ITEM 1. BUSINESS
General
Popular is a diversified, publicly-owned financial holding company, registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”) and subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Popular was incorporated in 1984 under the laws of the Commonwealth of Puerto Rico and is the largest financial institution based in Puerto Rico, with consolidated assets of $44.3 billion, total deposits of $35.5 billion and stockholders’ equity of $5.1 billion at December 31, 2017. At December 31, 2017, we ranked among the 50 largest U.S. banks based on total assets according to information gathered and disclosed by the Federal Reserve Board.
We operate in two principal markets:
• Puerto Rico: We provide retail, mortgage and commercial banking services through our principal banking subsidiary, Banco Popular de Puerto Rico (“Banco Popular” or “BPPR”), as well as auto and equipment leasing and financing, investment banking, broker-dealer and insurance services through specialized subsidiaries.
• Mainland United States: We operate Banco Popular North America (“BPNA”), a community bank providing a broad range of financial services and products to the communities it serves. BPNA operates branches in New York, New Jersey and Florida, under the name of Popular Community Bank (“PCB”).
Our two reportable business segments for accounting purposes, BPPR and BPNA, correspond to our Puerto Rico and mainland United States businesses, respectively. We report our 16.10% ownership interest in EVERTEC, Inc. (“EVERTEC”), the financial transaction processing and technology company that provides those services to our business, and our 15.84% ownership interest in Centro Financiero BHD León, S.A., a diversified financial services institution operating in the Dominican Republic, in our “Corporate” group, which also includes the holding company operations and certain other equity investments.
Unless otherwise stated, all references in this Form 10-K to total loan portfolio, total credit exposure or loan portfolios, exclude covered loans, which represent loans acquired in the Westernbank FDIC-assisted transaction that are covered under loss sharing agreements with the FDIC and non-covered loans held-for-sale, which amounted to $517 million and $132 million, respectively at December 31, 2017.
The sections that follow provide a description of significant matters and transactions that have impacted or will impact our current and future operations.
SIGNIFICANT EVENTS
Entry into an Agreement to Acquire Wells Fargo’s Auto Finance Business in Puerto Rico
On February 14, 2018, Popular, Inc. announced that BPPR has agreed to acquire and assume from Reliable Financial Services, Inc. and Reliable Finance Holding Company, subsidiaries of Wells Fargo & Company (“Wells Fargo”), certain assets and liabilities related to Wells Fargo’s auto finance business in Puerto Rico (“Reliable”).
As part of the transaction, BPPR will acquire approximately $1.5 billion in retail auto loans and $340 million in commercial loans. The acquired auto loan portfolio has credit characteristics that are similar to BPPR’s existing self-originated portfolio. BPPR will also acquire certain other assets and assume certain liabilities of Reliable.
The purchase price for the all-cash transaction is expected to be approximately $1.7 billion, reflecting an aggregate discount of 4.5% on the assets to be acquired. BPPR will fund the purchase price with existing liquidity. The transaction is not subject to the receipt by the parties of any further regulatory approvals. Subject to satisfaction of customary closing conditions, Popular anticipates the transaction to close during the second quarter of 2018 and be accretive to earnings.
On or after closing, Reliable employees will become employees of BPPR. Reliable will continue operating independently as a division of BPPR for a period of time after closing to provide continuity of service to Reliable customers while allowing us to assess best practices before integrating Reliable’s operations with Popular Auto’s operations.
Hurricanes Irma and Maria
During September 2017, Hurricanes Irma and Maria (the “hurricanes”) impacted Puerto Rico, the U.S. and British Virgin Islands, causing extensive damage and disrupting the markets in which BPPR does business.
Puerto Rico and the USVI were declared disaster zones by President Trump due to the impact of the hurricanes, thus making them eligible for Federal assistance. Notwithstanding the significant recovery operation that is underway by the Federal, state and local governments, as of the date of this report, a number of businesses and homes in Puerto Rico and the USVI remain without power, and some businesses are partially operating or remain closed, while others have permanently closed.
The damages caused by the hurricanes are substantial and have had a material adverse impact on economic activity in Puerto Rico. It is still, however, too early to fully assess and quantify the extent of the damages caused by the hurricanes, as well as their long-term impact on economic activity. Employment levels have also decreased in the short-term and could continue to decline as a result of impact of the hurricanes on economic activity and outmigration trends.
Decline as a result of the impact of the hurricane on economic activity and outmigration trends
During the year ended December 31, 2017, the Corporation recorded $88.0 million in pre-tax hurricane-related expenses, including an incremental provision for loan losses of $67.7 million, which includes $5.8 million for the covered loan portfolio (described below). These amounts are net of amounts receivable for related insurance claims of $1.1 million related to physical damages to the Corporation’s premises, equipment and other real estate owned (“OREO”).
In addition to the incremental provision and direct operating expenses, results for year ended December 31, 2017 were impacted by the hurricanes in the form of a reduction in revenue resulting from reduced merchant transaction activity, the waiver of certain late fees and service charges, including ATM transaction fees, to businesses and consumers in hurricane-affected areas, as well as the economic and operational disruption in the Corporation’s mortgage origination, servicing and loss mitigation activities due to the hurricanes’ operational and economic impact. These resulted in a decrease in revenue of approximately $31 million when compared to pre-hurricane levels.
While significant progress has been made in economic and transactional activity since September, we continue to assess the impact of the hurricanes on our customers and our loan portfolios.
Refer to additional information on Note 2 to the Financial Statements, Hurricanes Irma and Maria, and the Overview, Provision for Loan Losses and Operating Expenses sections of Management’s Discussion and Analysis included in this Form 10-k.
Tax Cuts and Jobs Act
On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”) was signed into law by President Trump. The Act, among other things, reduced the maximum corporate tax rate from 35% to 21% in the U.S. As a result, during the fourth quarter of 2017, the Corporation recorded an income tax expense of $168.4 million related to the write-down of the deferred tax asset (“DTA”) from its U.S. operations.
The Act contains other provisions, effective on January 1, 2018, which may impact the Corporation’s tax calculations and related income tax expense in future years.
Puerto Rico Business
We offer in Puerto Rico a variety of retail and commercial banking services through our principal bank subsidiary, BPPR. BPPR was organized in 1893 and is Puerto Rico’s largest bank with consolidated total assets of $34.7 billion, deposits of $29.1 billion and stockholder’s equity of $3.7 billion at December 31, 2017. BPPR accounted for 78% of our total consolidated assets at December 31, 2017. BPPR’s deposits are insured under the Deposit Insurance Fund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”).
The banking operations of BPPR are primarily based in Puerto Rico, where BPPR has the largest retail banking franchise. BPPR also conducts banking operations in the U.S. Virgin Islands, the British Virgin Islands and New York. The following table contains information of BPPR’s operations as of December 31, 2017:
Our Puerto Rico operations include those of Popular Auto, LLC, a wholly-owned subsidiary of BPPR, a vehicle and equipment financing, leasing and daily rental company. The residential mortgage origination business is conducted by Popular Mortgage, a division of BPPR. In Puerto Rico, we also offer financial advisory, investment and securities brokerage services for institutional and retail customers through our securities broker-dealer Popular Securities, LLC, (“Popular Securities”), a wholly-owned subsidiary of Popular. As of December 31, 2017, Popular Securities had $26.1 million in total assets and $4.1 billion in assets under management. In addition, BPPR has various special purpose vehicles holding specific assets acquired in satisfaction of loans for real estate development projects and commercial loans.
We offer insurance and reinsurance services through Popular Insurance, LLC, a general insurance agency, and Popular Life RE, a reinsurance company, with total revenues of $19.1 million and $18.6 million, respectively, for the year ended December 31, 2017. We also own Popular Risk Services, LLC, an insurance broker, and Popular Insurance V.I., Inc., an insurance agency operating in the Virgin Islands.
Mainland United States Business
Popular North America, Inc. (“PNA”) functions as the holding company for our operations in the mainland United States. PNA, a wholly-owned subsidiary of Popular, was organized in 1991 under the laws of the State of Delaware and is a registered bank holding company under the BHC Act. As of December 31, 2017, PNA had one principal subsidiary, BPNA, a full service commercial bank incorporated in the state of New York.
The banking operations of BPNA in the United States mainland are based in three states and are conducted under the name of Popular Community Bank. The following table contains information of BPNA’s operations as of December 31, 2017:
In addition, BPNA owns all of the outstanding stock of E-LOAN, Inc., Popular Insurance Agency USA, and Popular Equipment Finance, Inc., which ceased originations and holds a run-off portfolio of a lease financing portfolio with a balance of $11.2 million at December 31, 2017. E-LOAN, Inc. supported BPNA’s deposit gathering through its online platform until March 31, 2017, when those operations were transferred to Popular Direct, a division of BPNA. Popular Insurance Agency USA, Inc. acts as an insurance agent or broker offering insurance and investment products across the BPNA branch network. Total revenues of Popular Insurance Agency USA, Inc. for the year ended December 31, 2017 were $3.1 million.
Lending Activities
We concentrate our lending activities in the following areas:
(1) Commercial. Commercial loans are comprised of (i) commercial and industrial (C&I) loans to commercial customers for use in normal business operations and to finance working capital needs, equipment purchases or other projects, and (ii) commercial real estate (CRE) loans (excluding construction loans) for income-producing real estate properties as well as owner-occupied properties. C&I loans are underwritten individually and usually secured with the assets of the company and the personal guarantee of the business owners. CRE loans consist of loans for income-producing real estate properties and the financing of owner-occupied facilities if there is real estate as collateral. We mitigate our risk on these loans by requiring collateral values that exceed the loan amount and underwriting the loan with cash flow sustainability that exceeds debt service requirements. Non-owner-occupied CRE loans are generally made to finance office and industrial buildings, healthcare facilities, multifamily buildings and retail shopping centers and are repaid through cash flows related to the operation, sale or refinancing of the property.
(2) Mortgage. Mortgage loans include residential mortgage loans to consumers for the purchase or refinancing of a residence and also include residential construction loans made to individuals for the construction or refurbishment of their residence. The majority of these loans are financed over a 15 to 30 year amortization term, and in most cases, the loans are extended to borrowers to finance their primary residence. In some cases, government agencies or private mortgage insurers guarantee the loan. Our general practice has been to sell a majority of our conforming loan originations in the secondary mortgage market.
(3) Consumer. Consumer loans are mainly comprised of personal loans, credit cards, and automobile loans, and to a lesser extent home equity lines of credit (“HELOCs”) and other loans made by banks to individual borrowers. In this area, BPPR and BPNA offer four unsecured products: personal loans, credit cards, personal credit lines and overdraft protection. HELOCs include both home equity loans and lines of credit secured by a first or second mortgage on the borrower’s residence, which allows customers to borrow against the equity in their homes. Real estate market values as of the time HELOCs are granted directly affect the amount of credit extended and, in addition, changes in these values impact our exposure to losses in this type of loan.
(4) Construction. Construction loans are CRE loans to companies or developers used for the construction of a commercial or residential property for which repayment will be generated by the sale or permanent financing of the property. Our construction loan portfolio primarily consists of retail, residential (land and condominiums), office and warehouse product types. These loans are generally underwritten and managed by a specialized real estate group that actively monitors the construction phase and manages the loan disbursements according to the predetermined construction schedule. BPPR is currently originating a limited amount of new construction loans.
(5) Lease Financings. Lease financings are offered by BPPR and are primarily comprised of automobile loans/leases made through automotive dealerships and equipment lease financings.
(6) Legacy. At BPNA, we carry a legacy portfolio comprised of commercial loans, construction loans and lease financings related to certain lending products exited by the Corporation as part of restructuring efforts carried out in prior years at BPNA.
Covered Loans.
On April 30, 2010, BPPR acquired most of the loan portfolio of the former Westernbank Puerto Rico from the FDIC, as receiver (the “Westernbank FDIC-assisted transaction”). Loans acquired in the Westernbank FDIC-assisted transaction that are subject to a loss sharing agreement with the FDIC are referred to as “covered loans.” “Covered” foreclosed other real estate properties are also subject to loss sharing agreements. Pursuant to the terms of the loss sharing agreements, the FDIC’s obligation to reimburse BPPR for losses with respect to assets covered by such agreements (the “covered assets”) begins with the first dollar of loss incurred. On a combined basis, the FDIC will reimburse BPPR for 80% of all qualifying losses with respect to the covered assets during the covered period. BPPR will reimburse the FDIC for 80% of qualifying recoveries with respect to losses for which the FDIC reimbursed BPPR. The FDIC loss sharing period under the loss sharing agreement for commercial (including construction) and consumer loans ended on June 30, 2015, with additional recovery sharing for three years thereafter. The loss sharing agreement for single-family residential mortgage loans provides for FDIC loss sharing and BPPR reimbursement to the FDIC for ten years (ending on the quarter ending June 30, 2020).
Because of the loss protection provided by the FDIC, the risks of the covered loans are significantly different from other loans in our portfolio, and thus we have determined to segregate them in our financial statements and in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Covered loans are reported in loans exclusive of the estimated FDIC loss share indemnification asset.
At December 31, 2017, covered loans totaled $ 517 million or 1% of total consolidated assets of Popular.
In connection with the Westernbank FDIC-assisted transaction, BPPR agreed to make a true-up payment to the FDIC following the expiration of the loss-share period or upon the final disposition of all covered assets if losses on the loss sharing agreements fail to reach expected levels. At December 31, 2017, the carrying amount of the true-up payment obligation amounted to $165 million. For a discussion of the true-up payment obligation, please refer to Note 11 to the accompanying financial statements.
Business Concentration
Since our business activities are currently concentrated primarily in Puerto Rico, our results of operations and financial condition are dependent upon the general trends of the Puerto Rico economy and, in particular, the residential and commercial real estate markets. The concentration of our operations in Puerto Rico exposes us to greater risk than other banking companies with a wider geographic base. Our asset and revenue composition by geographical area is presented in “Financial Information about Geographic Areas” below and in Note 41, “Segment Reporting”, to the consolidated financial statements included in the Annual Report.
Our loan portfolio is diversified by loan category. However, approximately 66% of our non-covered loan portfolio at December 31, 2017 consisted of real estate-related loans, including residential mortgage loans, construction loans and commercial loans secured by commercial real estate. The table below presents the distribution of our non-covered loan portfolio by loan category at December 31, 2017. “Legacy” refers to loans remaining from lines of businesses we exited as a result of the restructuring of our U.S. operations in 2008 and 2009.
Except for the Corporation’s exposure to the Puerto Rico Government sector, no individual or single group of related accounts is considered material in relation to our total assets or deposits, or in relation to our overall business. For a discussion of our loan portfolio and our exposure to the Government of Puerto Rico, see “Financial Condition - Loans” and “Credit Risk - Geographical and Government Risk” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of the Annual Report.
Credit Administration and Credit Policies
Interest from our loan portfolios is our principal source of revenue. Whenever we make loans, we expose ourselves to credit risk. At December 31, 2017, our credit exposure was centered in our $ 24.3 billion non-covered loan portfolio which represented 60% of our earning assets excluding covered loans. Credit risk is controlled and monitored through active asset quality management, including the use of lending standards, thorough review of potential borrowers and active asset quality administration.
Business activities that expose us to credit risk are managed within the Board of Director’s Risk Management policy, and the Credit Risk Tolerance Limits policy which establishes limits that consider factors such as maintaining a prudent balance of risk-taking across diversified risk types and business units, compliance with regulatory guidance, controlling the exposure to lower credit quality assets, and limiting growth in, and overall exposure to, any product or risk segment where we do not have sufficient experience and a proven ability to predict credit losses.
Our Credit Strategy Committee (“CRESCO”) is management’s top policy-making body with respect to credit-related matters and credit strategies. CRESCO reviews the activities of each subsidiary to ensure a proactive and coordinated management of credit granting, credit exposures and credit procedures. CRESCO’s principal functions include reviewing the adequacy of the allowance for loan losses and periodically approving appropriate provisions, monitoring compliance with charge-off policy, establishing portfolio diversification, yield and quality standards, establishing credit exposure reporting standards, monitoring asset quality, and approving credit policies and amendments thereto for the subsidiaries and/or business lines, including special lending approval authorities when and if appropriate. The analysis of the allowance adequacy is presented to the Risk Management Committee of the Board of Directors for review, consideration and ratification on a quarterly basis.
We also have a Corporate Credit Risk Management Division (“CCRMD”). The CCRMD is a centralized unit, independent of the lending function. The CCRMD’s functions include identifying, measuring and controlling credit risk independently from the business units, evaluating the credit risk rating system and reviewing the adequacy of the allowance for loan losses in accordance with Generally Accepted Accounting Principles (“GAAP”) and regulatory standards. The CCRMD also ensures that the subsidiaries comply with the credit policies and applicable regulations, and monitors credit underwriting standards. Also, the CCRMD performs ongoing monitoring of the portfolio, including potential areas of concern for specific borrowers and/or geographic regions.
The Corporation also has a Corporate Loan Review and Model Risk Monitoring (“CLR & MRM“) Division. Through the Commercial Loan Review Unit at the Corporate Loan Review Department (“CLRD”), CLR & MRM evaluates compliance with the Bank’s Commercial Credit Norms and Procedures and the precision of risk rating accuracy. The CLRD performs annual credit process reviews of several commercial portfolios, including small and middle market, construction, asset-based and corporate banking lending groups in BPPR, as well as BPNA’s commercial and construction portfolios. This group evaluates the credit risk profile of each originating unit along with each unit’s credit administration effectiveness, including the assessment of the risk rating representative of the current credit quality of the loans, and the evaluation of credit and collateral documentation. The monitoring performed by CLRD contributes to assess compliance with credit policies and underwriting standards, to determine the current level of credit risk, to evaluate the effectiveness of the credit management process and to identify control deficiencies that may arise in the credit-origination and management processes. Based on its findings, CLRD develops recommendations to implement corrective actions, if necessary, that help in maintaining a sound credit process and that credit risk is kept at an acceptable level.
We maintain comprehensive credit policies for all lines of business in order to mitigate credit risk. Our credit policies are ratified by our Board of Directors and set forth, among other things, underwriting standards and procedures for monitoring and evaluating loan portfolio quality. Our credit policies also require prompt identification and quantification of asset quality deterioration or potential loss in order to ensure the adequacy of the allowance for loan losses. Included in these policies, primarily determined by the amount, type of loan and risk characteristics of the credit facility, are various approval levels and lending limit constraints, ranging from the branch or department level to those that are more centralized.
Our credit policies and procedures establish strict documentation requirements for each loan and related collateral type, when applicable, during the underwriting, closing and monitoring phases. During the initial loan underwriting process, the credit policies require, at a minimum, historical financial statements or tax returns of the borrower and any guarantor, an analysis of financial information contained in a credit approval package, a risk rating determination in the case of commercial and construction loans, reports from credit agencies and appraisals for real estate-related loans. The credit policies also set forth the required closing documentation depending on the loan and the collateral type.
Although we originate most of our loans internally in both the Puerto Rico and mainland United States markets, we occasionally purchase or participate in loans originated by other financial institutions. When we purchase or participate in loans originated by others, we conduct the same underwriting analysis of the borrowers and apply the same criteria as we do for loans originated by us. This also includes a review of the applicable legal documentation.
Set forth below are the general parameters under which we analyze our major loan categories:
Commercial and Construction: Commercial and construction loans are underwritten using a comprehensive analysis of the borrower’s operations, including the borrower’s business model, management, financial statements, pro-forma financial condition including financial projections, use of funds, debt service capacity, leverage and the financial strength of any guarantor. Most of our commercial and construction loans are secured by real estate and other collateral. A review of the quality and value of collateral, including independent third-party appraisals of machinery and equipment and commercial real estate, as appropriate, is also conducted. Physical inspection of the collateral and audits of receivables is conducted when appropriate. Our credit policies provide maximum loan-to-value ratios that limit the size of a loan to a maximum percentage of the value of the real estate collateral securing the loan. The loan-to-value percentage varies by the type of collateral. Our loan-to value limitations are, in certain cases, determined by other risk factors such as the financial strength of the borrower or guarantor, the equity provided to the project and the viability of the project itself. Most CRE loans are originated with full recourse or limited recourse to all principals and owners. Non-recourse lending is limited to borrowers with very solid financial capacity.
As of December 31, 2017, $ 4.5 billion, or 61%, of our commercial and construction loans in Puerto Rico were secured by real estate, while in the mainland United States these figures totaled $ 4.0 billion, or 80%, respectively.
Consumer, Mortgage and Lease Financings: Our consumer, mortgage and lease financings are originated consistent with the underwriting approach described above, but also include an assessment of each borrower’s personal financial condition, including verification of income, assets and Fair Isaac Corporation (FICO) credit score. Credit reports are obtained and reconciled with the financial statements provided to us. Although a standard industry definition for subprime loans does not exist, for risk assessment purposes, subprime consumer and mortgage loans in the BPPR segment are determined based on the final rule definition of higher risk consumer loans issued by the FDIC which was made effective during 2013. A higher-risk consumer loan is defined as a loan where, as of origination, or as of refinance, the probability of default (PD) within two years is greater than 20%. In Puerto Rico, as of December 31, 2017, consumer and mortgage loans with subprime characteristics consisted of $119.8 million (4% of the Puerto Rico consumer loan portfolio) and $645.1 million (10% of the Puerto Rico mortgage loan portfolio), respectively. Since the final rule definition is not applicable to our U.S. operation, subprime loans in the BPNA segment are defined as borrowers with one or a combination of certain credit risk factors, such as FICO credit scores (generally less than 620 for secured products and 660 for unsecured products), high debt to income ratios (higher than 50%) and inferior payment history, including factors such as defaults and limited credit history. As of December 31, 2017, our mainland United States consumer and mortgage loans with subprime characteristics consisted of $54.6 million (or 11% of the U.S. mainland consumer loan portfolio) and $195.3 million (or 28% of U.S. mainland mortgage loans portfolio). As part of the restructuring in 2008 of our U.S. mainland operations, we discontinued originating loans with subprime characteristics in those operations, including the U.S. non-conventional mortgage loan portfolio and E-LOAN, Inc. Popular does not target subprime borrowers and does not offer products specifically designed for subprime borrowers.
As of December 31, 2017, there was a nominal amount of interest-only loans in our consumer loans portfolio and $76.0 million of interest-only loans in our mortgage loan portfolio, all of which were at BPPR. Also, we did not have a significant amount of adjustable rate mortgage loans in our Puerto Rico portfolio, except for a special step loan mortgage product to purchasers of units within construction projects financed by BPPR. This product, with a term of up to 40 years, provides for 100% financing at a 2.99% interest rate for the first five years of the term of the loan and 5.88% fixed-rate for the remaining term. Consistent with our credit policies, the underwriting and loan approval process for our step loan mortgage product is based on a number of factors, including an assessment of each borrower’s personal financial condition (including verification of income, assets and FICO credit score), as well as debt-to-equity ratio, reserves, loan-to-value and prior mortgage experience. While Popular has not established specific limits for FICO credit scores, debt-to-income ratios and loan-to-values applicable to this product, the underwriting parameters applied to this product are generally similar to the standards used for the underwriting of our non-conforming loans, except for higher loan-to-value ratios (90% or higher). As of December 31, 2017, Popular had $330.5 million of these step loans.
As of December 31, 2017, $6.6 billion, or 66%, of our total consumer loans, including mortgage loans, in Puerto Rico were secured by real estate. In the United States mainland, these figures totaled $ 0.9 billion, or 75%, respectively. Lease financings are also secured by the underlying asset.
Loan extensions, renewals and restructurings
Loans with satisfactory credit profiles can be extended, renewed or restructured. Many commercial loan facilities are structured as lines of credit, which are mainly one year in term and therefore are required to be renewed annually. Other facilities may be restructured or extended from time to time based upon changes in the borrower’s business needs, use of funds, timing of completion of projects and other factors. If the borrower is not deemed to have financial difficulties, extensions, renewals and restructurings are done in the normal course of business and are not considered concessions, and the loans continue to be recorded as performing.
We evaluate various factors in order to determine if a borrower is experiencing financial difficulties. Indicators that the borrower is experiencing financial difficulties include, for example: (i) the borrower is currently in default on any of its debt or it is probable that the borrower would be in payment default on any of its debt in the foreseeable future without the modification; (ii) the borrower has declared or is in the process of declaring bankruptcy; (iii) there is significant doubt as to whether the borrower will continue to be a going concern; (iv) currently, the borrower has securities that have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange; and (v) based on estimates and projections that only encompass the current business capabilities, the borrower forecasts that its entity-specific cash flows will be insufficient to service the debt (both interest and principal) in accordance with the contractual terms of the existing agreement through maturity; and absent the current modification, the borrower cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a non-troubled debtor.
We have specialized workout officers who handle substantially all commercial loans that are past due 90 days and over, borrowers experiencing financial difficulties, and those that are considered problem loans based on their risk profile. As a general policy, we do not advance additional money to borrowers that are 90 days past due or over. In commercial and construction loans, certain exceptions may be approved under certain circumstances, including (i) when past due status is administrative in nature, such as expiration of a loan facility before the new documentation is executed, and not as a result of payment or credit issues; (ii) to improve our collateral position or otherwise maximize recovery or mitigate potential future losses; and (iii) with respect to certain entities that, although related through common ownership, are not cross defaulted nor cross-collateralized and are performing satisfactorily under their respective loan facilities. Such advances are underwritten following our credit policy guidelines and approved up to prescribed policy limits, which are dependent on the borrower’s financial condition, collateral and guarantee, among others.
In addition to the legal lending limit established under applicable state banking law, discussed in detail below, business activities that expose the Corporation to credit risk should be managed within guidelines described in the Credit Risk Tolerance Limits policy. Limits are defined for loss and credit performance metrics, portfolio composition and concentration, and industry and name-level, which monitors lending concentration to a single borrower or a group of related borrowers, including specific lending limits based on industry or other criteria, such as a percentage of the banks’ capital.
Loans to borrowers with financial difficulties can be modified as a loss mitigation alternative. New terms and conditions of these loans are individually evaluated to determine a feasible loan restructuring. In many consumer and mortgage loans, a trial period is established where the borrower has to comply with three consecutive monthly payments under the new terms before implementing the new structure. Loans that are restructured, renewed or extended due to financial difficulties and the terms reflect concessions that would not otherwise be granted are considered as Troubled Debt Restructurings (“TDRs”). These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. These concessions stem from an agreement between the creditor and the debtor or are imposed by law or a court. TDRs also include loans for which the Corporation has entered into liquidation proceedings with borrowers in which neither principal or interest is forgiven, but the Corporation accepts payments which are different than the contractual payment schedule. Refer to additional information on TDRs on Note 10 to the consolidated financial statements included in the Annual Report for the year ended December 31, 2017.
Loans classified as TDRs are reported in non-accrual status if the loan was in non-accruing status at the time of the modification. The TDR loan will continue in non-accrual status until the borrower has demonstrated a willingness and ability to make the restructured loan payments (at least six months of sustained performance after classified as TDR and management has concluded whether it is probable that the borrower would not be in payment default in a foreseeable future). If the loan was appropriately on accrual status prior to the restructuring, the borrower has demonstrated performance under the previous terms (for a period of at least six months, as defined), and the bank’s credit evaluation shows the borrower’s capacity to continue to perform under the restructured terms (both principal and interest payments), it is likely that the appropriate conclusion is for the loan to remain on accrual at the time of the restructuring. Loans classified as TDRs are excluded from TDR status if performance under the restructured terms exists for a reasonable period (at least twelve months of sustained performance after being classified) and the loan yields a market rate.
Competition
The financial services industry in which we operate is highly competitive. In Puerto Rico, our primary market, the banking business is highly competitive with respect to originating loans, acquiring deposits and providing other banking services. Most of our direct competition for our products and services comes from commercial banks. The principal competitors for BPPR include locally based commercial banks and a few large U.S. and foreign banks with operations in Puerto Rico. On February 27, 2015, BPPR entered into an FDIC assisted-transaction in which, in an alliance with co-bidders, including BPNA, it acquired certain assets and all deposits, except for certain non-brokered deposits, under receivership of Doral Bank. While the number of banking competitors in Puerto Rico has been reduced in recent years as a result of consolidations, these transactions have allowed some of our competitors to gain greater resources, such as a broader range of products and services. As of December 31, 2017, there were 8 commercial banks operating in Puerto Rico.
We also compete with specialized players in the local financial industry that are not subject to the same regulatory restrictions as domestic banks and bank holding companies. Those competitors include brokerage firms, mortgage companies, insurance companies, automobile and equipment finance companies, local and federal credit unions (locally known as “cooperativas”), credit card companies, consumer finance companies, institutional lenders and other financial and non-financial institutions and entities. Credit unions generally provide basic consumer financial services. These competitors collectively represent a significant portion of the market and have lower cost structure and fewer regulatory constraints. As previously mentioned, on February 14, 2018, BPPR entered into an agreement to acquire $1.8 billion in retail auto and commercial loans from Reliable Financial Services, Inc., Wells Fargo’s auto finance business in P.R.
In the United States we continue to face substantial competitive pressure as our footprint resides in two large, metropolitan markets of New York City / Northern New Jersey and the greater Miami area. There is a large number of Community and Regional banks along with national banking institutions present in both markets, many of which have a larger amount of resources than us.
In both Puerto Rico and the United States, the primary factors in competing for business include pricing, convenience of branch locations and other delivery methods, range of products offered, and the level of service delivered. We must compete effectively along all these parameters to be successful. We may experience pricing pressure as some of our competitors seek to increase market share by reducing prices. Competition is particularly acute in the market for deposits, where pricing is very aggressive. Increased competition could require that we increase the rates offered on deposits or lower the rates charged on loans, which could adversely affect our profitability.
Economic factors, along with legislative and technological changes, will have an ongoing impact on the competitive environment within the financial services industry. We work to anticipate and adapt to dynamic competitive conditions whether it may be developing and marketing innovative products and services, adopting or developing new technologies that differentiate our products and services, cross-marketing, or providing personalized banking services. We strive to distinguish ourselves from other community banks and financial services providers in our marketplace by providing a high level of service to enhance customer loyalty and to attract and retain business. However, we can provide no assurance as to the effectiveness of these efforts on our future business or results of operations, as to our continued ability to anticipate and adapt to changing conditions, and to sufficiently improve our services and/or banking products, in order to successfully compete in our primary service areas.
Employees
At December 31, 2017, we employed 7,784 full time equivalent employees, of which 7,101 were located in Puerto Rico and the Virgin Islands and 683 in the U.S. mainland. None of our employees is represented by a collective bargaining group.
Financial Information About Segments
Our corporate structure consists of two reportable segments - BPPR and BPNA. A “Corporate” group has been defined to support the reportable segments. Revenue from the 16.10% ownership interest in EVERTEC is reported as non-interest income in the Corporate group.
Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. The segments were determined based on the organizational structure, which focuses primarily on the markets the segments serve, as well as on the products and services offered by the segments.
For further information about our segments, see “Reportable Segment Results” in the Management’s Discussion and Analysis section of the Annual Report and Note 41, “Segment Reporting” to the consolidated financial statements included in the Annual Report.
Financial Information About Geographic Areas
Our revenue composition by geographical area is presented in Note 41, “Segment Reporting” to the consolidated financial statements included in the Annual Report.
The following table presents our long-lived assets by geographical area, other than financial instruments, long-term customer relationships, mortgage and other servicing rights and deferred tax assets. Long-lived assets located in foreign countries represent the investments under the equity method in the Dominican Republic.
Regulation and Supervision
Described below are the material elements of selected laws and regulations applicable to Popular, PNA and their respective subsidiaries. Such laws and regulations are continually under review by Congress and state legislatures and federal and state regulatory agencies. Any change in the laws and regulations applicable to Popular and its subsidiaries could have a material effect on the business of Popular and its subsidiaries. We will continue to assess our businesses and risk management and compliance practices to conform to developments in the regulatory environment.
General
Popular and PNA are bank holding companies subject to consolidated supervision and regulation by the Federal Reserve Board under the BHC Act. BPPR and BPNA are subject to supervision and examination by applicable federal and state banking agencies including, in the case of BPPR, the Federal Reserve Board and the Office of the Commissioner of Financial Institutions of Puerto Rico (the “Office of the Commissioner”), and, in the case of BPNA, the Federal Reserve Board and the New York State Department of Financial Services (the “NYSDFS”).
The Federal Reserve Board requires institutions with average total consolidated assets greater than $10 billion, such as Popular and BPPR, to conduct an annual company-run stress test of capital, consolidated earnings and losses. Our capital ratios reflected in the stress test calculations are an important factor considered by the Federal Reserve Board in evaluating the capital adequacy of Popular and its subsidiaries and the appropriateness of any proposed payments of dividends or stock repurchases.
U.S. bank holding companies with total consolidated assets of $50 billion or more are subject to enhanced prudential standards, including risk-based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, stress test requirements and a debt-to-equity limit for companies that the Financial Stability Oversight Council has determined would pose a grave threat to financial stability were they to fail such limits. In addition, publicly traded U.S. bank holding companies with total consolidated assets of $10 billion or more are required to establish enterprise-wide risk committees; Popular has a Risk Management committee and is in compliance with this requirement.
As of December 31, 2017, Popular had total consolidated assets of $44.3 billion. As of the same date, BPPR and BPNA had total consolidated assets of $34.7 billion and $9.2 billion, respectively.
Prompt Corrective Action
The Federal Deposit Insurance Act (the “FDIA”) requires, among other things, the federal banking agencies to take prompt corrective action in respect of insured depository institutions that do not meet minimum capital requirements. The FDIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”. A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors.
An insured depository institution will be deemed to be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a CET1 capital ratio of 6.5% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a CET1 capital ratio of 4.5% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a CET1 capital ratio less than 4.5%, a Tier 1 risk-based capital ratio of less than 6.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a CET1 capital ratio less than 3%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. An insured depository institution’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the institution’s overall financial condition or prospects for other purposes.
The FDIC generally prohibits an insured depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company, if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution’s holding company must guarantee the capital restoration plan, up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it becomes undercapitalized or the amount of the capital deficiency, when the institution fails to comply with the plan. The federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.
The capital-based prompt corrective action provisions of the FDIA apply to the FDIC-insured depository institutions such as BPPR and BPNA, but they are not directly applicable to holding companies such as Popular and PNA, which control such institutions. As of December 31, 2017, both BPPR and BPNA were well capitalized.
Transactions with Affiliates
BPPR and BPNA are subject to restrictions that limit the amount of extensions of credit and certain other “covered transactions” (as defined in Section 23A of the Federal Reserve Act) between BPPR or BPNA, on the one hand, and Popular, PNA or any of our other non-banking subsidiaries, on the other, and that impose collateralization requirements on such credit extensions. A bank may not engage in any covered transaction if the aggregate amount of the bank’s covered transactions with that affiliate would exceed 10% of the bank’s capital stock and surplus or the aggregate amount of the bank’s covered transactions with all affiliates would exceed 20% of the bank’s capital stock and surplus. In addition, any transaction between BPPR or BPNA, on the one hand, and Popular, PNA or any of our other non-banking subsidiaries, on the other, is required to be carried out on an arm’s length basis.
Source of Financial Strength
The Dodd-Frank Act requires bank holding companies, such as Popular and PNA, to act as a source of financial and managerial strength to their subsidiary banks and to commit resources to support each subsidiary bank. Popular and PNA are expected to commit resources to support their subsidiary banks, including at times when Popular and PNA may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary depository institutions are subordinated in right of payment to depositors and to certain other indebtedness of such subsidiary depository institution. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal banking agency to maintain the capital of a subsidiary depository institution will be assumed by the bankruptcy trustee and entitled to a priority of payment. BPPR and BPNA are currently the only insured depository institution subsidiaries of Popular and PNA.
Resolution Planning
Bank holding companies with consolidated assets of $50 billion or more are required to report periodically to the FDIC and the Federal Reserve Board such company’s plan for its rapid and orderly resolution in the event of material financial distress or failure. In addition, insured depository institutions with total assets of $50 billion or more are required to submit to the FDIC periodic contingency plans for resolution in the event of the institution’s failure.
As of December 31, 2017, Popular, PNA, BPPR and BPNA’s total assets were below the thresholds for applicability of these rules.
Dividend Restrictions
The principal sources of funding for Popular and PNA have included dividends received from their banking and non-banking subsidiaries, asset sales and proceeds from the issuance of debt and equity. Various statutory provisions limit the amount of dividends an insured depository institution may pay to its holding company without regulatory approval. A member bank must obtain the approval of the Federal Reserve Board for any dividend, if the total of all dividends declared by the member bank during the calendar year would exceed the total of its net income for that year, combined with its retained net income for the preceding two years, less any required transfers to surplus or to a fund for the retirement of any preferred stock. In addition, a member bank may not declare or pay a dividend in an amount greater than its undivided profits as reported in its Report of Condition and Income, unless the member bank has received the approval of the Federal Reserve Board. A member bank also may not permit any portion of its permanent capital to be withdrawn unless the withdrawal has been approved by the Federal Reserve Board. Pursuant to these requirements, BPNA may not declare or pay a dividend without the prior approval of the Federal Reserve Board or the NYSDFS. BPNA paid a dividend of $10.4 million during the year ended December 2017 after receiving the prior approval of the Federal Reserve Board and the NYSDFS. During the year ended December 31, 2017, BPPR declared cash dividends of $192 million, a portion of which was used by Popular for the payments of the cash dividends on its outstanding common stock and a $75 million accelerated stock repurchase. Subject to the Federal Reserve’s ability to establish more stringent specific requirements under its supervisory or enforcement authority, at December 31, 2017, BPPR could have declared a dividend of approximately $341 million. It is Federal Reserve Board policy that bank holding companies generally should pay dividends on common stock only out of net income available to common shareholders over the past year and only if the prospective rate of earnings retention appears consistent with the organization’s current and expected future capital needs, asset quality and overall financial condition. Moreover, under Federal Reserve Board policy, a bank holding company should not maintain dividend levels that place undue pressure on the capital of depository institution subsidiaries or that may undermine the bank holding company’s ability to be a source of strength to its banking subsidiaries. For further information please refer to Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
Subject to compliance with certain conditions, distributions of U.S. sourced dividends to a corporation organized under the laws of the Commonwealth of Puerto Rico are subject to a withholding tax of 10% instead of the 30% applied to other “foreign” corporations.
See “Puerto Rico Regulation” below for a description of certain restrictions on BPPR’s ability to pay dividends under Puerto Rico law.
FDIC Insurance
Substantially all the deposits of BPPR and BPNA are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC, and BPPR and BPNA are subject to FDIC deposit insurance assessments to maintain the DIF. Deposit insurance assessments are based on the average consolidated total assets of the insured depository institution minus the average tangible equity of the institution during the assessment period. For larger depository institutions with over $10 billion in assets, such as BPPR, the FDIC uses a “scorecard” methodology that seeks to capture both the probability that an individual large institution will fail and the
magnitude of the impact on the deposit insurance fund if such a failure occurs. The FDIC has the ability to make discretionary adjustments to the total score based upon significant risk factors that are not adequately captured in the calculations. Beginning in the third quarter of 2016, the initial base deposit insurance assessment rate for depositary institutions with $10 billion or more in assets, including BPPR, ranges from 3 to 30 basis points on an annualized basis. After the effect of potential base-rate adjustments, the total base assessment rate could range from 1.5 to 40 basis points on an annualized basis. As of July 1, 2016, the FDIC imposes a surcharge on the assessments of depository institutions with $10 billion or more in assets, including BPPR, through the earlier of the quarter that the reserve ratio first reaches or exceeds 1.35% and December 31, 2018.
The Deposit Insurance Funds Act of 1996 separated the Financing Corporation (“FICO”) assessment to service the interest on its bond obligations from the DIF assessment. The amount assessed on individual institutions by the FICO is in addition to the amount paid for deposit insurance according to the FDIC’s risk-related assessment rate schedules. The FICO assessment rate for the first quarter of 2018 was 0.460 basis points of the assessment base.
As of December 31, 2017, we had a DIF average total asset less average tangible equity assessment base of approximately $38 billion.
Brokered Deposits
The FDIA and regulations adopted thereunder restrict the use of brokered deposits and the rate of interest payable on deposits for institutions that are less than well capitalized. There are no such restrictions on a bank that is well capitalized. Popular does not believe the brokered deposits regulation has had or will have a material effect on the funding or liquidity of BPPR and BPNA.
Capital Adequacy
Popular, BPPR and BPNA are each required to comply with applicable capital adequacy standards established by the Federal Reserve Board. In July 2013, the federal bank regulators approved final rules (the “Basel III Capital Rules”) implementing the December 2010 final capital framework for strengthening international capital standards, known as Basel III, as well as certain provisions of the Dodd-Frank Act.
Among other matters, the Basel III Capital Rules: (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”) and the related regulatory capital ratio of CET1 to risk-weighted assets; (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain revised requirements; (iii) mandate that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital; and (iv) expand the scope of the deductions from and adjustments to capital as compared to prior regulations. Under the Basel III Capital Rules, for most banking organizations, including Popular, the most common form of Additional Tier 1 capital is non-cumulative perpetual preferred stock and the most common form of Tier 2 capital is subordinated notes and a portion of the allocation for loan and lease losses, in each case, subject to the Basel III Capital Rules’ specific requirements.
Pursuant to the Basel III Capital Rules, the minimum capital ratios are:
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4.5% CET1 to risk-weighted assets;
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6.0% Tier 1 capital (that is, CET1 plus Additional Tier 1 capital) to risk-weighted assets;
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8.0% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets; and
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4% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (known as the “leverage ratio”).
The Basel III Capital Rules also introduce a new “capital conservation buffer,” composed entirely of CET1, on top of these minimum risk-weighted asset ratios. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. Thus, when fully phased-in on January 1, 2019, Popular, BPPR and BPNA will be required to maintain such additional capital conservation buffer of 2.5% of CET1, effectively resulting in minimum ratios of (i) CET1 to risk-weighted assets of at least 7%, (ii) Tier 1 capital to risk-weighted assets of at least 8.5%, and (iii) Total capital to risk-weighted assets of at least 10.5%. The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will increase by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019.
The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such items, in the aggregate, exceed 15% of CET1. Implementation of the deductions and other adjustments to CET1 began on January 1, 2015 and phased in through January 1, 2018 (beginning at 40% on January 1, 2015 and increasing by an additional 20% per year thereafter).
In addition, under prior risk-based capital rules, the effects of accumulated other comprehensive income or loss (“AOCI”) items included in shareholders’ equity (for example, marks-to-market of securities held in the available for sale portfolio) under U.S. GAAP were reversed for the purposes of determining regulatory capital ratios. Pursuant to the Basel III Capital Rules, the effects of certain AOCI items are not excluded; however, non-advanced approaches banking organizations, including Popular, BPPR and BPNA, may make a one-time permanent election to continue to exclude these items. Popular, BPPR and BPNA have made this election in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of their securities portfolios.
The Basel III Capital Rules preclude certain hybrid securities, such as trust preferred securities, from inclusion in bank holding companies’ Tier 1 capital. Trust preferred securities no longer included in Popular’s Tier 1 capital may nonetheless be included as a component of Tier 2 capital. Popular has not issued any trust preferred securities since May 19, 2010. At December 31, 2017, Popular has $427 million of trust preferred securities outstanding which no longer qualify for Tier 1 capital treatment, but instead qualify for Tier 2 capital treatment.
Failure to meet capital guidelines could subject Popular and its depository institution subsidiaries to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC and to certain restrictions on our business. See “- Prompt Corrective Action.”
In September 2017, the federal bank regulators proposed to revise and simplify the capital treatment for certain deferred tax assets, mortgage servicing assets, investments in non-consolidated financial entities and minority interests for banking organizations, such as Popular, BPPR and BPNA, that are not subject to the advanced approaches. In November 2017, the federal banking regulators revised the Basel III Capital Rules to extend the current transitional treatment of these items for non-advanced approaches banking organizations until they issue a final rule adopting the amendments set forth in the September 2017 proposal. The September 2017 proposal would also change the capital treatment of certain commercial real estate loans under the standardized approach, which we use to calculate our capital ratios.
In December 2017, the Basel Committee on Banking Supervision published standards that it described as the finalization of the Basel III post-crisis regulatory reforms (the standards are commonly referred to as “Basel IV”). Among other things, these standards revise the Basel Committee’s standardized approach for credit risk (including by recalibrating risk weights and introducing new capital requirements for certain “unconditionally cancellable commitments,” such as unused credit card lines of credit) and provide a new standardized approach for operational risk capital. These standards will generally be effective on January 1, 2022, with an aggregate output floor phasing in through January 1, 2027. Under the current U.S. capital rules, operational risk capital requirements and a capital floor apply only to advanced approaches institutions, and not to Popular, BPPR and BPNA. The impact of Basel IV on us will depend on the manner in which it is implemented by the federal bank regulators.
Refer to the Consolidated Financial Statements, Note 24 “Regulatory Capital Requirements” and Table 16 of Management’s Discussion and Analysis for the capital ratios of Popular, BPPR and BPNA under Basel III.
Interstate Branching
The Dodd-Frank Act amended the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Act”) to authorize national banks and state banks to branch interstate through de novo branches. For purposes of the Interstate Banking Act, BPPR is treated as a state bank and is subject to the same restrictions on interstate branching as are other state banks.
Activities and Acquisitions
In general, the BHC Act limits the activities permissible for bank holding companies to the business of banking, managing or controlling banks and such other activities as the Federal Reserve Board has determined to be so closely related to banking as to be properly incidental thereto. Bank holding companies whose subsidiary depository institutions meet management, capital and Community Reinvestment Act standards may elect to be treated as a financial holding company and engage in a substantially broader range of nonbanking financial activities, including securities underwriting and dealing, insurance underwriting and making merchant banking investments in nonfinancial companies.
In order for a bank holding company to elect to be treated as a financial holding company, (i) all of its depository institution subsidiaries must be well capitalized (as described above) and well managed and (ii) it must file a declaration with the Federal Reserve Board that it elects to be a “financial holding company.” A bank holding company electing to be a financial holding company must also be and remain well capitalized and well managed. Popular and PNA have elected to be treated as financial holding companies. A depository institution is deemed to be “well managed” if, at its most recent inspection, examination or subsequent review by the appropriate federal banking agency (or the appropriate state banking agency), the depository institution received at least a “satisfactory” composite rating and at least a “satisfactory” rating for the management component of the composite rating. If, after becoming a financial holding company, the company fails to continue to meet any of the capital or management requirements for financial holding company status, the company must enter into a confidential agreement with the Federal Reserve Board to comply with all applicable capital and management requirements. If the company does not return to compliance within 180 days, the Federal Reserve Board may extend the agreement or may order the company to divest its subsidiary banks or the company may discontinue, or divest investments in companies engaged in, activities permissible only for a bank holding company that has elected to be treated as a financial holding company.
The Federal Reserve Board may in certain circumstances limit our ability to conduct activities and make acquisitions that would otherwise be permissible for a financial holding company. In addition, we are required to obtain prior Federal Reserve Board approval before engaging in certain banking and other financial activities both in the United States and abroad.
Bank holding companies with total consolidated assets greater than $50 billion (regardless of whether such bank holding companies have elected to be treated as financial holding companies) must provide prior written notice to the Federal Reserve Board before acquiring shares of certain financial companies with assets in excess of $10 billion, unless an exception applies. In addition, a financial holding company (regardless of its size) must obtain prior written approval from the Federal Reserve Board before acquiring a nonbank company with $10 billion or more in total consolidated assets. As of December 31, 2017, Popular had total consolidated assets of $44.3 billion.
The so-called “Volcker Rule” issued under the Dodd-Frank Act restricts the ability of Popular and its subsidiaries, including BPPR and BPNA, to sponsor or invest in private funds or to engage in certain types of proprietary trading. Popular and its subsidiaries generally do not engage in the businesses prohibited by the Volcker Rule; therefore, the Volcker Rule does not have a material effect on our operations. Development and monitoring of the required compliance program, however, may require the expenditure of significant resources and management attention.
Anti-Money Laundering Initiative and the USA PATRIOT Act
A major focus of governmental policy relating to financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA PATRIOT Act”) strengthened the ability of the U.S. government to help prevent, detect and prosecute international money laundering and the financing of terrorism. Title III of the USA PATRIOT Act imposed significant compliance and due diligence obligations, created new crimes and penalties and expanded the extra-territorial jurisdiction of the United States. Failure of a financial institution to comply with the USA PATRIOT Act’s requirements could have serious legal and reputational consequences for the institution.
Community Reinvestment Act
The Community Reinvestment Act requires banks to help serve the credit needs of their communities, including extending credit to low- and moderate-income individuals and geographies. Should Popular or our bank subsidiaries fail to serve adequately the community, potential penalties may include regulatory denials of applications to expand branches, relocate, add subsidiaries and affiliates, expand into new financial activities and merge with or purchase other financial institutions.
Interchange Fees Regulation
The Federal Reserve Board has established standards for debit card interchange fees and prohibited network exclusivity arrangements and routing restrictions. The maximum permissible interchange fee that an issuer may receive for an electronic debit transaction is the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. Additionally, the Federal Reserve Board allows for an upward adjustment of no more than 1 cent to an issuer’s debit card interchange fee if the issuer develops and implements policies and procedures reasonably designed to achieve certain fraud-prevention standards.
Consumer Financial Protection Act of 2010
The Dodd-Frank Act created a new consumer financial services regulator, the Consumer Financial Protection Bureau (the CFPB), which assumed most of the consumer financial services regulatory responsibilities previously exercised by federal banking regulators and other agencies. The CFPB’s primary functions include the supervision of “covered persons” (broadly defined to include
any person offering or providing a consumer financial product or service and any affiliated service provider) for compliance with federal consumer financial laws. The CFPB also has the broad power to prescribe rules applicable to a covered person or service provider identifying as unlawful, unfair, deceptive, or abusive acts or practices in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. We are subject to examination and regulation by the CFPB.
Office of Foreign Assets Control Regulation
The U.S. Treasury Department Office of Foreign Assets Control (“OFAC”) administers economic sanctions that affect transactions with designated foreign countries, nationals and others. The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country; and (ii) a blocking of assets in which the government of the sanctioned country or other specially designated nationals have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the United States or the possession or control of U.S. persons outside of the United States). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.
Protection of Customer Personal Information and Cybersecurity
The privacy provisions of Gramm-Leach-Bliley Act of 1999 generally prohibit financial institutions, including us, from disclosing nonpublic personal financial information of consumer customers to third parties for certain purposes (primarily marketing) unless customers have the opportunity to opt out of the disclosure. The Fair Credit Reporting Act restricts information sharing among affiliates for marketing purposes and governs the use and provision of information to consumer reporting agencies.
The federal banking regulators have also issued guidance and proposed rules regarding cybersecurity that are intended to enhance cyber risk management standards among financial institutions. A financial institution is expected to establish lines of defense and to ensure that its risk management processes address the risk posed by compromised customer credentials. A financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. If we fail to observe the regulatory guidance, we could be subject to various regulatory sanctions, including financial penalties.
Puerto Rico and state regulators have also been increasingly active in implementing privacy and cybersecurity standards and regulations. For instance, Puerto Rico law requires businesses to implement information security controls to protect consumers’ personal information from breaches, as well as to provide notice of any breach to the affected customers. In 2017, several states adopted regulations requiring certain financial institutions to implement cybersecurity programs and providing detailed requirements with respect to these programs, including data encryption requirements. Many states have also recently implemented or modified their data breach notification and data privacy requirements. We expect this trend to continue, and are continually monitoring developments in Puerto Rico and the states in which we operate.
Incentive Compensation
The Federal Reserve Board reviews, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as Popular, that are not “large, complex banking organizations.” Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
The Federal Reserve Board, OCC and FDIC have issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.
The Federal Reserve Board, other federal banking agencies and the SEC have jointly published proposed rules on incentive-based payment arrangements at specified regulated entities having at least $1 billion in total assets (including Popular, PNA, BPPR and BPNA). The proposed revised rules would establish general qualitative requirements applicable to all covered entities, and additional requirements for entities with total consolidated assets of at least $50 billion. These additional requirements would not be applicable to Popular, PNA, BPPR and BPNA, each of which currently has less than $50 billion in total consolidated assets. Although the proposed revised rules include more stringent requirements, it cannot be determined at this time whether or when a final rule will be adopted.
Puerto Rico Regulation
As a commercial bank organized under the laws of Puerto Rico, BPPR is subject to supervision, examination and regulation by the Office of the Commissioner of Financial Institutions, pursuant to the Puerto Rico Banking Act of 1933, as amended (the “Banking Law”).
Section 27 of the Banking Law requires that at least ten percent (10%) of the yearly net income of BPPR be credited annually to a reserve fund. The apportionment must be done every year until the reserve fund is equal to the total of paid-in capital on common and preferred stock. During 2017, $ 27.1 million was transferred to the statutory reserve account. During 2017, BPPR was in compliance with the statutory reserve requirement.
Section 27 of the Banking Law also provides that when the expenditures of a bank are greater than its receipts, the excess of the former over the latter must be charged against the undistributed profits of the bank, and the balance, if any, must be charged against the reserve fund. If the reserve fund is not sufficient to cover such balance in whole or in part, the outstanding amount must be charged against the capital account and no dividend may be declared until capital has been restored to its original amount and the reserve fund to 20% of the original capital.
Section 16 of the Banking Law requires every bank to maintain a legal reserve that, except as otherwise provided by the Office of the Commissioner, may not be less than 20% of its demand liabilities, excluding government deposits (federal, state and municipal) which are secured by collateral. If a bank is authorized to establish one or more bank branches in a state of the United States or in a foreign country, where such branches are subject to the reserve requirements of that state or country, the Office of the Commissioner may exempt said branch or branches from the reserve requirements of Section 16. Pursuant to an order of the Federal Reserve Board dated November 24, 1982, BPPR has been exempted from the reserve requirements of the Federal Reserve System with respect to deposits payable in Puerto Rico. Accordingly, BPPR is subject to the reserve requirements prescribed by the Banking Law.
Section 17 of the Banking Law permits a bank to make loans to any one person, firm, partnership or corporation, up to an aggregate amount of fifteen percent (15%) of the paid-in capital and reserve fund of the bank. As of December 31, 2017, the legal lending limit for BPPR under this provision was approximately $277 million. In the case of loans which are secured by collateral worth at least 25% more than the amount of the loan, the maximum aggregate amount is increased to one third of the paid-in capital of the bank, plus its reserve fund. If the institution is well capitalized and had been rated 1 in the last examination performed by the Office of the Commissioner or any regulatory agency, its legal lending limit shall also include 15% of 50% of its undivided profits and for loans secured by collateral worth at least 25% more than the amount of the loan, the capital of the bank shall also include 33 1/3% of 50% of its undivided profits. Institutions rated 2 in their last regulatory examination may include this additional component in their legal lending limit only with the previous authorization of the Office of the Commissioner. There are no restrictions under Section 17 on the amount of loans that are wholly secured by bonds, securities and other evidence of indebtedness of the Government of the United States or Puerto Rico, or by current debt bonds, not in default, of municipalities or instrumentalities of Puerto Rico.
Section 14 of the Banking Law authorizes a bank to conduct certain financial and related activities directly or through subsidiaries, including finance leasing of personal property and originating and servicing mortgage loans. BPPR engages in finance leasing through its wholly-owned subsidiary, Popular Auto, LLC, which is organized and operates in Puerto Rico. The origination and servicing of mortgage loans is conducted by Popular Mortgage, a division of BPPR.
Available Information
We maintain an Internet website at www.popular.com. Via the “Investor Relations” link at our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) Securities Exchange Act of 1934, as amended (the “Exchange Act”), are available, free of charge, as soon as reasonably practicable after such forms are electronically filed with, or furnished to, the SEC. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room, located at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. You may obtain copies of our filings on the SEC site.
We have adopted a written code of ethics that applies to all directors, officers and employees of Popular, including our principal executive officer and senior financial officers, in accordance with Section 406 of the Sarbanes-Oxley Act of 2002 and the rules of the SEC promulgated thereunder. Our Code of Ethics is available on our corporate website, www.popular.com, in the section
entitled “Corporate Governance.” In the event that we make changes in, or provide waivers from, the provisions of this Code of Ethics that the SEC requires us to disclose, we intend to disclose these events on our corporate website in such section. In the Corporate Governance section of our corporate website, we have also posted the charters for our Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee, as well as our Corporate Governance Guidelines. In addition, information concerning purchases and sales of our equity securities by our executive officers and directors is posted on our website.
All website addresses given in this document are for information only and are not intended to be an active link or to incorporate any website information into this document.
ITEM 1A.
ITEM 1A. RISK FACTORS
Popular, like other financial institutions, faces a number of risks inherent to our business, financial condition, liquidity, results of operations and capital position. These risks could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report.
The risks described in this report are not the only risks facing us. Additional risks and uncertainties not currently known by us or that we currently deem to be immaterial, or that are generally applicable to all financial institutions, also may materially adversely affect our business, financial condition, liquidity, results of operations or capital position.
RISKS RELATING TO THE BUSINESS AND ECONOMIC ENVIRONMENT AND OUR INDUSTRY
Recent hurricanes caused extensive damage in Puerto Rico, our primary market, and in other markets in which we operate, which could have a material adverse effect on such jurisdictions’ economies and could materially adversely affect us.
During the month of September 2017, Hurricanes Irma and Maria, two major hurricanes, caused extensive destruction in Puerto Rico, the U.S. Virgin Islands (“USVI”) and the British Virgin Islands (“BVI”), disrupting the primary markets in which BPPR does business. Most relevant, Hurricane Maria made landfall on September 20, 2017, causing severe wind and flood damage to infrastructure, homes and businesses throughout Puerto Rico. Following the passage of Hurricane Maria, all Puerto Rico was left without electrical power, other basic utility and infrastructure services (such as water, communications, ports and other transportation networks) were severely curtailed and the government imposed a mandatory curfew. The hurricanes caused a significant disruption to the island’s economic activity. Most business establishments, including retailers and wholesalers, financial institutions, manufacturing facilities and hotels, were temporarily closed.
Puerto Rico and the USVI were declared disaster zones by President Trump due to the impact of the hurricanes, thus making them eligible for Federal assistance. Notwithstanding the significant recovery operation that has been carried out by Federal, state and local governments during the past five months, and that is still underway, as of the date of this report, approximately 13% of the clients of the government’s electric utility in Puerto Rico remain without power (according to the government’s estimates), and a number businesses are partially operating or remain closed, while others have permanently closed. Electronic transactions, a significant source of revenue for the bank, declined significantly following the hurricanes as a result of the lack of power and telecommunication services, but have already returned to pre-hurricane levels. Several reports indicate that the hurricanes have also accelerated the outmigration trends that Puerto Rico was experiencing, with many residents moving to the mainland United States, either on a temporary or permanent basis.
The damage caused by the hurricanes is substantial and has had a material adverse impact on economic activity in Puerto Rico. The Commonwealth government’s proposed fiscal plan under the Puerto Rico Oversight, Management and Economic Stability Act (“PROMESA”) estimates an 11% decrease in real GNP in fiscal year 2018 (July 2017-June 2018), as well as a steep decrease in the government’s tax revenues. It is still, however, too early to fully assess and quantify the extent of the damage caused by the hurricanes, as well as their long-term impact on economic activity. Furthermore, the hurricanes severely damaged or destroyed buildings, homes and other structures, impacting the value of such properties, some of which may serve as collateral to our loans. While our collateral is generally insured, the value of such insured structures, as well as other structures unaffected by the hurricanes, may be significantly impacted, and the cost of such insurance could increase. Although some of the impact of the hurricanes, including its short-term impact on economic activity, may be offset by recovery and reconstruction activity and the influx of Federal emergency funds and private insurance proceeds, it is too early to know the total amount of Federal and private insurance money to be received and whether such transfers will significantly offset the negative economic, fiscal and demographic impact of the hurricanes.
Our credit exposure is concentrated in Puerto Rico, which accounted as of December 31, 2017 for approximately 80% of our year-to-date revenues, 76% of our total assets and 78% of our deposits. As such, our financial condition and results of operations are dependent upon the general trends of the Puerto Rico economy and, in particular, the residential and commercial real estate markets and asset values in Puerto Rico. The deterioration in economic activity and potential impact on asset values resulting from the hurricanes, when added to Puerto Rico’s ongoing fiscal crisis and recession, could materially adversely affect our business, financial condition, liquidity, results of operations and capital position in a manner greater than estimated by management and reflected in our financial statements for the year ended December 31, 2017. To a lesser extent, we are also exposed to other areas that were similarly affected by the hurricanes, such as the US and British Virgin Islands, where as of December 31, 2017 we had 2% of our total assets, 4% of our deposits and accounted for approximately 3% of our year-to-date revenues.
A significant portion of our business is concentrated in Puerto Rico, where a prolonged economic recession and a current fiscal crisis has adversely impacted and may continue to adversely impact us.
A significant portion of our financial activities and credit exposure is concentrated in Puerto Rico, which, even before the impact of Hurricanes Irma and Maria in September 2017, was experiencing a severe economic and fiscal crisis resulting from continuing economic contraction, persistent and significant budget deficits, a high debt burden, unfunded legacy pension obligations and lack of access to the capital markets, among other factors.
Puerto Rico entered recession in the fourth quarter of fiscal year 2006 and its gross national product (GNP) thereafter contracted in real terms every year between fiscal year 2007 and fiscal year 2016 (inclusive), except for growth of 0.5% in fiscal year 2012 (likely as a result of the large amount of governmental stimulus and deficit spending in that fiscal year). GNP is projected to have further contracted in fiscal year 2017 and is expected to continue to contract in fiscal year 2018, exacerbated by the impact of the hurricanes. The Commonwealth’s structural imbalance between revenues and expenditures, on the one hand, and unfunded legacy pension obligations, on the other hand, coupled with the Commonwealth’s inability to access financing in the capital markets or from private lenders, have resulted in the Commonwealth and various public corporations defaulting on their public debt and entering into bankruptcy proceedings under PROMESA.
In response to this crisis, in June 2016, the U.S. Federal Government enacted PROMESA, which, among other things, established a seven-member Federally-appointed oversight board (the “Oversight Board”) with broad powers over the finances of the Commonwealth and its instrumentalities and provides to the Commonwealth, its public corporations and municipalities, broad-based restructuring authority, including through a bankruptcy-type process similar to that of Chapter 9 of the U.S. Bankruptcy Code.
PROMESA also requires the certification by the Oversight Board of fiscal plans for the Commonwealth and certain instrumentalities. The fiscal plan certified by the Oversight Board for the Commonwealth on March 2017 projected that, even after the implementation of a number of fiscal measures, the Commonwealth government would not have sufficient revenues to cover its debt service obligations in full while continuing to provide essential government services, thus recognizing the need for significant debt restructuring and/or write-downs. At the request of the Oversight Board, however, the Commonwealth government submitted a revised fiscal plan in February 2018. The revised fiscal plan takes into account, among other things, the adverse impact of the hurricanes and the expected positive impact of increased federal support and significant reconstruction spending, and projects a significant economic contraction of 11% in fiscal year 2018 followed by a period of economic growth in the next five fiscal years. Although the revised fiscal plan projects a cash flow surplus (excluding the payment of any debt service) over the six-year period, the fiscal plan reaffirms the need for significant debt restructurings and/or write-downs. The Oversight Board expects to certify a revised fiscal plan for the Commonwealth by March 30, 2018. For additional information regarding the fiscal plans, refer to “Geographic and government risk” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Annual Report.
The credit quality of BPPR’s loan portfolio necessarily reflects, among other things, the general economic conditions in Puerto Rico and other adverse conditions affecting Puerto Rico consumers and businesses. The effects of the prolonged recession are reflected in limited loan demand, an increase in the rate of foreclosures and delinquencies on loans granted in Puerto Rico. The measures taken to address the fiscal crisis and those that may have to be taken in the near future could affect many of our individual customers and customers’ businesses, which could cause credit losses that adversely affect us. The size of the financing gap indicated by the Commonwealth’s fiscal projections suggest that the level of fiscal adjustment of any fiscal plan approved by the Oversight Board, and its resulting impact on the local economy, will be significant. The fiscal adjustment may also result in significant resistance from local politicians and other stakeholders, which may lead to social and political instability. The Puerto Rico economy could also be adversely impacted as a result of the enactment by the U.S. Congress of the Tax Cuts and Jobs Act of 2017, which imposes a 12.5% tax on income generated from patents and licenses held by companies outside of the United States, including those operating in Puerto Rico. That new tax could affect Puerto Rico’s ability to attract or retain foreign corporations engaged in manufacturing, a dominant sector in the Puerto Rico economy. Considering these factors, coupled with the impact of the hurricanes, the Commonwealth’s proposed fiscal plan estimates an 11% contraction in real GNP for fiscal year 2018. The aforementioned conditions may negatively affect consumer confidence, which would likely aggravate the adverse effects of these conditions and cause decreased borrowings, either due to reduced demand or reductions in the borrowing base available for customer loans. Any reduction in consumer spending because of these issues may also adversely impact our interest and non-interest revenues.
If global or local economic conditions worsen or the Government of Puerto Rico is unable to manage its fiscal crisis, including consummating an orderly restructuring of its debt obligations while continuing to provide essential services, those adverse effects could continue or worsen in ways that we are not able to predict and that are outside of our control. While PROMESA provides the Commonwealth with tools to restructure the debt obligations of the Commonwealth and its instrumentalities in an orderly manner, these tools are new and untested. Furthermore, the size of the fiscal gaps suggested by the Commonwealth’s projections indicates the possibility of significant creditor losses. Both of these factors have made the PROMESA debt restructuring process highly adversarial and protracted. Under such circumstances, we could experience an increase in the level of provision for loan losses, nonperforming assets, net charge-offs and reserve for credit losses. These factors could have a material adverse impact on our earnings and financial condition.
Our assets and revenue composition by geographical area and by business segment reporting are presented in Note 41 to the consolidated financial statements. For additional information regarding the Puerto Rico economy, the current fiscal crisis and the impact of Hurricanes Irma and Maria, refer to “Geographic and government risk” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Annual Report.
Further deterioration in collateral values of properties securing our construction, commercial and mortgage loan portfolios would result in increased credit losses and continue to harm our results of operations.
The value of properties in some of the markets we serve, in particular in Puerto Rico, has declined in recent years as a result of adverse economic conditions. Further deterioration of the value of real estate collateral securing our construction, commercial and mortgage loan portfolios would result in increased credit losses. As of December 31, 2017, approximately 4%, 31% and 30% of our non-covered loan portfolio consisted of construction loans, commercial loans secured by real estate and mortgage loans, respectively.
Substantially our entire loan portfolio is located within the boundaries of the U.S. economy. Whether the collateral is in Puerto Rico, the USVI, the BVI or the U.S. mainland, the performance of our loan portfolio and the collateral value backing the transactions are dependent upon the performance of and conditions within each specific real estate market. Recent economic reports related to the real estate market in Puerto Rico indicate that several sectors of the real estate market are subject to further reductions in value related to general economic conditions. In particular, the value of real estate collateral located in Puerto Rico may be further affected by the recent impact of Hurricanes Irma and Maria and also by actions taken by the Commonwealth or the Oversight Board to address Puerto Rico’s fiscal and economic crisis. Not only are such actions likely to have negative economic effects in the short run, but also certain measures recommended by the Oversight Board for inclusion in the fiscal plan, such as reforming the local property tax regime, could have a direct impact on the value of local real estate.
We measure loan impairment based on the fair value of the collateral, if the loan is collateral dependent, which is derived from estimated collateral values, principally obtained from appraisal reports that take into consideration prices in observed transactions involving similar assets in similar locations, size and supply and demand. An appraisal report is only an estimate of the value of the property at the time the appraisal is made. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. In addition, given the current slowdown in the real estate market in Puerto Rico, the properties securing these loans may be difficult to dispose of, if foreclosed.
During the year ended December 31, 2017, net charge-offs specifically related to values of properties securing our non-covered commercial, construction and mortgage loan portfolios totaled $28.6 million, none and $12.7 million, respectively. Continued deterioration of the fair value of real estate properties for collateral dependent impaired loans would require increases in our provision for loan losses and allowance for loan losses. Any such increase would have an adverse effect on our future financial condition and results of operations. For more information on the credit quality of our construction, commercial and mortgage portfolio, see the Credit Risk section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Annual Report.
Our results of operations and financial condition could be adversely affected by difficult conditions in the U.S. and global financial industries.
During the financial crisis that commenced in 2008, market instability and lack of investor confidence led many lenders and institutional investors to reduce or cease providing funding to borrowers, including other financial institutions. This led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and
widespread reduction of business activity in general. The resulting economic pressures on consumers and uncertainty about the financial markets adversely affected our industry and our business, results of operations and financial condition. A re-occurrence of these or other difficult conditions would exacerbate the economic challenges facing us and others in the financial industry.
Legislative and regulatory reforms may have a significant impact on our business and results of operations.
Popular is subject to extensive regulation, supervision and examination by federal, New York and Puerto Rico banking authorities. Any change in applicable federal, New York or Puerto Rico laws or regulations could have a substantial impact on our operations. Additional laws and regulations may be enacted or adopted in the future that could significantly affect our powers, authority and operations, which could have a material adverse effect on our financial condition and results of operations. Further, regulators in the performance of their supervisory and enforcement duties, have significant discretion and power to prevent or remedy unsafe and unsound practices or violations of laws by banks and bank holding companies. The exercise of this regulatory discretion and power could have a negative impact on Popular.
Furthermore, the Commonwealth has enacted various reforms in response to its fiscal problems and is likely to implement additional reforms as part of its fiscal plan under PROMESA. In particular, the Commonwealth’s fiscal plan contemplates a comprehensive tax reform that could include a reduction in the statutory corporate tax rates. While such a reduction could decrease our effective tax rate prospectively, it would result in a significant decrease to our Puerto Rico deferred tax asset, with a corresponding non-cash increase to income tax expense, and a decrease to capital in the year of enactment. Other legislative changes, particularly other changes in tax laws and the enactment of laws affecting creditor’s rights, including to provide relief to persons and businesses affected by the recent hurricanes, could adversely impact our results of operations.
RISKS RELATING TO OUR BUSINESS
We are subject to default risk in our loan portfolio.
We are subject to the risk of loss from loan defaults and foreclosures with respect to the loans we originate or acquire. We establish provisions for loan losses, which lead to reductions in the income from operations, in order to maintain the allowance for loan losses at a level which is deemed appropriate by management based upon an assessment of the quality of the loan portfolio in accordance with established procedures and guidelines. This process, which is critical to our financial results and condition, requires difficult, subjective and complex judgments about the future, including forecasts of economic and market conditions that might impair the ability of our borrowers to repay the loans. For example, we recorded an incremental provision for loan losses of $67.6 million in 2017 representing management’s estimate, based on currently available information, of the impact of Hurricanes Irma and Maria on the loan portfolios. There can be no assurance that management has accurately estimated the level of future loan losses or that Popular will not have to increase the provision for loan losses in the future as a result of future increases in non-performing loans or for other reasons beyond our control. As discussed below, the temporary payment moratorium we instituted in response to the recent hurricanes has further limited our visibility regarding the impact of these events on the credit quality of our portfolio. Any such increases in our provisions for loan losses or any loan losses in excess of our provisions for loan losses would have an adverse effect on our future financial condition and result of operations. We will continue to evaluate our provision for loan losses and allowance for loan losses and may be required to increase such amounts.
Recent hurricanes caused significant disruptions to BPPR’s operations and resulted in the implementation by BPPR of various measures to address customer needs, including fee waivers and a temporary payment moratorium across most loan portfolios.
The recent hurricanes, especially Hurricane Maria, significantly disrupted our operations, including our branch and ATM network. As of February 28, 2018, however, we have been able to resume operations in 168 or 95% of BPPR’s branches and 578 or 89% of our ATMs are operational.
Furthermore, given the widespread level of disruption to basic infrastructure and commercial activity in the regions impacted by Hurricanes Irma and Maria, BPPR decided to adopt certain measures to assist its customers in affected areas. These measures included the waiver of certain fees and charges, such as late payment charges and ATM transaction fees, and a temporary payment moratorium to eligible borrowers across most loan portfolios during which BPPR continued to accrue interest on the loans.
These measures, while important to assist in the recovery of our customers post-hurricane, negatively impacted our results of operations for 2017. For example, the waiver of fees and other charges reduced our non-interest revenues for the third and fourth quarters of 2017. In the case of loans serviced by BPPR for certain third parties (including those under the FNMA and GNMA programs), we are required to advance to the owners the payment of principal and interest on a scheduled basis even when such payment was not collected from the borrower, as was the case with borrowers electing to take advantage of the moratorium program. During 2018, we may incur additional losses associated with the repurchase liability on loans subject to credit recourse as a result of the hurricanes.
These measures, while important to assist in the post-hurricane recovery of our customers, negatively impacted our results of operations for 2017. For example, the waiver of fees and other charges reduced our non-interest revenues for the third and fourth quarters of 2017. In the case of loans serviced by BPPR for certain third parties (including those under the FNMA and GNMA programs), we are required to advance to the owners the payment of principal and interest on a scheduled basis even when such payment was not collected from the borrower, as was the case with borrowers electing to take advantage of the moratorium program. Under our servicing agreements, we continue to report the delinquency status of these loans without considering the moratorium resulting in an increase in the reported past due loans. In order to reduce the servicing cost of these loans (mostly related to principal and interest advances), we may decide to repurchase some of these delinquent mortgage loans and restructure their terms. However, under the GNMA program, loans originated by BPPR and pooled into GNMA securities in our servicing portfolio that are 90 days or more past due result in us having a repurchase option and for accounting purposes, we are required to rebook these loans in our financial statements irrespective of our intent to repurchase the loans. At December 31, 2017, our loan balances includes $840 million related to rebooked GNMA loans. See MD&A and Note 9 of the Consolidated Financial Statements for additional information.
Additionally, at December 31, 2017 the Corporation serviced $1.5 billion in residential mortgage loans subject to credit recourse provisions. During 2018, we may incur additional losses associated with the potential repurchase liability on these loans as a result of the hurricanes.
Furthermore, as discussed above, because of the moratoriums, we still have limited visibility as to the impact of the hurricanes on the financial condition of our retail customers and the credit quality of our loan portfolio, as borrowers are resuming loan repayments in the first quarter of 2018. The moratoriums, however, led to lower inflows to non-performing loans during the moratorium period and, as a result, our credit quality metrics as of December 31, 2017 may not accurately reflect any adverse impact to the credit quality of our loan portfolio we may experience as a result of Hurricanes Irma and Maria.
These hurricanes adversely affected our operations and financial performance for 2017, resulting in additional operating expenses (net of insurance receivables) of approximately $17.0 million and an incremental provision for loan losses related to the impact of the hurricanes of approximately $67.6 million. In addition, we experienced a decrease in revenues of approximately $31 million when compared to pre-hurricane levels, reflecting, in part, the impact of the hurricanes in a number revenue categories, including revenues from merchant transaction activity, credit and debit card fees and other service fees and charges.
The impact of the hurricanes is expected to continue to adversely affect us during 2018, as many of our customers continue to be significantly affected. Although management has made estimates as to the probable losses related to the hurricanes as part of its evaluation of the allowance for loan and lease losses, such estimates involve significant judgment and are made in the context of significant uncertainty as to the impact that the hurricanes will have on the credit quality of our loan portfolios. In affected areas, the value of our loan collateral and the extent to which damages to properties collateralizing loans, among other factors, may further impact those estimates of losses. The extent of the economic impact of the hurricanes is also impossible to determine with certainty at this time as it is partly dependent on the time it takes the Commonwealth government to fully restore power and other basic infrastructure services and the effects of Federal emergency funds and private insurance proceeds. As management continues to assess the impact of these hurricanes on economic activity, asset values in Puerto Rico, and our customers in particular, our results of operations may continue to be adversely affected, and such adverse impact could be material to us and exceed management’s current estimates.
A deterioration of the fiscal and economic condition in Puerto Rico could materially adversely affect the value and performance of our portfolio of Puerto Rico government securities and our loans to Puerto Rico government entities, as well as the value and performance of commercial, mortgage and consumer loans to private borrowers who have significant relationships with the government or could be directly affected by government action.
We have direct and indirect lending and investment exposure to the Puerto Rico government, its public corporations and municipalities. A deterioration of the Commonwealth’s fiscal and economic condition, including as a result of actions taken by the Commonwealth government or the Oversight Board to address the ongoing fiscal and economic crisis in Puerto Rico, could materially adversely affect the value and performance of our Puerto Rico government obligations, as well as the value and performance of commercial, mortgage and consumer loans to private borrowers who have significant relationships with the government or could be directly affected by government action, resulting in losses to us.
At December 31, 2017, our direct exposure to Puerto Rico government obligations was limited to obligations from various municipalities and amounted to $484 million. Of the amount outstanding at December 31, 2017, $435 million consisted of loans and $49 million consisted of securities. These municipal obligations are mostly general obligations backed by property tax revenues and to which the applicable municipality has pledged its good faith, credit and unlimited taxing power, or “special obligations,” to which the applicable municipality has pledged other revenues. At December 31, 2017, 74% of our exposure to municipal loans and securities
was concentrated in the municipalities of San Juan, Guaynabo, Carolina and Bayamón. Although the Oversight Board has not designated any of the Commonwealth’s 78 municipalities as covered entities under PROMESA, it may decide to do so in the future. For a discussion of the implications of being designated a covered entity under PROMESA, refer to the Geographic and Government Risk section in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Annual Report.
Neither the Commonwealth’s certified fiscal plan nor its proposed fiscal plan submitted to the Oversight Board pursuant to PROMESA contemplates a restructuring of the debt of Puerto Rico’s municipalities. The plans, however, provide for the gradual reduction of budgetary subsidies from the central government to municipalities (by 80% of current levels by fiscal year 2023), which constitute a material portion of the operating revenues of certain municipalities. Although the proposed fiscal plan contemplates that the reduction in subsidies could be offset by other measures, such as the implementation of a modernized property tax regime, the reduction in subsidies could have a material negative impact on the financial condition of various municipalities. Furthermore, municipalities are also likely to be affected by the negative economic and other effects resulting from expense, revenue or cash management measures taken to address the Commonwealth’s fiscal and liquidity shortfalls.
We also have indirect exposure to loans or securities issued or guaranteed by Puerto Rico governmental entities, but whose principal source of repayment are non-governmental entities, which amounted to $386 million at December 31, 2017. In such obligations, the Puerto Rico governmental entity guarantees any shortfall in collateral in the event of borrower default. These included $310 million in residential mortgage loans guaranteed by the Puerto Rico Housing Finance Authority (“HFA”), an entity that has been designated as a covered entity under PROMESA. These mortgage loans are secured by the underlying properties and the HFA guarantee serves to cover shortfalls in collateral in the event of a borrower default. Also, we had $44 million in Puerto Rico housing bonds issued by HFA, which are secured by second mortgage loans on Puerto Rico residential properties, $7 million in pass-through securities that have been economically defeased and refunded and for which collateral has been escrowed, and $25 million of commercial real estate notes issued by government entities, but payable from rent paid by private parties.
BPPR’s commercial loan portfolio also includes loans to private borrowers who are service providers, lessors, suppliers or have other relationships with the Puerto Rico government. These borrowers could be negatively affected by the fiscal measures to be implemented to address the Commonwealth’s fiscal crisis and the ongoing Title III proceedings under PROMESA described above. Similarly, BPPR’s mortgage and consumer loan portfolios include loans to government employees which could also be negatively affected by fiscal measures such as employee layoffs or furloughs.
The soundness of other financial institutions could adversely affect us.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including broker-dealers, commercial banks, investment banks, mutual funds, hedge funds, and other institutional clients. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to us. There can be no assurance that any such losses would not materially and adversely affect our results of operations or earnings.
We have procedures in place to mitigate the impact of a default among our counterparties. We request collateral for most credit exposures with other financial institutions and monitor these on a regular basis. Nonetheless, market volatility could impact the valuation of collateral held by us and result in losses.
Our ability to raise financing is dependent in part on market confidence. In times when market confidence is affected by events related to well-known financial institutions, risk aversion among participants may increase substantially and make it more difficult for us to borrow in the credit or capital markets.
We are exposed to credit risk from mortgage loans that have been sold or are being serviced subject to recourse arrangements.
Popular is generally at risk for mortgage loan defaults from the time it funds a loan until the time the loan is sold or securitized into a mortgage-backed security. We have furthermore retained, through recourse arrangements, part of the credit risk on sales of mortgage loans, and we also service certain mortgage loan portfolios with recourse. At December 31, 2017, we serviced $1.5 billion in residential mortgage loans subject to credit recourse provisions, principally loans associated with Fannie Mae and Freddie Mac programs. In the event of any customer default, pursuant to the credit recourse provided, we are required to repurchase the loan or reimburse the third-party investor for the incurred loss. As discussed above, BPPR advanced the payment of principal and interest to such third-party investors on a scheduled basis during the temporary payment moratoriums implemented following Hurricane María, even if such payments were not received by BPPR. The maximum potential amount of future payments that we would be required to make under the recourse arrangements in the event of nonperformance by the borrowers is equivalent to the total outstanding balance of the residential mortgage loans serviced with recourse and interest, if applicable. During 2017, we repurchased approximately $ 29 million in mortgage loans subject to the credit recourse provisions. In the event of nonperformance by the borrower, we have rights to the underlying collateral securing the mortgage loan. During 2018, we may incur additional losses associated with the potential repurchase liability on loans subject to recourse as a result of the hurricanes. As of December 31, 2017, our liability established to cover the estimated credit loss exposure related to loans sold or serviced with credit recourse amounted to $ 59 million. We may suffer losses on these loans when the proceeds from a foreclosure sale of the property underlying a defaulted mortgage loan are less than the outstanding principal balance of the loan plus any uncollected interest advanced and the costs of holding and disposing of the related property.
Defective and repurchased loans may harm our business and financial condition.
In connection with the sale and securitization of loans, we are required to make a variety of customary representations and warranties regarding Popular and the loans being sold or securitized. Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and they relate to, among other things:
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compliance with laws and regulations;
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underwriting standards;
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the accuracy of information in the loan documents and loan file; and
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the characteristics and enforceability of the loan.
A loan that does not comply with these representations and warranties may take longer to sell, may impact our ability to obtain third party financing for the loan, and be unsalable or salable only at a significant discount. If such a loan is sold before we detect non-compliance, we may be obligated to repurchase the loan and bear any associated loss directly, or we may be obligated to indemnify the purchaser against any loss, either of which could reduce our cash available for operations and liquidity. Management believes that it has established controls to ensure that loans are originated in accordance with the secondary market’s requirements, but mistakes may be made, or certain employees may deliberately violate our lending policies. We seek to minimize repurchases and losses from defective loans by correcting flaws, if possible, and selling or re-selling such loans. We have established specific reserves for probable losses related to repurchases resulting from representations and warranty violations on specific portfolios. At December 31, 2017, our reserve for estimated losses from representation and warranty arrangements amounted to $12 million, which was included as part of other liabilities in the consolidated statement of financial condition. Nonetheless, we do not expect any such losses to be significant, although if they were to occur, they would adversely impact our results of operations and financial condition.
Increases in FDIC insurance premiums may have a material adverse effect on our earnings.
Substantially all the deposits of BPPR and BPNA are insured up to applicable limits by the FDIC’s DIF, and as a result, BPPR and BPNA are subject to FDIC deposit insurance assessments. For 2017, the FDIC deposit insurance expense of Popular totaled $ 26 million. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, our level of non-performing assets increase, or our risk profile changes or our capital position is impaired, we may be required to pay even higher FDIC premiums than the recently increased levels. Any future increases or special assessments may materially adversely affect our results of operations. See the “Supervision and Regulation-FDIC Insurance” discussion within Item 1. Business of the Annual Report for additional information related to the FDIC’s deposit insurance assessments applicable to BPPR and BPNA.
If our goodwill or amortizable intangible assets become impaired, it may adversely affect our financial condition and future results of operations.
As of December 31, 2017, we had approximately $ 627 million and $30 million of goodwill and amortizable intangible assets recorded on our balance sheet related to our Puerto Rico and United States operations, respectively. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. Under GAAP, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of the goodwill or amortizable intangible assets may not be recoverable, include a decline in Popular’s stock price related to macroeconomic conditions in the global market as well as the weakness in the Puerto Rico economy and fiscal situation, reduced future cash flow estimates and slower growth rates in the industry.
The goodwill impairment evaluation process requires us to make estimates and assumptions with regards to the fair value of our reporting units. Actual values may differ significantly from these estimates. Such differences could result in future impairment of goodwill that would, in turn, negatively impact our results of operations and the reporting unit where the goodwill is recorded. Declines in our market capitalization could also increase the risk of goodwill impairment in the future.
If we are required to record a charge to earnings in our consolidated financial statements because an impairment of the goodwill or amortizable intangible assets is determined, our results of operations would be adversely affected.
Our compensation practices are subject to oversight by applicable regulators.
Our success depends, in large part, on our ability to retain key senior leaders, and competition for such senior leaders can be intense in most areas of our business. Our compensation practices are subject to review and oversight by the Federal Reserve Board. We also may be subject to limitations on compensation practices by the FDIC or other regulators, which may or may not affect our competitors.
The Federal Reserve Board, other federal banking agencies and the SEC have jointly published proposed revised rules on incentive-based payment arrangements at specified regulated entities having at least $1 billion in total assets, such as Popular, PNA, BPPR and BPNA. The proposed revised rules would establish general qualitative requirements applicable to all covered entities. Although the proposed revised rules include more stringent requirements than in the originally proposed rules, it cannot be determined at this time whether or when a final rule will be adopted. Compliance with such a final rule may substantially affect the manner in which we structure compensation for our executives and other employees. For a more detailed discussion of these proposed rules, see the “Supervision and Regulation-Incentive Compensation” section within Item 1. Business of the Annual Report.
The scope and content of the U.S. banking regulators’ policies on executive compensation are continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whether compliance with such policies will adversely affect the ability of Popular and our subsidiaries to hire, retain and motivate key employees. Limitations on our compensation practices could have a negative impact on our ability to attract and retain talented senior leaders in support of our long-term strategy.
As a holding company, we depend on dividends and distributions from our subsidiaries for liquidity.
We are a bank holding company and depend primarily on dividends from our banking and other operating subsidiaries to fund our cash needs. These obligations and needs include capitalizing subsidiaries, repaying maturing debt and paying debt service on outstanding debt. Our banking subsidiaries, BPPR and BPNA, are limited by law in their ability to make dividend payments and other distributions to us based on their earnings and capital position. In addition, based on its current financial condition, BPNA may not declare or pay a dividend without the prior approval of the Federal Reserve Board and the NYSDFS. A failure by our banking subsidiaries to generate sufficient cash flow to make dividend payments to us may have a negative impact on our results of operation and financial position. Also, a failure by the bank holding company to access sufficient liquidity resources to meet all projected cash needs in the ordinary course of business may have a detrimental impact on our financial condition and ability to compete in the market.
We are subject to risk related to our own credit rating; actions by the rating agencies or having capital levels below well-capitalized could raise the cost of our obligations, which could affect our ability to borrow or to enter into hedging agreements in the future and may have other adverse effects on our business.
Actions by the rating agencies could raise the cost of our borrowings since lower rated securities are usually required by the market to pay higher rates than obligations of higher credit quality. Our credit ratings were reduced substantially in 2009, and our senior unsecured ratings are now “non-investment grade” with the three major rating agencies. The market for non-investment grade securities is much smaller and less liquid than for investment grade securities. Therefore, if we were to attempt to issue preferred stock or debt securities into the capital markets, it is possible that there would not be sufficient demand to complete a transaction and the cost could be substantially higher than for more highly rated securities.
Our banking subsidiaries currently do not use borrowings that are rated by the major rating agencies, as these banking subsidiaries are funded primarily with deposits and secured borrowings. At December 31, 2017, the banking subsidiaries had $12 million in deposits that were subject to rating triggers.
In addition, changes in our ratings and capital levels below well-capitalized could affect our relationships with some creditors and business counterparties. For example, a portion of our hedging transactions include ratings triggers or well-capitalized language that permit counterparties to either request additional collateral or terminate our agreements with them based on our below investment grade ratings. The fair value of derivative instruments in a liability position subject to financial covenants approximated $10 million at December 31, 2017, with Popular providing collateral totaling $94 thousand to cover the net liability position with counterparties on these derivative instruments. Although we have been able to meet any additional collateral requirements thus far and expect that we would be able to enter into agreements with substitute counterparties if any of our existing agreements were terminated, changes in our ratings or capital levels below well capitalized could create additional costs for our businesses.
Our banking subsidiaries have servicing, licensing and custodial agreements with third parties that include ratings covenants. Servicing rights represent a contractual right and not a beneficial ownership interest in the underlying mortgage loans. Upon failure to maintain the required credit ratings, the third parties could have the right to require us to engage a substitute fund custodian and/or increase collateral levels securing the recourse obligations. Popular services residential mortgage loans subject to credit recourse provisions. Certain contractual agreements require us to post collateral to secure such recourse obligations if our required credit ratings are not maintained. Collateral pledged by us to secure recourse obligations approximated $48 million at December 31, 2017. We could be required to post additional collateral under the agreements. Management expects that we would be able to meet additional collateral requirements if and when needed. The requirements to post collateral under certain agreements or the loss of custodian funds could reduce our liquidity resources and impact its operating results. The termination of those agreements or the inability to realize servicing income for our businesses could have an adverse effect on those businesses. Other counterparties are also sensitive to the risk of a ratings downgrade and the implications for our businesses and may be less likely to engage in transactions with us, or may only engage in them at a substantially higher cost, if our ratings remain below investment grade.
We are subject to regulatory capital adequacy guidelines, and if we fail to meet these guidelines our business and financial condition will be adversely affected.
Under regulatory capital adequacy guidelines, and other regulatory requirements, Popular and our banking subsidiaries must meet guidelines that include quantitative measures of assets, liabilities and certain off-balance sheet items, subject to qualitative judgments by regulators regarding components, risk weightings and other factors. If we fail to meet these minimum capital guidelines and other regulatory requirements, our business and financial condition will be materially and adversely affected. If a financial holding company fails to maintain well-capitalized status under the regulatory framework, or is deemed not well managed under regulatory exam procedures, or if it experiences certain regulatory violations, its status as a financial holding company and its related eligibility for a streamlined review process for acquisition proposals, and its ability to offer certain financial products, may be compromised and its financial condition and results of operations could be adversely affected.
Under the Dodd-Frank Act, all financial companies with more than $10 billion in total consolidated assets, such as Popular, that are supervised by a primary federal financial regulatory agency, are required to perform an annual stress test. This stress test supports the regulator’s analysis of the adequacy of a banking organization’s capital and is required as part of our capital management and review. The stress test is performed utilizing a variety of hypothetical stressed economic scenarios dictated by the Federal Reserve Board. If we are deemed to have inadequate capital under the hypothetical scenarios, then our regulator could prohibit us from taking certain capital actions, such as paying dividends or repurchasing common stock, or require us to increase our regulatory capital, including through the issuance of common stock that would dilute the ownership of existing shareholders.
The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and their depository institution subsidiaries and will be fully-phased in January 1, 2019. The need to maintain more capital than has been historically required and calculated under revised standards could limit our business activities, including lending, and our ability to expand, either organically or through acquisitions. It could also depress our return on equity, thereby making it more difficult to earn our cost of capital. Moreover, although these new requirements are being phased-in over time, U.S. federal banking agencies have been taking into account future expectations regarding the ability of banks to meet these new requirements, including under stress conditions, in approving actions that represent uses of capital, such as dividends and acquisitions.
Due to the importance and complexity of the stress test process and capital rules calculations under Basel III, we have dedicated additional resources to comply with these requirements. No assurance can be provided, however, that these resources will be deemed sufficient or that we will be deemed to have adequate capital under the hypothetical economic stress scenarios, which would affect our ability to take certain capital actions in the future. In addition, the Basel Committee on Banking Supervisions published Basel IV in December 2017. Basel IV significantly revises the Basel capital framework, and the impact on us will depend on the manner in which the revisions are implemented in the U.S. See the “Supervision and Regulation - Capital Adequacy” discussion within Item 1. Business of the Annual Report for additional information related to the Basel III Capital Rules and Basel IV.
The resolution of pending litigation and regulatory proceedings, if unfavorable, could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects.
We face legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects. For further information relating to our legal risk, see Note 27 - “Commitments & Contingencies”, to the Consolidated Financial Statements.
We and our subsidiaries and affiliates, as well as EVERTEC, conduct business with financial institutions and/or card payment networks operating in countries whose nationals, including some of our customers’ customers, engage in transactions in countries that are the targets of U.S. economic sanctions and embargoes. If we or our subsidiaries or affiliates or EVERTEC are found to have failed to comply with applicable U.S. sanctions laws and regulations in these instances, we could be exposed to fines, sanctions and other penalties or other governmental investigations.
We and our subsidiaries and affiliates, as well as EVERTEC, conduct business with financial institutions and/or card payment networks operating in countries whose nationals, including some of our customers’ customers, engage in transactions in countries that are the target of U.S. economic sanctions and embargoes. As U.S. - based entities, we and our subsidiaries and affiliates, as well as EVERTEC, are obligated to comply with the economic sanctions regulations administered by OFAC. These regulations prohibit U.S.-based entities from entering into or facilitating unlicensed transactions with, for the benefit of, or in some cases involving the property and property interests of, persons, governments or countries designated by the U.S. government under one or more sanctions regimes and also prohibit transactions that provide a benefit that is received in a country designated under one or more sanctions regimes. Failure to comply with U.S. sanctions and embargoes may result in material fines, sanctions or other penalties being imposed on us. In addition, various state and municipal governments, universities and other investors maintain prohibitions or restrictions on investments in companies that do business involving sanctioned countries or entities, and this could adversely affect the market for our securities. For these reasons, we have established risk-based policies and procedures designed to assist us and our personnel in complying with applicable U.S. laws and regulations. EVERTEC has also done this. These policies and procedures employ software to screen transactions for evidence of sanctioned-country and person’s involvement. Consistent with a risk-based approach and the difficulties in identifying all transactions of our customers’ customers that may involve a sanctioned country, there can be no assurance that our policies and procedures will prevent us from violating applicable U.S. laws and regulations in transactions in which we engage, and such violations could adversely affect our reputation, business, financial condition and results of operations.
From time to time we have identified and voluntarily self-disclosed to OFAC transactions that were not timely identified and blocked by our policies and procedures for screening transactions that might violate the economic sanctions regulations administered by OFAC. Although OFAC’s response to our voluntary self-disclosures of these apparent violations has been to issue cautionary letters to us, there can be no assurances that our failures to comply with U.S. sanctions and embargoes will not result in material fines, sanctions or other penalties being imposed on us.
We have agreed to indemnify EVERTEC for certain claims or damages related to the economic sanctions regulations administered by OFAC. We cannot predict the timing, total costs or ultimate outcome of any OFAC review, or to what extent, if at all, we could be subject to indemnification claims, fines, sanctions or other penalties.
RISKS RELATING TO OUR OPERATIONS
We are subject to a variety of cybersecurity risks that, if realized, could adversely affect how we conduct our business.
Information security risks for large financial institutions such as Popular have increased significantly in recent years in part because of the proliferation of new technologies, such as Internet and mobile banking to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, nation-states, hacktivists and other parties. In the ordinary course of business, we rely on electronic communications and information systems to conduct our operations and to store sensitive data. We employ a defensive approach that employs people, processes and technology to manage and maintain cybersecurity controls. We employ a variety of preventative and detective tools to monitor, block, and provide alerts regarding suspicious activity, as well as to identify suspected advanced persistent threats. Notwithstanding our defensive measures and the significant resources we devote to protect the security of our systems, there is no assurance that all of our security measures will be effective, especially as the threat from cyber-attacks is continuous and severe, attacks are becoming more sophisticated and increasing in volume, and attackers respond rapidly to changes in defensive measures. We recently learned of a phishing scam targeting our customers as a result of a recent data security incident that compromised email accounts of several Popular employees. We are contacting customers and others that we suspect may have had confidential information accessed or that may have been targeted and are taking measures to protect them from possible adverse effects. We have addressed the vulnerability that permitted the compromise and implemented enhanced security measures. There can be no assurances, however, that this or another incident will not result in a further breach of sensitive customer information.
The most significant cyber-attack risks that we may face are e-fraud, denial-of-service, ransomware and computer intrusion that might result in loss of customer or proprietary data. Loss from e-fraud occurs when cybercriminals breach and extract funds from customer or bank accounts. Denial-of-service disrupts services available to our customers through our on-line banking system. Computer intrusion attempts might result in the breach of sensitive customer data, such as account numbers and social security numbers, and could present significant reputational, legal and/or regulatory costs to Popular if successful. Risks and exposures related to cyber security attacks are expected to remain high for the foreseeable future due to the rapidly evolving nature and sophistication of these threats, as well as due to the expanding use of Internet banking, mobile banking and other technology-based products and services by us and our customers. Although we are regularly targeted by unauthorized parties, we have not, to date, experienced any material losses as a result of cyber-attacks.
A successful penetration or circumvention of the security of our systems could cause serious negative consequences for us, including significant disruption of our operations and those of our clients, customers and counterparties, misappropriation of confidential information of us or that of our clients, customers, counterparties or employees, or damage to computers or systems of us and those of our clients, customers and counterparties, and could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, significant litigation exposure and harm to our reputation, all of which could have a material adverse effect on us. In particular, if personal, non-public, confidential or proprietary information in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. For a discussion of the guidance that federal banking regulators have released regarding cybersecurity and cyber risk management standards, see “Regulation and Supervision” in Part I, Item 1 - Business, included in this Annual Report. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees, or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
We rely on third parties for the performance of a significant portion of our information technology functions and the provision of information technology and business process services. The most important of these third-party service providers for us is EVERTEC, and certain risks particular to EVERTEC are discussed below under “Risks Relating to Our Relationship with EVERTEC.” The success of our business depends in part on the continuing ability of these (and other) third parties to perform these functions and services in a timely and satisfactory manner, which performance could be disrupted or otherwise adversely affected due to failures or other information security events originating at the third parties or at the third parties’ suppliers or vendors (so-called “fourth party risk”). We may not be able to effectively monitor or mitigate fourth-party risk, in particular as it relates to the use of common suppliers or vendors by the third parties that perform functions and services for us.
As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our layers of defense or to investigate and remediate any information security vulnerabilities. System enhancements and updates may also create risks associated with implementing new systems and integrating them with existing ones. Due to the complexity and interconnectedness of information technology systems, the process of enhancing our layers of defense can itself create a risk of systems disruptions and security issues. In addition, addressing certain information security vulnerabilities, such as hardware-based vulnerabilities, may affect the performance of our information technology systems. The ability of our hardware and software providers to deliver patches and updates to mitigate vulnerabilities in a timely manner can introduce additional risks, particularly when a vulnerability is being actively exploited by threat actors.
We rely on other companies to provide key components of our business infrastructure.
Third parties provide key components of our business operations such as data processing, information security, recording and monitoring transactions, online banking interfaces and services, Internet connections and network access. The most important of these third-party service providers for us is EVERTEC, and certain risks particular to EVERTEC are discussed below under “Risks Relating to Our Relationship with EVERTEC.” While we select third-party vendors carefully, we do not control their actions. Any problems caused by these third parties, including those resulting from disruptions in services provided by a vendor, breaches of a
vendor’s systems, failure of a vendor to handle current or higher volumes, failure of a vendor to provide services for any reason or poor performance of services, or failure of a vendor to notify us of a reportable event, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business. Financial or operational difficulties of a third-party vendor could also hurt our operations if those difficulties interfere with the vendor’s ability to serve us. Replacing these third-party vendors could also create significant delay and expense. Accordingly, use of such third parties creates an unavoidable inherent risk to our business operations.
In addition, the assessment and management by financial institutions of the risks associated with third party vendors have been subject to greater regulatory scrutiny. We expect to incur additional costs and expenses in connection with our oversight of third party relationships, especially those involving significant banking functions, shared services or other critical activities. Our failure to properly manage risks associated to our third party relationships could result in potential liability to clients and customers, fines, penalties or judgments imposed by our regulators, increased operating expenses and harm to our reputation, any of which could materially and adversely affect us.
Hurricanes and other weather-related events, as well as man-made disasters, could cause a disruption in our operations or other consequences that could have an adverse impact on our results of operations.
A significant portion of our operations are located in Puerto Rico and the USVI and BVI, a region susceptible to hurricanes and other weather-related events. In 2017, our operations in Puerto Rico, and the USVI and BVI were significantly disrupted by the impact of Hurricanes Irma and Maria, as discussed above under “Risks Relating to the Recent Impact of Hurricanes.” Future weather events can again cause disruption to our operations and could have a material adverse effect on our overall results of operations. We maintain hurricane insurance, including coverage for lost profits and extra expense; however, there is no insurance against the disruption that a catastrophic hurricane could produce to the markets that we serve and the potential negative impact to economic activity. Further, future hurricane in any of our market areas could again adversely impact the ability of borrowers to timely repay their loans and may further adversely impact the value of any collateral held by us. Man-made disasters and other events connected with the regions in which we operate could have similar effects. The severity and impact of future hurricanes and other weather-related events are difficult to predict and may be exacerbated by global climate change. The effects of future hurricanes and other weather-related events could have an adverse effect on our business, financial condition or results of operations.
RISKS RELATED TO ACQUISITION TRANSACTIONS
Potential acquisitions of businesses or loan portfolios could increase some of the risks that we face, and may be delayed or prohibited due to regulatory constraints.
Since 2010, we have acquired the assets of two Puerto Rico based banks from the FDIC, as receiver, and various loan portfolios from financial institutions. These acquisitions have been part of our strategy to sustain and grow our base of earning assets, particularly in Puerto Rico, where the economy has been in a prolonged recession and the population base has been decreasing mostly as a result of outmigration trends, which have increased following Hurricanes Irma and Maria. In the future, to the extent permitted by our applicable regulators, we will continue to pursue strategic acquisition opportunities. Acquiring other banks or businesses, however, involves various risks commonly associated with acquisitions, including, among other things, potential exposure to unknown or contingent liabilities of the target company, exposure to potential asset quality issues of the target company, potential disruption to our business, the possible loss of key employees and customers of the target company, and difficulty in estimating the value of the target company. If in connection with an acquisition we pay a premium over book or market value, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our business, financial condition and results of operations.
Similarly, acquiring loan portfolios involves various risks. When acquiring loan portfolios, management makes various assumptions and judgments about the collectability of the loans, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of secured loans. In estimating the extent of the losses, we analyze the loan portfolio based on historical loss experience, volume and classification of loans, volume and trends in delinquencies and nonaccruals, local economic conditions, and other pertinent information. If our assumptions are incorrect, however, our actual losses could be higher than estimated and increased loss reserves may be needed to respond to different economic conditions or adverse developments in the acquired loan portfolios, which would negatively affect our operating results.
Finally, certain acquisitions by financial institutions, including us, are subject to approval by a variety of federal and state regulatory agencies. The process for obtaining these required regulatory approvals has become substantially more difficult in recent years. Regulatory approvals could be delayed, impeded, restrictively conditioned or denied due to existing or new regulatory issues we have. We may fail to pursue, evaluate or complete strategic and competitively significant acquisition opportunities as a result of our inability, or perceived or anticipated inability, to obtain regulatory approvals in a timely manner, under reasonable conditions or at all. Difficulties associated with potential acquisitions that may result from these factors could have a material adverse effect on our business, financial condition and results of operations.
Our acquisition and assumption of certain assets and liabilities from Reliable, if consummated, could magnify certain of the risks our business already faces and could present new risks.
On February 14, 2018, BPPR entered into an agreement to acquire and assume certain assets and liabilities from Reliable Financial Services and Reliable Finance Holding Company, subsidiaries of Wells Fargo & Company, related to Wells Fargo’s retail auto loan and commercial auto dealership financing business in Puerto Rico (“Reliable”). Refer to “Business - Significant Events” for a description of this transaction. The transaction, if consummated, could present new risks or magnify certain of the risks our business already faces that are described in these “Risk Factors,” including the following:
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risks associated with weak conditions in the economy of Puerto Rico, the job market, consumer confidence and spending habits, which may affect, among other things, the continued status of the loans we acquired as performing assets, charge-offs and provision expense;
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risks that our assumptions and judgments regarding the fair value of assets acquired could be inaccurate, and that our actual losses are higher than estimated;
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risks associated with the transition, supervision and integration of Reliable’s operations, including compliance with banking and consumer protection laws and regulations;
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exposure to any unrecorded liabilities or issues not identified during due diligence investigations that are not subject to indemnification or reimbursement;
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changes in interest rates and market liquidity which may reduce interest margins;
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changes in market rates and prices that may adversely impact the value of financial assets and liabilities; and
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risks related to the anticipated loan servicing agreement whereby BPPR would service Reliable’s retail auto loans that have no FICO score and retail auto loans with the lowest FICO score which will not be acquired by BPPR in the transaction; and
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failure to realize the anticipated acquisition benefits, including synergies, in the amounts and within the timeframes we expect.
Our ability to obtain reimbursement under the loss sharing agreements on covered assets entered into in connection with the Westernbank FDIC-assisted transaction depends on our compliance with the terms of the loss sharing agreements as well as the FDIC’s interpretation thereof.
In connection with the Westernbank FDIC-assisted transaction, BPPR entered into loss sharing agreements with the FDIC which provide that 80% of losses related to specified loan portfolios that we acquired would be borne by the FDIC, subject to BPPR’s compliance with specific terms and conditions regarding the management of the covered assets. The FDIC has the right to refuse or delay payment for loan losses if the loss sharing agreements are not managed in accordance with their terms. Additionally, the loss sharing agreements have limited terms. The one applicable to commercial loans expired on June 30, 2015 (with additional recovery sharing in favor of the FDIC for three years thereafter), while the one applicable to single-family residential mortgage loans expires on June 30, 2020. Therefore, any charge-off of related losses that we experience after the term of the loss sharing agreements will not be reimbursed by the FDIC and will negatively impact our results of operations.
Since 2012, BPPR and the FDIC engaged in various disputes with respect to the commercial loss share agreement, which resulted in us having to make a material negative adjustment to the value of our loss share asset and the related true-up payment obligation to the FDIC. The last of these disputes was settled in March 2017. As of December 31, 2017, the carrying value of covered loans approximated $ 573 million, mainly comprised of single-family residential mortgage loans. To the extent that estimated losses on covered loans are not realized before the expiration of the applicable loss sharing agreement or that the FDIC disputes our claims under the terms of the loss share agreement, such losses would not be subject to reimbursement from the FDIC or we may receive substantially less than claimed, which could require us to make a material adjustment in the value of our loss share asset and the related true-up payment obligation to the FDIC and could have a material adverse effect on our financial results for the period in which such adjustment is taken.
RISKS RELATING TO OUR RELATIONSHIP WITH EVERTEC
We are dependent on EVERTEC for certain of our core financial transaction processing and information technology services, which exposes us to a number of operational risks that could have a material adverse effect on us.
In connection with the sale of a 51% ownership interest in EVERTEC in the third quarter of 2010, we entered into a long-term Amended and Restated Master Services Agreement (the “MSA”) with EVERTEC, pursuant to which we agreed to receive from EVERTEC, on an exclusive basis, certain core financial transaction processing and information technology services, including future modifications and enhancements to such services. The term of the MSA extends until September 30, 2025. Under the MSA, we also granted EVERTEC a right of first refusal over certain services or products. We also entered into several other agreements, generally coterminous with the MSA, pursuant to which BPPR agreed to sponsor EVERTEC as an independent sales organization with respect to certain credit card associations, agreed to certain exclusivity and non-solicitation restrictions with respect to merchant services, and agreed to support the ATH brand and network, among other matters. As a result, we are now dependent on EVERTEC for the provision of essential services to our business, including our core banking business, and there can be no assurances that the quality of the services will be appropriate or that EVERTEC will be able to continue to provide us with the necessary financial transaction processing and technology services. As a result, our relationship with EVERTEC exposes us to a number of operational and business risks that could have a material adverse effect on us.
Moreover, as a result of our agreements with EVERTEC, we are particularly exposed to the operational risks of EVERTEC, including those relating to a breakdown or failure of EVERTEC’s systems, as a result of security breaches or attacks, employee error or malfeasance, system breakdowns, or otherwise. Over the term of the MSA, we have experienced various interruptions and delays in key services provided by EVERTEC. Future interruptions in the operation of EVERTEC’s information systems, or breaches to the confidentiality of the information that resides in such systems, could harm our business by disrupting our delivery of services and damage our reputation, which could have a material adverse impact on our financial condition and results of operations. Our ability to recover from EVERTEC for breach of the MSA may not fully compensate us for the damages we may suffer as a result of such breach.
If EVERTEC is unable to meet constant technological changes and evolving industry standards, we may be unable to enhance our current services and introduce new products and services in a timely and cost-effective manner, placing us at a competitive disadvantage and significantly affecting our business, financial condition and results of operations.
The banking and financial services industry is rapidly evolving and it is highly competitive on the basis of the quality and variety of products and services offered, innovation, price and other factors. In order to compete effectively, we need to constantly develop enhancements to our product and service offerings and introduce new products and services that keep pace with developments in the financial services industry and satisfy shifting customer needs and preferences. These enhancements and new products and services require the delivery of technology services by EVERTEC pursuant to the MSA, making our success dependent on EVERTEC’s ability to timely complete and introduce these enhancements and new products and services in a cost-effective manner.
Some of our competitors rely on financial services technology and outsourcing companies that are much larger than EVERTEC and that may have better technological capabilities and product offerings. Furthermore, EVERTEC is highly leveraged, which, besides exposing it to a number of financial and business risks, requires it to dedicate a substantial portion of its cash flow to meeting debt service requirements, reducing its operational flexibility and ability to invest resources in capital and other expenditures to improve and develop its business services in a constantly changing environment. In addition, financial services technology companies typically make capital investments to develop and modify their product and service offerings to facilitate their customers’ compliance with the extensive and evolving regulatory and industry requirements, and in most cases such costs are borne by the technology provider. Because of our relationship with EVERTEC, however, we bear the full cost of such developments and modifications pursuant to the MSA.
If EVERTEC’s technology services are not competitive in terms of price, speed and scalability versus comparable offerings from larger companies, our future success may be adversely affected. Furthermore, if our relationship with EVERTEC hinders our ability to compete successfully, including by satisfying shifting customer needs and preferences through enhancements to our existing products and services and the introduction of new products and services that keep pace with developments in the financial services industry, our ability to attract and retain customers and to match products and services offered by competitors could be impaired and our business, financial condition and results of operations could be harmed.
Our ability to transition to a new financial services technology provider, and to replace the other services that are provided to us by EVERTEC, may be lengthy and complex.
Switching from one vendor of core bank processing and related technology services to a new vendor is a complex process that carries business and financial risks, even where such a switch can be accomplished without violating our contractual obligations to EVERTEC. The implementation cycle for such a transition can be lengthy and require significant financial and management resources from us. Such a transition can also expose us, and our clients, to increased costs (including conversion costs) and business disruption. If we decided to transition to a new financial services technology provider, either at the end of the term of the MSA and related agreements or earlier upon the occurrence of a termination event, these potential transition risks could result in an adverse effect on our business, financial condition and results of operations. Although EVERTEC has agreed to provide certain transition assistance to us in connection with the termination of the MSA, we are ultimately dependent on their ability to provide those services in a responsive and competent manner.
Under the MSA we are required to provide written notice of non-renewal not less than one year prior to the relevant termination date in order to avoid an automatic three-year renewal. In practice, however, if we decided to switch to a new provider, we would have to commence procuring and working on a transition process much earlier. Furthermore, if we were unsuccessful or decided not to complete the transition after expending significant funds and management resources, it could also result in an adverse effect on our business, financial condition and results of operations.
The value of our remaining ownership interest in EVERTEC, and the revenues we derive from EVERTEC, could be materially reduced if we decided not to renew our agreements with EVERTEC or were to terminate them before the expiration of their term.
We continue to have a 16.10% ownership interest in EVERTEC and account for this investment under the equity method. As such, we include our investment in EVERTEC in other assets and our proportionate share of income or loss is included in other operating income in our consolidated statements of operations. For 2017, our share of EVERTEC’s changes in equity recognized in income was $11.6 million. The carrying value of our investment in EVERTEC was, as of December 31, 2017, approximately $48 million. Meanwhile, the services EVERTEC delivers to us represent a significant portion of EVERTEC’s revenues (approximately 43% for 2017). As a result, if we were not to renew the MSA and our other agreements with EVERTEC, or otherwise terminate them before the end of their term, EVERTEC’s financial position and results of operations could be materially adversely affected and the value of our remaining ownership interest in EVERTEC, and the income we report from this investment, may be materially reduced. Furthermore, revenue from EVERTEC’s merchant acquiring business, which constitutes approximately 21% of EVERTEC’s revenues, depends, in part, on EVERTEC’s alliance with BPPR. If such relationship were to suffer, EVERTEC’s business may be adversely affected.
Furthermore, future sales of our EVERTEC common stock, or the perception that these sales could occur, could adversely affect the market price of EVERTEC common stock and thus the value we may be able to realize on the sale of our remaining holdings.
RISKS RELATING TO AN INVESTMENT IN OUR SECURITIES
The issuance of additional shares of equity securities could further dilute existing holders of our Common Stock.
We have not issued equity securities since 2010, other than in connection with compensation plans or our dividend reinvestment plan. In the future, however, we may raise capital through public or private equity financings to fund our operations or expansions, to pursue acquisitions or to increase our capital to comply with regulatory capital measures. If we raise funds by issuing equity securities, or instruments that are convertible into equity securities, the ownership interest of our existing common stockholders would be reduced, the new equity securities may have rights and preferences superior to those of our Common Stock or outstanding Preferred Stock, and the issuance could be at a price which is dilutive to current stockholders.
Dividends on our Common Stock and Preferred Stock may be suspended and stockholders may not receive funds in connection with their investment in our Common Stock or Preferred Stock without selling their shares.
Holders of our Common Stock and Preferred Stock are only entitled to receive such dividends as our Board of Directors may declare out of funds legally available for such payments. During 2009, we suspended dividend payments on our Common Stock and Preferred Stock. We resumed payment of dividends on our Preferred Stock in December 2010 and on our Common Stock in October 2015. There can be no assurance that any dividends will be declared on the Preferred Stock or Common Stock in any future periods.
This could adversely affect the market price of our Common Stock and Preferred Stock. Also, we are a bank holding company and our ability to declare and pay dividends is dependent on certain Federal regulatory considerations, including the guidelines of the Federal Reserve Board regarding capital adequacy and dividends. It is Federal Reserve Board policy that bank holding companies should pay dividends on common stock only out of the net income available to common shareholders over the past year and only if the prospective rate of earnings retention appears consistent with the organization’s current and expected future capital needs, asset quality and overall financial condition.
In addition, the terms of our outstanding junior subordinated debt securities held by each trust that has issued trust preferred securities, prohibit us from declaring or paying any dividends or distributions on our capital stock, including our Common Stock and Preferred Stock, or from purchasing, acquiring, or making a liquidation payment on such stock, if we have given notice of our election to defer interest payments but the related deferral period has not yet commenced or a deferral period is continuing.
Accordingly, shareholders may have to sell some or all of their shares of our Common Stock or Preferred Stock in order to generate cash flow from their investment. Shareholders may not realize a gain on their investment when they sell the Common Stock or Preferred Stock and may lose the entire amount of their investment.
Certain of the provisions contained in our Certificate of Incorporation have the effect of making it more difficult to change the Board of Directors, and may make the Board of Directors less responsive to stockholder control.
Our certificate of incorporation provides that the members of the Board of Directors are divided into three classes as nearly equal as possible. At each annual meeting of stockholders, one-third of the members of the Board of Directors will be elected for a three-year term, and the other directors will remain in office until their three-year terms expire. Therefore, control of the Board of Directors cannot be changed in one year, and at least two annual meetings must be held before a majority of the members of the Board of Directors can be changed. Our certificate of incorporation also provides that a director, or the entire Board of Directors, may be removed by the stockholders only for cause by a vote of at least two -thirds of the combined voting power of the outstanding capital stock entitled to vote for the election of directors. These provisions have the effect of making it more difficult to change the Board of Directors, and may make the Board of Directors less responsive to stockholder control. These provisions also may tend to discourage attempts by third parties to acquire Popular because of the additional time and expense involved and a greater possibility of failure, and, as a result, may adversely affect the price that a potential purchaser would be willing to pay for the capital stock, thereby reducing the amount a stockholder might realize in, for example, a tender offer for our capital stock.
For further information of other risks faced by Popular please refer to the Management’s Discussion & Analysis section of the Annual Report.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 2017, BPPR owned and wholly or partially occupied approximately 67 branch premises and other facilities throughout Puerto Rico. It also owned 6 parking garage buildings and approximately 36 lots held for future development or for parking facilities also in Puerto Rico, one building in the U.S. Virgin Islands and one in the British Virgin Islands. In addition, as of such date, BPPR leased properties mainly for branch operations in approximately 113 locations in Puerto Rico and 7 locations in the U.S. Virgin Islands. At December 31, 2017, BPNA had 62 offices (principally bank branches) of which 6 were owned and 56 were leased. These offices were located in New York, New Jersey and Florida. Our management believes that each of our facilities is well maintained and suitable for its purpose. The principal properties owned by Popular for banking operations and other services are described below:
Puerto Rico
Popular Center, the twenty-story Popular and BPPR headquarters building, located at 209 Muñoz Rivera Avenue, Hato Rey, Puerto Rico. In addition, it has an adjacent parking garage and open parking area facilities with capacity for approximately 780 cars. BPPR operates a full service branch at the plaza level and our centralized units and subsidiaries occupy approximately 40.5% of the office floors space. Approximately 55.3% of the office and commercial spaces are leased to outside tenants and 4.5% is available for office and retail use.
Popular Center North Building, a three-story building, on the same block as Popular Center. These facilities are connected to the main building by the parking garage and to the Popular Street building by a pedestrian bridge. It provides additional office space and shares the parking facilities with Popular Center. It also houses six movie theatres with stadium type seating for approximately 600 persons.
Popular Street Building, a parking and office building located at Ponce de León Avenue and Popular Street, Hato Rey, Puerto Rico. The six stories of office space and the basement are occupied by BPPR units and the Corporate Credit Risk Division. At the ground level, Popular Auto occupies approximately 10.5% of the retail type space and the remaining spaces are leased to outside tenants and the recently inaugurated Casa de Niños Popular. It has parking facilities for approximately 1,100 cars.
Cupey Center Complex, one building, three-stories high, two buildings, two-stories high each, and one building three-stories high each located in Cupey, Río Piedras, Puerto Rico. These buildings are leased to EVERTEC. BPPR maintains a full service branch and some support services in these facilities. The Complex also includes a parking garage building with capacity for approximately 1,136 cars, open parking area facilities with capacity for an additional 600 cars and houses a recreational center for employees.
Stop 22 Building, a twelve story structure located in Santurce, Puerto Rico. A BPPR branch, the Human Resources Division, the Asset Protection Division, and the International Banking Center and Foreign Exchange Department are the main occupants of this facility.
Centro Europa Building, a seven-story office and retail building in Santurce, Puerto Rico. The BPPR’s training center, Loss mitigation and Default Management units occupy approximately 59% of this building. The remaining space is leased or available for leasing to outside tenants. The building also includes a parking garage with capacity for approximately 614 cars.
Old San Juan Building, a twelve-story structure located in Old San Juan, Puerto Rico. BPPR occupies approximately 36% of the building for a branch operation, an exhibition room and other facilities. The rest of the building is leased or available for leasing to outside tenants.
Guaynabo Corporate Office Park Building, a two-story building located in Guaynabo, Puerto Rico. This building is fully occupied by Popular Insurance, Inc. as its headquarters. The property also includes an adjacent four-level parking garage with capacity for approximately 303 cars, a potable water cistern and a diesel storage tank.
Altamira Building, a nine-story office building located in Guaynabo, Puerto Rico. A seven-level parking garage with capacity for approximately 540 cars is also part of this property that houses the centralized offices Popular Auto, LLC. It also includes a full service branch and BPPR mortgage loans and servicing units.
El Señorial Center, a four-story office building and a two-story branch building located in Río Piedras, Puerto Rico. The property also includes an eight-level parking garage adjacent to the office building and four-levels of underground parking in the branch building, which together with the available ground parking space, provide for approximately 1,032 automobiles. As of December 31, 2016, a BPPR branch, the Río Piedras regional office and the Commercial Credit Center operate at the branch building while a number of centralized BPPR offices occupy the main building. The Technology Management Division, Retail Lending, Retail Banking, PCB and Operations, are some of its occupants.
Caparra Center Building, a ten-story office building located at 1451 FD Roosevelt Avenue, San Juan, Puerto Rico. The property also includes a nine-level parking garage with capacity for approximately 897 cars and a main file/storage industrial building. As of December 31, 2017, a BPPR branch and the Customer Contact Center (Telebanco) occupy the main building.
Ponce de León 167 Building, a five-story office building located in Hato Rey, Puerto Rico. As of December 31, 2017, the building is the headquarters of Fundación Banco Popular which occupies all of the building.
Virgin Islands
BPPR Virgin Islands Center, a three-story building located in St. Thomas, U.S. Virgin Islands housing a BPPR branch and centralized offices. The building is fully occupied by BPPR personnel.
Popular Center -Tortola, a four-story building located in Tortola, British Virgin Islands. A BPPR branch is located in the first story while the commercial credit department occupies the second story. The third floor has been leased to an outside tenant (KPMG), while the fourth floor is partially saved for BPPR business expansion and outside tenants.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
For a discussion of Legal proceedings, see Note 27, “Commitments and Contingencies”, to the Consolidated Financial Statements.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURE
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Common Stock
Popular’s Common Stock is traded on the NASDAQ Global Select Market under the symbol “BPOP”. Information concerning the range of high and low sales prices for the Common Stock for each quarterly period during 2017 and the previous four years, as well as cash dividends declared, is contained under Table 4, “Common Stock Performance”, in the Management’s Discussion and Analysis of the Annual Report, and is incorporated herein by reference.
In June 2009, Popular announced the suspension of dividends on the Common Stock. During the third quarter of 2015, Popular resumed the quarterly cash dividend of $0.15 per share on its Common Stock. On January 23, 2017, the Corporation’s Board of Directors approved an increase in the quarterly Common Stock dividend of $0.25 per share, payable on April 3, 2017 to shareholders of record as of March 17, 2017. The Common Stock ranks junior to all series of Preferred Stock as to dividend rights and/or as to rights on liquidation, dissolution or winding up of Popular. Our ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, the Common Stock is subject to certain restrictions in the event that Popular fails to pay or set aside full dividends on the Preferred Stock for the latest dividend period.
Additional information concerning legal or regulatory restrictions on the payment of dividends by Popular, BPPR and BPNA is contained under the caption “Regulation and Supervision” in Item 1 herein.
As of February 23, 2018, Popular had 7,919 stockholders of record of the Common Stock, not including beneficial owners whose shares are held in record names of brokers or other nominees. The last sales price for the Common Stock on that date was $42.93 per share.
Preferred Stock
Popular has 30,000,000 shares of authorized Preferred Stock that may be issued in one or more series, and the shares of each series shall have such rights and preferences as shall be fixed by the Board of Directors when authorizing the issuance of that particular series. Popular’s Preferred Stock issued and outstanding at December 31, 2017 consisted of:
•
885,726 shares of 6.375% non-cumulative monthly income Preferred Stock, Series A, no par value, liquidation preference value of $25 per share.
•
1,120,665 shares of 8.25% non-cumulative monthly income Preferred Stock, Series B, no par value, liquidation preference value of $25 per share.
All series of Preferred Stock are pari passu. Dividends on each series of Preferred Stock are payable if declared by our Board of Directors. Our ability to declare and pay dividends on the Preferred Stock is dependent on certain Federal regulatory considerations, including the guidelines of the Federal Reserve Board regarding capital adequacy and dividends. The Board of Directors is not obligated to declare dividends and dividends do not accumulate in the event they are not paid.
Monthly dividends on the Preferred Stock amounted to a total of $3.7 million for 2017. There can be no assurance that any dividends will be declared on the Preferred Stock in any future periods.
Dividend Reinvestment and Stock Purchase Plan
Popular offers a dividend reinvestment and stock purchase plan for our stockholders that allows them to reinvest their dividends in shares of the Common Stock at a 5% discount from the average market price at the time of the issuance, as well as purchase shares of Common Stock directly from Popular by making optional cash payments at prevailing market prices.
Equity Based Plans
For information about the securities authorized for issuance under our equity based plans, refer to Part III, Item 12.
In April 2004, our shareholders adopted the Popular, Inc. 2004 Omnibus Incentive Plan. The maximum number of shares of Common Stock issuable under this Plan is 3,500,000. The Corporation has to date used shares purchased in the market to make grants under the Plan. There were no purchases of Common Stock during the quarter ended December 31, 2017 under the 2004 Omnibus Incentive Plan.
Equity Compensation Plans
For information about our equity compensation plans, refer to Part III, Item 12.
Stock Performance Graph (1)
The graph below compares the cumulative total stockholder return during the measurement period with the cumulative total return, assuming reinvestment of dividends, of the Nasdaq Bank Index and the Nasdaq Composite Index.
The cumulative total stockholder return was obtained by dividing (i) the cumulative amount of dividends per share, assuming dividend reinvestment since the measurement point, December 31, 2012, plus (ii) the change in the per share price since the measurement date, by the share price at the measurement date.
COMPARISON OF FIVE YEAR CUMULATIVE RETURN
Total Return as of December 31
December 31, 2012 = 100
(1) Unless Popular specifically states otherwise, this Stock Performance Graph shall not be deemed to be incorporated by reference and shall not constitute soliciting material or otherwise be considered filed under the Securities Act of 1933 or the Securities Exchange Act of 1934.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this item appears in Table 1, “Selected Financial Data”, and the text under the caption “Statement of Operations Analysis” in the Management Discussion and Analysis of Financial Condition and Results of Operations, and is incorporated herein by reference.
Our ratio of earnings to fixed charges and of earnings to fixed charges and Preferred Stock dividends on a consolidated basis for each of the last five years is as follows:
(1) The computation of earnings to fixed charges and preferred stock dividends excludes the results of discontinued operations.
(A) During 2014, earnings were not sufficient to cover fixed charges or preferred stock dividends and the ratios were less than 1:1. The Corporation would have had to generate additional earnings of approximately $161 million to achieve ratios of 1:1 in the corresponding period of 2014.
For purposes of computing these consolidated ratios, earnings represent income before income taxes, plus fixed charges. Fixed charges include interest costs both expensed and capitalized (ratios are presented both excluding and including interest on deposits), and the portion of net rental expense, which is deemed representative of the interest factor.
Our long-term senior debt and Preferred Stock on a consolidated basis as of December 31 of each of the last five years is:
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item appears in the Annual Report under the caption Management’s Discussion and Analysis of Financial Condition and Results of Operations, and is incorporated herein by reference.
Table 23, “Maturity Distribution of Earning Assets”, in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Annual Report, takes into consideration prepayment assumptions as determined by management based on the expected interest rate scenario.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information regarding the market risk of our investments appears under the caption “Risk Management” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Annual Report, and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item appears in the Annual Report under the caption “Statistical Summaries”, and is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Popular in the reports that we file or submit under the Exchange Act and such information is accumulated and communicated to management, as appropriate, to allow timely decisions regarding required disclosures.
Assessment on Internal Control Over Financial Reporting
The information under the captions “Report of Management on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” are located in our Annual Report and are incorporated by reference herein.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended on December 31, 2017, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information contained under the captions “Security Ownership of Certain Beneficial Owners and Management”, “Section 16 (a) Beneficial Ownership Reporting Compliance”, “Corporate Governance”, “Nominees for Election as Directors and Other Directors” and “Executive Officers” in the Proxy Statement are incorporated herein by reference. The Board has adopted a Code of Ethics to be followed by our employees, officers (including the Chief Executive Officer, Chief Financial Officer and Corporate Comptroller) and directors to achieve conduct that reflects our ethical principles. The Code of Ethics is available on our website at www.popular.com. We will post on our website any amendments to the Code of Ethics or any waivers from a provision of Code of Ethics granted to the Chief Executive Officer, Chief Financial Officer, or Principal Accounting Officer.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information in the Proxy Statement under the caption “Executive and Director Compensation,” including the “Compensation Discussion and Analysis,” the “2017 Executive Compensation Tables and Compensation Information” and the “Compensation of Non-Employee Directors,” and under the caption “Committees of the Board - Compensation Committee-Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS
The information under the captions “Principal Shareholders” and “Shares Beneficially Owned by Directors and Executive Officers of Popular” in the Proxy Statement is incorporated herein by reference.
The following tables sets forth information as of December 31, 2017 regarding securities issued and issuable to directors and eligible employees under our equity based compensation plans.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information under the caption “Board of Directors’ Independence”, and “Certain Relationships and Transactions” in the Proxy Statement is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information regarding principal accountant fees and services is set forth under Proposal 3 - Ratification of Appointment of Independent Registered Public Accounting Firm in the Proxy Statement, which is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a). The following financial statements and reports included on pages 81 through 233 of the Financial Review and Supplementary Information of Popular’s Annual Report to Shareholders are incorporated herein by reference:
(1) Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Financial Condition as of December 31, 2017 and 2016
Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 2017
Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2017
Consolidated Statements of Changes in Stockholders’ Equity for each of the years in the three-year period ended December 31, 2017
Consolidated Statements of Comprehensive Income (Loss) for each of the years in the three-year period ended December 31, 2017
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules: No schedules are presented because the information is not applicable or is included in the Consolidated Financial Statements described in (a) (1) above or in the notes thereto.
(3) Exhibits
ITEM 16. FORM 10-K SUMMARY
None.
The exhibits listed on the Exhibits Index on page 48 of this report are filed herewith or are incorporated herein by reference.
Exhibit Index
(1) Included herewith
* This exhibit is a management contract or compensatory plan or arrangement.
Popular, Inc. has not filed as exhibits certain instruments defining the rights of holders of debt of Popular, Inc. not exceeding 10% of the total assets of Popular, Inc. and its consolidated subsidiaries. Popular, Inc. hereby agrees to furnish upon request to the Commission a copy of each instrument defining the rights of holders of senior and subordinated debt of Popular, Inc., or of any of its consolidated subsidiaries.
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 on March 1, 2018.
POPULAR, INC.
(Registrant)
By:
/S/ IGNACIO ALVAREZ
Ignacio Alvarez
President and
Chief Executive Officer
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.