<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
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FORM 10-Q
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X QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
--- ACT OF 1934
For the quarter ended June 30, 1996
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
--- SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission File Number 0-1100
-----------------------
HAWTHORNE FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 95-2085671
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
2381 ROSECRANS AVENUE, EL SEGUNDO, CA 90245
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (310) 725-5000
-----------------------
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by section 13 or 15 (d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date: The
Registrant had 2,599,275 shares outstanding of Common stock, $0.01 par
value per share, as of August 14, 1996.
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<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
FORM 10-Q INDEX
FOR THE QUARTER ENDED JUNE 30, 1996
PART I - FINANCIAL INFORMATION Page
----
ITEM 1. Financial Statements
Consolidated Statements of Financial Condition
at June 30, 1996 (Unaudited) and December 31, 1995 3
Consolidated Statements of Operations (Unaudited)
for the Three and Six Months Ended June 30, 1996 and 1995 4
Consolidated Statement of Stockholders' Equity (Unaudited)
for the Six Months Ended June 30, 1996 5
Consolidated Statements of Cash Flows (Unaudited)
for the Three and Six Months Ended June 30, 1996 and 1995 6
Notes to Consolidated Financial Statements (Unaudited) 8
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings 33
ITEM 2. Changes in Securities 33
ITEM 3. Defaults upon Senior Securities 33
ITEM 4. Submission of Matters to a Vote of Security Holders 33
ITEM 5. Other Information 33
ITEM 6. Exhibits and Reports on Form 8-K 33
2
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
June 30, December 31,
1996 1995
(unaudited) (audited)
------------- -------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 33,983 $ 14,015
Investment securities available-for-sale 38,448 62,793
Loans held for investment (net of allowance for estimated credit losses
of $15,762 in 1996 and $15,192 in 1995) 644,305 617,328
Real estate owned (net of allowance for estimated losses
of $11,909 in 1996 and $15,725 in 1995) 22,404 37,905
Investment in capital stock of Federal Home Loan Bank - at cost 6,569 6,312
Office property and equipment-at cost, net 5,081 9,597
Accrued interest receivable 4,256 3,583
Deferred tax assets 3,483
Other assets 2,633 2,050
------------- -------------
$ 761,162 $ 753,583
------------- -------------
------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposit accounts $ 621,965 $ 698,008
Borrowings 75,000
Senior notes 12,150 12,006
Accounts payable and other liabilities 5,910 4,603
------------- -------------
715,025 714,617
Stockholders' equity
Capital stock - $0.01 par value; authorized, 20,000,000
shares; issued and outstanding, 2,604,675 shares 26 26
Cumulative perpetual preferred stock, series A - $0.01 par
value; $50,000 liquidation preference; authorized 10,000,000
shares; issued and outstanding 270 shares
Capital in excess of par value - common stock 7,745 7,745
Capital in excess of par value - preferred stock 11,592 11,592
Unrealized gains (losses) on available-for-sale securities, net (140) 6
Retained earnings 27,099 19,788
------------- -------------
46,322 39,157
Less
Treasury stock, at cost - 5,400 shares (48) (48)
Loan to Employee Stock Ownership Plan (137) (143)
------------- -------------
46,137 38,966
------------- -------------
$ 761,162 $ 753,583
------------- -------------
------------- -------------
</TABLE>
3
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
1996 1995 1996 1995
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Interest revenues
Loans $ 14,386 $ 11,387 $ 28,797 $ 22,725
Investments 2,105 492 3,124 1,468
Mortgage-backed securities 839 1,739
-------- -------- -------- --------
16,491 12,718 31,921 25,932
-------- -------- -------- --------
Interest costs
Deposits 9,294 8,349 18,232 15,815
Borrowings 121 138 121 585
Senior notes 484 955
-------- -------- -------- --------
9,899 8,487 19,308 16,400
-------- -------- -------- --------
Net interest margin inclusive of contractual interest due
on nonaccrual loans 6,592 4,231 12,613 9,532
Contractual interest due on nonaccrual loans (447) (677) (1,076) (1,407)
-------- -------- -------- --------
Net interest margin 6,145 3,554 11,537 8,125
Provision for estimated credit losses 2,489 3,689 12,745
-------- -------- -------- --------
Net interest margin after provision for credit losses 3,656 3,554 7,848 (4,620)
Non-interest revenues 491 278 931 554
Non-interest expenses
Employee 2,310 2,641 4,604 5,403
Operating 1,258 870 2,307 1,725
Occupancy 703 663 1,426 1,439
SAIF premium and OTS assessment 594 542 1,179 1,091
Professional 467 489 915 956
Goodwill amortization 12 12 24 24
-------- -------- -------- --------
5,344 5,217 10,455 10,638
-------- -------- -------- --------
Real estate operations, net (395) 949 46 1,415
Gain on sale of loans 75 68 228 68
Gain on sale of securities 147 3,049
Gain on sale of other assets 6,411 86 6,452 86
Other revenues (expenses) (153) (1) 407
-------- -------- -------- --------
Net earnings (loss) before income taxes 4,741 (135) 5,049 (9,679)
Income (taxes) benefit 1,230 3,483 (585)
-------- -------- -------- --------
Net earnings (loss) $ 5,971 $ (135) $ 8,532 $(10,264)
-------- -------- -------- --------
-------- -------- -------- --------
Net earnings (loss) available for Common (NOTE 3) $ 5,524 $ (135) $ 7,653 $(10,264)
-------- -------- -------- --------
-------- -------- -------- --------
Net earnings (loss) per share (NOTE 3) $ 1.07 $ (0.05) $ 1.49 $ (4.11)
-------- -------- -------- --------
-------- -------- -------- --------
Weighted average shares outstanding (NOTE 3) 5,155 2,599 5,155 2,599
-------- -------- -------- --------
-------- -------- -------- --------
</TABLE>
4
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
Accrued
Change in dividends
Balance at unrealized Net on Balance at
December 31, gains earnings preferred June 30,
1995 (losses) (loss) stock Repayments 1996
------------ ----------- --------- ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Capital stock $ 26 $ 26
Cumulative perpetual - preferred stock
Capital in excess of par value
Common stock 7,745 7,745
Preferred stock 11,592 11,592
Unrealized gains (losses) on
available-for-sale securities, net 6 (146) (140)
Retained earnings 19,788 8,532 (1,221) 27,099
Treasury stock (48) (48)
Loan to employee stock ownership plan (143) 6 (137)
------------ ----------- --------- ------------ ------------ -------------
Total stockholders' equity $ 38,966 $ (146) $ 8,532 $ (1,221) $ 6 $ 46,137
------------ ----------- --------- ------------ ------------ -------------
------------ ----------- --------- ------------ ------------ -------------
</TABLE>
5
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- ------------------
1996 1995 1996 1995
-------- -------- -------- --------
<S> <C> <C> <C> <C>
NET CASH FLOWS FROM OPERATING ACTIVITIES
Net earnings (loss) $ 5,971 $ (135) $ 8,532 $(10,264)
Adjustments
Provision (benefit) for income taxes (1,230) (3,483) 585
Provision for estimated credit losses on loans 2,489 3,689 12,745
Provision for estimated credit losses on real estate owned 1,011 1,711
Net gain on sale of branches (6,413) (86) (6,413) (86)
Net gain on sale of securities (147) (3,049)
Net recoveries from sales of real estate owned (538) (324) (1,281) (324)
Net gain from sale of other assets (72) (68) (268) (68)
Loan fee and discount accretion (831) (415) (1,381) (1,348)
Depreciation and amortization 536 458 772 987
FHLB dividends (93) (77) (257) (177)
Goodwill amortization 12 12 24 24
(Increase) decrease in accrued interest receivable (329) 661 (663) 330
(Increase) decrease in other assets 209 289 (1,062) (627)
Increase (decrease) in other liabilities (56) 918 (2) (717)
Other, net (28) 182 (118) 403
-------- -------- --------- --------
Net cash provided (used) by operating activities 638 1,268 (200) (1,586)
-------- -------- --------- --------
NET CASH FLOWS FROM INVESTING ACTIVITIES
Investment securities
Purchases (14,516) (104,482) (111)
Maturities 70,797 128,729
Sales proceeds 30,144 45,521
Mortgage-backed securities
Principal amortization 1,513 33 2,975
Sales proceeds 1,438
Loans
New loans funded (74,477) (40,353) (109,480) (64,710)
Construction disbursements (11,836) (2,231) (21,615) (2,600)
Payoffs 17,710 5,164 30,386 12,255
Sales proceeds 36,030 19,350 68,750 19,350
Principal amortization 3,350 5,282 7,488 9,142
Other, net (3,905) (2,349) (1,533) (3,689)
Real estate owned
Sale proceeds 6,747 6,769 17,577 14,330
Capitalized costs (2,474) (3,716) (5,306) (6,448)
Other, net (1) 311 (2) 132
Redemption of FHLB stock 1,015 1,015
Office property and equipment
Sales proceeds 1,829 565 4,551 565
Additions (139) (502) (180) (1,134)
-------- -------- --------- --------
Net cash provided (used) by investing activities 29,115 20,962 14,916 28,031
-------- -------- --------- --------
</TABLE>
6
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- ------------------
1996 1995 1996 1995
-------- -------- -------- --------
<S> <C> <C> <C> <C>
NET CASH FLOWS FROM FINANCING ACTIVITIES
Payment for sale of deposits $(178,884) $(16,807) $(178,884) $(16,807)
Net growth in deposits 92,278 5,670 109,130 37,709
Net change in borrowings 75,000 (8,585) 75,000 (47,141)
Collection of ESOP loan 2 6 8
--------- -------- --------- --------
Net cash (used) provided by financing activities (11,606) (19,720) 5,252 (26,231)
--------- -------- --------- --------
INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS 18,147 2,510 19,974 214
CASH AND CASH EQUIVALENTS
AT BEGINNING OF PERIOD 15,836 15,767 14,015 18,063
--------- -------- --------- --------
CASH AND CASH EQUIVALENTS
AT END OF PERIOD $ 33,983 $ 18,277 $ 33,983 $ 18,277
--------- -------- --------- --------
--------- -------- --------- --------
SUPPLEMENTAL DISCLOSURES OF
CASH FLOW INFORMATION
Cash paid during the period for
Interest $ 10,193 $ 8,770 $ 18,890 $ 17,008
Non-cash investing and financing activities
Real estate acquired in settlement of loans $ 6,404 $ 14,792 $ 10,050 $ 22,629
Loans originated to finance property sales 4,252 231 11,730 446
Net unrealized gains (losses) on available-for-sale securities (80) (140)
Transfer of held to maturity securities to available-for-sale 30,168
Loan activity
Total commitments and permanent fundings $ 103,606 $ 46,376 $ 167,676 $ 73,956
Less:
Change in undisbursed funds on construction commitments (7,559) (3,561) (18,012) (6,200)
Loans originated to finance property sales (4,252) (231) (11,730) (446)
Undisbursed portion of new lines of credit (5,482) (6,839)
--------- -------- --------- --------
Net construction disbursements and loans funded $ 86,313 $ 42,584 $ 131,095 $ 67,310
--------- -------- --------- --------
--------- -------- --------- --------
</TABLE>
7
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 1996
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES
The consolidated financial statements include the accounts of Hawthorne
Financial Corporation and its wholly-owned subsidiary, Hawthorne Savings,
F.S.B. ("Bank"), collectively referred to as the "Company". All material
intercompany transactions and accounts have been eliminated.
In the opinion of management, the unaudited consolidated financial
statements contain all adjustments (consisting solely of normal recurring
accruals) necessary to present fairly the Company's financial position as of
June 30, 1996, and December 31, 1995, and the results of its operations and
its cash flows for the six months ended June 30, 1996 and 1995. Certain
information and note disclosures normally included in financial statements
prepared in accordance with Generally Accepted Accounting Principles ("GAAP")
have been condensed or omitted pursuant to the rules and regulations of the
Securities and Exchange Commission ("SEC"). Operating results for the six
months ended June 30, 1996, are not necessarily indicative of the results
that may be expected for the full year ending December 31, 1996.
These unaudited consolidated financial statements should be read in
conjunction with the audited consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K for the year
ended December 31, 1995.
NOTE 2 - RECLASSIFICATION
Certain amounts in the 1995 consolidated financial statements have been
reclassified, where practicable, to conform with classifications in 1996.
8
<PAGE>
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 1996
(AMOUNTS ARE IN THOUSANDS, EXCEPT BOOK VALUE AND PER SHARE DATA)
NOTE 3 - BOOK VALUE AND EARNINGS PER SHARE
The table below sets forth the Company's book value and earnings per
share calculations for June 30, 1996, using the Modified Treasury Stock
Method as prescribed under GAAP. All other calculations shown, using
alternate methods, are for informational purposes only. In the table below,
(1) Warrants refers to the warrants issued by the Company in December 1995,
which have an exercise price of $2.25 per share and can be exercised
beginning three years from the issue date and for a period of ten years from
the issue date, and (2) Preferred Stock refers to the Cumulative Perpetual
Preferred Stock issued by the Company in December 1995, which carries an
annual dividend equal to 18% of the face amount of the Preferred Stock,
permits any dividend thereon to be paid in equivalent value of the Company's
common stock and has an initial dividend payment in June 1997.
<TABLE>
<CAPTION>
Three Months Ended June 30, 1996 Six Months Ended June 30, 1996
--------------------------------------- -------------------------------------
Modified Modified
Treasury Actual Shares, Treasury Actual Shares,
Stock Actual Warrants, Stock Actual Warrants,
Method Shares and Options Method Shares and Options
---------- --------- ---------------- ----------- --------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Shares Outstanding
Common 2,599 2,599 2,599 2,599 2,599 2,599
Warrants 2,376 2,376 2,376 2,376
Options 700 700 700 700
Less Treasury shares (520) (520)
----------- --------- ----------- ------------ --------- -----------
Total 5,155 2,599 5,675 5,155 2,599 5,675
----------- --------- ----------- ------------ --------- -----------
----------- --------- ----------- ------------ --------- -----------
Stockholders' Equity
Common $ 34,545 $ 34,545 $ 34,545 $ 34,545 $ 34,545 $ 34,545
Warrants 5,346 5,346 5,346 5,346
Options 3,462 3,465 3,462 3,465
Less Treasury shares (2) (3,534) (3,094)
----------- --------- ----------- ------------ --------- -----------
Total $ 39,819 $ 34,545 $ 43,356 $ 40,259 $ 34,545 $ 43,356
----------- --------- ----------- ------------ --------- -----------
----------- --------- ----------- ------------ --------- -----------
Net Earnings (Loss)
Net earnings for the period $ 5,971 $ 8,532
Partial reduction in interest expense (1) 159 342
Preferred stock dividends (606) (1,221)
----------- ------------
Adjusted earnings available for Common $ 5,524 $ 7,653
----------- ------------
----------- ------------
Book value per share $ 7.72 $ 13.29 $ 7.64 $ 7.81 $ 13.29 $ 7.64
----------- --------- ----------- ------------ --------- -----------
----------- --------- ----------- ------------ --------- -----------
Earnings per share $ 1.07 $ 2.06 $ .95 $ 1.49 $ 2.82 $ 1.29
----------- --------- ----------- ------------ --------- -----------
----------- --------- ----------- ------------ --------- -----------
</TABLE>
- ---------------------------
(1) Under the Modified Treasury Stock Method, it is assumed that the
Company will use 20% of the proceeds from the proforma exercise of the
Warrants and Options to acquire Treasury shares and use any remaining
assumed proceeds to reduce the outstanding balance of the Company's
Senior Notes. The partial reduction in interest expense of $159,000
and $342,000 represents the proforma reduction in interest expense as
a result of the proforma reduction in the outstanding balance of
Senior Notes.
(2) Treasury shares were assumed to be repurchased at the average closing
stock price for the respective periods.
9
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The Company reported net earnings of $6.0 million for the quarter ended
June 30, 1996, compared to a net loss of $0.1 million for the same period in
1995. The Company earned $2.6 million for the quarter ended March 31, 1996.
For the years ended December 31, 1995 and 1994, respectively, the Company
reported losses of $14.2 million and $3.0 million. The second quarter of
1996 is the third consecutive quarter in which the Company has reported net
earnings, following nearly four years of quarterly and annual losses.
For the six months ended June 30, 1996, the Company reported net
earnings of $8.5 million as compared to a net loss of $10.3 million for the
same period in 1995. The growth in capital produced by the earnings
generated during the first half of 1996 increased the Bank's core and
risk-based capital ratios to 7.06% and 11.62%, respectively, at June 30,
1996, in excess of the regulatory minimums which define a "well capitalized"
institution.
During the second quarter of 1996, the Company (1) earned $1.9 million
from its core business operations (before credit loss provisions), (2)
realized a pretax gain of $6.4 million from the sale of its San Diego
County-based deposits, (3) augmented loan and property loss reserves by $3.5
million, (4) recorded income tax benefits of $1.2 million, (5) incurred $0.5
million in interest costs associated with the Senior Notes issued in December
1995 as part of the Company's recapitalization, and (6) realized other net
revenues of $0.5 million.
For the first six months of 1996, the Company (1) realized pretax
earnings (before credit loss provisions) of $3.6 million from its core
business operations, (2) increased loan and property loss reserves by $5.4
million, (3) recorded a gain of $6.4 million from the sale of its San Diego
deposit franchise, (4) recognized $3.5 million of income tax benefits, (5)
incurred $1.0 million of interest costs on the Senior Notes, and (6) realized
other net revenues of $1.4 million, principally associated with the Company's
property disposal operations.
By comparison, the results for the three and six months ended June 30,
1995 include (1) a loss from the Company's core business operations (before
credit loss provisions) of $0.7 million and $0.7 million, respectively, (2)
additions to loan and property loss reserves of $0 and $12.7 million,
respectively, (3) net gains of $0.6 million and $3.7 million, respectively,
from sales of securities, properties and loans, and (4) other net revenues of
$0.7 million and $0.2 million, respectively.
The continuing improvement in the Company's financial performance is
attributable to (1) the growing success in penetrating its targeted financing
markets, which produced completed financings of $167.7 million during the
first half 1996 compared to $74.0 million during the first half of 1995, and
(2) the continued reduction in nonperforming assets which, net of all credit
losses, declined to $40.5 million at June 30, 1996 from $80.1 million at June
30, 1995. Though still high by comparison to other financial institutions,
the Company's net nonperforming assets represented 5.3% of total assets at
June 30, 1996, compared to 11.5% of total assets at June 30, 1995.
These two factors contributed to the growth in average interest-earning
assets, which in turn has significantly enhanced the Company's net interest
margins. For the three and six months ended June 30, 1996, the Company's net
interest margin, excluding credit loss provisions, was $6.1 million and $11.5
million, respectively. For the same periods in 1995, the Company's net
interest margin, before credit loss provisions, was $3.6 million and $8.1
million, respectively.
Though most of the Company's financial performance indicators are
improving and trending positively, the Company's operating results continue
to be diluted by weakness in the performance of loans originated prior to
1994, and the continued high cost of carrying a significant investment in
nonperforming assets. Because most of the loans in this segment of the
portfolio were originated during the period 1987 through 1992, prior to the
steep and prolonged decline in real estate values throughout Southern
California, collateral values in many instances are less than the outstanding
balance of the Company's loans. As a consequence, the Company remains
susceptible to future credit losses arising from adverse borrower performance
related to this portfolio, which may require further significant reserve
additions.
10
<PAGE>
At June 30, 1996, the Company's portfolio of loans originated since 1994
stood at $292.2 million, or 43.8% of total loans, and carried a weighted
average interest rate of 9.47%. By comparison, the Company's portfolio of
loans originated prior to 1995 represented 56.2% of total loans at June 30,
1996 and carried a weighted average interest rate of 7.81%. At June 30,
1996, none of the loans originated since 1994 were in default, nor had the
Company completed foreclosure actions related to any post-1994 financings.
Since its re-emergence as an active lender at the beginning of 1995, the
Company has provided financing to owners and purchasers of estate-quality
homes, income-producing properties, and residential construction, in each
instance limited to its core Southern California markets.
In late June, the Company completed the sale of deposits from its three
San Diego County retail banking offices to Hemet Federal Savings. Total
deposits of $185.2 million were sold, which produced a net gain of $6.4
million. The transfer of deposits was principally funded by (1) a net growth
since the end of 1995 of $92.3 million in the deposits held by the Company's
remaining six retail banking offices, (2) an advance of $75.0 million against
the Bank's $200.0 million line of credit with the Federal Home Loan Bank of
San Francisco ("FHLB") and (3) the sale of $36.0 million of seasoned,
fixed-rate, single-family residence mortgage loans during the quarter. The
Company's six remaining retail banking locations in the greater Los Angeles
metropolitan area maintained average customer deposit balances of $103.7
million at June 30, 1996. The continued growth of deposit balances in the
Company's core markets, coupled with its FHLB line of credit, are expected to
provide the Company with sufficient capacity to support its real
estate-secured financing opportunities.
At June 30, 1996, the Company had total assets of $761.2 million, up
from total assets of $753.6 million at year end 1995 and $705.1 million at
June 30, 1995.
OPERATING RESULTS
INTEREST MARGIN
The Company's net interest margin, or the difference between the
interest earned on loans and investment securities and the cost of deposits
and borrowings, is affected by several factors, including (1) the level of,
and the relationship between, the dollar amount of interest-earning assets
and interest-bearing liabilities, (2) the maturity of the Company's
adjustable-rate and fixed-rate loans and short-term investment securities and
its deposits and borrowings, (3) the relationship between market interest
rates and local deposit rates offered by competing institutions, and (4) the
magnitude of the Company's nonperforming assets.
11
<PAGE>
The table below sets forth the Company's average balance sheet, and the
related effective yields and costs on average interest-earning assets and
interest-bearing liabilities, for the six months ended June 30, 1996, and
1995. In the table, interest revenues are net of interest associated with
nonaccrual loans (dollars are in thousands).
<TABLE>
<CAPTION>
SIX MONTHS ENDED
------------------------------------------------------------
JUNE 30, 1996 JUNE 30, 1995
---------------------------- ----------------------------
REVENUES/ YIELD/ REVENUES/ YIELD/
AMOUNT COSTS COST AMOUNT COSTS COST
-------- ------- ------ -------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
ASSETS
Interest-earning assets
Loans $642,080 $27,721 8.63% $566,915 $21,318 7.52%
Investments and other securities 118,682 3,124 5.26% 48,031 1,468 6.11%
Mortgage-backed securities 54,999 1,739 6.32%
-------- ------- -------- -------
Total interest-earning assets 760,762 30,845 8.10% 669,945 24,525 7.32%
Noninterest-earning assets 29,431 ------- ----- 55,135 ------- ----
-------- --------
Total assets $790,193 $725,080
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities
Deposits $726,365 18,232 5.05% $666,084 15,815 4.79%
Borrowings 4,120 121 5.91% 19,212 585 6.06%
Senior Notes 12,091 955 15.80%
-------- ------- -------- -------
Total interest-bearing liabilities 742,623 19,308 5.25% 685,296 16,400 4.83%
------- ----- ------- ----
Noninterest-bearing liabilities 6,016 6,999
Stockholders' equity 41,554 32,785
-------- --------
Total liabilities & stockholders' equity $790,193 $725,080
-------- --------
-------- --------
Net interest margin ($) $11,537 $ 8,125
------- -------
------- -------
Net interest margin (% to
interest-earning assets) 2.85% 2.49%
----- ----
----- ----
</TABLE>
The table below summarizes the components of the changes in the
Company's interest revenues and costs for the six months ended June 30, 1996
and 1995 (dollars are in thousands).
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30, 1996 AND 1995
INCREASE (DECREASE) DUE TO CHANGE IN
--------------------------------------------------
RATE AND NET
VOLUME RATE VOLUME (1) OTHER (3) CHANGE
------ ------ ---------- --------- -------
<S> <C> <C> <C> <C> <C>
INTEREST REVENUES
Loans (2) $2,826 $3,158 $ 419 $ - $ 6,403
Investments and other securities 2,165 (206) (303) 1,656
Mortgage-backed securities (1,739) (1,739)
------ ------ ---------- --------- -------
3,252 2,952 116 6,320
------ ------ ---------- --------- -------
INTEREST COSTS
Deposits 1,416 850 77 74 2,417
Borrowings (460) (17) 13 (464)
Senior notes 955 955
------ ------ ---------- --------- -------
1,911 833 90 74 2,908
------ ------ ---------- --------- -------
NET MARGIN $1,341 $2,119 $ 26 $(74) $ 3,412
------ ------ ---------- --------- -------
------ ------ ---------- --------- -------
</TABLE>
- ----------
(1) Calculated by multiplying change in rate by change in volume.
(2) Interest on loans is net of interest on nonaccrual loans and includes
amortization of loan fees and discounts.
(3) Extra day of interest expense due to leap year.
12
<PAGE>
The Company's net interest margin, expressed as a percentage of
interest-earning assets, has been steadily rising over the past eighteen
months. The Company commenced operation of several new financing businesses
early in 1995, each targeted on a narrow segment of the real estate finance
markets in Southern California and designed to produce meaningful new loan
volumes with yields substantially higher than the Company's pre-1995 loan
portfolio while maintaining the Company's established credit quality
standards. During the six months ended June 30, 1996, the Company originated
$167.7 million of new permanent and construction loan commitments with a
weighted average interest rate of 9.78% at origination. By comparison, new
permanent and construction loan commitments during the six months ended June
30, 1995, were $74.0 million, and carried a weighted average interest rate at
origination of 9.74%. At June 30, 1996, approximately $292.2 million of the
loans originated since 1994 remained in the Company's portfolio and had an
aggregate weighted average interest rate of 9.47%. Loans originated prior to
1995 totaled $375.3 million at June 30, 1996, and had an aggregate weighted
average interest rate of 7.81%. Most of the loans originated during 1995 and
1996 are adjustable-rate, adjusting quarterly or more frequently, and utilize
a variety of indices, including the Eleventh District Cost of Funds Index
("11th DCOFI"), the Prime Rate and the One-Year Constant Maturity Treasury
Index. The more frequent adjustments of, and the wider array of indices
utilized by, the Company's post-1994 originations have steadily improved the
Company's sensitivity to movements in market interest rates. At June 30,
1996, approximately 90% of the Company's adjustable rate loans, and 69% of
all loans, had repricing intervals of six months or less. By comparison, at
June 30, 1995, 85% of the Company's adjustable rate loans, and 60% of all
loans, had repricing intervals of six months or less.
PROVISIONS FOR ESTIMATED CREDIT LOSSES ON LOANS
For the three and six months ended June 30, 1996, the Company recorded
loan loss provisions of $2.5 million and $3.7 million, respectively, compared
with provisions of $12.7 million recorded during the six months ended June
30, 1995, all of which was recorded in the first quarter of 1995. The
reduction in loan loss provisions from 1995 to 1996 resulted primarily from
an improvement in asset quality. At June 30, 1996, net nonperforming assets
and performing loans classified "Substandard", "Doubtful" or "Loss" totaled
$98.6 million compared with $136.3 million at June 30, 1995. Within these
totals, the net carrying value of real estate owned totaled $22.4 million and
$63.5 million, respectively, at June 30, 1996, and 1995. The majority of the
provisions recorded in the first six months of 1995 were attributable to an
increase in the capitalization rates utilized by the Company to value its
portfolios of owned apartment buildings and classified apartment loan
collateral.
Notwithstanding the measurable improvement in the Company's asset
quality during the past twelve months, the magnitude of the Company's
nonperforming asset and classified performing loan portfolios remains
substantially above peer levels and represents a significant portion of the
Company's assets. These portfolios dilute the Company's operating results,
through a combination of funding and management costs and incremental loss
provisions. Further, these assets expose the Company to the potential for
additional losses to the extent that borrowers are unable to make their
payments to the Company, requiring the Company to pursue foreclosure of its
collateral, and to the extent that the submarkets in which the Company's
collateral is located (principally the South Bay area of Los Angeles County),
or the type of property securing the Company's loans, continue to be
resistant to growth in real estate values. As a result, management continues
to diligently manage this portfolio of troubled assets and to measure in a
timely fashion adverse portfolio migration trends and the adequacy of the
Bank's reserves for future credit losses.
13
<PAGE>
NON-INTEREST REVENUES
The table below sets forth the Company's non-interest revenues for the
three-month and six-month periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ----------------------------
1996 1995 CHANGE 1996 1995 CHANGE
------ ------ ------ ------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
Other loan and escrow fees $ 333 $ 137 $ 196 $ 601 $ 233 $ 368
Deposit account fees 118 139 (21) 279 319 (40)
Other revenues 40 2 38 51 2 49
------ ------ ------ ------- ------- ------
$ 491 $ 278 $ 213 $ 931 $ 554 $ 377
------ ------ ------ ------- ------- ------
------ ------ ------ ------- ------- ------
</TABLE>
Other loan and escrow fees in 1996 were higher than in 1995 due primarily
to increased loan production.
OPERATING COSTS
The table below details the Company's operating costs for the three-month
and six-month periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ----------------------------
1996 1995 CHANGE 1996 1995 CHANGE
------ ------ ------ ------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
Employee $2,310 $2,641 $(331) $ 4,604 $ 5,403 $(799)
Operating 1,258 870 388 2,307 1,725 582
Occupancy 703 663 40 1,426 1,439 (13)
SAIF insurance premium
and OTS assessment 594 542 52 1,179 1,091 88
Professional 467 489 (22) 915 956 (41)
Goodwill amortization 12 12 24 24
------ ------ ------ ------- ------- ------
$5,344 $5,217 $ 127 $10,455 $10,638 $(183)
------ ------ ------ ------- ------- ------
------ ------ ------ ------- ------- ------
</TABLE>
The overall reduction in year-to-date operating costs reflects the
higher cost deferral under GAAP associated with the Company's expanding loan
origination activities. The Company has also reduced its accruals for
incentive cash compensation, consistent with the awarding of stock options to
all key managers during the fourth quarter of 1995. Offsetting this
positive trend, during the second quarter of 1996, the Company had an
increase in operating costs, compared to 1995, primarily due to an ongoing
participation in an affordable, community based housing program, an increase in
the SAIF premium as a result of higher deposit balances, and an adjustment to
depreciation on certain fixed assets.
14
<PAGE>
REAL ESTATE OPERATIONS
The table below sets forth the revenues and costs attributable to the
Company's foreclosed properties for the periods indicated. The compensatory
and legal costs directly associated with the Company's property management
and disposal operations are included in the table above in OPERATING COSTS
(dollars are in thousands).
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ----------------------------
1996 1995 CHANGE 1996 1995 CHANGE
------ ------ ------ ------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
EXPENSES ASSOCIATED WITH
REAL ESTATE OWNED
Property taxes $ (47) $ (9) $ (38) $ (130) $ (32) $ (98)
Repairs, maintenance and renovation (57) (80) 23 (98) (208) 110
Insurance (41) (52) 11 (119) (89) (30)
------- ----- ------- ------- ------ -------
(145) (141) (4) (347) (329) (18)
NET RECOVERIES FROM SALE
OF PROPERTIES 538 324 214 1,282 503 779
RENTAL INCOME, NET 223 766 (543) 822 1,241 (419)
PROVISION FOR ESTIMATED LOSSES ON
REAL ESTATE OWNED (1,011) (1,011) (1,711) (1,711)
------- ----- ------- ------- ------ -------
$ (395) $ 949 $(1,344) $ 46 $1,415 $(1,369)
------- ----- ------- ------- ------ -------
------- ----- ------- ------- ------ -------
</TABLE>
The costs included in the table above (and, therefore, excluded from
operating costs (see OPERATING COSTS), reflect holding costs directly
attributable to the portfolio of real estate owned assets.
Net revenues from owned properties principally include the net operating
income (collected rental revenues less operating expenses and certain
renovation costs) from foreclosed apartment buildings or receipt, following
foreclosure, of similar funds held by receivers during the period the
original loan was in default. During the three and six months ended June 30,
1996, provisions for estimated losses on foreclosed real estate in the
amounts of $1.0 million and $1.7 million, respectively, were recorded,
principally associated with a continued decline in value on certain owned
non-apartment properties and higher-than-expected renovation costs for the
Company's owned apartment portfolio. During the six months ended June 30,
1996, the Company sold 103 properties generating net proceeds of $29.3
million and aggregate net recoveries of $1.3 million. During the three
months ended June 30, 1996, the Company sold 52 properties generating net
proceeds of $18.5 million and aggregate net recoveries of $0.6 million.
As of June 30, 1996, the Company's portfolio of properties consisted of
240 individual homes, apartment buildings, and land parcels. In addition, as
of that date the Company's defaulted loan portfolio was represented by 84
loans and its portfolio of performing project concentration loans secured 430
individual homes. See RISK ASSETS. Because of the large aggregate number of
units represented by these risk portfolios, management expects that the costs
incurred to manage the property disposal and loan restructuring operations of
the Company, plus the holding costs associated with these portfolios (other
than interest lost following a loan's default and subsequent foreclosure),
will continue to be significant for the next several quarters.
OTHER NON-OPERATING REVENUES
Other non-operating revenues include gain on sale of loans, gain on sale
of securities, gain on sale of other assets, and other revenues. For the six
months ended June 30, 1996, other operating revenues included (1) gains of
$6.5 million primarily as a result of the $185.2 million branch deposit sale,
(2) gains of $0.2 million as a result of $68.9 million in loan sales, (3) legal
recoveries of $0.2 million and (4) other expenses of $0.2 million primarily
due to an upward adjustment to the deferred loan fees balance, to correct for
overamortization in prior periods. For the six months ended June 30, 1995,
other non-operating revenues included (1) gains of $3.0 million primarily as
a result of the sale of $11.5 million in marketable equity securities, (2) legal
recoveries of $0.4 million, (3) a gain of $0.1 million on the sale of
$17.1 million in branch deposits and (4) a gain of $0.1 million on the sale of
$19.2 million in loans.
15
<PAGE>
INCOME TAXES
At December 31, 1995, the Company retained accumulated income tax
benefits of $35.5 million, which principally consisted of net operating loss
carryforwards. The utilization of these net operating loss carryforwards is
limited to the demonstrated ability of the Company to generate pretax
earnings during the carryforward period, which generally runs for fifteen
years from the date the loss was generated. In accordance with Statement of
Financial Accounting Standards No. 109, ACCOUNTING FOR INCOME TAXES ("SFAS
109"), the Company recorded an income tax benefit of $1.2 million and
$3.5 million, respectively, during the three and six months ended June 30, 1996.
Among other things, SFAS 109 permits the recognition of an income tax
benefit, and the corresponding recording of a deferred tax asset, to the
extent pretax earnings are reasonably expected to be generated. For
regulatory capital purposes, the Office of Thrift Supervision ("OTS") limits
the cumulative amount of any deferred tax asset to the lesser of pretax
earnings reasonably expected to be generated during the succeeding twelve
month period or 10% of an institution's tangible capital. At June 30, 1996,
the deferred tax asset recorded by the Company represented 6.5% of the Bank's
tangible capital.
FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY AND ASSET QUALITY
ASSETS
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, deposits at
correspondent banks and Federal funds sold. The Company maintains balances
at correspondent banks to cover daily inclearings, wire activities and other
charges. Cash and cash equivalents at June 30, 1996, were $34.0 million, an
increase from $14.0 million at December 31, 1995. This increase in cash
balances at June 30, 1996, was due to the accumulation of excess cash in the
second quarter in anticipation of the sale of deposits from the Company's
three San Diego branches at the end of June. The excess cash was made
available through two loan sales totaling approximately $68.9 million, as well
as deposit growth in the Company's remaining six branches.
INVESTMENT SECURITIES
The cost basis and estimated fair value of investment securities
available-for-sale are summarized as follows (dollars are in thousands):
June 30, 1996
-----------------------------------------------
Estimated
Amortized Gross Unrealized Fair
------------------
Cost Gains Losses Value
----------- -------- --------- ------------
U.S. Government $ 38,588 $ 14 $ (154) $ 38,448
----------- -------- --------- ------------
----------- -------- --------- ------------
December 31, 1995
-----------------------------------------------
Estimated
Amortized Gross Unrealized Fair
------------------
Cost Gains Losses Value
----------- -------- --------- ------------
U.S. Government $ 62,787 $ 11 $ (5) $ 62,793
----------- -------- --------- ------------
----------- -------- --------- ------------
The available-for-sale amounts at June 30, 1996 and December 31, 1995,
include U.S. Government securities purchased with proceeds from the
recapitalization of the Company in December 1995 that have been pledged as
security for the payment of interest expense associated with the Senior Notes
(as defined herein) that were issued in the recapitalization. These pledged
securities had a cost basis and fair value of $4.1 million and $4.0 million,
respectively, at June 30, 1996.
16
<PAGE>
The cost basis and estimated fair value of investment securities
available-for-sale at June 30, 1996, are summarized by contractual maturity
as follows (dollars are in thousands):
Estimated
Fair
Cost Basis Value
------------ -----------
Due in less than one year $ 1,633 $ 1,627
Due in one year through five years 36,955 36,821
------------ -----------
$ 38,588 $ 38,448
------------ -----------
------------ -----------
REAL ESTATE LOANS
GENERAL
The two tables below set forth the composition of the Company's loan
portfolio, and the percentage of composition by type of security, delineated
by the year of origination and in total, as of the dates indicated (dollars
are in thousands).
June 30, 1996
-------------------------------------
Pre-1995 Post-1994 Total
----------- ----------- -----------
PERMANENT
Single family (non-project)
Estate $ - $ 86,855 $ 86,855
Other 125,325 21,287 146,612
Loan concentrations 64,717 1,102 65,819
Multi-family
2 to 4 units 28,334 11,186 39,520
5 or more units 133,506 108,087 241,593
Commercial 2,716 57,512 60,228
Land 851 2,757 3,608
RESIDENTIAL CONSTRUCTION 58,511 58,511
OTHER 18 1,591 1,609
----------- ----------- -----------
GROSS LOANS RECEIVABLE $ 355,467 $ 348,888 $ 704,355
----------- ----------- -----------
----------- ----------- -----------
17
<PAGE>
<TABLE>
<CAPTION>
June 30, 1996 December 31, 1995 June 30, 1995
------------------- -------------------- --------------------
Balance Percent Balance Percent Balance Percent
--------- --------- ---------- --------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
PERMANENT LOANS
Single family
Non-project $ 233,467 33.1% $ 255,956 39.0% $ 244,371 42.1%
Loan concentrations 65,819 9.3% 67,189 10.2% 72,540 12.5%
Multi-family
2 to 4 units 39,520 5.6% 44,640 6.8% 47,269 8.2%
5 or more units 241,593 34.4% 216,420 33.0% 184,629 31.9%
Commercial 60,228 8.6% 31,258 4.8% 7,407 1.3%
Land 3,608 0.5% 5,579 0.9% 3,779 0.7%
RESIDENTIAL CONSTRUCTION 58,511 8.3% 33,347 5.1% 16,525 2.9%
OTHER 1,609 0.2% 1,554 0.2% 2,226 0.4%
--------- --------- ---------- --------- ---------- ---------
GROSS LOANS RECEIVABLE 704,355 100.0% 655,943 100.0% 578,746 100.0%
--------- --------- ---------
--------- --------- ---------
LESS
Participants' share (2,493) (2,219) (1,949)
Undisbursed loan funds (33,605) (15,208) (5,855)
Deferred loan fees and
credits, net (8,190) (5,996) (3,676)
Allowance for estimated losses (15,762) (15,192) (20,690)
--------- ---------- ----------
NET LOANS RECEIVABLE $ 644,305 $ 617,328 $ 546,576
--------- ---------- ----------
--------- ---------- ----------
</TABLE>
The Company's loan portfolio is exclusively concentrated in Southern
California real estate. At June 30, 1996 and 1995, respectively, 42% and 55%
of the Company's loan portfolio consisted of permanent loans secured by
single family residences, 40% and 40% consisted of permanent loans secured by
multi-unit residential properties, and 18% and 5% consisted of loans to
finance commercial properties, the acquisition of land and the construction
of single family housing.
Historically, the Company actively financed the construction of
residential properties, principally small-to-medium sized tracts of detached
single family homes and condominiums, and small apartment buildings
(generally, less than 37 units). With respect to for-sale housing
developments, the Company typically provided permanent financing to buyers of
individual homes and condominiums within projects for which it provided the
construction financing. In addition, the Company generally provided a
permanent loan commitment following its financing for the construction of
apartment buildings.
The Company's performance continues to be adversely affected by the
weakness evident in its portfolio of loans originated prior to 1994 and a
high volume of foreclosures associated with this pre-1994 portfolio, though
foreclosures have been declining over the past six quarters. These asset
quality trends reflect the general weakness of the Southern California
economy, and the direct translation of this weakness to local real estate
markets. These factors have been, and will continue to be, exacerbated by
several factors unique to the Company's loan portfolio, including (1) its
portfolio of loans secured by apartment buildings, for which property cash
flows are, or may become, inadequate to meet borrowers' debt service
requirements, (2) the concentration within the Company's loan and property
portfolios of multiple permanent loans and foreclosed properties within a
single integrated development, and (3) the concentration within the Company's
portfolio of loans to one or more individuals, or groups of individuals,
who are affiliated and with respect to which there remain limited financial
resources to fund debt service payments where property cash flows (either
from sales of homes or from income property cash flows) are, or may become,
inadequate.
18
<PAGE>
LENDING OPERATIONS
During 1995, the Company aggressively re-entered the mortgage finance
business, specializing in providing financings secured by income properties,
very expensive homes and residential construction projects. For the eighteen
months ended June 30, 1996, the Company originated $364.7 million of
permanent loans and construction loan commitments.
The Company's principal competitors in its pursuit of new permanent
financing business generally exclude the large, in-market banking and thrift
companies, principally because these companies do not offer products similar
to those on which the Company now focuses, including financings secured by
income-producing properties and very expensive homes. The Company's
principal competition for this business tends to come from FDIC-insured
thrift and loans (income property financings), small-to-medium sized life
insurance companies and mortgage conduits (income property financings) and
large investment banking companies (estate financing). On the other hand,
competition in the conventional permanent loan business, which is the
smallest component of the Company's business, is widespread and extremely
price competitive.
To acquire new business which meets the Company's goals for
profitability, return on capital and credit quality, the Company offers
prospective borrowers efficient and effective service (e.g., quick and
comprehensive response to financing requests and timely funding), a
willingness to tailor the terms and conditions of the transaction to
accomplish the borrower's objectives (while satisfying the Company's credit
standards), and a real estate orientation which generally permits the Company
to contribute proactively in helping borrowers accomplish their near-term or
long-term financial objectives. Management believes these attributes, taken
together, clearly distinguish the Company from its competitors and permit the
Company to charge a premium price for its permanent financing products
(except for the modest amount of financings involving conventional single
family loan transactions). The Company obtains its permanent financing
sourcing through independent mortgage brokers, rather than through a captive
sales force.
Unlike the Company's narrowly focused permanent financing businesses,
its pursuit of development financing opportunities is very competitive, with
banks and thrifts of all sizes generally being active in the marketplace.
Generally, pricing and underwriting standards in this market are defined
around a fairly narrow range. In this environment, the Company distinguishes
itself from its competitors by offering prospective customers efficient
pre-funding evaluation and post-funding funds control, as well as an intimate
knowledge of the development process. Unlike the Company's permanent
financing businesses, development financing is generally sourced directly
from builders and developers.
19
<PAGE>
RISK ASSETS
At June 30, 1996, the Company's problem asset ratios were far higher than
those of most lenders within its lending markets. The table below sets forth
the composition, measured by gross and net investment, of the Company's Risk
Asset portfolio. Risk Assets include owned properties, nonaccrual loans, and
performing loans which have been adversely classified pursuant to OTS
regulations and guidelines ("Performing/Classified" loans). Loans categorized
as "Special Mention" are not classified pursuant to regulatory guidelines, but
are included in these tables as a broader indication of the Company's asset
quality (dollars are in thousands).
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31, JUNE 30,
1996 1995 1995
-------- ------------ ---------
<S> <C> <C> <C>
PROPERTIES $ 34,313 $ 53,630 $ 77,016
NONACCRUAL LOANS 22,576 21,709 23,222
Performing loans
Classified Loss, Doubtful and Substandard 63,828 57,049 58,592
Designated Special Mention 59,990 54,851 63,655
-------- -------- --------
GROSS RISK ASSETS 180,707 187,239 222,485
LESS
Specific reserves (16,265) (18,049) (23,522)
General reserves (8,141) (11,160) (6,834)
-------- -------- --------
NET RISK ASSETS $156,301 $158,030 $192,129
-------- -------- --------
-------- -------- --------
NET LOANS RECEIVABLE
AND PROPERTIES $666,709 $655,233 $610,085
-------- -------- --------
-------- -------- --------
PERCENTAGE TO NET LOANS RECEIVABLE AND PROPERTIES
Net risk assets 23.4% 24.1% 31.5%
-------- -------- --------
-------- -------- --------
Net classified assets (Net risk assets less
net designated Special Mention) 14.8% 16.2% 24.0%
-------- -------- --------
-------- -------- --------
PERCENTAGE OF NET CLASSIFIED ASSETS TO CORE CAPITAL 184.4% 244.3% 515.4%
-------- -------- --------
-------- -------- --------
</TABLE>
The Company currently places loans on nonaccrual status when (1) they
become one or more payments delinquent or (2) management believes that, with
respect to performing loans, continued collection of principal and interest from
the borrower is not reasonably assured.
The performance of the Company's loan portfolio continued to improve during
the quarter, consistent with the improvement realized since 1993. The carrying
value of nonperforming assets (i.e., foreclosed properties, loans delinquent one
or more payments and performing loans placed on nonaccrual status) declined to
$40.5 million, or 5.3% of total assets, at June 30, 1996, from $55.5 million, or
7.4% of total assets, at December 31, 1995, and $80.8 million, or 11.5% of total
assets, at June 30, 1995. The carrying value of nonperforming assets peaked at
more than $150.0 million in early 1994. The reduction in nonperforming assets
reflects the continued sales of foreclosed properties and the decrease in the
rate of borrower defaults. As described above, the Company places any loan
delinquent one or more payments on nonaccrual status and includes such amounts
as loans in default for reporting purposes. At June 30, 1996, December 31, 1995
and June 30, 1995, the principal amount of nonaccrual loans included $6.6
million, $10.4 million and $9.8 million, respectively, of loans with respect to
which payments were either current or delinquent less than three payments.
Management classifies the Company's performing loans based upon
objective and measurable criteria. For single family-secured (non-project)
loans, loans are classified or designated Special Mention based upon a risk
grading approach, which considers the value of the Company's collateral in
relation to the balance of the Company's loan, the borrower's recent and
historical performance, the borrower's credit profile and other factors.
Performing loans within loan concentrations (see LOAN CONCENTRATIONS) are
classified or designated Special Mention based upon the recent and historical
performance of the permanent loans originally made by the Company to finance
the purchase of units by individuals from the developer, supply and demand
trends for units in each individual project and pricing trends for units.
Performing apartment loans are classified or designated Special Mention based
upon the debt service coverage afforded by current property cash flows and
the valuation of the Company's collateral based
20
<PAGE>
upon current and stabilized property cash flows and the imposition of current
market capitalization rates. Through June 30, 1996, management has completed
one or more loan and collateral reviews for virtually all of the Company's
loan concentration and apartment-secured loan portfolios and for over 50% of
the Company's pre-1994 single family residence-secured loans. Because of the
generally empirical approach to loan classification applied by the Company,
management believes that any future decrease in the Company's classified
assets will result from either (1) borrower defaults, which will result in
foreclosure and sale of the Company's collateral, or (2) an improvement in
the underlying economics which support the Company's collateral (i.e., higher
operating cash flows from apartment buildings, higher prices for units
securing concentration loans).
The table below shows the Company's gross loan portfolio, by
classification, as of June 30, 1996 (dollars are in thousands).
<TABLE>
<CAPTION>
CLASSIFIED LOANS
-----------------------
SPECIAL LOSS, DOUBTFUL NONACCRUAL
PASS MENTION AND SUBSTANDARD LOANS TOTAL
-------- ------- --------------- ----------- --------
<S> <C> <C> <C> <C> <C>
Single family homes
Non-project $206,067 $10,210 $ 8,170 $ 9,020 $233,467
Loan concentrations 32,204 19,485 7,306 6,824 65,819
Multi-family
2 to 4 units 34,867 1,943 1,822 888 39,520
5 or more units 172,129 24,721 38,943 5,800 241,593
Commercial properties 50,409 2,623 7,196 60,228
Land 2,165 1,008 391 44 3,608
Residential construction
SFR 36,562
36,562
Tract development 21,949 21,949
Other collateralized loans 1,609 1,609
-------- ------- ------- ------- --------
$557,961 $59,990 $63,828 $22,576 $704,355
-------- ------- ------- ------- --------
-------- ------- ------- ------- --------
</TABLE>
SINGLE FAMILY (NON-PROJECT)
In the preceding table, non-project single family homes consist of
defaulted, performing/classified and nonclassified loans secured by single
family homes which are not part of an integrated development with respect to
which the Company financed the construction of the development or financed the
purchase of homes from the developer by individuals. At June 30, 1996, the
Company (1) owned 9 homes which were being actively marketed for sale, (2) had
41 defaulted loans secured by single family (non-project) homes, (3) had 21
loans which were performing but had been classified "Substandard", and (4) had
51 loans which were performing but had been designated "Special Mention". The
Company has valued its owned single family homes at their estimated net
liquidation values. The defaulted loan portfolio secured by single family homes
(non-project) has been valued, in the aggregate, consistently with the Company's
historical migration and loss rates.
LOAN CONCENTRATIONS
Prior to 1994, the Company made permanent loans, amortizing over, and
maturing at the end of, thirty years, to a large number of purchasers of
individual units from developers in for-sale housing developments with respect
to which the Company financed construction. A majority of these permanent
"takeout" loans were originated during the period 1988 through 1992 and were
made on terms that fell outside the parameters normally associated with
conforming or conventional single family home loans.
Because most of these loans were made on favorable terms to foster sales of
units in developments in which unit sales were sluggish, and because the current
retail value of units in many developments has declined significantly when
compared with the stated purchase price paid by the Company's borrowers, the
performance of this portfolio has been extremely poor.
21
<PAGE>
At the peak in early 1994, management had identified 63 separate loan
concentrations, involving loan principal of $90.6 million and foreclosed
inventory of $23.3 million. Approximately two-thirds of this aggregate
investment was in 13 projects, with respect to which the Company had provided
the initial takeout loans for over 50% of the units in the project or had
foreclosed upon more than 50% of the entire project prior to the sale of
completed units. At June 30, 1996, the Company's aggregate investment in its
portfolio of loan concentrations (loan principal plus foreclosed inventory
before reserves) consisted of 53 separate loan concentrations totaling $70.7
million. This represents a decrease of $43.2 million, or 38%, principally as
the result of foreclosure of the Company's collateral, sales of foreclosed units
and the acceptance of discounted payments from borrowers on several loans. At
June 30, 1996, the Company owned 51 foreclosed units and 25 loans, representing
$3.7 million of loan principal, which were delinquent one or more payments.
Management expects that the performance of this portfolio will continue to
be quite poor, principally because the underlying risk factors which have given
rise to the historically poor performance - poorly-qualified borrowers and
significant declines in the value of the Company's collateral - are not expected
to change in the near-term.
APARTMENT BUILDINGS
At June 30, 1996, the Company owned 27 apartment buildings, and loans
secured by 17 apartment buildings were in default. The Company's foreclosed
inventory and its defaulted loan collateral are predominantly located in the
South Bay region of Los Angeles, are between five and ten years old and average
less than 15 units in size.
Prior to late 1995, management determined to accumulate the Company's
portfolio of foreclosed apartment buildings and to operate them for their
cash flow yield. During the Company's holding period, the Company's internal
property management staff made necessary capital improvements to each
property and upgraded the quality of each buildings' tenants. In September
1995, management commenced an aggressive sales program to liquidate the
Company's then portfolio of 71 buildings, premised upon its belief that the
buildings had reached sustainable cash flow production and had been improved
to the extent required to command a retail, as opposed to a wholesale, price
in the market. Commencing in September 30, 1995 and continuing through June
30, 1996, virtually all of the Company's initial inventory of buildings had
been sold, largely leaving buildings foreclosed upon during the last three
quarters in inventory at the end of June 1996. The Company has financed all
building sales involving five or more units, generally on market terms (i.e.,
the 11th DCOFI plus 3.00%, with downpayments by purchasers of between 20% and
25%). These financings have been discounted to provide the Company with a
yield to maturity equivalent to the 11th DCOFI plus 4.00%, which yield
approximates the Company's marginal lending rate for new, apartment-secured
financings.
The Company records its investment in foreclosed apartment buildings at
their fair market values, generally by reference to the existing and
projected cash flows generated by the building and the application of
appropriate market capitalization ratios. Management has concluded that the
maximum benefit to the Company is obtainable through the orderly liquidation
of this portfolio.
The carrying value of the defaulted apartment loan portfolio has been
determined on the same basis as for owned apartment buildings, where property-
specific information is available, or based upon the average per unit valuation
for owned buildings of similar unit size and unit mix. For performing apartment
loans either classified "Substandard" or designated "Special Mention", reserves
have been established based upon property-specific valuations which utilize
current cash flows and estimated stabilized cash flows and incorporate
management's assessment of future event risk.
22
<PAGE>
RESIDENTIAL CONSTRUCTION
At June 30, 1996, the Company maintained investments in 4 residential
construction developments previously acquired through foreclosure. These
developments, when completed, will entail the construction and sale of 275
homes. At June 30, 1996, the Company had sold 191 homes in these developments,
18 homes had been completed and had not been sold, and 66 homes remained to be
built or are model units. The cost to complete construction of the remaining
homes within these developments (approximately $11.0 million) has been
incorporated into the carrying values for each development at June 30, 1996.
LAND
At June 30, 1996, the Company's portfolio of owned land parcels consisted
of 5 properties with a net carrying value of $2.3 million. The Company also had
3 classified loans totaling $1.4 million. The Company's investment in land has
been valued by reference to comparable land sales (where available), current
appraisals and discounted cash flow land residual analyses.
CREDIT LOSSES
The Company maintains reserves against specific assets in those instances
in which it believes that full recovery of the Company's gross investment is
unlikely. As of June 30, 1996, the Company had established specific reserves
based upon (1) management's strategy in managing and disposing of the asset and
the corresponding financial consequences, (2) current indications of property
values from (a) complete, recent sales from the Company's property portfolio,
(b) real estate brokers, and (c) potential buyers of the Company's properties,
and (3) current property appraisals. In addition, management establishes
general valuation allowances ("GVA") against its loan and property portfolios
when sufficient information does not exist to support establishing specific
reserves. The loss factors utilized to establish general reserves are based
upon (1) the actual loss experience for similar loans and properties within the
Company's portfolio, when such loss experience is available and representative
of the assets being valued, or (2) estimates of current liquidation values for
collateral securing performing loans for a representative sampling of each
portfolio segment.
The table below sets forth the amounts and percentages of general and
specific reserves for the Company's loan and property portfolios as of June 30,
1996 (dollars are in thousands).
<TABLE>
<CAPTION>
LOANS
--------------------------
PERFORMING IN DEFAULT PROPERTIES TOTAL
---------- ---------- ---------- -------
<S> <C> <C> <C> <C>
AMOUNTS
Specific reserves $ 2,371 $3,279 $10,615 $16,265
General reserves 8,933 1,179 1,294 11,406
------- ------ ------- -------
Total reserves for estimated losses $11,304 $4,458 $11,909 $27,671
------- ------ ------- -------
------- ------ ------- -------
PERCENTAGES
% of total reserves to gross investment 1.8% 19.7% 34.7% 4.0%
% of general reserves to gross investment 1.4% 5.2% 3.8% 1.6%
</TABLE>
23
<PAGE>
The table below summarizes the activity of the Company's reserves for the
periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
1996 1995 1996 1995
------------- ------------ ------------- ----------
<S> <C> <C> <C> <C>
LOANS
Balance at beginning of period $15,353 $ 26,019 $15,192 $ 21,461
Provision for estimated losses 2,489 3,689 12,700
Transfer to property and other reserves (234) (2,796) 166 (9,407)
Charge-offs (1,846) (2,533) (3,285) (4,066)
------- -------- ------- --------
Balance at end of period $15,762 $ 20,690 $15,762 $ 20,690
------- -------- ------- --------
------- -------- ------- --------
PROPERTIES
Balance at beginning of period $12,317 $35,045 $15,725 $ 33,517
Provision for estimated losses 1,011 1,711
Transfer from loan reserves 234 2,796 (166) 9,407
Charge-offs (1,653) (24,334) (5,361) (29,417)
------- -------- ------- --------
Balance at end of period $11,909 $ 13,507 $11,909 $ 13,507
------- -------- ------- --------
------- -------- ------- --------
</TABLE>
24
<PAGE>
Because the Company's loan and property portfolios are not homogeneous,
but rather consist of discreet segments with different collateral and
borrower risk characteristics, management separately measures reserve
adequacy, and establishes and maintains reserves for credit losses, for each
identifiable segment of its property and loan portfolios. The table below
summarizes credit loss reserves (dollars are in thousands).
JUNE 30, 1996
-----------------------------------
LOANS PROPERTIES TOTAL
-------- ------------- ----------
PERMANENT
Single family homes
Non-project $ 2,097 $ 300 $ 2,397
Loan concentrations 4,206 1,980 6,186
Multi-family
2 to 4 units 1,151 483 1,634
5 or more units 7,074 1,938 9,012
Commercial 987 105 1,092
Land 128 980 1,108
RESIDENTIAL CONSTRUCTION 119 6,123 6,242
-------- ------------- ----------
$ 15,762 $ 11,909 $ 27,671
-------- ------------- ----------
-------- ------------- ----------
REAL ESTATE OWNED
Real estate acquired in satisfaction of loans is transferred from loans
to properties at estimated fair values, less any estimated disposal costs.
The difference between the fair value of the real estate collateral and the
loan balance at the time of transfer is recorded as a loan charge-off. Any
subsequent declines in the fair value of the properties after the date of
transfer are recorded through the establishment of, or additions to, specific
reserves. Recoveries and losses from the disposition of properties are also
included in REAL ESTATE OPERATIONS.
The table below summarizes the composition of the Company's property
portfolio at June 30, 1996 and 1995 and at December 31, 1995 (dollars are in
thousands).
JUNE 30, DECEMBER 31, JUNE 30,
1996 1995 1995
--------- ------------- ----------
SINGLE FAMILY RESIDENCES
Non-project $ 2,135 $ 4,975 $ 3,638
Loan concentrations 5,596 6,419 10,916
MULTI-FAMILY
2 to 4 units 1,930 3,840 1,478
5 or more units 6,539 18,877 32,625
COMMERCIAL 346 346 346
LAND 3,286 3,759 7,719
RESIDENTIAL CONSTRUCTION 14,481 15,414 20,294
--------- ------------- ----------
GROSS INVESTMENT (1) 34,313 53,630 77,016
ALLOWANCE FOR ESTIMATED LOSSES (11,909) (15,725) (13,507)
--------- ------------- ----------
NET INVESTMENT $ 22,404 $ 37,905 $ 63,509
--------- ------------- ----------
--------- ------------- ----------
- ------------------------
(1) Loan principal at foreclosure, plus post-foreclosure capitalized costs,
less cumulative charge-offs.
25
<PAGE>
OFFICE PROPERTY AND EQUIPMENT
At June 30, 1996, the Company's office property and equipment of $5.1
million was down from $9.6 million at December 31, 1995. The decrease was
primarily due to $3.7 million in sales of branch facilities, of which $2.2
million related to the sale of the Company's Oceanside branch office facility
in February 1996 and $1.5 million related to the sale of the Company's Rancho
Bernardo and Vista branch facilities in June 1996, in conjunction with the
sale of deposits at the Company's three San Diego branches. A gain of $6.4
million was recorded on the sale of these deposits and facilities and is
included in gain on sale of other assets.
LIABILITIES
GENERAL
The Company derives funds principally from deposits and, to a lesser
extent, from borrowings from the FHLB. In addition, recurring cash flows are
generated from loan repayments and payoffs and, since late 1993, from sales
of foreclosed properties. In addition to the Company's recurring sources of
funds, the Company has generated funds by identifying certain of its
securities and seasoned real estate loans as available-for-sale, and selling
such assets in the open market. During 1995 and 1996, the Company sold
$88.1 million of loan principal secured primarily by single family homes
originated prior to 1994 and $93.3 million of securities. Generally, the
Company no longer originates the types of loans which have been, or will be,
sold and the proceeds therefrom have been redeployed in the Company's current
financing activities.
DEPOSITS
Total deposits at June 30, 1996, were $622.0 million, a decrease from
$698.0 million at December 31, 1995, and $670.0 million at June 30, 1995. In
June 1996 the Company sold the deposits housed in its three San Diego County
branches. At the time of the sale, these branches had total deposits of
$185.2 million. The Company funded the transfer of deposits with a
combination of borrowings from the FHLB (see BORROWINGS) and excess
liquidity, which had been accumulated through loan sales totaling $68.9
million and deposit growth at the Company's remaining six branches.
The table below summarizes the balances, weighted average interest rates
("WAIR") and weighted average remaining maturities in months ("WARM") for the
Company's deposits (dollars are in thousands).
<TABLE>
<CAPTION>
JUNE 30, 1996 DECEMBER 31, 1995
--------------------------- -----------------------------
DESCRIPTION BALANCE WAIR WARM BALANCE WAIR WARM
- ------------------------ --------- ------- --------- ---------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Transaction accounts $ 70,699 1.23% - $ 94,459 1.19% -
Certificates of Deposit
7 day maturities 58,345 4.59% 60,552 4.78%
Less than 6 months 18,564 4.65% 2 28,053 4.69% 2
6 months to 1 year 343,487 5.40% 5 356,013 5.74% 5
1 year to 2 years 84,349 5.96% 9 90,432 5.85% 9
Greater than 2 years 46,521 6.00% 15 68,499 6.08% 16
--------- ------- --------- ---------- -------- --------
Total $ 621,965 4.95% 5 $ 698,008 5.04% 5
--------- ------- --------- ---------- -------- --------
--------- ------- --------- ---------- -------- --------
</TABLE>
26
<PAGE>
BORROWINGS
A primary alternative funding source for the Company is a $200.0 million
credit line with the FHLB. The FHLB system functions as a source of credit
to savings institutions which are members of a Federal Home Loan Bank System.
Advances are typically secured by the Company's mortgage loans and the
capital stock of the FHLB owned by the Company. Subject to the FHLB of San
Francisco's advance policies and requirements, these advances can be
requested for any business purpose in which the Company is authorized to
engage. In granting advances, the FHLB considers a member's credit
worthiness and other relevant factors.
The balance and rate of the Company's FHLB advances at June 30, 1996, are
summarized as follows (dollars are in thousands).
TERM PRINCIPAL RATE
----------- --------- -----
1 Month $ 25,000 5.71%
4 Months 25,000 5.82%
12 Months 25,000 6.24%
--------- -----
$ 75,000 5.92%
--------- -----
--------- -----
SENIOR NOTES
The Company has Senior Notes, which have a face amount of $13.5 million,
and a current, amortized fair value of $12.2 million at June 30, 1996. The
Senior Notes carry an annual stated interest rate of 12% and have an annual
effective rate of approximately 16.5%, after the recording of original issue
discount ("OID") of $1.5 million. The OID is accreted using the constant
yield method over the five year term of the Senior Notes. Interest, which is
required to be paid semi-annually at the stated interest rate, has been
prefunded for three years out of the proceeds of the Company's recapitalization
in December 1995. This prefunded interest of $4.9 million was invested in
U.S. Government securities. Thereafter, interest will be payable either in
cash or, as permitted by the relevant agreements, in an equivalent value
(determined in accordance with the provisions of the relevant agreement) in
common stock of the Company.
CAPITAL
The Financial Institutions Reform, Recovery and Enforcement Act of 1989
("FIRREA") and the capital regulations of the OTS thereunder require the Bank to
maintain (1) Tangible Capital of at least 1.5% of Adjusted Total Assets (as
defined in the regulations); (2) Core Capital of at least 3.0% of Adjusted Total
Assets (as defined in the regulations); and (3) Total Risk-based Capital of at
least 8.0% of Total Risk-weighted Assets (as defined in the regulations).
27
<PAGE>
The following table summarizes the regulatory capital requirements under
FIRREA for the Bank at June 30, 1996. As indicated in the table, the Bank's
capital levels exceed all three of the currently applicable minimum FIRREA
capital requirements (dollars are in thousands).
<TABLE>
<CAPTION>
TANGIBLE CAPITAL CORE CAPITAL RISK-BASED CAPITAL
---------------- --------------- ------------------
BALANCE % BALANCE % BALANCE %
-------- ------ -------- ----- -------- -------
<S> <C> <C> <C> <C> <C> <C>
Stockholders' equity $ 53,368 $ 53,368 $ 53,368
Adjustments
General valuation allowances 6,494
Unrealized (gains) losses 102 102 102
Interest rate risk component (1)
-------- ------ -------- ----- -------- -------
Regulatory capital 53,470 7.06% 53,470 7.06% 59,964 11.62%
Required minimum 11,357 1.50% 22,714 3.00% 41,272 8.00%
-------- ------ -------- ----- -------- -------
Excess capital $ 42,113 5.56% $ 30,756 4.06% $ 18,692 3.62%
-------- ------ -------- ----- -------- -------
-------- ------ -------- ----- -------- -------
Adjusted assets (2) $757,137 $757,137 $515,900
-------- -------- --------
-------- -------- --------
</TABLE>
- -------------------
(1) At June 30, 1996, the OTS had temporarily suspended the application
of its interest rate risk regulation. Had the regulation been in
effect at June 30, 1996, the Bank would not have been required to
deduct from risk-based capital any amount due to an interest rate
risk exposure component as computed by the OTS as one-half of the
excess of the estimated change in the Bank's net portfolio value
(determined in accordance with OTS regulations) over a normal change
in net portfolio value (2%) assuming an immediate and sustained
200 basis point increase in interest rates, using the Bank's reported
balance sheet information as of March 31, 1996.
(2) The term "adjusted assets" refers to the term "adjusted total assets"
as defined in 12 C.F.R. Section 567.1(a) for purposes of tangible and
core capital requirements, and for purposes of risk-based capital
requirements, refers to the term "risk-weighted assets" as defined in
12 C.F.R. Section 567.1(b).
Under the Federal Deposit Insurance Corporation Improvement Act ("FDICIA"),
which supplemented FIRREA, the OTS has issued "prompt corrective action"
regulations with specific capital ranking tiers for thrift institutions.
Progressively more stringent operational limitations and other corrective
actions are required as an institution declines in the capital ranking tiers.
Principal elements of the five qualifying tiers are set forth below.
<TABLE>
<CAPTION>
RATIO OF RATIO OF
RATIO OF CORE CAPITAL TOTAL CAPITAL
CORE CAPITAL TO RISK-WEIGHTED TO RISK-WEIGHTED
TO TOTAL ASSETS ASSETS ASSETS
--------------- ---------------- ----------------
<S> <C> <C> <C>
Well capitalized 5% or above 6% or above 10% or above
Adequately capitalized 4% or above 4% or above 8% or above
Under capitalized Under 4% Under 4% Under 8%
Significantly undercapitalized Under 3% Under 3% Under 6%
Critically undercapitalized Ratio of tangible equity to adjusted total assets of 2% or less
</TABLE>
The Bank's ratios at June 30, 1996 are set forth below.
Ratio of Core Capital to Total Assets (Leverage ratio) 7.06%
Ratio of Core Capital to Risk-weighted Assets 10.36%
Ratio of Total Capital to Risk-weighted Assets 11.62%
At June 30, 1996, the Bank's capital ratios exceeded the capital ratio
requirements for the Bank to qualify as a "well capitalized" institution.
28
<PAGE>
The OTS has authority, after an opportunity for a hearing, to downgrade
an institution from "well-capitalized" to "adequately capitalized" or to
subject an "adequately capitalized" or "undercapitalized" institution to the
supervisory actions applicable to the next lower category, if the OTS deems
such action to be appropriate as a result of supervisory concerns.
The thrift industry is exposed to economic trends and fluctuations in
real estate values. In recent periods, those trends have been recessionary
in nature, particularly in Southern California. Accordingly, the trends have
adversely affected both the delinquencies being experienced by institutions
such as the Company and the ability of such institutions to recoup principal
and accrued interest through acquisition and sale of the underlying
collateral. No assurances can be given that such trends will not continue in
future periods, creating increasing downward pressure on the earnings and
capital of thrift institutions.
CAPITAL RESOURCES AND LIQUIDITY
The Company's liquidity position refers to the extent to which the
Company's funding sources are sufficient to meet its current and long-term
cash requirements. Federal regulations currently require a savings
institution to maintain a monthly average daily balance of liquid and
short-term liquid assets equal to at least 5.0% and 1.0%, respectively, of
the average daily balance of its net withdrawable accounts and short-term
borrowings during the preceding calendar month. The Bank had liquidity and
short-term liquidity ratios of 20.06% and 15.61%, respectively, as of June
30, 1996, and 8.50% and 5.95%, respectively, as of December 31, 1995.
The Company's current primary funding resources are deposit accounts,
principal payments on loans, proceeds from property sales, advances from the
FHLB and cash flows from operations. Other possible sources of liquidity
available to the Company include reverse repurchase transactions involving
the Company's investment securities, whole loan sales, commercial bank lines
of credit, and direct access, under certain conditions, to borrowings from
the Federal Reserve System. The cash needs of the Bank are principally for
the payment of interest on and withdrawals of deposit accounts, the funding
of loans, operating costs and expenses, and holding and refurbishment costs
on foreclosed properties.
INTEREST RATE RISK MANAGEMENT
The objective of interest rate risk management is to stabilize the
Company's net interest income ("NII") while limiting the change in its net
portfolio value ("NPV") from interest rate fluctuations. The Company seeks to
achieve this objective by matching its interest sensitive assets and
liabilities, and maintaining the maturity and repricing of these assets and
liabilities at appropriate levels given the interest rate environment. When the
amount of rate sensitive liabilities exceeds rate sensitive assets, the net
interest income will generally be negatively impacted during a rising rate
environment. The speed and velocity of the repricing of assets and liabilities
will also contribute to the effects on net interest income.
The Company utilizes two methods for measuring interest rate risk. Gap
analysis is the first method, with a focus on measuring absolute dollar amounts
subject to repricing within periods of time. With the majority of the focus
typically at the one-year maturity horizon, a negative gap occurs when the
interest sensitive liabilities maturing or repricing in a given period exceed
the interest sensitive assets maturing or repricing in that same period. The
negative one-year maturity gap indicates, absent offsetting factors, that the
Company has more exposure to interest rate risk in an increasing interest rate
environment.
In addition to utilizing gap analysis in measuring interest rate risk, the
Company performs periodic interest rate simulations. These simulations provide
the Company with an estimate of both the dollar amount and percentage change in
net interest income under various interest rate scenarios. All assets and
liabilities are subjected to tests of up
29
<PAGE>
to 400 basis points in increases and decreases in interest rates. Under each
interest rate scenario, the Company projects its net interest income and the
net portfolio value of its current balance sheet. From these results, the
Company can then develop alternatives for dealing with the tolerance
thresholds.
A principal mechanism used by the Company in the past for interest rate
risk management was the origination of ARMs tied to the 11th DCOFI. The
basic premise was that the Company's actual cost of funds would parallel the
11th DCOFI and, as such, the net interest margins would generate the desired
operating results. Loans having adjustable rate characteristics were 87% of
the Company's total dollar originations during 1995 and 80% for the six
months ended June 30, 1996. ARMs represented 77% and 75% of the Company's
loan portfolio at June 30, 1996, and December 31, 1995, respectively.
ARMs tied to 11th DCOFI are slower in responding to current interest
rate environments than other types of variable rate loans because the index
is a compilation of the average rates paid by member institutions of the 11th
District of the FHLB. This index typically lags market rate changes in both
directions. If interest rates on deposit accounts increase due to market
conditions and competition, it may be anticipated that the Company will,
absent offsetting factors, experience a decline in the percentage of net
interest income to average interest-earning assets (the "Net Interest
Margin"). A contributing factor would be the lag in upward pricing of the
ARMs tied to the 11th DCOFI. However, the lag inherent in the 11th DCOFI will
also cause the ARMs to remain at a higher rate for a longer period after
interest rates on deposits begin to decline. The 11th DCOFI lag during a
falling rate environment should benefit, in the short-term, the Company's Net
Interest Margin, but the actual dynamics of prepayments and the fact that
ARMs reprice at various intervals (and are subject to maximum periodic rate
adjustment limits) may alter this expected benefit (dollars are in
thousands).
<TABLE>
<CAPTION>
June 30, 1996 December 31, 1995 June 30, 1995
------------------ ----------------- -----------------
Balance Rate Balance Rate Balance Rate
--------- ------- --------- ------- --------- ------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets
Loans (1) $ 667,545 8.54% $ 637,472 8.22% $ 570,219 7.68%
Cash and investment securities 70,594 5.70% 77,357 4.60% 18,453 5.04%
Mortgage-backed securities 52,980 6.22%
--------- --------- ---------
738,139 8.26% 714,829 7.82% 641,652 7.49%
--------- ------ --------- ----- --------- -----
Interest-bearing liabilities
Deposit accounts (621,965) (5.03%) (698,008) (5.04%) (670,019) (5.06%)
Borrowings (75,000) (5.92%)
Senior notes (12,150) (16.50%) (12,006)(16.50%)
--------- --------- ---------
(709,115) (5.25%) (710,014) (5.32%) (670,019) (5.06%)
--------- ------ --------- ----- --------- -----
Interest-bearing gap/stated
interest margin 29,024 3.01% 4,815 2.50% (28,367) 2.20%
Nonaccrual loans (22,576) (0.26%) (21,709) (0.28%) (23,222) (0.28%)
--------- ------ --------- ----- --------- -----
Adjusted interest-bearing gap $ 6,448 2.75% $ (16,894) 2.22% $ (51,589) 1.92%
--------- ------ --------- ----- --------- -----
--------- ------ --------- ----- --------- -----
</TABLE>
- -------------------------
(1) Contractual yield, exclusive of the amortization of loan fees deferred at
origination.
30
<PAGE>
PROSPECTS
The Company successfully completed its recapitalization by the sale of
investment units in December 1995, from which the majority of the proceeds
($19 million) were contributed to the Bank as additional Tier 1 capital. As
a result, the Bank reported core and risk-based capital ratios at December
31, 1995, of 5.80% and 10.27%, respectively, which defined the Bank as a
"well-capitalized" institution for regulatory capital purposes. With the net
earnings reported for the six months ended June 30, 1996, the Bank's core and
risk-based capital ratios increased to 7.06% and 11.62%, respectively.
As described more fully elsewhere herein, the Company has been
successful since early 1995 in establishing itself as a provider of
financings secured by very expensive homes, income properties and residential
construction developments. These post-1994 financings account for about
one-half of the Company's total loans at June 30, 1996, and carry margins
well in excess of those associated with the Company's pre-1995 loans.
Management expects that the Company will continue to be successful in further
penetrating its target loan markets and will be able to price its financings
at a premium to more generic mortgages because of its service levels,
portfolio retention strategy and internal real estate expertise.
Accordingly, management expects that its post-1994 loan portfolio will
continue to grow as a percentage of total loans and will contribute to the
gradual growth in the Company's total assets and interest margin.
Management expects that the magnitude of the Company's Risk Assets will
continue to dilute the margins generated from the Company's new financing
activities. Though the Company has been successful in gradually reducing the
adverse impact to earnings of nonperforming assets, and the prospective risk
to earnings from performing, classified loans, the relationship of these
portfolios to total assets and to the Company's capital remain well above
peer levels. During the remainder of 1996, management will continue to employ
the strategies which have, to date, been successful in reducing these
portfolios, including (1) aggressively pursuing foreclosure of the Company's
collateral in those circumstances where the borrower defaults on their
obligation, (2) considering restructurings of individual loans, or groups of
loans, only in limited circumstances in which the borrowers have the financial
means and demonstrated intention of satisfying their obligations to the
Company, and (3) liquidating the Company's inventory of foreclosed properties
in an orderly fashion utilizing retail sales strategies.
GENERAL REGULATION
The FDIC administers two separate deposit insurance funds. The Bank
Insurance Fund ("BIF") insures the deposits of commercial banks and other
institutions that were insured by the FDIC prior to the enactment of the
FIRREA. The SAIF insures the deposits of savings institutions that were
insured by the Federal Savings and Loan Insurance Corporation ("FSLIC") prior
to the enactment of FIRREA. The FDIC is authorized to increase insurance
premiums payable by institutions of either fund if it determines that such
increases are appropriate to maintain the reserves of that fund or to pay the
costs of administration of the FDIC. In addition, the FDIC is authorized to
levy emergency special assessments on BIF and SAIF members.
FDIC deposit insurance premiums are assessed pursuant to a "risk-based"
system under which institutions are classified on the basis of capital ratios,
supervisory evaluations by their primary federal regulatory agency and other
information determined by the FDIC to be relevant. Each of nine resulting
subgroups of institutions is assigned a deposit insurance premium assessment
rate which, for SAIF-insured institutions, currently ranges from 0.23% to
0.31%. The Bank's current deposit insurance premium assessment rate is
0.29%.
The SAIF and the BIF are each required by statute to attain and
thereafter to maintain a reserve to deposits ratio of 1.25%. The BIF has
reached the required reserve level, whereas, based upon projections by the
FDIC, the SAIF is not expected to reach its targeted ratio until at least the
year 2002, or later. This disparity arises from the BIF's greater premium
revenues and the requirement that a substantial portion of the SAIF premiums
be used to repay bonds (commonly referred to as the "FICO Bonds") that were
issued by a specially created federal corporation for the purpose of funding
failed thrift institutions. In November 1995, the FDIC reduced its deposit
insurance premiums for BIF member institutions to a range of 0.00% of
deposits plus a statutory minimum of $2,000 in annual assessment per
institution to 0.27%, with an historical low average of approximately 0.04%,
effective beginning with the semiannual period commencing January 1, 1996.
The FDIC maintained the range of deposit insurance premiums assessable
against SAIF member institutions at 0.23% to 0.31%.
31
<PAGE>
The deposit premium rate disparity between BIF-insured institutions and
SAIF-insured institutions places SAIF-insured institutions at a significant
competitive disadvantage due to their higher premium costs and may worsen the
financial condition of the SAIF by leading to a shrinkage in its deposit
base. A number of proposals for assisting the SAIF in attaining its required
reserve level, and thereby permitting SAIF deposit insurance premiums to be
reduced to levels at or near those paid by BIF-insured institutions, have
been under discussion in Congress and among various of the affected parties
and relevant government agencies. Congress proposed, as part of the budget
reconciliation bill submitted to and vetoed by the President, a one-time,
special assessment on all savings institutions to recapitalize the SAIF. The
proposal would have required SAIF-insured institutions to pay a one-time
special assessment on January 1, 1996 (estimated to be between approximately
80 and 90 basis points on deposits) and would provide for a pro rata sharing
by all federally insured institutions of the obligation, now borne entirely
by SAIF-insured institutions, to repay the above-mentioned FICO Bonds.
Subsequent efforts to enact similar legislation have not been successful to
date. If such proposed legislation were ultimately to become law, the
special assessment would be reported in the Bank's Statement of Operations in
the quarter during which the budget reconciliation bill (or such other bill
to which such legislation may be attached) is finally agreed to by Congress
and signed by the President.
Both houses of Congress have recently passed legislation, which, if
signed by the President, will repeal the tax rules formerly applicable to bad
debt reserves of thrift institutions for taxable years beginning after
December 31, 1995. The Company will thereupon be required to change its tax
method of accounting for bad debts from the reserve method formerly permitted
under section 593 of the Internal Revenue Code (the "Code") to the "specific
charge-off" method effective as of the beginning of the tax year ending
September 30, 1997. Under the specific charge-off method, tax deductions may
be taken for bad debts only as and to the extent that the loans become wholly
or partially worthless. The pending legislation would generally require
thrift institutions, such as the Company, which have previously utilized the
section 593 reserve method to recapture (i.e., include in taxable income)
over a six-year period a portion of their existing bad debt reserves equal to
their "applicable excess reserves." The Company does not believe that any of
its bad debt reserves will be subject to such recapture. In addition, if the
pending legislation becomes law, the remainder of the Company's bad debt
reserve balance as of September 30, 1996 (approximately $22.5 million) will in
future years be subject to recapture in whole or in part upon the occurrence
of certain events such as a distribution to stockholders in excess of the
Company's current accumulated earnings and profits, a redemption of shares,
or upon a partial or complete liquidation of the Company. Contrary to
current law, the amount that would be subject to recapture under such
circumstances would be computed without regard to the portion of such
reserves that would have been allowed under the experience method. The
Company does not intend to make distributions to its stockholders that would
result in recapture of any portion of its bad debt reserves.
Management cannot predict whether or in what form legislation of the
types described above will be enacted or the effect of such legislation, if
adopted, on the Bank's operations and financial condition. Management
believes, however, that certain of the provisions of such proposed
legislation could benefit the Bank and its stockholders through eliminating
one source of financial uncertainty facing thrift institutions in the current
environment and by providing greater operating flexibility to pursue its
business strategies. A significant increase in SAIF premiums or a
significant surcharge to recapitalize the SAIF, however, would have an
adverse effect on the operating expenses and results of operations of the
Bank and the Company during the period thereof and would reduce the Bank's
regulatory capital on at least a temporary basis.
32
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings
On October 12, 1995, the Company and the directors of the Company,
excluding Mr. Herbst, were named as defendants in a class and
derivative action entitled ARTHUR GLICK AND WILLIAM GURNEY, ON BEHALF
OF THEMSELVES AND ALL OTHERS SIMILARLY SITUATED VS. HAWTHORNE
FINANCIAL CORPORATION, ET.AL., filed in the United States District
Court of California, Case No. 95-6855-ER (the "Action"). On May 22,
1996, the Action was dismissed by the Court upon declaration by the
plaintiffs that they had not suffered any loss and were, therefore,
not proper class representatives. The dismissal of the Action barred
the individual claims of the plaintiffs with respect to the matters
alleged in the complaint.
The Company is involved in a variety of other litigation matters
which, for the most part, arise out of matters and events which were
alleged to have occurred prior to 1994. Many of these lawsuits either
allege construction defects or allege improper servicing of the loan.
In the opinion of management, none of these cases will have a material
adverse effect on the Bank's or the Company's financial condition.
ITEM 2. Changes in Securities - None
ITEM 3. Defaults upon Senior Securities - None
ITEM 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Stockholders of the Company was held on May 20,
1996. The eight nominees for Director, Marilyn Garton Amato, Scott A.
Braly, Timothy R. Chrisman, R. Michael Hall, Charles S. Jacobs, Harry
F. Radcliffe, Howard E. Ritt and Robert C. Troost, were all elected to
a one year term.
ITEM 5. Other Information - None
ITEM 6. Exhibits and Reports on Form 8-K
1. Reports on Form 8-K - None
2. Other required exhibits - None
33
<PAGE>
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HAWTHORNE FINANCIAL CORPORATION
Dated August 14, 1996 /s/ NORMAN A. MORALES
------------------------------------
Norman A. Morales
Executive Vice President and
Chief Financial Officer
Dated August 14, 1996 /s/ JESSICA VLACO
------------------------------------
Jessica Vlaco
Senior Vice President and
Principal Accounting Officer
34
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<PAGE>
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<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> JUN-30-1996
<CASH> 8,883
<INT-BEARING-DEPOSITS> 618,695
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<DEPOSITS> 621,965
<SHORT-TERM> 87,150
<LIABILITIES-OTHER> 5,910
<LONG-TERM> 0
0
11,592
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