically, the Company has generally retained the servicing rights on most loans sold, however, some loans are sold servicing released. In addition, the Company invests in securities issued by the U.S. Government and agencies thereof, mortgage-backed securities ("MBS") and other permitted investments under applicable federal laws and regulations. The Company's revenues are derived principally from interest on its mortgage loans, and to a lesser extent, mortgage loan servicing activities, and interest and dividends on its investment securities and MBS.
The Company's primary sources of funds are deposits, borrowings from the FHLB of San Francisco ("FHLB advances"), securities sold under agreements to repurchase, principal and interest payments on loans and MBS and proceeds from the sale of loans. At June 30, 2000, the
Company had deposits of approximately $808.2 million, including approximately $183.6 million in certificates of deposit of $100,000 or more. The Company's borrowings at June 30, 2000 included $290.3 million in FHLB advances. See "-- Sources of Funds."
For the year ended June 30, 2000, the Company reported net earnings of $11.8 million, $2.23 per share diluted. This compares to net earnings of $9.6 million, $1.70 per share diluted, and $6.6 million, $1.14 per share diluted, for the years ended June 30, 1999 and 1998, respectively. The increase in fiscal 2000 earnings over fiscal 1999 was primarily due to an increase in net interest income partially offset by an increase in other expenses. The increase in fiscal 1999 earnings over fiscal 1998 was also primarily due to an increase in net interest income partially offset by an increase in other expenses.
Total assets of the Company were $1.2 billion at June 30, 2000, an increase of $188.5 million compared to June 30, 1999. The increase in assets was primarily in loans, with commercial real estate loans increasing $56.1 million, multifamily loans increasing $113.8 million and one-to-four family loans increasing $3.3 million. The asset growth was funded primarily by an increase in deposits of $130.4 million and $55.6 million of FHLB advances. Included in the increase of $130.4 million of deposits during fiscal 2000 is $45.9 million of retail deposits purchased from another financial institution and its branch office located in Rowland Heights, California. In addition, while the vast majority of the Bank's deposits are retail in nature, the Bank accepted $55 million in time deposits from a political subdivision during fiscal 2000. The Bank considers these funds to be wholesale deposits and an alternative borrowing source rather than a customer relationship and their levels are determined by management's decision as to the most economic funding source. At June 30, 2000, the Company had total deposits of $808.2 million and total FHLB advances of $290.3 million.
The southern California economy and real estate market in the Company's primary lending area have continued to be strong. The Company's level of nonperforming assets declined from June 30, 1999. The Company includes nonaccrual loans, troubled debt restructured loans and real estate acquired through foreclosure ("REO") in determining its level of nonperforming assets. At June 30, 2000, the Company reported $4.4 million in nonperforming assets compared to $7.5 million and $9.8 million at June 30, 1999 and 1998, respectively. The Company recorded provisions for loan losses of $1.6 million for the year ended June 30, 2000 compared to $1.7 million and $1.5 million for the years ended June 30, 1999 and 1998, respectively. See "--Allowances for Loan and Real Estate Losses" and "Management's Discussion and Analysis ("MD&A")--Results of Operations."
Lending Activities
Loan and MBS Portfolio Composition. Historically, the Company's principal business was the making of one-to-four family and multifamily loans. In every year for which data is presented in this report, i.e., 1996 through 2000, the Company's multifamily loan portfolio has increased in total dollar amount and has represented a significant portion of the Company's total loan portfolio. Beginning principally with the hiring announced in January 1998 of the income property lending staff of another southern California financial institution, the Company has increased its focus on commercial real estate lending. The Company currently intends to continue its emphasis on multifamily and commercial real estate lending, with their higher risk-adjusted rates of return, rather than on lower yielding one-to-four family lending. At June 30, 2000, the Company had $1.0 billion of gross loans outstanding, 68.33% of which was secured by either multifamily properties or commercial real estate. Gross loans outstanding at June 30, 2000 included $505.4 million of multifamily loans, representing 49.20% of gross loans, $196.5 million of commercial real estate loans, representing 19.13% of gross loans, and $315.7 million of one- to-four family loans, representing 30.73% of gross loans. The remainder of gross loans at June 30, 2000 consisted of $1.5 million of land loans, or 0.14% of gross loans, and other loans of $8.2 million, or 0.80% of gross loans. Included in these amounts at June 30, 2000 were $21.2 million of loans held for sale, comprising 2.06% of gross loans.
The net increase in the Company's multifamily loans during fiscal 2000 was $113.8 million, representing an increase of 29.07% in the multifamily loan portfolio as compared to June 30, 1999. The net increase in the Company's commercial real estate loans during fiscal 2000 was $56.1 million, representing an increase of 39.92% in the commercial real estate loan portfolio as compared to June 30, 1999. The net increase in the Company's one- to-four family loans during fiscal 2000 was $3.3 million, representing an increase of 1.05% in the one-to-four family loan portfolio as compared to June 30, 1999. As a percentage of gross loans, multifamily loans increased by 3.27%, commercial loans increased by 2.65% and one-to-four family loans decreased by 5.92% from June 30, 1999 to June 30, 2000. These percentage changes in the composition of the gross mortgage loan portfolio are a result of the relative growth of the multifamily and commercial real estate loan portfolios and the Company's sale of approximately 40% of the one-to-four family loans it originated during the 2000 fiscal year. The Company currently intends to continue to focus on multifamily and commercial real estate lending. During fiscal 2000, the Company purchased $85.8 million in loans of which, $46.0 million were one-to-four family. The Company anticipates that the purchase of one-to-four family loans will remain a focus of the Company in fiscal 2001.
The Company invests in MBS, including securities guaranteed by the Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC"). To a limited extent the Company also invests in privately issued MBS which typically have received a "AA" or "AAA" credit rating from at least one nationally recognized rating service. The Company invests in both adjustable- rate and fixed-rate MBS. In an effort to reduce the potential interest rate risk inherent in fixed-rate assets, the Company purchases fixed-rate MBS with a variety of coupon rates, maturities, and prices. Furthermore, the assets are typically purchased with fixed-rate FHLB advances of various terms to maturity primarily ranging from one month to five years in order to mitigate the Company's exposure to changes in interest rates. The adjustable-rate MBS in the Company's portfolio typically have life caps that will prevent the MBS from further upward adjustments in rate should interest rates rise above the cap limit. Prior to purchase, management considers the Company's overall tolerance to interest rate risk and invests accordingly. At June 30, 2000, the Company's MBS portfolio (including MBS available for sale) totaled $109.9 million or 9.15% of total assets. The Company's MBS are comprised of $81.8 million of agency securities, $1.5 million issued by other financial institutions and $26.5 million in collateralized mortgage obligations ("CMO's"). Of the $26.5 million in CMO's 65.91% or $17.4 million are agency guaranteed. For all years presented, the CMO's represent non-equity senior interests in mortgage pass-through certificates and were of investment grade. At June 30, 2000, $24.4 million in MBS were classified as available for sale.
The following table sets forth the composition of the Company's loan and MBS portfolios in dollar amounts and percentages of the respective portfolio at the dates indicated.
Loan Maturity. The following table shows the contractual maturity of the Company's gross loans and MBS at June 30, 2000. The table includes loans held for sale of $21.2 million and MBS available for sale of $24.4 million. The table does not include estimated principal repayments. Actual principal repayments on loans totaled $127.3 million, $145.6 million and $91.8 million for the years ended June 30, 2000, 1999 and 1998, respectively. Principal repayments on MBS totaled $13.4 million, $25.0 million, and $29.6 million for the years ended June 30, 2000, 1999, and 1998, respectively.
The following table sets forth at June 30, 2000, the dollar amount of all loans due after June 30, 2001, and whether such loans are fixed-rate or adjustable rate mortgage ("ARM") loans.
- -------- (1) ARM loans include loans that adjust monthly, semiannually, annually or once every five years. Five year ARM loans total $2.0 million one-to-four family, $43.7 million multifamily and $79.3 million commercial real estate.
Origination, Purchase, Sale and Servicing of Loans. The Company's mortgage lending activities are conducted primarily through its executive and branch offices. The Company originates both fixed- rate and ARM loans. Its ability to originate ARM loans as opposed to fixed-rate loans is dependent upon the relative customer demand, which is affected by the current and expected future level of interest rates.
Additionally, the Company purchases or participates in loans originated by other institutions. The determination to purchase loans is based upon the Company's investment needs and market
opportunities. Subject to regulatory restrictions applicable to savings associations, the Company's current loan policies allow all loan types to be purchased. The determination to purchase specific loans or pools of loans is subject to the Company's underwriting policies, which require consideration of the financial condition of the borrower and the appraised value of the property and, with respect to multifamily and commercial real estate loans, the net operating income of the mortgaged property before debt service and depreciation and the debt service coverage ratio (the ratio of net operating income to debt service), among other factors. The Company has purchased loans from independent parties in various transactions. During the year ended June 30, 2000, of the $352.2 million of loans generated by the Company in fiscal 2000 through origination or purchase, $85.8 million, or 24.35%, were purchased. Of the $85.8 million of loans purchased during fiscal 2000, $28.1 million were multifamily loans, $11.7 million were commercial real estate loans and $46.0 million were one-to-four family loans.
At origination or time of purchase, the Company designates loans as held for investment or held for sale. Historically, loans held for sale have been sold in the secondary market to FNMA, FHLMC and other investors. The Company generally retains the servicing rights on most loans sold, however, certain loans are sold servicing released. The determination to sell a specific loan or pool of loans is made based upon the Company's investment needs, growth objectives and market opportunities.
In an attempt to further minimize interest rate risk associated with fixed- rate loans designated as held for sale, the Company may enter into commitments with FNMA and other investors (known as forward commitments) to sell loans at a future date at a specified price. The Company will then simultaneously process and close the loans, thereby attempting to protect the price of loans in process from interest rate fluctuations that may occur from application to sale. There is risk involved in this forward commitment activity. In a declining interest rate environment, borrowers may choose not to close loans, but the Company would remain obligated to fulfill its forward commitments. The inability of the Company to originate or acquire loans to fulfill these commitments may result in the Company being required to pay non-delivery fees. In an increasing interest rate environment, the Company is subject to interest rate risk in the event its commitments to make loans to borrowers exceeds its commitments to sell loans. At June 30, 2000, the Company had no forward commitments with respect to fixed rate loans held for sale. The Company does not intend to enter into forward commitments on ARM loans.
The Company sells loans and participations in loans with yield rates to the investors based upon current market rates. Gain or loss is recognized to the extent that the selling prices differ from the carrying value of the loans sold based on the estimated relative fair values of the assets sold and any retained interests, less any liabilities incurred. The assets obtained on sale are generally loan servicing assets. Liabilities incurred in a sale may include recourse obligations or servicing liabilities. At June 30, 2000, the Company had originated mortgage servicing assets with a book value of $72,000.
In addition to retaining the servicing assets for originated loans, the Company may also purchase mortgage servicing assets related to mortgage loans originated by other institutions. The Company's current loan policies provide that the aggregate amount of purchased mortgage servicing shall not exceed 75% of the total loans in the Company's portfolio that are serviced for others. At June 30, 2000, the Company had purchased mortgage servicing assets with a book value of $197,000.
The following table sets forth activity in the Company's loan and MBS portfolios for the periods indicated:
Multifamily Lending. During the year ended June 30, 2000, the Company originated $167.2 million of multifamily loans. The Company originates multifamily mortgage loans generally secured by apartment buildings located in southern California metropolitan areas. To a lesser extent multifamily loans are also originated and purchased in Central and Northern California. In originating a multifamily loan, the Company considers the qualifications of the borrower as well as the securing property. Some of the foremost factors to be considered are the net operating income of the mortgaged property before debt service and depreciation, the debt service coverage ratio (the ratio of net operating income to debt service) and the ratio of the loan amount to the appraised value of the property. Pursuant to the Company's underwriting policies, a multifamily loan generally may only be made in an amount up to 80% of the appraised value of the underlying property. The Company also generally requires a debt service coverage ratio of at least 110%. Properties securing a loan are appraised by an independent appraiser and title insurance is required on all loans. The average outstanding loan balance on multifamily loans at June 30, 2000 was approximately $383,000, with the largest loan being $4.8 million. The property collateralizing this loan is located in Chula Vista, California and the loan was not classified at June 30, 2000. Declines in the real estate values in the Company's primary lending area may result in increases in the loan-to-value ratio on some multifamily mortgage loans subsequent to origination.
When evaluating the qualifications of the borrower for a multifamily loan, the Company considers the financial resources and income level of the borrower, the borrower's experience in owning or managing similar property, and the Company's lending experience with the borrower. The Company's underwriting policies require that the borrower be able to demonstrate strong management skills and the ability to maintain the property with current rental income. The borrower should also present evidence of the ability to repay the mortgage and a history of making mortgage payments on a timely basis. In assessing the creditworthiness of the borrower, the Company generally reviews the financial statements, employment and credit history of the borrower, as well as other related documentation.
At June 30, 2000, the Company's multifamily loan portfolio had increased to $505.4 million, or 49.20% of gross loans, from $391.6 million, or 45.93% of gross loans, at June 30, 1999, an increase of $113.8 million. The multifamily loan portfolio increased in total dollar amount during fiscal 2000 by 29.06%, and as a percentage of gross loans by 3.27%. Of the $505.4 million multifamily loans outstanding at June 30, 2000, 4.49% were fixed-rate loans and 95.51% were ARM loans. Of the 95.51% of ARM loans, 9.06% or $43.7 million are tied to a treasury bill based index that adjusts once every five years.
Multifamily loans are generally considered to involve a higher degree of credit risk and to be more vulnerable to adverse conditions in the real estate market and to deteriorating economic conditions, particularly changes in interest rates than one-to-four family residential mortgage loans. These loans typically involve higher loan principal amounts and the repayment of such loans generally depend on the income produced by the operation or sale of the property being sufficient to cover operating expenses and debt service. Sometimes multifamily loans are made to groups of related borrowers, which concentration could increase the Company's exposure should the circumstances of one borrower negatively affect the ability of other related borrowers to repay their loans in full on a timely basis. Recessionary economic conditions tend to result in higher vacancy and reduced rental rates and net operating incomes from multifamily residential properties. Of the Company's $139,000 of charge-offs in fiscal 2000, none, were for multifamily loans. See "-- Allowances for Loan and Real Estate Losses."
Commercial Real Estate Lending. During fiscal 2000, the Company originated $72.8 million of commercial real estate loans. The Company originates commercial real estate loans that are generally secured by properties used for business purposes such as small office buildings, multi-tenant industrial properties or a combination of residential and retail facilities located primarily in southern California. To a lesser extent, commercial real estate loans are also originated and purchased in Central and Northern California. The Company's underwriting procedures provide that commercial real estate loans generally may be made in amounts up to 75% of the appraised value of the property. These loans may be made with terms up to 30 years for ARM loans. The Company's underwriting standards and procedures are similar to those applicable to its multifamily loans, wherein the Company considers the net operating income of the property and the borrower's expertise, credit history and profitability. The Company has generally required that the properties securing commercial real estate loans have debt service coverage ratios of at least 110%. The average outstanding loan balance on commercial real estate loans at June 30, 2000 was approximately $695,000. The largest commercial real estate loan in the Company's portfolio, located in Huntington Beach, California had an outstanding principal balance at June 30, 2000 of $3.4 million and the loan was not classified.
At June 30, 2000, the Company's commercial real estate loan portfolio had increased to $196.5 million, or 19.13% of gross loans, from $140.4 million, or 16.48% of gross loans, at June 30, 1999, an increase of $56.1 million, or 2.65% of gross loans. This $56.1 million increase in the commercial real estate loan portfolio during fiscal 2000 represents a 39.92% increase in the total dollar amount of the commercial real estate portfolio. Of the $196.5 million commercial real estate loans outstanding at June 30, 2000, 19.30% were fixed-rate loans and 80.70% were ARM loans. Of the 80.70% of ARM loans, 50.03% or $79.3 million are tied to a treasury bill bond index that adjusts once every five years.
Commercial real estate loans are generally considered to involve a higher degree of credit risk and to be more vulnerable to adverse conditions in the real estate market and to deteriorating economic conditions, particularly changes in interest rates than one-to-four family residential mortgage loans. These loans typically involve higher loan principal amounts and the repayment of such loans generally depend on the income produced by the operation or sale of the property being sufficient to cover operating expenses and debt service. Sometimes commercial real estate loans are made to groups of related borrowers, which concentration could increase the Company's exposure should the circumstances of one borrower negatively affect the ability of other related borrowers to repay their loans in full on a timely basis. Recessionary economic conditions tend to result in higher vacancy and reduced rental rates and net operating incomes from commercial properties. In addition, commercial real estate values tend to be cyclical. Of the Company's $139,000 of charge- offs in fiscal 2000, none were for commercial real estate loans. The Company has significantly increased its commercial real estate loan portfolio during the past two fiscal years. Both because the size of the commercial real estate loan portfolio has increased significantly and most of the loans comprising the portfolio are unseasoned, having been originated within the last two fiscal years, the Company's past loss experience with respect to its commercial real estate loan portfolio may not be representative of the risk of loss in such portfolio in the future. See "--Allowances for Loan and Real Estate Losses."
One-to-Four Family Lending. The Company originates both fixed-rate mortgage loans and ARM loans secured by one-to-four family residences, including, to a lesser extent, condominium and cooperative units with maturities up to 30 years. Originated loans are predominantly secured by property located in southern California. Loan originations are generally obtained from existing or past customers, members of the local communities and loan brokers. One-to-four family loans are purchased with properties securing the loans located throughout the state of California and in certain circumstances outside of California. Included in one-to-four family loans are outstanding balances of $19.3 million of adjustable rate home equity credit lines tied to the Wall Street Prime index. These loans are generally secured by a first or second trust deed, with maturities up to 25 years.
During the year ended June 30, 2000, the Company originated $25.8 million of one-to-four family loans. The Company's policy is to originate one-to-four family loans in amounts generally up to 80% of the lower of the appraised value or the selling price of the property securing the loan and up to 95% of the appraised value or selling price if private mortgage insurance is obtained. Declines in the real estate values in the Company's lending areas may result in increases in the loan-to-value ratio on some one-to-four family loans subsequent to origination.
At June 30, 2000, the Company's one-to-four family loan portfolio had increased to $315.7 million, or 30.73% of gross loans, from $312.4 million, or 36.65% of gross loans, at June 30, 1999, an increase of $3.3 million. Although the one-to-four family loan portfolio increased in total dollar amount during fiscal 2000 by 1.05%, it decreased as a percentage of gross loans by 5.92%. During fiscal 2000 one-to-four family loans purchased were $46.0 million. Of the $315.7 million one-to-four family loans outstanding at June 30, 2000, 42.64% were fixed-rate loans and 57.36% were ARM loans.
Certain Loan Terms. Since 1982, the Company has emphasized the origination of ARM loans for retention in its portfolio. This practice has enabled the Company to reduce its interest rate risk exposure by concentrating its loan portfolio in assets with either shorter terms or more frequent repricing, or both. At June 30, 2000, approximately 97.67% of the Company's multifamily, 87.76% of its commercial real estate and 57.36% of its one-to-four family loans were ARM loans. The Company also originates fixed-rate loans in response to customer demand. The type of loans the Company originates is dependent upon the relative customer demand for fixed-rate or ARM loans, which in turn is affected by the current and expected level of interest rates. Historically, the Company has sold fixed-rate loans in the secondary market to FNMA, FHLMC and others. During fiscal 2000, the Company retained certain fixed-rate loans in its portfolio.
The interest rates for approximately 43% of the Company's ARM loans in portfolio are indexed to the 11th District Cost of Funds Index ("COFI"). The Company currently offers a number of ARM loan programs with interest rates tied to Treasury bill based and COFI indices that adjust monthly, semi- annually, annually or once every five years, some of which have payment caps. Because of payment caps and the different times at which interest rate adjustments and payment adjustments are made, in periods of rising interest rates monthly payments may not be sufficient to pay the interest accruing on some of the Company's ARM loans. The amount of any shortfall ("negative amortization") is added to the principal balance of the loan to be repaid through future monthly payments, which could cause increases in the amount of principal owed to the Company over that which was originally lent. The Company currently has approximately $531.3 million in mortgage loans that may be subject to negative amortization. During the years ended June 30, 2000, 1999 and 1998, the negative amortization associated with these loans totaled $109,000, $223,000 and $478,000, respectively. Significant negative amortization can increase the associated risk of default on loans, particularly for loans originated with relatively high loan-to-value ratios. Based on historical experience, management does not believe that the loss experience on the loans that are subject to negative amortization is materially different from the loss experience on the balance of its portfolio.
Mortgage loans originated by the Company, generally include due-on-sale clauses which provide the Company with the contractual right to deem the loan immediately due and payable in the event the borrower transfers ownership of the property without the Company's consent. Due-on-sale clauses are an important means of adjusting the rates on the Company's fixed rate multifamily and commercial mortgage loan portfolios and the Company has generally exercised its rights under these clauses.
Loan Approval Procedures and Authority. The Company's Board of Directors has a standing Loan Committee. The Loan Committee is primarily responsible for establishing the lending policies of the Company and reviewing properties offered as security. The Board of Directors has authorized the following persons to approve loans up to the amounts indicated: mortgage loans in amounts of $1.0 million and below may be approved by the respective Loan Division Manager or his designate; mortgage loans in excess of $1.0 million and up to $1.5 million require the approval of the President or any member of the Loan Committee; and mortgage loans in excess of $1.5 million requires the approval of at least two members of the Loan Committee.
For all loans originated by the Company, upon receipt of a completed loan application from a prospective borrower, a credit report is ordered and certain other information is verified by an independent credit agency and, if necessary, additional financial information is required. Appraisals of the real estate intended to secure proposed loans over $150,000 are required, which appraisals currently are performed by independent appraisers designated and approved by the Company. The Company's Board annually approves the independent appraisers used by the Company and approves the Company's appraisal policy. The Company's policy is to obtain title and hazard insurance on all real estate loans. If the original loan amount exceeds 80% of the underlying property's value on a sale or refinance of a first trust deed loan, private mortgage insurance is required and the borrower will be required to make payments to a mortgage impound account from which the Company makes disbursements for property taxes and mortgage insurance.
Delinquencies and Classification of Assets
Delinquent Loans. Management performs a monthly review of all delinquent loans and reports to the Company's Board of Directors regarding the same. The procedures taken by the Company with respect to delinquencies vary depending on the nature of the loan and period of delinquency.
The Company's policies generally provide that delinquent mortgage loans be reviewed and that written notices be mailed after the 11th and 17th day of delinquency. The Company's policies provide that telephone contact will be attempted to ascertain the reasons for delinquency and the prospects of repayment. When contact is made with the borrower at any time prior to foreclosure, the Company will attempt to obtain full payment or work out a repayment schedule with the borrower to avoid foreclosure. See also "-- Nonperforming Assets and Restructured Loans."
At June 30, 2000, 1999 and 1998, delinquencies in the Company's loan portfolio were as follows:
The loans in the above table have been considered in connection with the Company's overall assessment of the adequacy of its allowance for loan losses. However, there can be no assurance that the Company will not have to establish additional loss provisions for these loans in the future. See "--Allowances for Loan and Real Estate Losses" and "MD&A--Problem Assets."
Classification of Assets. Federal regulations and the Company's Classification of Assets Policy require that the Company utilize an internal asset classification system as a means of reporting problem and potential problem assets. The Company has incorporated the OTS internal asset classifications as a part of its credit monitoring system. The Company currently classifies problem and potential problem assets as "Substandard," "Doubtful" or "Loss" assets. An asset is considered "Substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the insured institution will sustain "some loss" if the deficiencies are not corrected. Loans can be considered "Substandard" for other reasons in addition to the paying capacity and underlying collateral, based on the Company's Classification of Assets Policy. Assets classified as "Doubtful" have all of the weaknesses inherent in those classified "Substandard" with the added characteristic that the weaknesses present make "collection or liquidation in full", on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." See "--Regulation and Supervision--Classification of Assets." The Company's Internal Asset Review Committee monthly reviews and classifies the Company's assets and reports the results of its review to the Company's Board of Directors.
The following table sets forth information with respect to the classified assets of the Company at June 30, 2000.
Pursuant to Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan", the Company recognizes impairment on troubled collateral dependent loans by creating a specific valuation allowance. At June 30, 2000 and 1999, the specific valuation allowances totaled $521,000 and $465,000, respectively. The loans for which a specific valuation allowance was established are in the process of collection. At such time that these loans are deemed uncollectible, the specific valuation allowance will be charged off.
In addition to adversely classified assets, assets which do not currently expose the Company to sufficient risk to warrant adverse classification but possess weaknesses are designated "Special Mention." According to OTS guidelines, Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. At June 30, 2000, $6.4 million of assets were graded as Special Mention, compared to $9.3 million at June 30, 1999.
These assets have been considered in connection with the Company's overall assessment of the adequacy of its allowance for loan losses; however, there can be no assurance that the Company will not establish additional loss provisions for these assets in the future. See "--Allowances for Loan and Real Estate Losses" and "MD&A--Problem Assets."
Nonperforming Assets and Restructured Loans
After 60 days, the Company ceases the accrual of interest on loans and any previously accrued interest is reversed. In addition, the Company may restructure a loan due to the debtor's financial difficulty and grant a concession which the Company would not have otherwise considered. REO is recorded at fair value less estimated costs of disposition.
The following table sets forth information regarding nonaccrual loans, troubled debt restructured loans and REO. There were no accruing loans past due 60 days or more for any of the periods presented below.
- -------- (1) Nonaccrual loans are net of specific allowances of $0, $68,000, $945,000, $1.0 million and $1.8 million for the years ended June 30, 2000, 1999, 1998, 1997 and 1996, respectively. (2) Nonperforming loans include nonaccrual and troubled debt restructured loans. Gross loans include loans held for sale. (3) Total allowance includes loan and REO valuation allowances. (4) Nonperforming assets include nonperforming loans and REO.
The gross amount of interest income on nonaccrual loans that would have been recorded during the years ended June 30, 2000, 1999 and 1998 if the nonaccrual loans had been current in accordance with their original terms was $312,000, $424,000 and $640,000, respectively. For the years ended June 30, 2000, 1999 and 1998, $247,000, $295,000 and $399,000, respectively, was actually earned on nonaccrual loans and is included in interest income on loans in the consolidated statements of operations for such years included in this report. Interest income earned on nonaccrual loans is generally recorded utilizing the cash-basis method of accounting. See "Financial Statements and Supplementary Data."
Impaired Loans
A loan is considered impaired when based on current circumstances and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Creditors are required to measure impairment of a loan based on any one of the following: (i) the present value of expected future cash flows from the loan discounted at the loan's effective interest rate, (ii) an observable market price or (iii) the fair value of the loan's underlying collateral. The Company measures impairment based on the fair value of the loan's underlying collateral property. Impaired loans exclude large groups of smaller balance homogeneous loans that are collectively evaluated for impairment. For the Company, loans collectively reviewed for impairment include all loans with principal balances of less than $300,000.
Factors considered as part of the periodic loan review process to determine whether a loan is impaired, as defined under SFAS 114, address both the amount the Company believes is probable that it will collect and the timing of such collection. As part of the Company's loan review process the Company considers such factors as the ability of the borrower to continue to meet the debt service requirements, assessments of other sources of repayment, the fair value of any collateral and the Company's prior history in dealing with the particular type of loan involved. In evaluating whether a loan is considered impaired, insignificant delays (less than twelve months) in the absence of other facts and circumstances would not alone lead to the conclusion that a loan was impaired.
At June 30, 2000 and 1999, the Company had a gross investment in impaired loans of $1.7 million and $3.5 million, respectively. During the years ended June 30, 2000 and 1999, the Company's average investment in impaired loans was $1.7 million and $5.9 million and for the years then ended, interest income on such loans totaled $126,000 and $531,000, respectively. Interest income on impaired loans which are performing is generally recorded utilizing the cash- basis method of accounting. Payments received on impaired loans which are performing under their contractual terms are allocated to principal and interest in accordance with the terms of the loans. At June 30, 2000 all impaired loans were performing in accordance with their contractual terms. Impaired loans totaling $1.7 million were not performing in accordance with their contractual terms at June 30, 1999, and have been included in nonaccrual loans at that date.
The Company recognizes impairment on troubled collateral dependent loans by creating a specific valuation allowance. The loans for which a specific valuation allowance was established are in the process of collection. At such time that these loans are deemed uncollectible, the specific valuation allowance is charged-off.
Impaired loans at June 30, 2000 include $1.7 million of loans for which specific valuation allowances of $379,000 had been established. At June 30, 1999, the Company had $1.0 million of impaired loans for which specific valuation allowances of $155,000 had been established and $2.5 million of such loans for which no specific valuation allowance was considered necessary. All such provisions for losses and related recoveries are recorded as part of the total allowance for loan losses.
Allowances for Loan and Real Estate Losses
The Company's allowance for loan losses is comprised of specific valuation allowances as well as a general valuation allowance ("GVA"). As discussed above, specific valuation allowances are generally established to recognize impairment on troubled collateral dependent loans. The GVA is maintained in an amount that management believes will be adequate to absorb probable losses that are anticipated on existing loan-related assets and off-balance sheet items.
The allowance for loan losses is established through a provision for loan losses based on management's evaluation of the risks inherent in its loan portfolio. The allowance for loan losses is
maintained at an amount management considers adequate to cover estimated losses in loans receivable which are deemed probable and estimable. The allowance is based upon a number of factors, including asset classifications, economic trends, industry experience and trends, industry and geographic concentrations, estimated collateral values, management's assessment of the credit risk inherent in the portfolio, historical loan loss experience, the Company's underwriting policies and the regulatory environment.
The Company has significantly increased its commercial real estate loan portfolio during the past fiscal year from $140.4 million at June 30, 1999 to $196.5 million at June 30, 2000 (an increase of approximately 39.92%). Both because the size of the commercial real estate loan portfolio has increased significantly and most of the loans comprising the portfolio are unseasoned, having been originated within the last two fiscal years, the Company's past loss experience with respect to its commercial real estate loan portfolio may not be representative of the risk of loss in such portfolio in the future. Multifamily and commercial real estate loans are generally considered to involve a higher degree of credit risk and to be more vulnerable to adverse conditions in the real estate market and to deteriorating economic conditions, particularly changes in interest rates than one-to-four family residential mortgage loans. These loans typically involve higher loan principal amounts and the repayment of such loans generally depend on the income produced by the operation or sale of the property being sufficient to cover operating expenses and debt service. Sometimes multifamily and commercial real estate loans are made to groups of related borrowers, which concentration could increase the Company's exposure should the circumstances of one borrower negatively affect the ability of other related borrowers to repay their loans in full on a timely basis. In addition, multifamily and commercial real estate values tend to be more cyclical and, while the southern California real estate market remained strong in fiscal 2000, recessionary economic conditions of the type that prevailed in prior years in the Company's lending market area tend to result in higher vacancy and reduced rental rates and net operating incomes from multifamily and commercial real estate properties. See "Business--Lending Activities--Multifamily Lending" and "--Commercial Real Estate Lending."
The Company recorded a provision for loan losses of $1.6 million for the year ended June 30, 2000, compared to $1.7 million, $1.5 million, $3.0 million and $2.1 million for the years ended June 30, 1999, 1998, 1997 and 1996, respectively. The slight decrease in the provision for 2000 is primarily the result of the continued decrease in nonperforming assets during the year. The slight increase in the provision for fiscal 1999 compared to 1998 was primarily a result of the overall growth in the loan portfolio as compared to the prior year, specifically in commercial real estate loans. In addition, certain one-to-four family loans purchased during fiscal 1999 were considered by the Company to have higher risk characteristics because they were loans outside of California, which has historically been considered the Company's primary market area for one-to-four family loans. The decrease in the provision for 1998 was primarily a result of decreased charge-offs and nonaccrual loans during this period. Management believed that the increases in the provisions for 1997 and 1996 were necessary to replenish the allowance for loan losses to what management believed was an adequate level due to charge- offs taken during these years. The increase in charge-offs in 1996 was primarily a result of acquiring title to or resolving properties damaged in the January 1994 Northridge earthquake as well as continued declines in the southern California economy during this year.
Although the Company believes that the allowance for loan losses at June 30, 2000 is adequate, there can be no assurance that the Company will not have to establish additional loss provisions based upon future events. The Company will continue to monitor and modify its allowances for loan losses as conditions dictate. In addition, the OTS and the FDIC, as an integral part of their examination process, periodically review the Company's valuation allowance. These agencies may require the Company to establish additional allowances, based on their judgments of the information available at the time of the examination. See "Regulation and Supervision--Classification of Assets."
It is the policy of the Company to "charge-off" consumer loans when it is determined that they are no longer collectible. The policy for loans secured by real estate, which comprise the bulk of the Company's portfolio, is to establish an allowance for loan losses in accordance with the Company's asset classification process, based on generally accepted accounting principles ("GAAP"). It has generally been the practice of the Company to "charge-off" losses after acquiring title to a property securing the loan. Prior to acquiring title to REO, losses are recognized through the establishment of valuation allowances. It is the Company's general policy to obtain appraisals on the underlying property for loans 90 days or more past due and over $500,000. If the loan amount is under $500,000, appraisals are obtained at the time of foreclosure. It is the policy of the Company to obtain an appraisal on all REO upon acquisition by the Company.
REO is initially recorded at fair value at the date of acquisition, less estimated costs of disposition. Thereafter, if there is a further deterioration in value, the Company writes down the REO directly for the diminution in value. Real estate held for investment is carried at the lower of cost or net realizable value. All costs of anticipated disposition are considered in the determination of net realizable value.
The following table sets forth activity in the Company's total allowance for loan losses and allowance for losses on REO.
- -------- (1) In 2000 recoveries were on multifamily loans.
The following table sets forth the Company's allowance for loan losses to total loans and the percentage of loans to total loans in each of the categories listed.
- ---------- (1) In 2000, 1999, 1998, 1997 and 1996, total specific allowances amounted to $521,000, $465,000, $1.7 million, $1.6 million and $2.2 million, respectively.
In fiscal 1999 the Company reevaluated its allowance methodology. This reevaluation resulted in additional allocations of the allowance to the one- to-four family and commercial real estate portfolios at June 30, 1999 as compared to June 30, 1998. The increase in the unallocated allowance at June 30, 1997 as compared to June 30, 1996, is a result of a decrease in the allocated allowance on multifamily loans as a result of a decline in multifamily charge-offs and nonaccrual multifamily loans during the year.
Investment Activities
Federally chartered savings associations such as the Bank have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Subject to various restrictions, federally chartered savings institutions may also invest their assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly. Additionally, a federally chartered savings institution such as the Bank must maintain minimum levels of investments that qualify as liquid assets under OTS regulations. See "--Regulation and Supervision--Required Liquidity." The Bank currently manages liquid assets at the minimum level required under OTS requirements in an effort to maximize overall yield on its investment portfolio.
The investment policy of the Company attempts to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complement the Company's lending activities. Specifically, the Company's policy generally limits investments to government and federal agency-backed securities and other non-government guaranteed securities, including corporate debt obligations, that are investment-grade. The Company's policy authorizes investment in marketable equity securities meeting the Company's guidelines. The policy requires that all investment purchases be ratified by the Board of Directors of the Company. At June 30, 2000, the Company had federal funds sold and other short-term investments and investment securities in the aggregate amount of $35.3 million with a fair value of $34.2 million.
The following table sets forth certain information regarding the amortized cost and fair values of the Company's federal funds sold and other short-term investments and investment securities portfolio at the dates indicated:
The table below sets forth certain information regarding the amortized cost, weighted average yields and contractual maturities of the Company's federal funds sold and other short-term investments and investment securities as of June 30, 2000.
Sources of Funds
General. Deposits, FHLB advances, securities sold under agreements to repurchase, loan repayments and prepayments, and proceeds from sales of loans are the primary sources of the Company's funds for use in lending, investing and for other general purposes.
Deposits. The Company offers a variety of deposit accounts with a range of interest rates and terms. The Company's deposits consist of passbook savings, checking accounts, money market accounts and certificates of deposit. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. The Company's deposits are obtained predominantly from the areas in which its branch offices are located. The Company relies primarily on customer service and long-standing relationships with customers to attract and retain these deposits; however, market interest rates and rates offered by competing financial institutions significantly affect the Company's ability to attract and retain deposits. Certificate of deposit accounts in excess of $100,000 are not actively solicited by the Company nor does the Company currently use brokers to obtain deposits. During the second quarter of fiscal 2000 the Bank purchased a retail branch office and its $45.9 million of deposits from another financial institution. This branch is located in Rowland Heights, California. In addition, while the vast majority of the Bank's deposits are retail in nature, the Bank accepted $55 million in time deposits from a political subdivision during fiscal 2000. The Bank considers these funds to be wholesale deposits and an alternative borrowing source rather than a customer relationship and their levels are determined by management's decision as to the most economic funding sources. Management continually monitors the Company's certificate accounts and historically the Company has retained a large portion of such accounts upon maturity. See "MD&A--Capital Resources and Liquidity--Sources of Funds and Liquidity."
The following table presents the deposit activity of the Company for the periods indicated:
The following table presents the amount and weighted average rate of time deposits equal to or greater than $100,000 at June 30, 2000:
The following table sets forth the distribution of the Company's average deposit accounts for the periods indicated and the weighted average interest rates on each category of deposits presented:
The following table presents, by various rate categories, the amount of certificate accounts outstanding at the dates indicated and the periods to contractual maturity of the certificate accounts outstanding at June 30, 2000:
Borrowings. From time to time the Company has obtained advances from the FHLB and may do so in the future as an alternative to retail deposit funds. FHLB advances may also be used to acquire certain other assets as may be deemed appropriate for investment purposes. These advances are collateralized by the capital stock of the FHLB held by the Company and certain of the Company's mortgage loans. See "--Regulation and Supervision--Federal Home Loan Bank System." Such advances are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The maximum amount that the FHLB will advance to member institutions, including the Company, for purposes other than meeting withdrawals, fluctuates from time to time in accordance with the policies of the OTS and the FHLB. During fiscal 2000, the Company periodically borrowed advances to provide needed liquidity and to supplement retail deposit gathering activity. See "MD&A--Capital Resources and Liquidity--Sources of Funds and Liquidity." At June 30, 2000, the Company had $290.3 million in outstanding advances from the FHLB. During fiscal 2000, the maximum amount of FHLB advances that the Company had outstanding at any month-end was $312.1 million.
The following table sets forth certain information regarding the Company's borrowed funds at or for the periods ended on the dates indicated:
For information regarding securities sold under agreements to repurchase, loan repayments and prepayments and proceeds from loan sales as sources of funds for the Company, see "MD&A--Capital Resources and Liquidity--Sources of Funds and Liquidity."
Subsidiary Activities
QCFC, a wholly owned subsidiary of the Bank, is currently engaged, on an agency basis, in the sale of casualty insurance, mutual funds and annuity products primarily to the Bank's customers and
members of the local community and as a trustee of the Bank's deeds of trust. In the past, QCFC has been involved in real estate development projects. The Bank does not currently intend to engage in any future real estate development projects through QCFC or otherwise. As of June 30, 2000, and for the year then ended, QCFC had $298,000 in total assets and net income of $227,000.
Competition
Savings associations face strong competition both in attracting deposits and making real estate loans. The Company's most direct competition for deposits has historically come from other savings associations and from commercial banks located in its principal market areas of Los Angeles and Orange Counties in California, including many large financial institutions which have greater financial and marketing resources available to them. In addition, particularly during times of high interest rates, the Company has faced significant competition for investors' funds from short-term money market securities and other corporate and government securities and mutual funds which invest in such securities. Periods of low interest rates have made the attraction and retention of deposits difficult as savers seek higher rates of return in alternative investments. The ability of the Company to attract and retain savings deposits depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. Furthermore, management considers the Company's reputation for financial strength and quality service provided through its contiguous branching network to local customers to be a major competitive advantage in attracting and retaining savings deposits.
The Company experiences strong competition for real estate loans principally from other savings associations, commercial banks and mortgage banking companies. It competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Management considers the Company's focus in multifamily and low- to-moderate income lending in the Los Angeles area to be a competitive advantage also. Competition may increase as a result of the continuing reduction in restrictions on the interstate operations of financial institutions.
Under legislation adopted by Congress in 1994, bank holding companies based in any state generally are allowed to acquire banks in California and banks based in any state generally are allowed to acquire by merger banks based in California. Under OTS regulations, federal savings associations have been generally able to branch nationwide as long as the association's assets attributable to each state outside of its home state in which it operates branches are predominantly housing-related assets. The increased authority of bank holding companies and banks to engage in interstate banking will allow them to compete more effectively with savings associations.
Personnel
As of June 30, 2000, the Bank had 159 full-time employees and 47 part-time employees. The employees are not represented by a collective bargaining unit and the Bank considers its relationship with its employees to be good.
Federal Taxation
General. The Company reports its income for tax purposes using the accrual method of accounting and will be subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company.
Tax Bad Debt Reserve. Prior to 1996, savings institutions such as the Bank which meet certain definitional tests primarily relating to their assets and the nature of their business ("qualifying thrifts")
were permitted to establish a reserve for bad debts and to make annual additions thereto, which additions, within specified formula limits, were deducted in arriving at their taxable income. The Bank's deduction with respect to "qualifying loans," generally loans secured by certain interests in real property, was computed using the Bank's actual loss experience, or 8% of the Bank's taxable income. Use of the percentage of taxable income method of calculating its deductible addition to its loss reserve had the effect of reducing the maximum marginal rate of federal tax on the Bank's income to 32.20%, exclusive of any minimum or environmental tax, as compared to the general maximum corporate federal income tax rate of 35%.
Pursuant to certain provisions appended to the Small Business Job Protection Act signed into law in August 1996 (the "Act"), the above-described bad debt deduction rules available to thrifts such as the Bank have been repealed. Under the Act, the Bank has changed its method of accounting for bad debts from the reserve method formerly permitted under section 593 of the Internal Revenue Code of 1986, as amended (the "Code") to the "specific charge-off" method. Under the specific charge-off method, which is governed by section 166 of the Code and the regulations thereunder, tax deductions may be taken for bad debts only if loans become wholly or partially worthless. Although the Act generally requires that qualifying thrifts recapture (i.e., include in taxable income) over a six-year period a portion of their existing bad debt reserves equal to their "applicable excess reserves," the Bank does not have applicable excess reserves subject to recapture. However, the Bank's tax bad debt reserve balance of approximately $10.9 million as of June 30, 2000 will, in future years, be subject to recapture in whole or in part upon the occurrence of certain events, such as a distribution to stockholders in excess of the Bank's current and accumulated earnings and profits, a redemption of shares, or upon a partial or complete liquidation of the Bank. The Bank does not intend to make distributions to stockholders that would result in recapture of any portion of its bad debt reserve. Since management intends to use the reserve only for the purpose for which it was intended, a deferred tax liability of approximately $3.8 million has not been recorded.
Distributions. To the extent that the Bank makes "non-dividend distributions" to stockholders that are considered to result in distributions from the tax bad debt reserve for losses on qualifying real property, then an amount based on the amount distributed will be included in the Bank's taxable income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank's tax bad debt reserves. Thus, any dividends to the Company that would reduce amounts appropriated to the Bank's tax bad debt reserves and deducted for federal income tax purposes may create a tax liability for the Bank.
The amount of additional taxable income created from a distribution from the tax bad debt reserve is an amount that when reduced by the tax attributable to the income is equal to the amount of the distribution. The result is to tax distributions from the tax bad debt reserve at approximately 51%. See "-- Regulation and Supervision--Savings and Loan Holding Company Regulation-- Payment of Dividends and Other Capital Distributions by Association" and "Market for the Registrant's Common Equity and Related Stockholder Matters" for limits on the payment of dividends of the Bank. The Bank does not intend to make distributions that would result in a recapture of any portion of its tax bad debt reserve.
The date of the Company's last complete Internal Revenue Service (IRS) tax audit was December, 1985. There is a three-year statute of limitations for federal tax filings. Tax years 1996 through 2000 are considered open tax years for IRS audit purposes.
Dividends Received Deduction and Other Matters. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations.
The corporate dividends received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company and the Bank own more than 20% of the stock of a corporation distributing a dividend 80% of any dividends received may be deducted.
State and Local Taxation
State of California. The California franchise tax rate applicable to the Company equals the franchise tax rate applicable to corporations generally plus an "in lieu" rate approximately equal to personal property taxes and business license taxes paid by such corporations (but not generally paid by banks or financial corporations such as the Bank); however, the total tax rate currently applicable to the Company cannot exceed 10.84% for the 2000 calendar year. Under California regulations, bad debt deductions are available in computing California franchise taxes using a three or six year weighted average loss experience method. The Company and its California subsidiary file California state franchise tax returns on a combined basis.
The date of the Company's last examination by the California Franchise Tax Board was December 1997. There is a four-year statute of limitations for state tax filings. Tax years 1998 through 2000 are considered open for California Franchise Tax audit purposes.
Delaware Taxation. As a Delaware holding company not earning income in Delaware, the Company is exempted from Delaware Corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware.
Environmental Regulation
The Company's business and properties are subject to federal and state laws and regulations governing environmental matters, including the regulation of hazardous substances and wastes. For example, under the federal Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and similar state laws, owners and operators of contaminated properties may be liable for the costs of cleaning up hazardous substances without regard to whether such persons actually caused the contamination. Such laws may affect the Company as an owner or operator of properties used in its business, and through the Bank, as a secured lender of property that is found to contain hazardous substances or wastes.
Although CERCLA and similar state laws generally exempt holders of security interests, the exemption may not be available if a secured party engages in the management of its borrower or the securing property in a manner deemed beyond the protection of the secured party's interest. Recent federal and state legislation, as well as guidance issued by the United States Environmental Protection Agency and a number of court decisions, have provided assurance to lenders regarding the activities they may undertake and remain within CERCLA's secured party exemption. However, these assurances are not absolute and generally will not protect a lender or fiduciary that participates or otherwise involves itself in the management of its borrower, particularly in foreclosure proceedings. As a result, CERCLA and similar state statutes may influence the Bank's decision whether to foreclose on property that is found to be contaminated. The Bank has adopted environmental underwriting requirements for commercial real estate loans. The Bank's general policy is to obtain an environmental assessment prior to foreclosure on commercial real estate. See "Business--General" and "--Lending Activities-- Loan and MBS Portfolio Composition" regarding the recent and rapid expansion of the Association's commercial real estate loan portfolio. The existence of hazardous substances or wastes on commercial real estate properties could cause the Bank to elect not to foreclose on the property, thereby limiting, and in some instances precluding, the Bank from realizing on the related loan. Should the Bank foreclose on property containing hazardous substances or wastes, the Bank would become subject to other environmental statutes, regulations and common law relating to matters such as, but
not limited to, asbestos abatement, lead-based paint abatement, hazardous substance investigation and remediation, air emissions, wastewater discharges, hazardous waste management, and third party claims for personal injury and property damage.
Regulation and Supervision
General
The Bank is a federally chartered savings association, a member of the FHLB of San Francisco, and is subject to regulation by the OTS and the FDIC. The Bank's deposits are insured by the FDIC through the SAIF, up to applicable limits. As a result of its ownership of the Bank, the Company is a savings and loan holding company subject to regulation by the OTS. As described in more detail below, statutes and regulations applicable to the Bank govern such matters as the investments and activities in which the Bank can engage; the amount of capital the Bank must hold; mergers and changes of control; establishment and closing of branch offices; and dividends payable by the Bank. Statutes and regulations applicable to the Company govern such matters as changes of control of the Company and transactions between the Bank and the Company.
The Company and the Bank are subject to the examination, supervision and reporting requirements of the OTS, their primary federal regulator, including a requirement for the Bank of at least one full scope, on-site examination every year. The Director of the OTS is authorized to impose assessments on the Bank to fund OTS operations, including the cost of examinations. The Bank is also subject to examination, when deemed necessary, and supervision by the FDIC, and the FDIC has "back-up" authority to take enforcement action against the Bank if the OTS fails to take such action after a recommendation by the FDIC. The FDIC may impose assessments on the Bank to cover the cost of FDIC examinations. The FDIC is no longer able to conduct separate examinations of the Bank except in exigent circumstances. In addition, the Bank is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB") with respect to certain aspects of its business.
The descriptions set forth below and elsewhere in this document of the statutes and regulations that are applicable to the Company do not purport to be a complete description of such statutes and regulations and their effects on the Company, or to identify every statute and regulations that may apply to the Company. The following description of statutory and regulatory provisions and proposals is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.
Activities Restrictions
Qualified Thrift Lender Test. The qualified thrift lender ("QTL") test requires that, in at least nine out of every twelve months, at least 65% of a savings bank's "portfolio assets" must be invested in a limited list of "qualified thrift investments," primarily investments related to housing loans and certain other assets. If the Bank fails to satisfy the QTL test and does not requalify as a QTL within one year, the Company must register and be regulated as a bank holding company, and the Bank must either convert to a commercial bank charter or become subject to restrictions on branching, business activities and dividends as if it were a national bank. At June 30, 2000, approximately 83.50% of the Bank's portfolio assets constituted qualified thrift investments and the Bank met the QTL test each month in fiscal 2000.
Investment and Loan Limits. In general, federal savings institutions such as the Bank may not invest directly in equity securities, debt securities that are not rated investment grade, or real estate, other than real estate used for the institution's offices and related facilities. Indirect equity investment in real estate through a subsidiary is permissible, but subject to limitations based on the amount of the institution's assets, and the institution's investment in such a subsidiary must be deducted from regulatory capital in full.
Loans by a savings institution to a single borrower are generally limited to 15% of the institution's "unimpaired capital and unimpaired surplus," which is similar but not identical to total capital. Aggregate loans by the Bank that are secured by nonresidential real property are generally limited to 400% of the institution's total capital. Commercial loans not secured by real property may not exceed 10% of the Bank's total assets, and consumer loans may not exceed 35% of the Bank's total assets. At June 30, 2000, the Bank was in compliance with the above investment limitations.
Activities of Subsidiaries. A savings institution seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through an existing subsidiary must provide 30 days prior notice to the FDIC and OTS. A subsidiary of the Bank may be able to engage in activities that are not permissible for the Bank directly, if the OTS determines that such activities are reasonably related to the Bank's business, but the Bank may be required to deduct its investment in such a subsidiary from capital. The OTS has the power to require a savings institution to divest any subsidiary or terminate any activity conducted by a subsidiary that the OTS determines to be a serious threat to the financial safety, soundness or stability of such savings institution or to be otherwise inconsistent with sound banking practices.
Safety and Soundness Standards. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") required the OTS to prescribe for savings associations minimum acceptable operational and managerial standards, and standards for asset quality, earnings, and stock valuation. The standards cover internal control, loan documentation, credit underwriting, interest rate exposure, asset growth, and employee compensation. Any institution that fails to meet the OTS regulations promulgated under the safety and soundness requirements must submit an acceptable plan for compliance or become subject to the ability of the OTS, in its discretion, to impose operational restrictions similar to those that would apply to a failure to meet minimum capital requirements as discussed below.
Real Estate Lending Standards. The OTS and the other federal banking agencies have adopted regulations which require institutions to adopt and at least annually review written real estate lending policies. The lending policies must include diversification standards, underwriting standards (including loan-to-value limits), loan administration procedures, and procedures for monitoring compliance with the policies. The policies must reflect consideration of guidelines adopted by the banking agencies that discuss certain loan-to-value and percentage of capital limits.
Deposit Insurance
Deposit Insurance Premium Assessments. The FDIC has established a risk-based system for setting deposit insurance assessments on deposits. Currently, all of the Bank's deposits are SAIF-insured. Under the risk-based assessment system, an institution's insurance assessment will vary depending on the level of capital the institution holds and the degree to which it is the subject of supervisory concern to the FDIC. SAIF-assessed deposits are currently subject to insurance premiums between 0.0% and 0.27%. The Bank's assessment rate was 0.0% as of June 30, 2000.
Also, the FDIC assesses SAIF member and BIF member institutions to fund interest payments on certain bonds issued by the Financing Corporation ("FICO debt"). Until December 31, 1999, BIF members were assessed at approximately one-fifth the rate at which SAIF members were assessed. After December 31, 1999, BIF and SAIF members are being assessed at the same rate of 0.0212% on deposits. Currently, all of the Bank's deposits are SAIF-insured. See "Business--Federal Taxation" for a discussion of recent changes concerning bad debt deductions historically available to qualifying thrift institutions.
Regulatory Capital Requirements
The OTS's capital regulations include three separate minimum capital requirements for the savings institution industry--a "tangible capital requirement," a "leverage limit" (also referred to as the
"core capital ratio"), and a "risk-based capital requirement." These capital standards must be no less stringent than the capital standards applicable to national banks. In addition, institutions whose exposure to interest rate risk is deemed to be above normal are required to deduct a portion of such exposure in calculating their risk-based capital requirements. The OTS also has the authority, after giving the affected institution notice and an opportunity to respond, to establish individual minimum capital requirements ("IMCR") for a savings institution which are higher than the industry minimum requirements, upon a determination that an IMCR is necessary or appropriate in light of the institution's particular circumstances. Savings institutions that do not meet their capital requirements are subject to a number of sanctions similar to but less restrictive than the sanctions under the Prompt Corrective Action system described below, and to a requirement that the OTS be notified of any changes in the institution's directors or senior executive officers.
The three industry minimum capital requirements are as follows:
Tangible capital of at least 1.5% of adjusted total assets. Tangible capital is composed of (1) an institution's common stock, perpetual non- cumulative preferred stock, and related earnings or surplus (excluding unrealized gains and losses on securities classified as available-for-sale), (2) certain nonwithdrawable accounts and pledged deposits and (3) the amount, if any, of equity investment by others in the institution's subsidiaries, after deducting (a) the institution's investments in and extensions of credit to subsidiaries engaged as principal in activities not permissible for national banks, net of any reserves established against such investments and (b) certain non- qualifying intangible assets. Deferred tax assets whose realization depends on the institution's future taxable income or on the institution's tax planning strategies must also be deducted from tangible capital to the extent that such assets exceed the lesser of (1) 10% of core capital, or (2) the amount of such assets that can be realized within one year, unless such assets were reportable as of December 31, 1992, in which case no deduction is required.
In general, adjusted total assets equal the institution's consolidated total assets, minus any assets that are deducted in calculating the amount of capital. At June 30, 2000, the Bank's ratio of tangible capital to adjusted total assets was 7.20%.
Core capital of at least 4% of adjusted total assets. Core capital consists of tangible capital plus (1) qualifying intangibles such as certain mortgage servicing rights and purchased credit card relationships and (2) any core deposit premium in existence on March 4, 1994 whose inclusion in core capital is grandfathered by the OTS. At June 30, 2000, the Bank's core capital ratio was 7.20%.
Total capital of at least 8% of risk-weighted assets. Total capital includes both core capital and "supplementary" capital items deemed less permanent than core capital, such as subordinated debt and general loan loss allowances (subject to certain limits). At least half of total capital must consist of core capital. Risk-weighted assets are determined by multiplying each category of an institution's assets, including certain assets sold with recourse and other off balance sheet assets, by an assigned risk weight based on the credit risk associated with those assets, and adding the resulting sums. The amount of risk-based capital, however, that may be required to be maintained by the institution for recourse assets cannot be greater than the total of the recourse liability. The four risk-weight categories include zero percent for cash and government securities, 20% for certain high-quality investments, 50% for certain qualifying one-to-four family and multifamily mortgage loans and 100% for assets (including past-due loans and real estate owned) that do not qualify for preferential risk-weighting. At June 30, 2000, the Bank's risk-based capital ratio was 12.03%, and accordingly the Bank exceeded all three of the industry minimum capital requirements.
FDICIA required the OTS and the federal bank regulatory agencies to revise their risk-based capital standards to ensure that those standards take adequate account of interest-rate risk,
concentration of credit risk, and risks of nontraditional activities. The regulations of the OTS and the other federal banking agencies provide that an institution may be required to hold risk-based capital in excess of regulatory minimums to the extent that it is determined either that (i) the institution has a high degree of exposure to interest-rate risk, prepayment risk, credit risk, certain risks arising from nontraditional activities or similar risks, or a high proportion of off-balance sheet risk or (ii) the institution is not adequately managing these risks. For this purpose, however, the agencies have stated that, in view of the statutory requirements relating to permitted lending and investment activities of savings institutions, the general concentration by such institutions in real estate lending activities would not, by itself, be deemed to constitute an exposure to concentration of credit risk that would require greater capital levels.
Prompt Corrective Action Requirements
FDICIA required and the OTS has established five capital categories to implement a "prompt corrective action" system. These categories are: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized."
An institution is treated as well capitalized if its risk-based capital ratio is at least 10.0%, its ratio of core capital to risk-weighted assets (the "Tier 1 risk-based capital ratio") is at least 6.0%, its leverage ratio or core capital is at least 5.0%, and it is not subject to any order or directive by the OTS to meet a specific capital level. At June 30, 2000, the Bank had a risk-based capital ratio of 12.03%, a Tier 1 risk-based capital ratio of 10.83%, and a core capital ratio of 7.20%, which qualified the Bank for the well-capitalized category. The Bank's capital category under the prompt corrective action system may not be an accurate representation of the Bank's overall financial condition or prospects.
An institution will be adequately capitalized if its risk-based capital ratio is at least 8.0%, its Tier 1 risk-based capital ratio is at least 4.0%, and its core capital ratio is at least 4.0% (3.0% if the institution receives the highest rating on the OTS CAMEL financial institutions rating system). An institution whose capital does not meet the amounts required in order to be adequately capitalized will be treated as undercapitalized. If an undercapitalized institution's capital ratios are less than 6.0%, 3.0%, or 3.0% respectively, it will be treated as significantly undercapitalized. Finally, an institution will be treated as critically undercapitalized if its ratio of "tangible equity" (core capital plus cumulative preferred stock minus intangible assets other than supervisory goodwill and purchased mortgage servicing rights) to adjusted total assets is equal to or less than 2.0%.
An institution that is undercapitalized or lower must submit a capital restoration plan to the OTS within 45 days after becoming undercapitalized, and the plan can be accepted only if the institution's performance under the plan is guaranteed, up to a maximum of 5% of the institution's assets, by every company that controls the institution. An institution that is undercapitalized is also subject to mandatory stringent limits on expansion and on the ability to make capital distributions, and is prohibited from accepting, renewing or rolling over brokered deposits and certain benefit plan deposits. In addition, an undercapitalized institution is subject to numerous other restrictions which the OTS may impose in its discretion, including restrictions on transactions with affiliates and interest rates, and to the ability of the OTS to order a sale of the institution, the replacement of directors and management, and the appointment of a conservator or receiver. A significantly undercapitalized institution is subject to additional sanctions and a critically undercapitalized institution generally must be placed into conservatorship or receivership.
Enforcement
All depository institutions, including savings associations, and "institution affiliated parties" such as directors, officers, employees, agents and controlling stockholders of depository institutions, including holding companies, are subject to regulatory agency enforcement authority. An institution or institution-affiliated party may be subject to a three-tier penalty regime that ranges from a maximum
penalty of $5,000 per day for a simple violation to a maximum penalty of $1 million per day for certain knowing violations including the failure to submit, or submission of incomplete, false or misleading, reports. An institution-affiliated party may also be subject to loss of voting rights with respect to the stock of depository institutions.
Savings and Loan Holding Company Regulation
Activities of the Company. As a savings and loan holding company, the Company must file periodic reports with the OTS, and is subject to OTS examination. As a savings and loan holding company that acquired control of only one savings association prior to May 4, 1999, the Company generally is not restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a QTL. See "Regulation--Activities Restrictions--QTL Test" for a discussion of the QTL requirements. If the Bank ceases to be a QTL, or if the Company were to acquire another savings association and hold such association as a subsidiary separate from the Bank, the Company would be subject to extensive restrictions on the types of business activities in which it could engage. Such restrictions would limit the Company to specified finance-, real estate- and insurance-related activities.
The Home Owners' Loan Act ("HOLA") prohibits a savings and loan holding company such as the Company, directly or indirectly, or through one or more subsidiaries, from (a) acquiring control of another savings institution or savings and loan holding company without prior written approval of the OTS; (b) acquiring or retaining, with certain exceptions, more than 5% of a non- subsidiary savings institution or a non-subsidiary savings and loan holding company; or (c) acquiring or retaining control of a depository institution that is not insured by the FDIC. In evaluating applications by holding companies such as the Company to acquire savings institutions, the OTS must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
Affiliate and Insider Transactions. The ability of the Company and its non- depository subsidiaries to deal with the Bank is limited by the affiliate transaction rules, including Sections 23A and 23B of the Federal Reserve Act which also govern BIF-insured banks. With very limited exceptions, these rules require that all transactions between the Bank and an affiliate must be on arms' length terms. The term "affiliate" covers any company that controls or is under common control with the Bank, but does not include individuals and generally does not include the Bank's subsidiaries.
Under Section 23A and section 11 of HOLA, specific restrictions apply to transactions in which the Bank provides funding to its affiliates: the Bank may not purchase the securities of an affiliate, make a loan to any affiliate that is engaged in activities not permissible for a bank holding company, or acquire from an affiliate any asset that has been classified, a nonaccrual loan, a restructured loan, or a loan that is more than 30 days past due. As to affiliates engaged in bank holding company-permissible activities, the aggregate of (a) loans, guarantees, and letters of credit provided by the savings bank for the benefit of any one affiliate, and (b) purchases of assets by the savings bank from the affiliate, may not exceed 10% of the savings bank's capital stock and surplus (20% for the aggregate of permissible transactions with all affiliates). All loans to affiliates must be secured by collateral equal to at least 100% of the amount of the loan (130% if the collateral consists of equity securities, leases or real property).
Loans by the Bank to its directors, executive officers, and 10% shareholders of the Bank, the Company, or the Company's subsidiaries (collectively, "insiders"), or to a corporation or partnership that is at least 10% owned by an insider (a "related interest") are subject to limits separate from the affiliate transaction rules. All loans to insiders and their related interests must be underwritten and made on non-preferential terms; loans in excess of $500,000 must be approved in advance by the
Bank's Board of Directors; and the Bank's total of such loans may not exceed 100% of the Bank's capital. Loans by the Bank to its executive officers are subject to additional limits which are even more stringent.
Limits on Change of Control. Subject to certain limited exceptions, control of the Bank or the Company may only be obtained with the approval (or in the case of an acquisition of control by an individual, the nondisapproval) of the OTS, after a public comment and application review process. Under OTS regulations defining "control," a rebuttable presumption of control arises if an acquiring party acquires more than 10% of any class of the Bank or the Company (or more than 25% of any class of stock, whether voting or non-voting) and is subject to any "control factors" as defined in the regulation. Control is conclusively deemed to exist if an acquirer holds more than 25% of any class of voting stock of the Bank or the Company, or has the power to control in any manner the election of a majority of directors.
Payment of Dividends and Other Capital Distributions by Bank. The payment of dividends, stock repurchases, and other capital distributions by the Bank to the Company is subject to regulation by the OTS. The OTS has promulgated a regulation that addresses a savings institution's ability to make a capital distribution according to the institution's capital position. Effective April 1, 1999, the OTS amended its capital distributions regulation. The new rule establishes a "safe-harbor" amounts for capital distributions that institutions can make without OTS prior approval or notice. It also sets forth certain conditions that specify whether a notice or an application for prior approval of the OTS is required if the safe harbor does not apply. The OTS retains discretion to subject institutions that meet their capital requirements to the more stringent capital distribution rules applicable to institutions with less capital if the OTS notifies the institution that it is in need of more than normal supervision. The OTS retains the authority to prohibit any capital distribution otherwise authorized under its regulations if the OTS determines that the distribution would constitute an unsafe or unsound practice.
Under its regulation, an application for the prior approval of the OTS to make a capital distribution is required if any of the following conditions are present: the institution would not be adequately-capitalized after the distribution, its examination ratings are not at least satisfactory or it is considered a problem association or in troubled condition, the total amount of all its capital distributions for the applicable calendar year (including the proposed distribution) would exceed its net income for that year to date plus its retained net income for the prior two years, or the distribution would violate an applicable prohibition or OTS imposed condition on the institution.
A 30-day advance notice is required if, as is the case with the Bank, the institution is a subsidiary of a holding company, the institution would not be well-capitalized after the distribution, or the distribution would reduce the amount of or retire any part of its common or preferred stock or retire any part of a debt instrument included in total capital (other than through a regular payment on the instrument). If none of the above conditions are present, an institution is not required to file an application or notice with the OTS before making a capital distribution.
In connection with a conversion from mutual to stock form, a savings institution is required to establish a liquidation account in an amount equal to the converting institution's net worth as of a practicable date prior to the conversion. The liquidation account is maintained for the benefit of certain eligible accountholders maintaining accounts at or prior to the date of conversion. In the event of a complete liquidation of the converted savings institution (and only in such event), each such accountholder is entitled to receive a distribution from the liquidation account equal to the then current adjusted balance of the holder's savings accounts with the savings institution. The Bank's ability to pay dividends to the Company is also subject to restriction arising from the existence of the liquidation account established upon the conversion of the Bank from mutual to stock form in December 1993. The Bank is not permitted to pay dividends to the Company if its regulatory capital would be reduced below the amount required for the liquidation account.
Additionally, as of June 30, 2000, the Bank had a tax bad debt reserve balance of approximately $10.9 million. Any distribution by the Bank to the Company that exceeds the Bank's current or accumulated earnings and profits as calculated for federal income tax purposes would be treated as a distribution of the bad debt reserve and would be subject to recapture taxes of up to 51%. See "Business--Federal Taxation" regarding recently enacted changes relating to bad debt reserve recapture. The Bank does not intend to make distributions to stockholders that would result in recapture of any portion of its bad debt reserve. Since management intends to use the reserve only for the purpose for which it was intended, a deferred tax liability of approximately $3.8 million has not been recorded.
Enforcement. Whenever the OTS has reasonable cause to believe that the continuation by a savings and loan holding company of any activity or of ownership or control of any non FDIC-insured subsidiary constitutes a serious risk to the financial safety, soundness, or stability of a savings and loan holding company's subsidiary savings institution and is inconsistent with the sound operation of the savings institution, the OTS may order the holding company, after notice and opportunity for a hearing, to terminate such activities or to divest such noninsured subsidiary. FIRREA also empowers the OTS, in such a situation, to issue a directive without any notice or opportunity for a hearing, which directive may (i) limit the payment of dividends by the savings institution, (ii) limit transactions between the savings institution and its holding company or its affiliates, and (iii) limit any activity of the association that creates a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution.
In addition, FIRREA includes savings and loan holding companies within the category of person designated as "institution-affiliated parties." An institution-affiliated party may be subject to significant penalties and/or loss of voting rights in the event such party took any action for or toward causing, bringing about, participating in, counseling, or aiding and abetting a violation of law or unsafe or unsound practice by a savings institution.
Classification of Assets
Savings institutions are required to classify their assets on a regular basis, to establish appropriate allowances for losses and report the results of such classification quarterly to the OTS. A savings institution is also required to set aside adequate valuation allowances to the extent that an affiliate possesses assets posing a risk to the institution, and to establish liabilities for off-balance sheet items, such as letters of credit, when loss becomes probable and estimable. The OTS has the authority to review the institution's classification of its assets and to determine whether and to what extent (a) additional assets must be classified, and (b) the institution's valuation allowances must be increased.
Troubled assets are classified into one of three categories as follows:
Substandard Assets. An asset is considered "Substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Prudent general valuation allowances are required to be established for such assets.
Doubtful Assets. Assets classified as "Doubtful" have all of the weaknesses inherent in those classified "Substandard" with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Prudent general valuation allowances are required to be established for such assets.
Loss Assets. Assets classified as "Loss" are those considered "uncollectible" and of such little value that their continuance as bankable assets is not warranted.
General valuation allowances for loan and lease losses are included within regulatory capital for certain purposes and up to certain limits, while specific allowances and other general allowances are not included at all.
The OTS and the other federal banking agencies have adopted a statement of policy regarding the appropriate levels of general valuation allowances for loan and lease losses that institutions should maintain. Under the policy statement, examiners will generally accept management's evaluation of adequacy of general valuation allowances for loans and lease losses if the institution has maintained effective systems and controls for identifying and addressing asset quality problems, analyzed in a reasonable manner all significant factors that affect the collectibility of the portfolio, and established an acceptable process for evaluating the adequacy of general valuation allowances. However, the policy statement also provides that OTS examiners will review management's analysis more closely if general valuation allowances for loan and lease losses do not equal at least the sum of (a) 15% of assets classified as Substandard, (b) 50% of assets classified as Doubtful, and (c) for the portfolio of unclassified loans and leases, an estimate of credit losses over the upcoming twelve months based on the institution's average rate of net charge-offs over the previous two or three years on similar loans, adjusted for current trends and conditions.
Community Reinvestment Act
The Community Reinvestment Act ("CRA") requires each savings institution, as well as other lenders, to identify the communities served by the institution's offices and to identify the types of credit the institution is prepared to extend within such communities. The CRA also requires the OTS to assess the performance of the institution in meeting the credit needs of its community and to take such assessment into consideration in reviewing applications for mergers, acquisitions, and other transactions. An unsatisfactory CRA rating may be the basis for denying such an application.
Under the CRA regulations of the OTS and the other federal banking agencies, an institution's performance in making loans and investments and maintaining branches and providing services in low-and moderate-income areas within the communities that it serves is evaluated. In connection with its assessment of CRA performance, the OTS assigns a rating of "outstanding," "satisfactory," "needs to improve," or "substantial noncompliance." Based on the latest examination conducted by the OTS in 1999, the Bank was rated outstanding.
Federal Home Loan Bank System
The Federal Home Loan Banks provide a credit facility for member institutions. As a member of the FHLB of San Francisco, the Bank is required to own capital stock in the FHLB of San Francisco in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid residential loans, residential purchase contracts and similar obligations at the end of each calendar year, assuming for such purposes that at least 30% of its assets were residential mortgage loans, or 5% of its advances from the FHLB of San Francisco. At June 30, 2000 the Bank was in compliance with this requirement. Furthermore, FHLB advances must be collateralized with certain types of assets. Accordingly, the Bank has pledged certain loans to the FHLB of San Francisco as collateral for its advances. See "--Financial Modernization Legislation," below regarding legislation proposing changes in the operation of the Federal Home Loan Bank system.
Required Liquidity
OTS regulations require savings institutions to maintain, for each calendar quarter, an average daily balance of liquid assets (including cash, certain time deposits, bankers' acceptances and specified United States government, state and federal agency obligations) equal to at least 4% of the quarter end balance of its deposits, excluding those with maturities exceeding one year, plus short-term borrowings.
The OTS may change this liquidity requirement from time to time to an amount within a range of 4% to 10% of such accounts and borrowings depending upon economic conditions and the deposit flows of member institutions, and may exclude from the definition of liquid assets any item other than cash and the balances maintained in satisfaction of FRB reserve requirements, described below. The Bank's average liquidity ratio exceeded the applicable requirement at all times during fiscal 2000.
Federal Reserve System
The Federal Reserve Board requires savings institutions to maintain reserves against certain of their transaction accounts (primarily deposit accounts that may be accessed by writing unlimited checks). For the calculation period including June 30, 2000, the Bank was not required to maintain reserves with the Federal Reserve Board because it maintains certain levels of cash on hand at its branches and with the requisite custodian. If balances are maintained to meet the reserve requirements imposed by the Federal Reserve Board, they do not earn interest but may be used to satisfy the Bank's liquidity requirements discussed above.
As a creditor and a financial institution, the Bank is subject to certain regulations promulgated by the Federal Reserve Board, including, without limitation, Regulation B (Equal Credit Opportunity Act), Regulation D (Reserves), Regulation E (Electronic Funds Transfers Act), Regulation F (limits on exposure to any one correspondent depository institution), Regulation Z (Truth in Lending Act), Regulation CC (Expedited Funds Availability Act), and Regulation DD (Truth in Savings Act). As creditors of loans secured by real property and as owners of real property, financial institutions, including the Bank, may be subject to potential liability under various statutes and regulations applicable to property owners, including statutes and regulations relating to the environmental condition of the property.
Financial Modernization Legislation
On November 12, 1999, President Clinton signed into law the Gramm-Leach- Bliley ("G-L-B Act") which significantly reforms various aspects of the financial services industry. The G-L-B Act authorizes affiliations between banking, securities, and insurance firms, and authorizes bank holding companies and national banks to engage in a variety of new financial activities. Among the new activities that will be permitted to qualifying bank holding companies are: insurance underwriting and brokerage, securities underwriting, and merchant banking. Moreover, under the G-L-B Act, the Federal Reserve Board, in consultation with the Department of Treasury, may approve additional financial activities for these qualifying bank holding companies.
The G-L-B Act also permits certain national banks to establish subsidiaries to engage in similar financial activities. National bank subsidiaries, however, are prohibited from insurance underwriting, real estate development and, for at least five years, merchant banking. The G-L-B Act generally will subject banks to the same securities regulation as other providers of securities products. The G-L-B Act also prohibits future acquisitions of existing unitary savings and loan holding companies, like the Company, by firms which are engaged in commercial activities, and limits the permissible activities of unitary savings and loan holding companies that were not, or had not submitted an application to become, a unitary savings and loan holding company by May 4, 1999.
The G-L-B Act imposes new requirements on financial institutions with respect to customer privacy. The G-L-B Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the G- L-B Act. On June 1, 2000, the federal banking agencies, including the OTS, issued a joint final rule implementing the privacy provisions of the G-L-B Act. The joint rule
becomes effective on November 13, 2000, with compliance optional until July 1, 2001. Management does not believe that complying with the new consumer privacy provisions or regulations will have a significant impact on our business.
The G-L-B Act contains significant revisions to the Federal Home Loan Bank System. The G-L-B Act imposes new capital requirements on the Federal Home Loan Banks and authorizes them to issue two classes of stock with differing dividend rates and redemption requirements. The G-L-B Act deletes the current requirement that the Federal Home Loan Banks annually contribute $300 million to pay interest on certain government obligations in favor of a 20% of net earnings formula. Accordingly, this change will result in a greater obligation in years where Federal Home Loan Banks have high-income levels, thereby reducing the returns on member's investments. In addition, the G-L-B Act expands the permissible uses of Federal Home Loan Bank advances by community financial institutions (under $500 million in assets) to include funding loans to small businesses, small farms and small agribusinesses. If the increase in the permissible uses for advances leads to an increase in demand, this may increase the cost of borrowing. The G-L-B Act, however, makes membership in the Federal Home Loan Bank voluntary for federal savings associations.
The Company is unable to predict the impact of the G-L-B Act on its operations at this time. Although the G-L-B Act reduces the range of companies which may acquire control of the Company and with which the Company may affiliate, it may facilitate affiliations with companies in the financial services industry. Also, it is expected that while the operations of some of our competitors may benefit from the G-L-B Act, those of others may be impaired.
ITEM 2.
ITEM 2. PROPERTIES.
At June 30, 2000, the Company conducted its business through an administrative office located in Whittier and fourteen retail full service branch offices. The Company believes that its current facilities are adequate to meet the present and immediately foreseeable needs of the Company.
* Leasehold improvements are in-progress.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No items were submitted to a vote of stockholders during the quarter ended June 30, 2000.
ITEM 4A. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth the names and principal occupations of the directors and executive officers of the Company as of June 30, 2000.
- -------- (1) Unless otherwise noted, the indicated principal occupation of the executive officers is with the Company and the Bank.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's common stock is traded on the National Market System of the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ-NMS") under the symbol QCBC. At September 21, 2000, the Company had approximately 307 stockholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 5,096,077 outstanding shares of common stock. The following table sets forth for the fiscal quarters indicated the range of high and low bid information per share of the common stock of the Company as reported on the NASDAQ-NMS.
The Company's ability to pay dividends is limited by certain restrictions generally imposed on Delaware corporations. In general, dividends may be paid only out of a Delaware corporation's surplus, as defined in the Delaware General Corporation Law, or net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. "Surplus" is defined for this purpose as the amount by which a corporation's net assets (total assets minus total liabilities) exceed the amount designated by the Board of Directors of the corporation in accordance with Delaware law as the corporation's capital. The Company may pay dividends out of funds legally available therefor at such times as the Board of Directors determines that dividend payments are appropriate, after considering the Company's net income, capital requirements, financial condition, alternate investment options, prevailing economic conditions, industry practices and other factors deemed to be relevant at the time. The Company has not paid cash dividends in the past and does not presently intend to pay cash dividends.
The Company's principal source of income in fiscal 2000 was interest from investments. Dividends from the Bank are a potential source of income for the Company. On May 19, 2000, the Bank declared a $1.0 million dividend payable to the Company based on a $5.0 million total authorization by the Board of Directors of the Bank. The payment of dividends and other capital distributions by the Bank to the Company is subject to regulation by the OTS. The OTS has promulgated a regulation that addresses a savings institution's ability to make a capital distribution according to the institution's capital position. Effective April 1, 1999, the OTS amended its capital distributions regulation. The new rule establishes a "safe-harbor" for capital distributions that institutions can make without OTS prior approval or notice. It also sets forth certain conditions that specify whether a notice or an application for prior approval of the OTS is required if the safe harbor does not apply. Under its regulation, an application for the prior approval of the OTS to make a capital distribution is required if any of the following conditions are present: the institution would not be adequately-capitalized after the distribution, its examination ratings are not at least satisfactory or it is considered a problem association or in troubled condition, the total amount of all its capital distributions for the applicable calendar year (including the proposed distribution) would exceed its net income for that year to date plus its retained net income for the prior two years, or the distribution would violate an applicable prohibition or OTS imposed condition on the institution. A 30-day advance notice is required if, as is the case with the Bank, the institution is a subsidiary of a holding company, the institution would not be well-capitalized after the distribution, or the distribution would reduce the amount of or retire any part of its common or preferred stock or retire any part of a debt instrument included in total capital (other than through a regular payment on the instrument). If none of the above conditions are present, an institution is not required to file an application or notice with the OTS before making a capital
distribution. See "Business--Regulation and Supervision--Savings and Loan Holding Company Regulation--Payment of Dividends and Other Capital Distributions by Bank."
The Bank's ability to pay dividends to the Company is also subject to restriction arising from the existence of the liquidation account established upon the conversion of the Bank from mutual to stock form in December 1993. The Bank is not permitted to pay dividends to the Company if its regulatory capital would be reduced below the amount required for the liquidation account. See "Business--Regulation and Supervision--Savings and Loan Holding Company Regulation--Payment of Dividends and Other Capital Distributions by Bank."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
- -------- (1) Includes $9,498, $1,819, and $1,432, of investment securities available for sale at June 30, 2000, 1998 and 1997, respectively. No investment securities were available for sale at June 30, 1999 and 1996. (2) Includes $24,404, $15,783 and $8,274 of mortgage-backed securities available for sale at June 30, 2000, 1999 and 1998, respectively. No mortgage-backed securities were available for sale in 1997 or 1996. (3) Diluted earnings per share in 2000, 1999, 1998, 1997 and 1996 were calculated based on weighted average shares outstanding of 5,279,141, 5,660,351, 5,795,480, 5,792,344 and 6,048,751, respectively. The weighted average shares have been adjusted to reflect the 25% stock dividends paid on May 30, 1997 and June 30, 1998.
- -------- (1) Includes one-time special SAIF assessment of $3.1 million in fiscal 1997. (2) The interest rate spread represents the difference between the weighted- average rate on interest-earning assets and the weighted-average rate on interest-bearing liabilities. (3) The net interest margin represents net interest income as a percentage of average interest-earning assets. (4) Efficiency ratio represents general and administrative expense as a percentage of net interest income plus other income (excluding nonrecurring items). (5) Nonperforming loans are net of specific allowances and include nonaccrual and troubled debt restructured loans. Gross loans include loans held for sale. (6) Nonperforming assets include nonperforming loans and REO. (7) Total allowance includes loan and REO valuation allowances.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
At June 30, 2000 the Company had total assets of $1.2 billion, total deposits of $808.2 million and stockholders' equity of $88.0 million compared to total assets of $1.0 billion, total deposits of $677.8 million and stockholders' equity of $81.3 million at June 30, 1999. These changes represent a 18.60% increase in total assets and a 8.28% increase in stockholders' equity during fiscal 2000.
The southern California economy and real estate markets in the Company's lending area have remained strong during the year. The Company's level of nonperforming assets declined from June 30, 1999, both in total dollar amount and as a percentage of total assets. The Company currently includes nonaccrual loans 60 or more days past due (less any specific allowances on these loans), troubled debt restructured loans and REO in determining its level of nonperforming assets. At June 30, 2000, the Company reported $4.4 million in nonperforming assets compared to $7.5 million and $9.8 million at June 30, 1999 and 1998, respectively. The Company recorded a provision for loan losses of $1.6 million for the year ended June 30, 2000 compared to $1.7 million and $1.5 million for the years ended June 30, 1999 and 1998, respectively. See "Business--Allowances for Loan and Real Estate Losses."
Results of Operations
General. The Company reported net earnings of $11.8 million, $2.23 per share diluted, for the year ended June 30, 2000, compared to net earnings of $9.6 million, $1.70 per share diluted, and $6.6 million, $1.14 per share diluted, for the years ended June 30, 1999 and 1998, respectively. This increase in earnings for fiscal 2000 compared to fiscal 1999 was primarily attributable to an increase in net interest income partially offset by an increase in other expenses. Net earnings for fiscal 2000 also includes $400,000 of recaptured accrued taxes as a result of a favorable tax audit ruling. Without this tax recapture, net earnings for the fiscal year ended June 30, 2000 would have been $11.4 million, $2.15 per share diluted, representing a 26% increase in earnings per share over the previous year. The increase in earnings in fiscal 1999 over 1998 was primarily attributable to an increase in net interest income and an increase in noninterest income due primarily to the one-time gain on sale of securities, partially offset by an increase in total other expense.
Interest Income. Interest income was $84.5 million, $71.9 million and $64.9 million for the years ended June 30, 2000, 1999, and 1998, respectively. The $12.6 million increase in interest income in 2000 compared to 1999 resulted from an increase in the average balance of interest-earning assets of $168.1 million while the average yield on interest-earnings assets decreased 0.08% to 7.87%. The $7.0 million increase in interest income in 1999 compared to 1998 resulted from an increase in the average balance of interest-earning assets of $83.1 million while the average yield on interest earning assets increased 0.05 to 7.95%.
Interest Expense. Interest expense was $48.9 million, $40.3 million, and $39.1 million for the years ended June 30, 2000, 1999, and 1998, respectively. The $8.6 million increase in 2000 compared to 1999 resulted from an increase in the average balance of interest-bearing liabilities of $160.3 million and an increase in the average cost on interest-bearing liabilities of 0.07% to 5.04%. The $1.2 million increase in 1999 compared to 1998 resulted from an increase in the average balance of interest-bearing liabilities of $70.2 million and partially offset by a decrease in the average cost on interest-bearing liabilities of 0.32% to 4.97%.
Net Interest Income Before Provision for Loan Losses. Net interest income before provision for loan losses was $35.6 million, $31.6 million, and $25.8 million for the years ended June 30, 2000,
1999, and 1998, respectively. The increase in 2000 compared to 1999 was primarily a result of the increase in interest-earning assets relative to interest-bearing liabilities during the year partially offset by the decrease in the yield on interest-earning assets and an increase in the cost of interest-bearing liabilities. The increase in 1999 compared to 1998 was primarily a result of the increase in interest-earning assets relative to interest-bearing liabilities, as well as a decrease in the cost of interest- bearing liabilities.
Provision for Loan Losses. During fiscal 2000, 1999, and 1998 the Company established $1.6 million, $1.7 million and $1.5 million, respectively, of provisions for losses on loans. The slight decrease in the provision for 2000 is primarily a result of the continued decrease in nonperforming assets during the year. The slight increase in the provision for fiscal 1999 compared to 1998 was primarily a result of the overall growth in the loan portfolio as compared to the prior year, specifically in commercial real estate. In addition, certain one-to-four family loans purchased during fiscal 1999 were considered by the Company to have higher risk characteristics because they are loans outside of California, which has historically been considered the Company's primary market area for one-to-four family loans. Management considers the level of nonperforming assets, the regional economic conditions and relevant real estate values and other factors when assessing the adequacy of the allowance for loan losses. The southern California economy and real estate markets in the Company's primary lending area continued to be strong during fiscal 2000, and management considers the level of allowance for loan losses at June 30, 2000 to be adequate. However, even though the local economy and real estate markets were strong during fiscal 2000, there can be no assurance that nonperforming assets will not increase and that the Company will not have to establish additional loss provisions based upon future events.
Other Income. Other income increased slightly in 2000 to $4.7 million compared to $4.6 million in 1999. Deposit fees increased to $1.6 million for 2000 compared to $1.1 million for 1999, a 47.84% increase as a result of a continued program, that began in the second quarter of fiscal 1998, with efforts to attract checking accounts as well as a larger deposit base. In addition, other income for fiscal 1999 reflected gains on sale of securities of $616,000 compared to none in fiscal 2000. Other income increased by $1.3 million in fiscal 1999 as compared to fiscal 1998. This increase was due to the $616,000 gain on sale of securities as well as transactional fee income for deposits and loans increasing due to a larger deposit and loan base and prepayment fees on loans increased due to a higher level of loans paying off in order to refinance in the lower rate environment during that time period.
Other Expense. Other expense increased $1.2 million, or 6.62%, from $17.5 million in fiscal 1999 to $18.7 million in fiscal 2000. This increase in other expense is primarily due to an increase in compensation and employee benefits and occupancy expense. These increases during fiscal 2000 are primarily a result of three retail banking branches opened during the year and the purchase of a branch facility and its deposits from another financial institution. Included in compensation and employee benefits are expenses related to the Employee Stock Ownership Plan ("ESOP"). Companies that established an ESOP after 1992 are required to account for the expense of the ESOP at the fair value of the related shares released. The expense related to the ESOP was $1.0 million, $1.0 million, and $1.1 million for the fiscal years ended June 30, 2000, 1999, and 1998, respectively.
Other expense increased $1.8 million, or 11.40%, from $15.7 million in fiscal 1998 to $17.5 million in fiscal 1999. The increase was primarily due to the opening of additional retail banking branches during February 1998, the relocation of an existing branch to a larger more accessible location in August 1998 and additional staffing in the income property lending department of the Company.
The following is a summary of other general and administrative expenses for the fiscal years ended:
Income Taxes. Income taxes increased by $865,000 from $7.5 million in fiscal 1999 to $8.3 million in fiscal 2000. Income taxes increased by $2.2 million from $5.3 million in fiscal 1998 to $7.5 million in fiscal 1999. The effective tax rate was 41.48%, 43.89% and 44.49% for the years ended June 30, 2000, 1999 and 1998, respectively. The decrease in the effective tax rate for 2000 as compared to 1999 is primarily a result of a $400,000 recapture of accrued taxes due to a favorable tax audit ruling. The decrease in the effective tax rate for 1999 as compared to 1998 is primarily a result of ESOP expense as a percentage of net earnings before income taxes being lower in fiscal 1999 due to the increase in net earnings before income taxes.
Extraordinary Item and Cumulative Effect of Change in Accounting Principle. During the fiscal year ended June 30, 1999, the Company prepaid approximately $8.0 million of its higher cost borrowings and replaced the funds with less expensive borrowings and retail deposits. In association with the debt prepayment, the Company paid a prepayment fee of $61,000, after tax. The prepayment fee is disclosed as an extraordinary item on the statement of earnings. The Company implemented SFAS No. 133 effective July 1, 1998. Upon implementation, approximately $78.0 million in MBS were reclassified from held to maturity to available for sale. The Company has accounted for the gains or losses on the sale of any such reclassified MBS sold within 90 days of the reclassification date as the cumulative effect of a change in accounting principle. Any gains or losses recorded on such reclassified securities sold 90 days or more after the reclassification date have been recorded as gain or losses on sale of securities available for sale. In the first quarter of 1999, the Company sold $29.6 million of these reclassified MBS for a gain after tax of $162,000.
Financial Condition
The Company's consolidated assets totaled $1.2 billion at June 30, 2000, compared to $1.0 billion at June 30, 1999. Stockholders' equity totaled $88.0 million at June 30, 2000 compared to $81.3 million at June 30, 1999. The increase in assets is primarily attributable to the implementation of the Company's growth strategies and was primarily funded by deposit growth and FHLB advances.
Loans and MBS (including assets held or available for sale) increased to $1.1 billion at June 30, 2000, from $938.1 million at June 30, 1999. Loans originated and purchased for investment were $299.2 million for the year ended June 30, 2000, compared to $276.4 million for the same period the previous year. MBS purchased for investment decreased to $12.0 million at June 30, 2000, from $70.6 million for the same period the previous year.
At June 30, 2000, the Company's multifamily loan portfolio totaled $505.4 million, or 49.20% of total loans, an increase of 29.07% as compared to $391.6 million at June 30, 1999, and its commercial loan portfolio totaled $196.5 million, or 19.13% of total loans, an increase of 39.92% as compared to $140.4 million at June 30, 1999. Of the Company's $139,000 of charge-offs in fiscal 2000, $125,000 or 81.93% were for one-to-four family loans and none were multifamily or for commercial real estate loans. The Company's commercial loan portfolio increased significantly during the past fiscal year,
increasing by approximately 39.92%. Both because the size of the commercial real estate loan portfolio has increased significantly and most of the loans comprising the portfolio are unseasoned, having been originated within the last three fiscal years, the Company's past loss experience with respect to its commercial loan portfolio may not be representative of the risk of loss in such portfolio in the future. See "Business--Allowances for Loan and Real Estate Losses." Multifamily and commercial real estate loans are generally considered to involve a higher degree of credit risk and to be more vulnerable to deteriorating economic conditions than one-to-four family residential mortgage loans. These loans typically involve higher loan principal amounts and the repayment of such loans generally depend on the income produced by the operation or sale of the property being sufficient to cover operating expenses and debt service. Even though the southern California real estate market was healthy in fiscal 2000, recessionary economic conditions of the type that have prevailed in recent years in the Company's lending market area tend to result in higher vacancy and reduced rental rates and net operating incomes from multifamily and commercial real estate properties. See "Business--Lending Activities--Multifamily Lending" and "--Commercial Real Estate Lending."
Loan sales decreased to $48.9 million for the year ended June 30, 2000, compared to $64.0 million for the same period ended June 30, 1999. The decrease in loan sales is primarily a result of a decrease in funding of fixed-rate loans during a period of higher interest rates during fiscal 2000 compared to 1999. These fixed rate loans were generally held for sale during this period. Loans serviced for others increased to $299.1 million at June 30, 2000 from $284.2 million at June 30, 1999 primarily due to a lower rate of loan prepayments in fiscal 2000 compared to fiscal 1999.
Capital Resources and Liquidity
Regulatory Capital Requirements
FIRREA and implementing OTS capital regulations require the Bank to maintain certain minimum tangible, core and risk-based regulatory capital levels. The minimum core capital requirement is 4% for all but the highest rated savings associations. See "Business--Regulation and Supervision--Regulatory Capital Requirements."
The following table summarizes the regulatory capital requirements for the Bank at June 30, 2000. As indicated in the table, the Bank's capital levels exceed all three of the currently applicable minimum capital requirements.
In addition, FDICIA required the OTS to implement a system of regulatory sanctions against institutions that are not adequately capitalized, with the sanctions growing more severe the lower the institution's capital. Under FDICIA, the OTS issued regulations establishing five separate capital categories: "well capitalized." "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized," differentiated by core capital ratio, level of core capital to risk-weighted assets and risk-based capital ratio. See "Business-- Regulation and Supervision--Prompt Corrective Action Requirements."
An institution is treated as "well capitalized" if its core capital ratio to adjusted total assets is at least 5%, its ratio of core capital to risk- weighted assets is at least 6% and its total capital to risk-
weighted assets ratio is at least 10%. The following table summarizes the capital ratios of the "well capitalized" category and the Bank's regulatory capital at June 30, 2000 as compared to such ratios. As indicated in the table, the Bank's capital levels exceeded the three minimum capital ratios of the "well capitalized" category.
For the year ended June 30, 2000 a total of 380,500 shares had been repurchased under previously announced plans to repurchase Company stock. Up to 270,000 additional shares could be repurchased in the future under current board authorization.
Sources of Funds and Liquidity
Sources of capital and liquidity for the Company on a stand-alone basis include distributions from the Bank. Dividends and other capital distributions from the Bank are subject to regulatory restrictions. See "Business-- Regulation and Supervision--Savings and Loan Holding Company Regulation-- Payment of Dividends and Other Capital Distributions by Bank" and "Market for the Registrant's Common Equity and Related Stockholder Matters."
The Bank's primary sources of funds in fiscal 2000 were deposits, FHLB advances, principal and interest payments on loans and proceeds from the sale of loans. While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by interest rates, economic conditions, and competition. The Bank also has other potential sources of liquidity, such as securities sold under agreements to repurchase and liquidating existing short-term assets.
The Bank has continued to maintain the required minimum levels of liquid assets as defined by OTS regulations. This requirement, which may be varied at the direction of the OTS depending upon economic conditions and deposit flows, is based upon a percentage of deposits and short-term borrowings. The required ratio is currently 4%. The Bank's average liquidity ratios were 4.33%, 4.49%, and 4.12%, at June 30, 2000, 1999, and 1998, respectively. Management currently attempts to maintain a liquidity ratio as close to the minimum as possible. Liquidity levels reflect management's strategy to invest excess liquidity in higher yielding interest-earning assets such as loans or MBS.
The Company's cash flows are comprised of three primary classifications: cash flows from operating activities, cash flows used by investing activities and financing activities. Cash flows from operating activities consisted primarily of cash flows from the sale of loans held for sale which totaled $48.9 million, $64.0 million, and $34.3 million for fiscal 2000, 1999, and 1998, respectively. The Company originated loans for sale of $53.0 million, $73.7 million, and $41.3 million during fiscal years 2000, 1999, and 1998, respectively. Net cash used by investing activities consisted primarily of loan originations, loan purchases and investment purchases, offset by principal collections on loans and proceeds from principal reductions on MBS and maturities of other investment securities. Loans originated and purchased for investment were $299.2 million, $276.4 million, and $143.4 million for fiscal 2000, 1999, and 1998, respectively. Proceeds from principal repayments on loans were
$127.3 million, $145.6 million and $91.8 million for fiscal years ended 2000, 1999, and 1998. Proceeds from maturities and principal payments of investment securities were $2.9 million, $9.1 million, and $31.6 million for fiscal years ended 2000, 1999, and 1998, respectively. Net cash used by financing activities consisting primarily of net activity in deposit accounts and proceeds from funding and repayments of FHLB advances. The net change in deposits was an increase of $130.4 million, $96.9 million, and $27.7 million for fiscal 2000, 1999 and 1998, respectively. During the second quarter of fiscal 2000 the Bank purchased a retail branch office and its $45.9 million of deposits from another financial institution. This branch is located in Rowland Heights, California. The Bank also opened three "in-store" branches in Wal- Mart stores, the nation's largest retailer, during the second half of fiscal 2000. A fourth Wal-Mart in-store branch was opened in August 2000 with plans to open, at least, two additional Wal-Mart "in-store" branches later in fiscal 2001. All of the Bank's existing and planned Wal-Mart "in-store" branches are located in the southern California area. In addition, while the vast majority of the Bank's deposits are retail in nature, the Bank accepted $55 million in time deposits from a political subdivision during fiscal 2000. The Bank considers these funds to be wholesale deposits and an alternative borrowing source rather than a customer relationship and their levels are determined by management's decision as to the most economic funding sources. The net proceeds from FHLB advances were $55.6 million, $18.7 million, and $53.3 million for fiscal 2000, 1999, and 1998, respectively.
Due to the Company's growth strategies and increased competition for retail deposits in fiscal 2000, 1999, and 1998, the Company's use of FHLB advances increased. At June 30, 2000, the Company had $290.3 million (26.06% of total liabilities) in advances outstanding from the FHLB compared to $234.7 million (25.18% of total liabilities) at June 30, 1999. The maximum amount of advances that the Company had outstanding at any month-end was $312.1 million. Management anticipates increased borrowing from the FHLB again in fiscal 2001. See "Business--Sources and Funds--Borrowings."
The Company's most liquid assets are cash and short-term investments. The levels of these assets are dependent on the Company's operating, financing, lending and investing activities during any given period. At June 30, 2000, cash and short-term investments totaled $14.1 million, a decrease of 57.40% from $33.1 million at June 30, 1999.
At June 30, 2000, the Company had outstanding commitments to originate loans of $15.0 million and no commitments to purchase loans. At June 30, 2000, the Company had $25.5 million of approved undisbursed lines of credit. The Company anticipates that it will have sufficient funds available to meet its current loan origination and purchase commitments. Certificates of deposits which have contractual maturities in one year or less from June 30, 2000, totaled $511.2 million. If a significant portion of the maturing certificates are not renewed at maturity, the Company's other sources of liquidity include FHLB advances, principal and interest payments on loans, proceeds from loan sales and other borrowings, such as repurchase transactions. The Company could also choose to pay higher rates to maintain maturing deposits, which could result in increased cost of funds. Historically, the Company has maintained a significant portion of maturing deposits. While management anticipates that there may be some outflow of these deposits upon maturity due to the current competitive rate environment, these are not expected to have a material impact on the long-term liquidity position of the Company.
Asset/Liability Management
The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest-rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest- earning assets maturing or repricing within a specific time
period and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of falling interest rates therefore, the net earnings of an institution with a positive gap theoretically may be adversely affected due to its interest-earning assets repricing to a greater extent than its interest- bearing liabilities. Conversely, during a period of rising interest rates, theoretically, the net earnings of an institution with a positive gap position may increase as it is able to invest in higher yielding interest-earning assets at a more rapid rate than its interest-bearing liabilities reprice. In addition, a positive gap may not protect an institution with a large portfolio of ARM loans from increases in interest rates for extended time periods as such instruments generally have periodic and lifetime interest rate caps. Additionally, the Company's ARM loans are predominantly tied to COFI, a lagging market index, and rapid increases in interest rates could have a negative impact on the Company's earnings. Accordingly, interest rates and the resulting cost of funds increases in a rapidly increasing rate environment could exceed the cap levels on these instruments and negatively impact net interest income. Declining interest rates have, in general, benefited the Company primarily due to the effect of the lagging market index which has resulted in interest income declining at a slower rate than interest expense.
At June 30, 2000, the Company's total interest-earning assets maturing or repricing within one year exceeded its total interest-bearing liabilities maturing or repricing in the same time by $60.6 million, representing a one year cumulative positive gap ratio of 5.04%. This compares to $4.3 million at June 30, 1999, which represented a positive GAP ratio of 0.42%.
This increase in the one year cumulative GAP ratio is primarily a result of the following:
. a significant amount of financing activity during the fiscal year in adjustable rate loans.
. The extension of the assumed repricing period of the Company's money market deposit accounts. This is consistent with the Company's actual experience with these accounts over the past fiscal year.
The Company manages the resulting interest rate risk by extending the maturities of various liabilities such as FHLB advances and retail certificates of deposit.
The Company closely monitors its interest rate risk as such risk relates to its operational strategies. The Bank's Board of Directors has established an Asset/Liability Committee, responsible for reviewing its asset/liability policies and interest rate risk position, which generally meets weekly and reports to the Board of Directors on interest rate risk and trends on a quarterly basis. The Company's cumulative gap position is at a level satisfactory to management. There can be no assurances that the Company will be able to maintain its positive gap position or that its strategies will not result in a negative gap position in the future. The level of the movement of interest rates, up or down, is an uncertainty and could have a negative impact on the earnings of the Company.
The Company does not currently engage in the use of trading activities, high risk derivatives and synthetic instruments or hedging activities in controlling its interest rate risk. Such uses are permitted at the recommendation of the Asset/Liability Committee with the approval of the Board of Directors, however, the Company does not anticipate engaging in such practices in the immediate future.
The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at June 30, 2000, which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of term to repricing or the contractual terms of the asset or liability. Specifically, the Company assumed a prepayment rate ranging from 6% to 18% on ARM
loans, and 6% to 15% on fixed rate loans. Additionally, the Company utilized deposit decay rate assumptions of 50% for passbook accounts, 15.8% for checking accounts and 10% to 50% for money market deposit accounts in the one year or less category. The range of decay rates for money market deposit accounts is due to the market rate sensitivity of various money market checking accounts. These decay rates are based upon the Company's historical experience, but there is no assurance that the assumed rates will correspond to future rates. For information regarding the contractual maturities of the Company's loans, investments and deposits, see "Business--Lending Activities," "--Investment Activities" and "--Sources of Funds."
- ---- (1) For purposes of the gap analysis, mortgage and other loans are reduced for nonperforming loans but are not reduced for the allowance for loan losses. (2) For purposes of the gap analysis, unearned discount and deferred fees are pro rated for loans receivable. (3) Includes assets held or available for sale. (4) Certain certificate accounts have potential repricing dates which are prior to the contractual maturity dates. The repricing dates were used for purposes of the gap analysis. (5) Certain FHLB Advances have call features which are prior to the contractual maturity dates. The call dates were used for purposes of the gap analysis. (6) Interest sensitivity gap represents the difference between net interest- earning assets and interest-bearing liabilities.
Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as ARM loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their ARM loans may decrease in the event of an interest rate increase.
Average Balance Sheet
The following table sets forth certain information relating to the Company for the years ended June 30, 2000, 1999, and 1998. The yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown except where noted otherwise. Average balances are derived from average month-end balances. Management does not believe that the use of average monthly balances instead of average daily balances has caused any material differences in the information presented. The average balance of loans receivable includes loans on which the Company has discontinued accruing interest. The yields and costs include fees which are considered adjustments to yields.
- ------ (1) Amount includes assets available for sale. (2) Amount is net of deferred loan fees, loan discounts, loans in process and loan loss allowances, and includes nonaccrual loans and loans held for sale. (3) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities. (4) Net interest margin represents net interest income divided by average interest-earning assets.
Rate/Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
- -------- (1) Includes nonaccrual loans. (2) Includes assets held or available for sale.
Year 2000
Beginning in 1997, the Company developed and implemented a program to make its systems and processes Year 2000 compliant. The Company's Year 2000 program included the preparation of a plan and a contingency plan as required by the Federal Financial Institutions Examination Council as well as the testing and replacement of information technology assets ("IT assets"), such as computer hardware, software and systems, and non-IT assets.
As of the date of this report, the Company has experienced no material disruption in the operation of its business as a result of the transition from 1999 to 2000. However, it is possible that the full impact of Year 2000 issues has not been fully recognized, and no assurances can be given that Year 2000 problems will not emerge.
The total cost of the Company's Year 2000 program was approximately $1.5 million, including approximately $330,000 incurred in the year ended June 30, 2000. Program costs consisted primarily of costs for acquiring equipment and software, which are being depreciated over their useful lives, and personnel and consulting costs, which were expensed as incurred. The Company has funded these Year 2000 expenditures primarily through operating cash flow.
Impact of Inflation and Changing Prices
The Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. See "Market Risk" and "--Asset/Liability Management."
Impact of New Accounting Standards
In March 2000, the FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation. This Interpretation clarifies certain issues relating to APB Opinion No. 25, Accounting for Stock Issued to Employees. FASB Interpretation No. 44 contains information relating to (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a non-compensatory plan, (c) the accounting consequence of various modifications to the term of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FASB Interpretation No. 44 is effective July 1, 2000. The effects of applying this Interpretation are recognized on a prospective basis from July 1, 2000.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. To that end, management actively monitors and manages its interest rate risk exposure. The Company does not currently engage in trading activities.
The Company's profitability is affected by fluctuations in interest rates. A sudden and substantial increase in interest rates may adversely impact the Company's earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the impact of changes in interest rates on its net interest income using several tools. One measure of the Company's exposure to differential changes in interest rates between assets and liabilities is shown in the Company's Maturity and Rate Sensitivity Analysis under the caption "MD&A--Asset/Liability Management." Another measure, required to be performed by OTS-regulated institutions, is the test specified by OTS Thrift Bulletin No. 13a, "Interest Rate Risk Management." This test measures the impact on net interest income and on net portfolio value of an immediate change in interest rates in 100 basis point increments. Net portfolio value is defined as the net present value of assets, liabilities, and off-balance sheet contracts. Following are the estimated impacts of immediate changes in interest rates at the specified levels at June 30, 2000, calculated in compliance with Thrift Bulletin No. 13a:
- -------- (1) The percentage change in this column represents net interest income for 12 months in a stable interest rate environment versus the net interest income in the various rate scenarios.
(2) The percentage change in this column represents net portfolio value of the Bank in a stable interest rate environment versus the net portfolio value in the various rate scenarios.
The Company's primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Company's net interest income and capital, while structuring the Company's asset-liability structure to obtain the maximum yield-cost spread on that structure. The Company relies primarily on its asset-liability structure to control interest rate risk.
The Company continually evaluates interest rate risk management opportunities, including the use of derivative financial instruments. Management has focused its efforts on increasing the Company's yield-cost spread through wholesale and retail growth opportunities.
The following table shows the Company's financial instruments that are sensitive to changes in interest rates, categorized by expected maturity, and the total balance of expected maturities and principal repayments and the instruments' fair values at June 30, 2000. Market risk sensitive instruments are generally defined as on- and off-balance sheet derivatives and other financial instruments.
- -------- (1) Loans are reduced for nonperforming loans but are not reduced for the allowance for loan losses.
(2) Total balance equals the notional amount of off-balance sheet items and interest rates are the weighted average interest rates of the underlying loans.
Expected maturities are contractual maturities adjusted for prepayments of principal. The Company uses certain assumptions to estimate fair values and expected maturities. For assets, expected maturities are based upon contractual maturity, projected repayments and prepayments of principal. The prepayment experience reflected herein is based on the Company's historical experience. The Company's average Constant Prepayment Rate ("CPR") on its total fixed-rate portfolio ranges from 6% to 15% and on its adjustable rate portfolio from 6% to 18% for interest-earning assets (excluding investment securities, which do not have prepayment features). For deposit liabilities, in accordance with standard industry practice and the Company's own historical experience, "decay factors," were used to estimate deposit runoff of 50%, 15.8%, and between 10% to 50% for passbook, checking and money market deposit accounts, respectively. The actual maturities of these instruments could vary substantially if future prepayments differ from the Company's historical experience.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
The Board of Directors Quaker City Bancorp, Inc.:
We have audited the accompanying consolidated statements of financial condition of Quaker City Bancorp, Inc. and subsidiaries (the Company) as of June 30, 2000 and 1999 and the related consolidated statements of earnings, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended June 30, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Quaker City Bancorp, Inc. and subsidiaries as of June 30, 2000 and 1999 and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2000 in conformity with accounting principles generally accepted in the United States of America.
KPMG llp
July 21, 2000 Los Angeles, California
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
June 30, 2000 and 1999
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
Years ended June 30, 2000, 1999 and 1998
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Years ended June 30, 2000, 1999 and 1998 (In thousands)
See accompanying notes to consolidated financial statements.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years ended June 30, 2000, 1999 and 1998
(In thousands)
See accompanying notes to consolidated financial statements.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended June 30, 2000, 1999 and 1998
(In thousands)
See accompanying notes to consolidated financial statements.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2000 and 1999
(1) Basis of Presentation and Summary of Significant Accounting Policies
Quaker City Bancorp, Inc., incorporated in Delaware, is primarily engaged in the savings and loan business through its wholly owned subsidiary, Quaker City Bank (the Bank). At June 30, 2000, the Bank operated fourteen retail banking offices in southern California. The Bank is subject to significant competition from other financial institutions, and is also subject to the regulations of various government agencies and undergoes periodic examinations by those regulatory authorities.
The following accounting policies, together with those disclosed elsewhere in the consolidated financial statements, represent the significant accounting policies of the Company.
Principles of Consolidation and Presentation
The consolidated financial statements include the accounts of Quaker City Bancorp, Inc., Quaker City Neighborhood Development, Inc., Quaker City Bank and its wholly owned subsidiary, Quaker City Financial Corporation. All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made to the prior years' consolidated financial statements to conform to the current year's presentation.
These consolidated financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition, and revenues and expenses for the periods. The most significant estimate for the Company relates to the allowance for loan losses. Actual results could differ from those estimates.
Financial Instruments
Accounting Standards require the disclosure of the fair value of financial instruments, whether or not recognized on the statement of financial condition, for which it is practicable to estimate the value. A significant portion of the Company's assets and liabilities are financial instruments as defined under applicable accounting standards. Fair values, estimates and assumptions are set forth in note 18, Fair Value of Financial Instruments.
Risks Associated with Financial Instruments
The credit risk of a financial instrument is the possibility that a loss may result from the failure of another party to perform in accordance with the terms of the contract. The most significant credit risk associated with the Company's financial instruments is concentrated in its loans receivable. Additionally, the Company is subject to credit risk on certain loans sold with recourse. The Company has established a system for monitoring the level of credit risk in its loan portfolio and for loans sold with recourse.
Concentrations of credit risk would exist for groups of borrowers when they have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The ability of the Company's borrowers to repay their commitments is contingent on several factors, including the economic conditions in the borrowers' geographic area and the individual financial condition of the borrowers. The Company generally
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) requires collateral or other security to support borrower commitments on loans receivable. This collateral may take several forms. Generally, on the Company's mortgage loans, the collateral will be the underlying mortgaged property. The Company's lending activities are primarily concentrated in southern California.
Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its lending, investing and deposit taking activities. To that end, management actively monitors and manages its interest rate risk exposure. The Company does not currently engage in trading activities. The Company is subject to interest rate risk to the degree that its interest-earning assets reprice on a different frequency or schedule than its interest-bearing liabilities. A majority of the Company's loans receivable and mortgage-backed securities reprice based on the Eleventh District Cost of Funds Index (COFI). The repricing of COFI tends to lag other interest rate indices. The Company closely monitors the pricing sensitivity of its financial instruments.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits and Federal funds sold and other short-term investments. Generally, Federal funds sold and short-term investments are held for one-day periods. The amounts included in cash and cash equivalents and qualifying investment securities generally constitute the Company's liquidity portfolio. The Company maintains liquidity to satisfy regulatory requirements. The liquidity portfolio is managed in a manner intended to maximize flexibility and yield, while minimizing interest rate risk, credit risk and the cost of the capital required to be maintained for such assets.
Assets Held or Available for Sale
The Company identifies those loans, mortgage-backed securities (MBS) and investment securities for which it does not have the positive intent and ability to hold to maturity. If management has the positive intent and the Company has the ability to hold such assets until maturity, they are classified as held to maturity and are carried at amortized historical cost. Securities that are to be held for indefinite periods of time and not intended to be held to maturity are generally classified as available for sale and are carried at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of income tax effect. However, if a decline in fair value is determined to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis, and the amount of the writedown is included in earnings. Gains and losses from the sales of MBS and investment securities available for sale are recognized at the time of sale and are determined by the specific-identification method. Premiums and discounts on MBS and investment securities available for sale are amortized utilizing the interest method over the contractual terms of the assets. Loans held for sale are carried at the lower of amortized historical cost or fair value as determined on an aggregate basis. Assets held for indefinite periods of time include assets that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk and other factors.
Assets Held to Maturity
Loans, MBS and investment securities, excluding those held or available for sale, are carried at amortized historical cost, adjusted for amortization of premiums and discounts utilizing the interest method over the contractual terms of the assets. The carrying value of these assets is not adjusted for
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) temporary declines in fair value since the Company has the positive intent and ability to hold them to maturity. If a decline in the fair value of securities is determined to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis and the amount of the writedown is included in earnings.
Interest Income on Loans Receivable
Interest income on loans receivable is accrued as it is earned. The Company defers and amortizes both loan origination fees and the incremental direct costs relating to the origination of loans held to maturity. Loan origination fees and incremental direct loan origination costs on loans held for sale are deferred and included in the computation of gain or loss upon sale of the loans. The deferred origination fees and costs on loans held to maturity are amortized into interest income utilizing the interest method over the lives of the related loans. Loans are placed on nonaccrual status after being delinquent 60 days, or earlier if the ultimate collectibility of the accrual is in doubt. Whenever the accrual of interest is stopped, previously accrued but uncollected interest income is reversed. Thereafter, interest is recognized only as cash is received until the loan is reinstated. Accretion of discounts and deferred loan fees is discontinued when loans are placed on nonaccrual status.
Allowance for Loan Losses
The allowance for loan losses is maintained at an amount management considers adequate to cover estimated losses on loans receivable which are deemed probable and estimable. The allowance is based upon a number of factors, including asset classifications, economic trends, industry experience and trends, industry and geographic concentrations, estimated collateral values, management's assessment of credit risk inherent in the portfolio, historical loss experience and the Company's underwriting practices. As a result of weaknesses in certain real estate markets, increases in the allowance for loan losses may be required in future periods. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. These agencies may require the Bank to establish additional valuation allowances, based on their judgments of the information available at the time of the examination.
Impaired Loans
A loan is considered impaired when based on current circumstances and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Creditors are required to measure impairment of a loan based on any one of the following: (i) the present value of expected future cash flows from the loan discounted at the loan's effective interest rate, (ii) an observable market price or (iii) the fair value of the loan's underlying collateral. The Company measures impairment based on the fair value of the loan's underlying collateral property. Impaired loans exclude large groups of smaller balance homogeneous loans that are collectively evaluated for impairment. For the Company, loans collectively reviewed for impairment include all loans with principal balances of less than $300,000.
Factors considered as part of the periodic loan review process to determine whether a loan is impaired address both the amount the Company believes is probable that it will collect and the timing of such collection. As part of the Company's loan review process, the Company will consider such factors as the ability of the borrower to continue to meet the debt service requirements, assessments of other sources of repayment, the fair value of any collateral and the creditor's prior history in dealing with these types of credits. In evaluating whether a loan is considered impaired, insignificant delays in payment,
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (less than 12 months) in the absence of other facts and circumstances would not alone lead to the conclusion that a loan was impaired.
The Company recognizes impairment on troubled collateral dependent loans by creating a valuation allowance. The valuation allowance is maintained while the loans are still in process of collection. At such time that the assets are deemed uncollectible, the loss is charged to the valuation allowance.
Loan Sales and Servicing
The Company sells loans and participations in loans with yield rates to the investors based upon current market rates. Gain or loss on the sale of loans is recognized to the extent that the selling prices differ from the carrying value of the loans sold based on the estimated relative fair values of the assets sold and any retained interests, less any liabilities incurred. The assets obtained on sale are generally loan servicing assets. Liabilities incurred in a sale may include recourse obligations or servicing liabilities.
The Company may also purchase mortgage servicing assets related to mortgage loans originated by other institutions. These mortgage servicing assets are measured initially at fair value, presumptively the price paid. The servicing asset is amortized in proportion to and over the period of estimated net servicing income and is assessed for impairment or increased obligation based on its fair value.
Real Estate Held for Sale
Real estate acquired through foreclosure (REO) is initially recorded at fair value at the date of foreclosure, less costs of disposition. Fair value is determined by an appraisal obtained at the time of foreclosure. Thereafter, if there is a further deterioration in value, the Company writes down the REO directly and charges operations for the diminution in value.
Real estate held for development is carried at the lower of cost or net realizable value. All costs of anticipated disposition are considered in the determination of net realizable value.
Revenue recognition on the disposition of real estate is dependent upon the transaction meeting certain criteria relating to the nature of the property sold and the terms of sale.
Depreciation and Amortization
Depreciation is computed utilizing the straight-line method over the estimated lives of the assets. Amortization of leasehold improvements is computed utilizing the straight-line method over the shorter of the estimated useful life of the assets or the terms of the respective leases.
Earnings per Share
The Company reports both basic and diluted earnings per share. Basic earnings per share is determined by dividing net income by the average number of shares of common stock outstanding, while diluted earnings per share is determined by dividing net income by the average number of shares of common stock outstanding adjusted for the dilutive effect of common stock equivalents.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Income Taxes
A deferred tax liability is recognized for taxable temporary differences (differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in future taxable amounts). A deferred tax asset is recognized for all deductible temporary differences (differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in deductible amounts in future years when the financial statement carrying amounts of the assets and liabilities are recovered and settled) and operating loss and tax credit carryforwards. The likelihood of realizing the tax benefits related to a potential deferred tax asset is evaluated and a valuation allowance is recognized to reduce that deferred tax asset if it is more likely than not that all or some portion of the deferred tax asset will not be realized. Deferred tax assets and liabilities are calculated at the beginning and end of the year; the change in the sum of the deferred tax asset, valuation allowance and deferred tax liability during the year generally is recognized as deferred tax expense or benefit. The effect on deferred taxes of a change in tax rates is recognized in income in the period for which the change becomes effective.
Stock Option Plans
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), the intrinsic value method, to account for stock based compensation. In accordance with the SFAS No. 123, "Accounting for Stock Based Compensation", the Company includes pro forma disclosures reflecting the impact of the fair value method on net earnings and earnings per share for stock options granted.
Segment Information and Disclosures
Accounting standards require the Company to report information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim reports to stockholders. These standards also require disclosures about products and services, geographic areas and major customers. The Company has concluded it has one reportable segment.
Derivatives
The Company accounts for derivative instruments in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." A derivative is considered either an asset or liability in the statement of financial position and measured at fair value. If a derivative is designated as a hedging instrument the changes in fair value of the derivative are either (a) recognized in earnings in the period of change together with the offsetting gain or loss on the hedged item or (b) reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings. For a derivative not designated as a hedging instrument, changes in fair value are recognized in earnings in the period of change. As of June 30, 2000, the Company has no derivative instruments.
Upon implementation of SFAS No. 133 effective July 1, 1998, approximately $78 million in MBS were transferred to available for sale. The Company has accounted for the gains or losses on the sale of any such reclassified MBS sold within 90 days of the reclassification date as the cumulative effect of a change in accounting principle. Any gains or losses recorded on such reclassified securities sold 90 days or more after the reclassification date have been recorded as gain or losses on sale of
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) securities available for sale. In the first quarter of 1999, the Company sold $29.6 million of these reclassified MBS for a nonrecurring gain after tax of $162,000, which is accounted for as a cumulative effect of a change in accounting principle in the accompanying consolidated statements of earnings. In the second quarter of fiscal 1999, the Company sold an additional $32.3 million of MBS for a pretax gain of $245,000 and an after tax gain of $142,000. The pretax gain of $245,000 is included as a gain on sale of securities available for sale in the accompanying consolidated statements of earnings.
Other Recent Accounting Pronouncements
In March 2000, the FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation. This Interpretation clarifies certain issues relating to APB Opinion No. 25, Accounting for Stock Issued to Employees. FASB Interpretation No. 44 contains information relating to (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a non-compensatory plan, (c) the accounting consequence of various modifications to the term of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FASB Interpretation No. 44 is effective July 1, 2000. The effects of applying this Interpretation are recognized on a prospective basis from July 1, 2000.
(2) Investment Securities
The following table provides a summary of investment securities with a comparison of amortized cost and fair values:
At June 30, 2000 and 1999, the Company had accrued interest receivable on investment securities of $435,000 and $212,000, respectively, which is included in accrued interest receivable and other assets in the accompanying consolidated statements of financial condition.
There were no sales of investment securities available for sale in 2000. Proceeds from sales of investment securities available for sale were $1.6 million during 1999. There were gross gains of $371,000 realized during 1999.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The contractual principal maturities of bond obligations for investment securities held to maturity as of June 30, 2000 are as follows:
(3) Loans Receivable, Net
The following table presents carrying values of loans receivable at the dates indicated:
The weighted average interest rate on the Company's loan portfolio was 8.22% and 7.86% at June 30, 2000 and 1999, respectively.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Certain mortgage loans aggregating $513.8 million and $370.7 million at June 30, 2000 and 1999, respectively, are collateral for FHLB advances.
At June 30, 2000 and 1999, the Bank had loans with an outstanding balance of $9.9 million and $10.3 million, respectively, under two separate agreements with the City of Los Angeles to guarantee up to a total of $15 million of multifamily housing revenue bonds primarily for the acquisition and renovation of earthquake-stricken properties. In conjunction with these guarantees, standby letters of credit were issued by the Federal Home Loan Bank. Additionally, the principal balances of other loans sold with recourse totaled $454,000 and $370,000 at June 30, 2000 and 1999, respectively.
At June 30, 2000 and 1999, the Bank had accrued interest receivable on loans of $6.2 million and $5.0 million, respectively, which is included in accrued interest receivable and other assets in the accompanying consolidated statements of financial condition.
The Company serviced loans for investors totaling $299.1 million, $284.2 million and $276.4 million at June 30, 2000, 1999 and 1998, respectively.
Activity in the allowance for loan losses is summarized as follows:
Credit Risk and Concentration
At June 30, 2000 and 1999, the balances of nonaccrual loans totaled $3.6 million and $5.0 million, respectively, net of specific allowances of $0 and $68,000. The Company's nonaccrual policy requires that loans be placed on nonaccrual status after being delinquent 60 days or earlier if warranted. There were no accruing loans contractually past due 60 days or more at June 30, 2000 and 1999.
The gross amount of interest income on nonaccrual loans that would have been recorded during the years ended June 30, 2000, 1999 and 1998 if the nonaccrual loans had been current in accordance with their original terms was $312,000, $424,000 and $640,000, respectively. For the years ended June 30, 2000, 1999 and 1998, $247,000, $295,000 and $399,000, respectively, were actually earned on nonaccrual loans and are included in interest income on loans in the accompanying consolidated statements of earnings. Interest income earned on nonaccrual loans is generally recorded utilizing the cash-basis method of accounting.
The Company's real estate loans are predominantly secured by properties located in southern California.
Impaired Loans
At June 30, 2000 and 1999, the Company had a gross investment in impaired loans of $1.7 million and $3.5 million, respectively. During the year ended June 30, 2000, 1999 and 1998, the Company's
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) average investment in impaired loans was $1.7 million, $5.9 million and $8.2 million, respectively, and for the years then ended, interest income on such loans totaled $126,000, $531,000 and $752,000, respectively. Interest income on impaired loans which are performing is generally recorded utilizing the cash-basis method of accounting. Payments received on impaired loans which are performing under their contractual terms are allocated to principal and interest in accordance with the terms of the loans. At June 30, 2000 all impaired loans were performing in accordance with their contractual terms. Impaired loans totaling $1.7 million were not performing in accordance with their contractual terms at June 30, 1999 and have been included in nonaccrual loans at that date.
Impaired loans at June 30, 2000 included $1.7 million of loans for which specific valuation allowances of $379,000 had been established. At June 30, 1999, the Company had $1.0 million of impaired loans for which specific valuation allowances of $155,000 had been established and $2.5 million of such loans for which no specific valuation allowance was considered necessary. All such provisions for losses and any related recoveries are recorded as part of the total allowance for loan losses.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(4) Mortgage-Backed Securities
Summarized below are the amortized cost and estimated fair values of MBS:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The contractual principal maturities for MBS as of June 30, 2000, are as follows:
The mortgage-backed securities included in the above table have contractual terms to maturity, but require periodic payments to reduce principal. In addition, expected maturities will differ from contractual maturities because borrowers have the right to prepay the underlying mortgages.
Proceeds from sales of mortgage-backed securities available for sale were $62.0 million during 1999. There were gross gains of $245,000 realized during 1999. There were no sales of mortgage-backed securities available for sale in 2000 and 1998. There were no gross gains or losses realized during 2000 and 1998.
The collateralized mortgage obligations held at June 30, 2000 and 1999 represented nonequity interests in mortgage pass-through certificates (Class A-1 Senior Certificates) and were of investment grade.
The Company had accrued interest receivable on mortgage-backed securities of $636,000 and $527,000 at June 30, 2000 and 1999, respectively, which is included in accrued interest receivable and other assets in the accompanying consolidated statements of financial condition.
(5) Real Estate Held for Sale
The following is a summary of real estate held for sale, net of valuation allowances:
Changes in the valuation allowance on real estate held for sale are summarized as follows:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following table summarizes real estate operations, net:
(6) Federal Home Loan Bank (FHLB) Stock
As a member of the FHLB System, the Bank is required to own capital stock in the FHLB of San Francisco in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations at the end of each year, or 5% of its outstanding borrowings from the FHLB of San Francisco. The Bank was in compliance with this requirement with an investment in FHLB of San Francisco stock at June 30, 2000 and 1999 of $15.6 million and $12.2 million, respectively. FHLB stock is recorded at historical cost.
(7) Office Premises and Equipment
The following is a summary of office premises and equipment, net:
The Company recorded depreciation and amortization expense on premises, equipment and leasehold improvements of $1.1 million, $1.0 million and $846,000 during 2000, 1999 and 1998, respectively.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(8) Deposits
The following is a summary of deposits:
The weighted average interest rates are at the end of the period and are based upon stated interest rates without giving consideration to daily compounding of interest or forfeiture of interest because of premature withdrawal.
Certificates of deposit of $100,000 or more accounted for $183.6 million and $99.6 million of deposits at June 30, 2000 and 1999 respectively.
At June 30, 2000 and 1999, the Company had accrued interest payable on deposits of $198,000 and $196,000, respectively, which is included in other liabilities in the accompanying consolidated statements of financial condition.
Deposits at June 30, 2000 mature as follows (in thousands):
Interest expense by type of deposit account is summarized in the following table for the periods indicated:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(9) Federal Home Loan Bank Advances
Federal Home Loan Bank (FHLB) advances are summarized as follows:
These advances are secured by the Bank's stock in the FHLB, certain MBS and certain mortgage loans aggregating $513.8 million and $370.7 million at June 30, 2000 and 1999, respectively. At June 30, 2000, the amount of additional credit available from the FHLB was $86.9 million.
The maturities of FHLB advances are as follows (in thousands):
During the fiscal year ended June 30, 1999, the Company prepaid approximately $8.0 million of its higher cost borrowings and replaced the funds with less expensive borrowings and retail deposits. In association with the debt prepayment, the Company paid a prepayment fee of $61,000, after tax. The prepayment fee is disclosed as an extraordinary item on the accompanying consolidated statements of earnings.
(10) Income Taxes
Income taxes for the fiscal years ended June 30, 2000, 1999 and 1998 are comprised of the following:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A reconciliation from expected Federal income taxes to consolidated effective income taxes for the periods indicated follows. The statutory Federal income tax rates for June 30, 2000, 1999 and 1998 were 35%, 35% and 34%, respectively.
The Bank's tax bad debt reserve balance of approximately $10.9 million as of June 30, 2000, will, in future years, be subject to recapture in whole or in part upon the occurrence of certain events, such as a distribution to stockholders in excess of the Bank's current and accumulated earnings and profit, a redemption of shares or upon a partial or complete liquidation of the Bank. The Bank does not intend to make distributions to stockholders that would result in recapture of any portion of its bad debt reserve. Since management intends to use the reserve only for the purpose for which it was intended, a deferred tax liability of approximately $3.8 million has not been recorded.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at June 30, 2000 and 1999 are presented below:
Deferred tax assets are initially recognized for differences between the financial statement carrying amount and the tax bases of assets and liabilities which will result in future deductible
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
amounts and operating loss and tax credit carryforwards. A valuation allowance is then established to reduce that deferred tax asset to the level at which it is "more likely than not" that the tax benefits will be realized. Realization of tax benefits of deductible temporary differences and operating loss or tax credit carryforwards depends on having sufficient taxable income of an appropriate character within the carryback and carryforward periods. Sources of taxable income that may allow for the realization of tax benefits include (1) taxable income in the current year or prior years that is available through carryback, (2) future taxable income, exclusive of the reversal of existing temporary differences, that will result from the reversal of existing taxable temporary differences and (3) future taxable income generated by future operations. In addition, tax planning strategies may be available to accelerate taxable income or deductions, change the character of taxable income or deductions, or switch from tax-exempt to taxable investments so that there will be sufficient taxable income of an appropriate character and in the appropriate periods to allow for realization of the tax benefits. Management believes that the above-described deferred tax assets are more likely than not to be realized and, accordingly, has not established a valuation allowance for the years ended June 30, 2000 and 1999.
Included in other assets are current taxes receivable of $1.4 million at June 30, 1999.
Included in other liabilities are current taxes payable of $282,000 and $585,000 at June 30, 2000 and 1999, respectively.
(11) Regulatory Capital and Earnings Per Share
The Bank is required to maintain certain minimum levels of regulatory capital as set forth by the OTS in capital standards applicable to all thrifts. These capital standards include a core capital requirement, a tangible capital requirement and a risk-based capital requirement. The Bank exceeds all capital requirements at June 30, 2000, as shown in the following table:
The Federal Deposit Corporation Improvement Act of 1991 contains prompt corrective action (PCA) provisions pursuant to which banks and savings institutions are to be classified into one of five categories, based primarily upon capital adequacy, and which require specific supervisory actions as capital levels decrease. The OTS regulations implementing the PCA provisions define the five capital categories. The following table sets forth the definitions of the categories and the Bank's ratios as of June 30, 2000 and 1999:
The OTS also has authority, after an opportunity for a hearing, to downgrade an institution from well-capitalized to adequately capitalized, or to subject an adequately capitalized or undercapitalized institution to the supervisory actions applicable to the next lower category, for supervisory concerns. At June 30, 2000 and 1999, the Bank was a well-capitalized institution. There are no conditions or events that management believes has changed the institution's category under the capital guidelines.
Dividends
Savings association subsidiaries of holding companies generally are required to provide their OTS District Director not less than 30 days' advance notice of any proposed declaration of a dividend on the association's stock. Under regulations adopted by the OTS, the insured institution's ability to declare and pay a dividend to its holding company is subject to certain limitations. The regulation establishes a three-tiered system of regulation, with the greatest flexibility being afforded to well-capitalized associations. The Bank is considered a well-capitalized institution for purposes of dividend declarations. On May 19, 2000, the Bank declared a $1.0 million dividend payable to the Company based on a $5.0 million total authorization by the Board of Directors of the Bank. No dividends were declared or paid by the Bank in 1999.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Earnings Per Share
The following is the reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the years as indicated:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(12) Retirement Plans
Defined Benefit/Cash Balance Plan
The Bank maintains a noncontributory defined benefit pension plan (the Plan). Employees become eligible to participate in the Plan upon attaining the age of 21 and completing one year of service during which they have served a minimum of 1,000 hours. Until December 31, 1999, the Plan was an income replacement retirement plan. The benefits were based on years of service and the three consecutive years of employment during which the participant earned the highest compensation. Contributions were intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. Effective December 31, 1993, the Plan was frozen for benefit service accrued, and employees hired after November 30, 1992 did not participate in the Plan.
Due to the December 31, 1993 freezing of participants' years of service credited, the Board of Directors approved the conversion of the Plan into a Cash Balance Plan effective January 1, 2000. Under the provisions of the Cash Balance Plan, a cash balance account is established for each participant at plan entry and increased over time with pay and interest credits. Pay credits are equal to 5.0% of eligible pay and are credited to each participant's cash balance account annually. Interest credits are based on ten-year Treasury Note rates and are credited to a participant's cash balance account quarterly. At termination of employment, a participant (if vested) becomes entitled to receive his or her cash balance account in a single payment or have it converted to a monthly annuity payable for life (or over a joint lifetime with his or her beneficiary) at retirement. Employees are eligible to participate in the Cash Balance Plan upon attaining the age of 21 and completing one year of service during which they have served a minimum of 1,000 hours. Although the Cash Balance Plan is intended to be an ERISA-qualified plan, the Bank has not yet submitted the Cash Balance Plan for approval as such, due to the recent Internal Revenue Service (IRS) moratorium on the consideration of cash balance plans. The Bank has implemented the Cash Balance Plan, effective January 1, 2000, on a provisional basis, and intends to apply for IRS approval as soon as practicable.
Plan assets, at fair value, are primarily comprised of government obligations and short-term investments.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table sets forth the Plan's funded status and amounts recognized in the Bank's consolidated statements of financial condition:
The weighted average discount rates used in determining the actuarial present value of the benefit obligations were 7.75% as of June 30, 2000 and 6.00% as of June 30, 1999. The salary increase assumption was 4.00% as of June 30, 2000 and 1999, respectively.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Supplemental Executive Retirement Plan
The Bank has a supplemental executive defined benefit pension plan covering specified employees. The benefits are based on employee compensation and length of service and are offset by benefits provided by Social Security and the Company's other qualified retirement plans.
The following table sets forth the Plan's funded status and amounts recognized in the Bank's consolidated statements of financial condition:
The weighted average discount rates used in determining the actuarial present value of the benefit obligations were 7.75% as of June 30, 2000 and 7.25% as of June 30, 1999. The salary increase assumption was 6.00% as of June 30, 2000 and 1999.
Retirement Benefit Equalization Plan
In conjunction with the conversion of the Bank's Defined Benefit Plan into a Cash Balance Plan effective January 1, 2000, the SERP was converted into a Retirement Benefit Equalization Plan (RBEP) for certain employees. The Retirement Benefit Equalization Plan (RBEP) is a supplemental plan to the Cash Balance Plan, 401(k) Plan, and ESOP and is intended to provide certain covered
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
employees with the total amount of retirement income that they would otherwise receive under these plans if not for legislated ceilings in compliance with certain sections of the Internal Revenue Code which limit retirement benefits payable from qualified plans.
Under the provisions of the RBEP, a cash balance account is established for each participant at plan entry and increased over time with contribution and interest credits. Contribution credits are equal to the amounts not contributed under the qualified plans due to IRS limitations and are credited to each participant's cash balance account annually.
Interest credits are based on ten-year Treasury Note rates and are credited to a participant's cash balance account quarterly.
During 2000, the expense for this plan totaled $47,000. As this plan was newly created, there were no expenses for this plan for 1999 or 1998.
Employee Stock Ownership Plan (ESOP)
The Company has established an ESOP for all employees who are age 21 or older and have completed one year of service with the Bank during which they have served a minimum of 1,000 hours. The ESOP is internally leveraged and borrowed $3.1 million from the Company to purchase 10% of the outstanding shares of the common stock of Quaker City Bancorp, Inc. issued in the original conversion to common stock ownership. The loan will be repaid principally from the Bank's discretionary contributions to the ESOP. In conjunction with the conversion of the Bank's Defined Benefit Plan into a Cash Balance Plan effective January 1, 2000, and the inclusion of all eligible employees as participants in the Plan, the Board of Directors approved an amendment to the ESOP which allows the loan underlying the ESOP to be reamortized over a longer period of time. ESOP participants will receive essentially the same benefit, but the length of time by which it will be received will be extended from September 2003 to December 2004. At June 30, 2000 and 1999, the outstanding balance on the loan was $1.0 million and $1.3 million, respectively. Shares purchased with the loan proceeds are held in a suspense account for allocation among participants as the loan is repaid. Contributions to the ESOP and shares released from the suspense account are allocated among participants on the basis of compensation, as described in the plan, in the year of allocation. Benefits generally become 100% vested after five years of vesting service. Vesting will accelerate upon retirement, death or disability of the participant or in the event of a change in control of the Bank or the Company. Forfeitures will be reallocated among remaining participating employees, in the same proportion as contributions. Benefits may be payable upon death, retirement, early retirement, disability or separation from service. Since the annual contributions are discretionary, the benefits payable under the ESOP cannot be estimated. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the Company reports compensation expense equal to the fair value of the shares allocated, and the allocated shares are considered outstanding for the computation of earnings per share. The expense related to the ESOP totaled $1.0 million, $1.0 million and $1.1 million for the fiscal years ended June 30, 2000, 1999 and 1998, respectively. At June 30, 2000 and 1999, unearned compensation related to the ESOP approximated $1.0 million and $1.3 million, respectively, and is shown as a reduction of stockholders' equity in the accompanying consolidated statements of financial condition.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The table below reflects ESOP activity for the periods indicated:
The fair value of unallocated ESOP shares totaled $3.2 million and $4.5 million at June 30, 2000 and 1999, respectively.
401(k) Plan
Effective July 1, 1997, the Bank implemented a 401(k) plan. Employees become eligible to participate in the Plan upon attaining the age of 21 and completing one year of service during which they have served a minimum of 1,000 hours. The benefits are based on employee compensation. During 2000, 1999 and 1998, the expense for this plan totaled $89,000, $57,000 and $52,000, respectively.
(13) Incentive Plans
Recognition and Retention Plan (RRP)
The Bank adopted the RRP as a method of providing officers, employees and nonemployee directors of the Bank with a proprietary interest in the Company in a manner designed to encourage such persons to remain with the Bank. The Bank contributed funds to the RRP to enable the trust to acquire, in the aggregate, 4% of the shares of common stock in the conversion. Under the RRP, awards are granted in the form of shares of common stock held by the RRP. These shares represent deferred compensation and have been accounted for as a reduction of stockholders' equity. Shares allocated vest over a period of three to five years commencing on January 1, 1995 and continuing on each anniversary date thereafter. Awards are automatically vested upon a change in control of the Company or the Bank. In the event that before reaching normal retirement, an officer or employee terminates service with the Company or the Bank, that person's nonvested awards are forfeited.
The expense related to the RRP for the fiscal years ended June 30, 1999 and 1998 was approximately $115,000 and $221,000, respectively. There was no expense related to the RRP for fiscal year ended June 30, 2000. All shares under the RRP were distributed as of January, 1999. Currently, there is no intention to continue this plan.
Stock Option and Incentive Plans
In March of 1994 the stockholders of the Company ratified two stock option plans, the 1993 Incentive Stock Option Plan (the Stock Plan) and the 1993 Stock Option Plan for Outside Directors (the Directors' Plan). In fiscal 1998, the stockholders of the Company ratified the 1997 Stock Incentive Plan (the 1997 Stock Plan). All Plans provide for the grant of options at an exercise price equal to the fair market value on the date of grant. The Plans are intended to promote stock ownership by directors and selected officers and employees of the Company to increase their proprietary interest in the success of the Company and to encourage them to remain in the employ of the Company or its subsidiaries. Awards granted under the Plans may include incentive stock options, nonstatutory options, limited rights which are exercisable only upon a change in control of the Bank or the Company, restricted stock, stock appreciation rights and other stock-based benefits.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company applies APB Opinion No. 25 and related interpretations for its plans, all of which are fixed stock option plans. Accordingly, the Company did not recognize compensation expense in connection with awards of stock options because the exercise price and the fair market value were the same at the dates of award. Had compensation cost for the Company Plans been recognized based upon the fair value of the options at the grant date consistent with the methodology specified in SFAS No. 123, the Company's net earnings and net earnings per share at June 30, 2000, 1999 and 1998 would have been reduced to the pro forma amounts indicated below (in thousands, except per share amounts):
The per share weighted-average fair value of stock options granted during 2000, 1999 and 1998 were $7.36, $6.69 and $8.42, respectively, on the date of grant using the Black-Scholes option-pricing model. The following weighted- average assumptions were used for fiscal 2000: volatility of 25.12%, no expected dividends, risk free interest rate of 6.33% and an expected life of 8 years. The following weighted-average assumptions were used for fiscal 1999: volatility of 18.54%, no expected dividends, risk-free interest rate of 5.93% and an expected life of 8 years. The following weighted-average assumptions were used for fiscal 1998: volatility of 25.27%, no expected dividends, risk- free interest rate of 5.66%, and an expected life of 10 years. During the initial phase-in period, the effects of applying SFAS No. 123 for these pro forma disclosures are not likely to be representative of the effects on reported income for future years as options vest over several years and additional awards may be made each year.
The Directors' Plan authorizes the granting of stock options for a total of 161,719 shares of common stock. The Stock Plan authorizes the granting of stock options for a total of 485,156 shares of common stock. All options granted under both plans were granted at an exercise price of $4.80 per share. The aggregate number of shares of common stock outstanding and available for issuance pursuant to the 1997 Stock Plan is 560,465 shares. Options covering a total of 100,257 shares were granted in fiscal 2000 at a weighted average exercise price of $15.70 per share, which was the fair market value on the grant date. Options covering a total of 110,000 shares were granted in fiscal 1999 at a weighted average exercise price of $16.13 per share, which was the fair market value on the grant date. Options covering a total of 181,250 shares were granted in fiscal 1998 at a weighted average exercise price of $16.50 per share, which was the fair market value on the grant date.
All options granted under the Directors' Plan became fully exercisable January 1, 1995. Each option granted under the Directors' Plan expires upon the earlier of ten years following the date of grant or one year following the date the optionee ceases to be a director. All options granted under the Stock Plan are exercisable in three equal annual installments commencing January 1, 1995 and continuing on each anniversary date thereafter. Each option granted under the Stock Plan expires upon the earlier of ten years following the date of grant or three months following the date on which
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) the employee ceases to perform services for the Bank or the Company, except that in the event of death, disability, retirement or upon a change in control of the Company or the Bank, options may be exercisable for up to one year thereafter or such longer period as determined by the Company. Each option granted under the 1997 Stock Plan expires upon the earlier of ten years following the date of grant or 30 days following the date on which the employee ceases to perform services for the Bank or the Company, except that in the event of death, disability, retirement or upon a change in control of the Company or the Bank, options may be exercisable for up to six months thereafter or such longer period as determined by the Company.
The table below reflects option activity for the periods indicated:
The following table summarizes information about stock options outstanding at June 30, 2000:
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(14) Commitments and Contingent Liabilities
The Company leases certain premises and equipment on a long-term basis. Some of these leases require the Company to pay property taxes and insurance. Lease expense was approximately $730,000, $524,000 and $430,000 in 2000, 1999 and 1998, respectively. Annual minimum lease commitments attributable to long-term operating leases at June 30, 2000 were (in thousands):
At June 30, 2000 and 1999, the Company had approved commitments to originate loans of approximately $15.0 million and $14.0 million, respectively, substantially all of which were for adjustable rate one to four unit residential loans and multifamily residential loans. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company minimizes its exposure to loss under these commitments by requiring that customers meet certain conditions prior to disbursing funds. The amount of collateral, if any, is based on a credit evaluation of the borrower and generally involves residential real estate.
At June 30, 2000 and 1999, the Company had $25.5 million and $21.1 million of approved undisbursed lines of credit, respectively.
At June 30, 2000 and 1999, the Company had commitments to sell loans of $11.2 million and $6.0 million, respectively, for which the related loans are included in loans held for sale. There were commitments to purchase loans of $3.7 million at June 30, 1999 and no commitments to purchase loans at June 30, 2000. The Company had no commitments to sell investment securities or MBS at June 30, 2000 and 1999. There were no commitments to purchase investment securities at June 30, 2000 and 1999.
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition and results of operations.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(15) Loan Servicing and Sale Activities
Loan servicing and sale activities are summarized as follows:
The Company originates mortgage loans, which depending upon whether the loans meet the Company's investment objectives, may be sold in the secondary market or to other private investors. The servicing of these loans may or may not be retained by the Company. Direct origination and servicing costs for loan servicing and sale activities cannot be presented as these operations are integrated with and not separable from the origination and servicing of portfolio loans and, as a result, cannot be accurately estimated.
In addition to retaining the servicing assets for originated loans, the Company may also purchase mortgage servicing assets related to mortgage loans originated by other institutions. At June 30, 2000, the Company had purchased mortgage servicing assets with a book value of $197,000 and originated mortgage servicing assets with a book value of $72,000.
(16) Parent Company Condensed Financial Information
This information should be read in conjunction with the other notes to the consolidated financial statements. The following are the condensed financial statements for Quaker City Bancorp, Inc. (parent company only) as of June 30, 2000 and 1999 and for the years ended June 30, 2000, 1999 and 1998:
Statements of Financial Condition
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Statements of Earnings
Statements of Cash Flows
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(17) Quarterly Results of Operations (Unaudited)
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(18) Fair Value of Financial Instruments
Pursuant to requirements under generally accepted accounting principles, the Company has included information about the fair values of the Company's financial instruments, whether or not such instruments are recognized in the accompanying consolidated statements of financial condition. In cases where quoted market prices are not available, fair values are estimated based upon discounted cash flows. Those techniques are significantly affected by the assumptions utilized, including the assumed discount rates and estimates of future cash flows. In this regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in an immediate sale or other disposition of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. All components of cash and cash equivalents and accrued interest receivable and payable are presumed to have approximately equal book and fair values because the periods over which such amounts are realized are relatively short. As a result of the assumptions utilized, the aggregate fair value estimates presented herein do not necessarily represent the Company's aggregate underlying fair value.
The fair values of investment securities and MBS are generally obtained from market bids for similar or identical securities, or are obtained from quotes from independent security brokers or dealers.
Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as one to four units, multifamily, commercial real estate and other. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the contractual term of the loans to maturity, adjusted for estimated prepayments. Fair value for nonperforming loans is based on management's evaluation of fair value as determined by specific borrower information and, if appropriate, the fair value of the underlying collateral.
The fair values of deposits are estimated based upon the type of deposit product. Demand and money market deposits are presumed to have equal book and fair values. The estimated fair values of time deposits are determined by discounting the cash flows of segments of deposits having similar maturities and rates, utilizing a yield curve that approximated the rates offered as of the reporting date. No value has been estimated for the Company's long-term relationships with depositors (commonly known as the core deposit premium) since such intangible asset is not a financial instrument pursuant to the definitions contained in SFAS No. 107.
The fair values of borrowings were estimated using current market rates of interest for similar borrowings.
The fair values of off-balance sheet items are based on rates for similar transactions as of the reporting date.
QUAKER CITY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table presents the carrying values and fair values of the Company's financial instruments at the dates indicated:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated herein by this reference is the information set forth in the sections entitled "DIRECTORS AND EXECUTIVE OFFICERS--Directors" and "-- Executive Officers" and SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE contained in the Company's Proxy Statement for its 2000 Annual Meeting of Stockholders (the "2000 Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated herein by this reference is the information set forth in the sections entitled "COMPENSATION AND OTHER INFORMATION" and "COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION" contained in the 2000 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated herein by this reference is the information set forth in the sections entitled "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "SECURITY OWNERSHIP OF MANAGEMENT" contained in the 2000 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by this reference is the information set forth in the section entitled "RELATED PARTY TRANSACTIONS" contained in the 2000 Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) Financial Statements
(a)(2) Financial Statement Schedules
All schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
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(a)(3) Exhibits
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- -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to the Annual Report on Form 10-K pursuant to Item 14(c) of Form 10-K. (1) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1994. (2) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1995. (3) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1996. (4) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1997.
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(5) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1998. (6) Incorporated by reference to the corresponding exhibit to the Registrant's Form 10-K as filed with the Securities and Exchange Commission for the fiscal year ended June 30, 1999.
(b) Reports on Form 8-K
None.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
QUAKER CITY BANCORP, INC., a Delaware corporation
/s/ Frederic R. (Rick) McGill By: _________________________________ Frederic R. (Rick) McGill President and Chief Executive Officer
DATE: September 27, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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