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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [NO FEE REQUIRED]
For the fiscal year ended December 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
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 NO.)
2381 ROSECRANS AVENUE, 2ND FLOOR 90245
EL SEGUNDO, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (310) 725-5000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.01 PER SHARE
(TITLE OF CLASS)
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 by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based on the closing stock price of such stock as of February
28, 1998 as reported by the National Association of Securities Dealers, was
$56,723,541.
The number of shares of Common Stock, par value $0.01 per share, of the
Registrant outstanding as of February 28, 1998 was 3,156,596 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Annual Report incorporates by reference portions of the
Proxy Statement to be filed with the Securities and Exchange Commission in
connection with the Registrant's 1998 Annual Meeting of Stockholders.
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HAWTHORNE FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10K
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PAGE
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PART I.
ITEM 1. Business....................................................................2
General.................................................................2
Background..............................................................3
New Business Generation.................................................4
Interest Rate Risk Management..........................................21
Certain Regulatory Matters.............................................22
Taxation...............................................................29
Risk Factors...........................................................30
ITEM 2. Properties.................................................................34
ITEM 3. Legal Proceedings..........................................................35
ITEM 4. Submission of Matters to a Vote of Security Holders........................36
ITEM 4A. Executive Officers.........................................................36
PART II.
ITEM 5. Market for Registrant's Common Stock and Related Stockholder Matters.......37
ITEM 6. Selected Financial Data....................................................38
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations ............................................................40
Operating Results......................................................40
Financial Condition, Capital Resources & Liquidity and Asset Quality...48
ITEM 7A. Quantitative and Qualitative Disclosure about Market Risks.................51
ITEM 8. Financial Statements and Supplementary Data................................53
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure.................................................................53
PART III.
ITEM 10. Directors and Executive Officers of the Registrant.........................53
ITEM 11. Executive Compensation.....................................................53
ITEM 12. Security Ownership of Certain Beneficial Owners and Management.............53
ITEM 13. Certain Relationships and Related Transactions.............................53
PART IV.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............54
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FORWARD LOOKING STATEMENTS
When used in this Form 10-K or future filings by the Company with the
Securities and Exchange Commission, in the Company's press releases or other
public or stockholder communications, or in oral statements made with the
approval of an authorized executive officer, the words or phrases "will likely
result", "are expected to", "will continue", "is anticipated", "estimate",
"project", "believe" or similar expressions are intended to identify
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. The Company wishes to caution readers that all
forward-looking statements are necessarily speculative and not to place undue
reliance on any such forward-looking statements, which speak only as of the date
made, and to advise readers that various risks and uncertainties, including
regional and national economic conditions, changes in levels of market interest
rates, credit risks of lending activities, and competitive and regulatory
factors, could affect the Company's financial performance and could cause the
Company's actual results for future periods to differ materially from those
anticipated or projected. The risks highlighted herein should not be assumed to
be the only things that could affect future performance of the Company.
The Company does not undertake, and specifically disclaims any
obligation, to publicly release the result of any revisions which may be made to
any forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
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P A R T I.
ITEM 1. BUSINESS
GENERAL
HAWTHORNE FINANCIAL CORPORATION
Hawthorne Financial Corporation ("Hawthorne Financial" or "Company"), a
Delaware corporation organized in 1959, is a savings and loan holding company
that owns 100% of the stock of Hawthorne Savings, F.S.B. ("Hawthorne Savings" or
"Bank"). Hawthorne Savings was incorporated in 1950 and commenced operations on
May 11, 1951. The Bank's six full-service retail offices are located in Southern
California.
HAWTHORNE SAVINGS
Hawthorne Savings is a federally-chartered stock savings bank (referred
to in applicable statutes and regulations as a "savings association")
incorporated and licensed under the laws of the United States. The Bank is a
member of the Federal Home Loan Bank of San Francisco ("FHLB"), which is a
member bank of the Federal Home Loan Bank System. The Bank's deposit accounts
are insured up to the $100,000 maximum amount currently allowable under federal
laws by the Savings Association Insurance Fund ("SAIF"), which is a separate
insurance fund administered by the Federal Deposit Insurance Corporation
("FDIC"). The Bank is subject to examination and regulation by the Office of
Thrift Supervision ("OTS") and the FDIC. Hawthorne Savings is further subject to
regulations of the Board of Governors of the Federal Reserve System ("FRB")
concerning reserves required to be maintained against deposits and certain other
matters.
The Company is a financial services company specializing in originating
real estate-secured loans in market niches which generally provide higher yields
of return and greater growth potential than the more traditional products
offered by most providers of mortgage loans. The Company generally seeks to
originate real estate-secured loans in which it can charge a premium price for
prompt, efficient execution and for tailoring the terms of its loans to meet the
objectives of both the Company and the borrower. Further the Company seeks to
originate a relatively limited number of high-balance loans in order to provide
reasonable leverage to its fixed loan origination cost structure. The Company
focuses primarily on originating (1) loans secured by very large homes located
principally throughout Southern California, (2) loans secured by multi-family
residential and commercial real estate and (3) loans for the construction of
individual and tracts of single-family residential homes and the acquisition and
development of land for the construction of such homes. The Company funds its
lending activities primarily with retail deposits obtained through the Bank's
branch system. At December 31, 1997, the Company had assets of $928.2 million,
deposits of $799.5 million and stockholders' equity of $42.3 million.
The Company is principally engaged in the business of attracting
deposits from the general public and using those deposits, together with
borrowings and other funds, to originate loans secured by residential and
non-residential real estate located throughout Southern California. The Company
generates revenues from the interest and fees charged borrowers and, to a much
lesser extent, the interest earned on its portfolio of liquid investments. The
Company's costs are centered in the interest paid to depositors and to other
providers of borrowed funds, as well as the costs to operate the Company's
business.
The Company's operating results and its growth prospects are most
directly and materially influenced by (1) the health and vibrancy of the
Southern California real estate markets, and the underlying economic forces
which affect such markets, (2) the overall complexion of the interest rate
environment, including the absolute level of market interest rates and the
volatility of such interest rates, (3) the prominence of competitive forces
which provide customers, or potential customers, of the Company with alternative
sources of mortgage funds or investments which compete with the Company's
deposit products and services, and (4) regulations promulgated by regulatory
authorities, including those of the OTS, the FDIC and the FRB. The Company's
success in identifying trends in each of these factors, and implementing
strategies to exploit such trends, strongly influence the Company's long-term
results and growth prospects.
The Company's operating results depend primarily on (1) the margin
("spread") between the yield earned on its loan portfolio (and to a much lesser
extent its portfolio of liquid investments) and the cost of borrowed funds, (2)
the
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size and relative amounts of its interest-earning assets and interest-bearing
liabilities, (3) the performance characteristics of its assets, and (4) the
extent to which the Company's business activities can be leveraged from a
largely fixed-cost infrastructure (people, technology and facilities).
At December 31, 1997, the Bank met and exceeded all three regulatory
capital requirements, with core capital to total assets of 7.55%, core capital
to risk-weighted assets of 10.23%, and total capital to risk-weighted assets of
11.48%. Based on the foregoing, the Bank qualified as a "well capitalized"
institution under the prompt corrective action rules of the OTS.
BACKGROUND
Prior to 1993, the Company was primarily engaged in the origination of
loans for the construction of residential subdivisions and apartment buildings
and permanent loans secured by individual single-family residential homes and
apartment buildings. In addition, the Company utilized its construction
financing activities as its principal sources of permanent loans, by converting
its construction loans to permanent loans and by providing permanent financing
to purchasers of units within the residential subdivisions which were
constructed with financing from the Company. Due to the severe economic
recession in California during the early 1990s, and the resulting decline in
real estate values, the Company's nonperforming and classified assets increased
significantly and the Company incurred substantial losses and reduced levels of
capital.
In mid-1993, the Board of Directors hired a new President and Chief
Executive Officer, Mr. Scott Braly, who in turn hired a full complement of
professionals experienced in troubled asset resolution, retail banking, and the
core operations of a financial services company. The Company's new management
undertook and completed a comprehensive restructuring of all of the Company's
operations, including the following principal initiatives:
- The Bank's branch system was reduced through sales and
consolidations from 19 locations at December 31, 1993, with
average deposits of $43.7 million per branch, to 6 locations,
with average deposits of $133.3 million per branch.
- Troubled and nonperforming assets were resolved, largely through
foreclosure of the Company's collateral and the subsequent
construction or renovation and retail disposition of foreclosed
properties, which reduced the Company's nonperforming assets to
$20.7 million at December 31, 1997 from $151.2 million at
December 31, 1993. During the five-year period ended December
31, 1997, the collateral securing $265.6 million of loan
principal was acquired via foreclosure, and post-foreclosure
investments for construction and renovation totaled an
additional $57.6 million.
- The Bank's regulatory core capital, which had declined to $27.7
million by June 30, 1995, was supplemented by a combination of
(1) proceeds raised in December 1995 from the issuance of $27.0
million of high-cost debt and preferred stock (which amounts
were repaid in full in December 1997 through the issuance of
market rate Senior Notes), and (2) accumulated earnings during
1996 and 1997, which together increased the Bank's regulatory
core capital to $69.9 million at December 31, 1997.
- Distinctive and tightly-focused long-term strategies designed to
re-establish the Company as a prominent provider of real
estate-secured credit throughout Southern California were
developed and implemented, which initiatives included the hiring
of and support for a full complement of lending professionals,
which produced loan commitment volumes of $495.0 million, $332.3
million, and $197.4 million for each of the three years ended
December 31, 1997, 1996 and 1995, respectively.
The successful implementation of these and related initiatives has
produced a return to, and consistent growth in, the Bank's and the Company's
profitability. The Company's improved operating results were a significant
contributing factor in permitting the Company to successfully refinance its
high-cost debt, taken on in late 1995 to recapitalize the Bank, in December
1997. The newly-issued $40.0 million of Senior Notes provided the Company with
excess proceeds of approximately $10.4 million, which is available to further
support the future growth of the Bank. See NEW BUSINESS GENERATION and ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
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NEW BUSINESS GENERATION
The Company's principal lending area encompasses Los Angeles and
Orange counties, with ancillary markets including the rest of southern
California. Since the beginning of 1995, the Company has emphasized the
origination of (1) loans secured by single-family residences, primarily very
large homes and unique estates, (2) permanent loans secured by multi-family
residential and commercial real estate, and (3) loans for the construction of
individual and tracts of single-family residential homes and the acquisition and
development of land for the construction of such homes. Though the types of
collateral securing loans made by the Company during the period 1995 through
1997 are generally similar to the types of collateral which secured loans made
by the Company prior to 1995, these older loans were underwritten under
significantly different criteria, and were made in much larger concentrations to
individual or affiliated borrowers, than loans made during the period 1995
through 1997.
The Company's current loan origination activities are tightly governed
by established policies and procedures appropriate to the risks inherent to the
types of collateral and borrowers financed by the Company. The Company's primary
competitive advantages, which include (1) a willingness and competence to tailor
the terms and conditions of individual transactions to optimize the borrower's
and the Company's objectives, (2) a strategy of holding in portfolio virtually
all new loan originations, and (3) highly effective and efficient transaction
execution, are consistent with the Company's relatively flat organizational and
decision-making structure, and its reliance upon relatively few, highly-skilled
lending professionals. This combination of competitive, organizational and
strategic distinctions contribute to the Company's success in attracting new
business and in its ability to receive a return believed by management to be
commensurate with the inherent and transaction-specific risks assumed and the
value added to its customers.
The Company's lending groups extend credit pursuant to a comprehensive
lending policy, tailored to the particular attributes of the Company's lending
activities. The Company's lending policy establishes requirements and defines
parameters covering loan applications, borrower financial informations, legal
and corollary agreements which support the vesting of title to the Company's
collateral, title policies, fire and extended liability coverage casualty
insurance, credit reports, and other necessary documents to support each
extension of credit. The real property collateral which secures the Company's
loans is appraised by either an independent fee appraiser approved by the
Company or by one of the Company's staff appraisers. All independent fee
appraisals are reviewed by the Company's Chief Appraiser prior to each extension
of credit.
The Company seeks to originate relatively few, high-dollar balance loans
within each of its lending businesses, with the exception of the Company's
conventional home financing group. Accordingly, the Company's internal "house
limit," applicable to individual transactions or to multiple loans with
affiliated borrowers (as defined in applicable federal regulations), is higher
than for many other regulated financial companies. As of December 31, 1997, the
Company's "house limit" was $6.0 million, or approximately 9% of the Bank's core
capital and 14% of the Company's stockholders' equity. Loan requests in excess
of $6.0 million and up to the Bank's legal lending limit ($11.9 million at
December 31, 1997) require approval of the Credit Committee of the Board of
Directors prior to funding.
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The following table sets forth information concerning the composition of
the Company's loan portfolio, and the percentage of the loan portfolio
represented by each type of loan, as of the dates indicated (dollars are in
thousands).
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DECEMBER 31,
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1997 1996 1995
----------------------------------- ----------------------------- ---------------------------
BALANCE PERCENT BALANCE PERCENT BALANCE PERCENT
------------- ------------------ ------------ -------------- ------------ ---------
<S> <C> <C> <C> <C> <C> <C>
SINGLE FAMILY
Estate (1) $ 173,764 17.9% $ 107,891 14.6% $ 51,142 7.8%
Conventional 224,006 23.1 231,306 31.2 318,703 48.5
INCOME PROPERTY
Multi-family 225,738 23.3 220,707 29.7 219,015 33.4
Commercial real estate 114,293 11.8 60,388 8.2 31,258 4.8
LAND 39,475 4.1 14,513 2.0 5,579 0.9
SINGLE FAMILY CONSTRUCTION
Individual residences 112,899 11.7 56,306 7.6 21,987 3.4
Tract development 68,653 7.1 33,791 4.6 6,800 1.0
OTHER 9,698 1.0 15,684 2.1 1,459 0.2
------------- ------------------ ------------ -------------- ------------ ---------
GROSS LOANS RECEIVABLE (2) 968,526 100.0% 740,586 100.0% 655,943 100.0%
===== ===== =====
LESS
Participants' share (1,141) (1,413) (2,219)
Undisbursed loan funds (108,683) (46,646) (15,208)
Deferred loan fees and
credits, net (7,177) (6,611) (5,996)
Reserves (13,274) (13,515) (15,192)
------------- ------------ ------------
NET LOANS RECEIVABLE $ 838,251 $ 672,401 $ 617,328
============= ============ ============
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DECEMBER 31,
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1994 1993
------------------------------- ------------------------------
BALANCE PERCENT BALANCE PERCENT
------------ --------------- ------------ --------------
<S> <C> <C> <C> <C>
SINGLE FAMILY
Estate (1) $ -- -- % $ -- -- %
Conventional 375,320 65.7 426,610 62.5
INCOME PROPERTY
Multi-family 172,641 30.2 193,468 28.4
Commercial real estate 7,757 1.4 7,630 1.1
LAND 3,797 0.7 22,179 3.3
SINGLE FAMILY CONSTRUCTION
Individual residences 3,270 0.6 6,603 1.0
Tract development 6,000 1.1 22,925 3.4
OTHER 1,654 0.3 2,013 0.3
------------ --------------- ------------ --------------
GROSS LOANS RECEIVABLE (2) 570,439 100.0 % 681,428 100.0 %
=============== ==============
LESS
Participants' share (3,072) (3,098)
Undisbursed loan funds (2,795) (966)
Deferred loan fees and
credits, net (6,091) (7,285)
Reserves (21,461) (46,629)
------------ ------------
NET LOANS RECEIVABLE $ 537,020 $ 623,450
============ ============
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(1) Applicable solely to loans, generally in excess of $1.0 million, made
subsequent to 1994. For periods prior to 1995, all loans secured by
single family homes are included with Conventional loans, irrespective
of size.
(2) Gross loans receivable includes outstanding balance plus outstanding
construction commitments.
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The Company's loan portfolio contains no loans to foreign governments,
foreign enterprises, foreign operations of domestic companies, nor any
concentration to borrowers engaged in the same or similar industries that exceed
10% of total loans.
The table below sets forth information concerning the Company's gross
loan portfolio at December 31, 1997 (dollars are in thousands).
<TABLE>
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PRINCIPAL NUMBER AVERAGE
BALANCE OF LOANS LOAN AMOUNT
-------- -------- --------
<S> <C> <C> <C>
SINGLE FAMILY
Estate $173,764 62 $ 2,803
Conventional 224,006 1,510 148
INCOME PROPERTY
Multi-family 225,738 368 613
Commercial real estate 114,293 55 2,078
LAND 39,475 36 1,097
SINGLE FAMILY CONSTRUCTION
Individual residences 112,899 120 941
Tract development 68,653 21 3,269
OTHER 9,698 58 167
-------- --------
GROSS LOANS RECEIVABLE (1) $968,526 2,230 $ 434
======== ======== ========
</TABLE>
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(1) Gross loans receivable includes outstanding balance plus outstanding
construction commitments.
Each of the Company's principal lending pursuits is discussed in the
sections below. In the discussion below, the weighted average interest rate
equals the weighted average coupon interest rate, and the effective yield is
calculated by adding to the weighted average coupon interest rate, loan fees
collected at origination (net of loan origination costs deferred) and loan
discounts, in each instance annualized over the contractual term of the loan.
For construction loans, the effective yield is calculated assuming that an
average of 60% of the commitment amount is outstanding during the term of such
loans. In all cases, the effective yield excludes revenues to which the Company
is entitled upon the maturity of certain loans (e.g., exit and release fees),
prepayment penalties, modification and extension fees.
SINGLE FAMILY ESTATE FINANCING. Beginning in early 1995, the Company has
provided a variety of financings secured by very large homes and unique estates
throughout Southern California, with values ranging up to $20 million, including
homes located in the communities of Bel-Air, Beverly Hills, Malibu, Newport
Beach, Santa Barbara and La Jolla. Generally, the Company's loans have
refinanced the borrower's existing mortgage debt, rather than financing the
borrower's purchase of a home. The Company generates virtually all of its new
financing opportunities of this type through contact with, and submissions by,
independent mortgage brokers.
The Company's estate financings generally involve loans with principal
amounts of $1.0 million or more which are secured homes with a wide range of
characteristics, from large, conventional homes located within mature areas to
very large, multiple acre, one-of-a-kind estates. The Company's financings also
encompass a wide range of borrower profiles, those with the demonstrated
capacity to service the loan to others with no verifiable source of recurring
cash flow. Loans which meet the highest standards of collateral quality and
borrower capacity and creditworthiness ("Tier 1 loans") are similar to
conventional home loans except for their size, and generally have higher
loan-to-value ratios and the most favorable pricing to the borrower. Loans with
respect to which the borrower's resources are limited or cannot be reliably
measured, or with respect to which the Company's collateral possesses such
unique characteristics, including size, amenity or location, so as to make its
valuation difficult to measure ("Tier 3 loans"), have the lowest loan-to-value
ratios and the highest pricing to the borrower. Loans which fall in between
these two sets of parameters ("Tier 2 loans") involve advances and pricing which
are tailored to the particular attributes of the property, the borrower and the
reason underlying the borrower's loan request. A substantial majority of the
Company's estate loans have been comprised of Tier 2 loans.
The Company compensates for the existence of one or more of these
attributes by limiting the advance it will make against its estimate of the
value of the collateral. Management determines the value of the proposed
collateral by reference to current appraisals and by detailed property
inspections by the Company's senior management. The Company will provide
financing for individual transactions in an amount up to, but not in excess of,
the Company's legal lending limit for loans-to-one borrower.
At December 31, 1997, Estate loan principal of $173.8 million was
outstanding. The weighted average interest rate and effective yield on
outstanding loan principal at December 31, 1997 was 9.67% and 9.89%,
respectively.
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SINGLE FAMILY CONVENTIONAL FINANCING. The Company provides conventional,
permanent financing secured by single-family homes, located principally in Los
Angeles county. The Company conducts this business both from its local retail
banking offices and from its corporate office. This business is the most
competitive and least profitable of all of the Company's financing businesses.
The Company lacks the size and scale of operations to profitably penetrate this
business, especially in view of the significant capacity already in the
marketplace in the form of very large banking and non-banking companies whose
principal business is to originate conventional single-family-secured loans,
many for resale in secondary mortgage markets. The Company targets the
origination of a modest volume of this business each year, generally
concentrated in and around its local retail banking offices.
At December 31, 1997, the Company had outstanding loan principal of
$222.9 million secured by non-Estate, single-family residences, $53.7 million of
which had been originated since 1994. The weighted average interest rate and
effective yield on the outstanding loan principal at December 31, 1997 was 7.67%
and 7.70%, respectively.
INCOME PROPERTY FINANCING. The Company provides financing to owners and
purchasers of apartment buildings and various types of non-residential
properties, such as retail centers, office buildings, and industrial buildings.
The Company generates a significant majority of its new financing opportunities
through contact with, and submissions to it by, independent mortgage loan
brokers. However, a growing proportion of the Company's new business is derived
from existing customer relationships or through referrals from existing
customers. Management believes that the Company is often able to obtain higher
returns for its financings because significant opportunities exist in the
marketplace to provide financing which requires tailored terms and conditions,
efficient response and execution, and specialized real estate expertise.
The financing of income properties is subject to the risk that the cash
flows being generated by the Company's collateral, as reported by the borrower,
will decline following the funding of the loan. The Company attempts to mitigate
this risk by (1) requiring its borrowers to demonstrate their commitment to the
property through a significant cash equity investment, (2) evaluating the
historical and current operations of the property, (3) investigating the rental
markets within the areas surrounding its collateral in order to validate the
revenue and expense assumptions which contribute to the Company's assessment of
the properties' current and potential cash flows, and (4) evaluating the
operating experience of the borrower with similar properties.
Management underwrites the proposed collateral which will secure income
property financings by reference to the historical, current and projected
operation of the property. In evaluating income-producing properties, management
requires that borrowers provide, at a minimum, current rent rolls, recent
operating statements and pro forma operating statements. As appropriate, the
Company's lending personnel adjust reported results to accommodate lease
expirations (from non-residential properties), tenant turnover, necessary
capital improvements and other relevant factors.
At December 31, 1997, the Company had $225.4 million of outstanding loan
principal secured by apartment buildings, $125.8 million of which had been
originated since 1994. This portfolio carried a weighted average interest rate
of 8.13% (8.44% with respect to loans originated subsequent to 1994) and an
effective yield of 8.27%. Also at December 31, 1997, the Company had $110.4
million of loans secured by nonresidential, income-producing real estate,
virtually all of which had been originated since 1994. The weighted average
interest rate and effective yield for this portfolio was 9.87% and 10.06%,
respectively, at December 31, 1997.
SINGLE FAMILY CONSTRUCTION FINANCING. The Company conducts two separate
construction financing businesses, each of which is separately targeted and
resourced.
The Tract Financing group provides construction financing to
small-to-medium-sized builders of single-family residential developments in
southern California. In this business, the Company believes its competitive
advantage is focused upon its efficient response and execution and, more often
than not, a pre-existing relationship with the borrower or particular knowledge
of the specific submarket and/or product type.
For tract development financings, management underwrites each proposed
development by reference to the borrower's quantified plan, including costs to
and at completion by line item, and sales and marketing projections, and by
utilizing, where appropriate, third party sources to validate the compatibility
of the proposed development and product to be built within the immediate
marketplace. The Company also reviews the borrower's previous experience with
construction projects in general, and with the particular product type being
proposed. The
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Company maintains a full complement of professionals responsible for business
development, underwriting and post funding project management, inclusive of
disbursement control and property inspection.
The Company generally attracts new tract financing business directly
from builders. Depending upon the scope of a proposed development, the Company
may provide a commitment of funds for land acquisition, infrastructure
development and construction of all of the homes or condominiums to be built.
For large-scope developments, the Company generally provides separate loans for
land acquisition and development and for each discreet phase of home
construction. In these instances, though the Company underwrites the feasibility
and economics of the entire project at the project's inception, the borrower
generally must attain agreed-upon performance thresholds (e.g., unit absorption
and pricing, cost achievement and timing) before the Company will release funds
for subsequent stages of the development.
At December 31, 1997, the Company had aggregate commitments of $68.7
million to finance tract development, of which $32.8 million had been disbursed,
with a weighted average interest rate and effective yield of 10.53% and 13.11%,
respectively.
The Single Family Residence ("SFR") Financing group provides individual
home construction financing to local builders and homeowners. To date, this
group has focused almost exclusively on providing construction financing in the
beach cities of the South Bay, the Malibu area of Los Angeles county and the
Newport Coast area of Orange county, with occasional financing of home
construction in other affluent areas throughout Southern California. A majority
of the Company's business to date has been generated through pre-existing
relationships between the Company's loan officers and local builders. At
December 31, 1997, the Company had aggregate commitments of $112.9 million to
finance SFR construction, of which $60.5 million had been disbursed, with a
weighted average interest rate and effective yield of 10.49% and 13.55%,
respectively.
Construction financing presents the Company with the risk that the
actual cost of development will substantially exceed original estimates, that
the price of the finished homes will not meet pre-development expectations, or
that the rate of absorption of completed homes will significantly lag
expectations. The Company attempts to mitigate these risks by (1) generally
limiting its advance to a percentage of expected development costs, and
requiring the borrower to fund the difference, (2) carefully evaluating the line
item costs to complete the development, utilizing its resident loan officers and
staff (or, where appropriate, third parties), (3) carefully evaluating the
product type to be built and the demand for the finished homes by reference to
recent sales of comparable homes, and (4) the development experience of, and the
success or failure of, the Company's borrower with similar projects.
8
<PAGE> 10
The table below summarizes the Company's loan origination activity for
1997, 1996 and 1995 (dollars are in thousands).
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------
TYPE OF LOAN 1997 1996 1995
- ------------ -------- -------- --------
<S> <C> <C> <C>
SINGLE FAMILY
Estate(1) $100,400 $ 72,500 $ 53,700
Conventional 25,700 27,400 11,400
INCOME PROPERTY
Multi-family(2) 51,700 70,700 66,100
Commercial real estate(3) 105,100 46,000 31,700
LAND(4) 35,700 12,500 2,400
SINGLE FAMILY CONSTRUCTION
Individual residences(5) 104,900 53,200 25,300
Tract development(6) 61,800 32,300 6,800
OTHER(7) 9,700 17,700 --
-------- -------- --------
$495,000 $332,300 $197,400
======== ======== ========
</TABLE>
- ------------
(1) Generally defined as individual loans with principal balances of more
than $1.0 million. This amount includes unfunded commitments under lines
of credit of $7.4 million, $2.8 million and $5.2 million at December 31,
1997, 1996 and 1995, respectively.
(2) Includes $5.0 million, $16.2 million and $13.8 million of financings
provided in connection with sales of previously foreclosed properties
for the years ended December 31, 1997, 1996 and 1995, respectively.
(3) Includes unfunded commitments of $15.9 million, $2.3 million and
$0 at December 31, 1997, 1996 and 1995, respectively.
(4) Includes unfunded commitments of $14.1 million, $3.4 million and
$0 at December 31, 1997, 1996 and 1995, respectively.
(5) Includes unfunded commitments of $50.8 million, $21.9 million and $9.9
million at December 31, 1997, 1996 and 1995, respectively
(6) Includes unfunded commitments of $33.6 million, $18.7 million and $5.0
million at December 31, 1997, 1996 and 1995, respectively.
(7) Includes unfunded commitments of $4.0 million at December 31, 1997.
Interest Rates and Maturities. The loans emphasized by the Company
generally have interest rates which adjust or float in accordance with a variety
of indices, including the 11th District Cost of Funds Index ("11th DCOFI"), the
"prime" or "reference" rate of a specified bank, the One-Year Constant Maturity
Index ("CMT") and the London Interbank Offer Rate ("LIBOR"). The principal index
historically used by the Company prior to 1995 was the 11th DCOFI because this
index was deemed by management at the time to be more likely to parallel the
Company's cost of funds. Because the 11th DCOFI is a compilation of the average
rates paid by institutions which are members of the 11th District of the FHLB
System, adjustable-rate loans tied to this index generally adjust slower than
adjustable-rate loans with interest rates based on other indices. At December
31, 1997, adjustable-rate loans amounted to $788.0 million, or 81.4% of the
Company's gross loan portfolio, of which $367.5 million, $315.0 million, $44.1
million and $61.4 million had interest rates based on the 11th DCOFI, a
designated prime rate, the CMT and other indices, respectively.
Since 1995, the Company's adjustable-rate loans generally have included
provisions which limit the amount the interest rate can decrease during the term
of the loan, which provides protection to the Company in a decreasing interest
rate environment. Typically, these interest rate floors represent the interest
rate on the loan at the time of origination. In addition, on most of its
financings since 1994, the Company utilizes interest rate caps, which limit the
amount that the interest rate on the loan can increase over its term.
9
<PAGE> 11
The table below sets forth, by contractual maturity, the Company's loan
portfolio at December 31, 1997 (dollars are in thousands). The table is based on
contractual loan maturities and does not consider amortization and prepayments
of loan principal.
<TABLE>
<CAPTION>
MATURING IN
----------------------------------------------------------
OVER OVER
ONE YEAR FIVE YEARS TOTAL
ONE YEAR THROUGH THROUGH OVER LOANS
OR LESS FIVE YEARS TEN YEARS TEN YEARS RECEIVABLE
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
SINGLE FAMILY
Estate $ 15,414 $ 63,645 $ 77,109 $ 17,596 $ 173,764
Conventional 118 2,273 6,541 215,074 224,006
INCOME PROPERTY
Multi-family 5,338 34,181 100,260 85,959 225,738
Commercial real estate 2,875 68,360 23,554 19,504 114,293
LAND 24,096 14,594 -- 785 39,475
SINGLE FAMILY CONSTRUCTION
Individual residences 104,478 8,421 -- -- 112,899
Tract development 40,705 27,948 -- -- 68,653
OTHER 8,049 1,649 -- -- 9,698
--------- --------- --------- --------- ---------
GROSS LOANS RECEIVABLE (1) $ 201,073 $ 221,071 $ 207,464 $ 338,918 968,526
========= ========= ========= =========
LESS
Participants' share (1,141)
Undisbursed funds (108,683)
Deferred loan fees and credits, net (7,177)
Reserves (13,274)
---------
NET LOANS RECEIVABLE $ 838,251
=========
</TABLE>
- ------------------
(1) Gross loans receivable includes outstanding balance plus undisbursed
construction commitments.
The table below sets forth, by interest rate, the Company's fixed rate
and interest-rate sensitive loans at December 31, 1997 (dollars are in
thousands). The table is based on contractual loan maturities and does not
consider amortization and prepayments of loan principal.
<TABLE>
<CAPTION>
MATURING IN
----------------------------------------------------------
OVER OVER
ONE YEAR FIVE YEARS TOTAL
LESS THAN THROUGH THROUGH OVER LOANS
ONE YEAR FIVE YEARS TEN YEARS TEN YEARS RECEIVABLE
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
FIXED INTEREST RATES $ 17,164 $ 41,255 $ 8,103 $ 113,998 $ 180,520
ADJUSTABLE INTEREST RATES
11th DCOFI 6,760 52,673 105,352 202,685 367,470
Prime rate 177,149 82,528 40,801 14,500 314,978
1 year CMT -- 13,662 28,220 2,232 44,114
Other -- 30,953 24,988 5,503 61,444
--------- --------- --------- --------- ---------
Total adjustable interest rates 183,909 179,816 199,361 224,920 788,006
--------- --------- --------- --------- ---------
GROSS LOANS RECEIVABLE (1) $ 201,073 $ 221,071 $ 207,464 $ 338,918 968,526
========= ========= ========= =========
LESS
Participants' share (1,141)
Undisbursed funds (108,683)
Deferred loan fees and credits, net (7,177)
Reserves (13,274)
---------
NET LOANS RECEIVABLE $ 838,251
=========
</TABLE>
- --------------------
(1) Gross loans receivable includes outstanding balance plus undisbursed
construction commitments.
10
<PAGE> 12
The foregoing table does not reflect the expected maturities of loans
because it does not take into account scheduled contractual amortization and
prepayments of loans. Moreover, because adjustable-rate loans are not shown in
the period in which they are first scheduled to adjust, such table also does not
reflect the sensitivity of the Company's loan portfolio to changes in interest
rates. See "-INTEREST RATE RISK MANAGEMENT" below.
ASSET QUALITY
The Company is exposed to the inherent risks associated with loaning
money on a secured basis, in which the security for the Company's loans is a fee
interest in real estate. These risks are mitigated, isolated and accounted for
by the Company's (1) comprehensive loan underwriting and appraisal processes,
(2) portfolio management professionals and processes, and (3) loan
classification and reserving processes.
The Company's portfolio management group is responsible for (1)
performing periodic reviews of selected loans subsequent to their funding to
assess the borrower's compliance with applicable loan covenants, the current
condition and approximate valuation of the Company's collateral, the borrower's
recent performance, and changes (if any) to the ownership of the Company's
collateral, (2) assessing, generally using available data from independent
sources, market trends affecting the Company's loan collateral, including
transaction volumes and pricing, and (3) pursuing and negotiating loan
restructurings, which to date have generally been limited to loans made prior to
1995.
The Company has an established asset review process and asset
classification system. This process utilizes information acquired and
accumulated by the portfolio management group in establishing specific and
general reserves and in classifying individual assets and groups of similar
assets. The results of these respective classifications, and the appropriateness
of valuation allowances, are reported to the Company's Audit Committee.
The Company uses the following terminology in connection with its
problem assets:
Classified asset is either: (1) REO; (2) a nonperforming loan
delinquent 90 days or more; (3) a loan 30 to 89 days past due; or (4) a
performing loan classified loss, doubtful or substandard.
Delinquent loan is a loan 30 days or more past due.
TDR is a troubled debt restructured loan, which is a loan whose
terms are modified in a manner which resulted in the loan being
classified as a TDR under generally accepted accounting principles.
Impaired loan means a loan which is either a TDR, a nonaccrual
loan which is 90 days or more delinquent or a loan which management
deems probable that all principal and interest will not be collected.
Nonaccrual loan is a loan in which the Company ceases to accrue
interest. The Company's present policy is to define a nonaccrual loan as
any loan which is 30 days or more delinquent or any loan which, in the
judgement of management, the probability of collection of all amounts
due according to the contractual terms is insufficient to warrant
further accrual, regardless of the loan's delinquency status. When a
loan is placed on nonaccrual status, it is the Company's policy to
reverse previously accrued but unpaid interest by a charge to interest
income in the current period.
Nonperforming asset is a loan which is 90 days or more past due
or an REO.
Nonperforming loan is a loan 90 days or more past due.
Other delinquent loan is a loan 30 to 89 days past due.
REO is real estate acquired upon foreclosure or by deed in lieu
of foreclosure.
11
<PAGE> 13
The following table provides information regarding the Company's
nonaccrual loans as of the dates indicated (dollars are in thousands).
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Loans past due 90 days or more $ 10,793 $ 16,643 $ 11,298 $ 18,103 $ 78,949
Loans past due 30 - 89 days 4,435 10,082 8,811 17,747 31,057
Other nonaccrual loans 168 1,899 1,600 3,546 --
-------- -------- -------- -------- --------
Total (1) $ 15,396 $ 28,624 $ 21,709 $ 39,396 $110,006
======== ======== ======== ======== ========
Reserves to loans past due 90 days or more 123.0% 81.2% 134.5% 118.5% 59.1%
Reserves to total nonaccrual loans 86.2% 47.2% 70.0% 54.5% 42.4%
</TABLE>
- --------------
(1) Includes $0.5 million, $5.6 million, $0, $0.1 million and $31.6 million
of TDRs at December 31, 1997, 1996, 1995, 1994 and 1993, respectively.
With respect to loans on nonaccrual status at December 31, 1997, 1996,
and 1995, the Company recognized $0.9 million, $1.9 million and $1.0 million of
interest revenue (representing cash payments by borrowers prior to their
default), respectively. Had such loans been performing for these entire
respective periods, the Company would have recognized $1.4 million, $2.8
million and $1.5 million, the difference compared to cash payments
received representing uncollected interest payments in each comparable period.
At December 31, 1997, the Company had 73 loans with an aggregate
principal amount of $29.6 million outstanding which were TDRs. Of this amount,
$29.1 million were performing in accordance with their modified terms and $0.5
million were nonaccrual. The Company generally classifies TDRs as "substandard"
for a period of at least six months following a loan's restructuring, after
which time the loan's classification is based upon the Company's classification
policies. At December 31, 1997, $3.9 million of the Company's TDRs were included
in the Company's classified loans. During the years ended December 31, 1997,
1996 and 1995, the Company recognized $2.5 million, $3.1 million, and $1.7
million, respectively, of interest revenue (representing cash payments by
borrowers on performing loans) on its troubled debt restructured loans. The
Company would have recognized interest revenue of $2.9 million, $3.8 million
and $1.9 million during these respective periods had the borrowers paid
according to the original contractual terms on such loans (absent any
modifications for reductions in interest rates, partial debt forgiveness, or
both).
Classified Assets. OTS regulations require that each insured savings
association classify its assets on a regular basis. In addition, in connection
with examinations of insured savings associations, OTS examiners have authority
to require problem assets to be classified. There are three classifications for
problem assets: "substandard," "doubtful" and "loss." Substandard assets have
one or more defined weaknesses and are characterized by the distinct possibility
that the savings association will sustain some loss if the deficiencies are not
corrected. Doubtful assets have the weaknesses of substandard assets with the
additional characteristic that collection or liquidation in full, on the basis
of currently existing facts, conditions and values are questionable, and there
is a high probability of loss. An asset classified loss is considered
uncollectible and of such little value that continuance as an asset of the
association is not warranted.
Another category designated "special mention" also must be established
and maintained for assets which do not currently expose an insured savings
association to a sufficient degree of risk to warrant classification as
substandard, doubtful or loss but do possess credit deficiencies or potential
weaknesses deserving management's close attention. An asset classified as "pass"
is considered of sufficient quality to preclude a designation as special mention
or an adverse classification. Pass assets generally are protected by the current
net worth or paying capacity of the obligor or by the value of the asset or
underlying collateral.
Based on the evaluation and classification of its assets, each savings
association is required by OTS regulations to establish adequate reserves or
charge-offs, as appropriate, consistent with generally accepted accounting
principles and the practices of the federal banking agencies.
12
<PAGE> 14
The table below sets forth certain information regarding the Company's
classified assets at the dates indicated (dollars are in thousands).
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Real estate owned, net $ 9,859 $ 20,140 $ 37,905 $ 62,613 $ 72,234
Nonperforming loans (1) 10,793 16,643 11,298 18,103 78,949
-------- -------- -------- -------- --------
Gross nonperforming assets 20,652 36,783 49,203 80,716 151,183
Other delinquent loans (2) 4,435 10,082 8,811 17,747 31,057
Performing loans classified loss,
doubtful and substandard (3)(4) 36,013 46,987 58,649 67,309 61,673
-------- -------- -------- -------- --------
Gross classified assets $ 61,100 $ 93,852 $116,663 $165,772 $243,913
======== ======== ======== ======== ========
Gross classified loans (4) (5) $ 51,241 $ 73,712 $ 78,758 $103,159 $171,679
======== ======== ======== ======== ========
Loans receivable (6) $851,525 $685,916 $632,520 $558,481 $670,079
======== ======== ======== ======== ========
Reserves on loans
Specific $ 3,878 $ 2,185 $ 3,426 $ 8,578 $ 23,294
General 9,396 11,330 11,766 12,883 23,335
-------- -------- -------- -------- --------
$ 13,274 $ 13,515 $ 15,192 $ 21,461 $ 46,629
======== ======== ======== ======== ========
Total reserves to net loans receivable (6) 1.56% 1.97% 2.40% 3.84% 6.96%
Total reserves to classified loans 25.91% 18.33% 19.29% 20.80% 27.16%
Total reserves to nonperforming loans 122.99% 81.21% 134.47% 118.55% 59.06%
Gross nonperforming assets to total assets 2.22% 4.34% 6.53% 10.85% 17.15%
</TABLE>
- --------------------
(1) Loans 90 days or more past due. All such loans are on nonaccrual status.
(2) Loans 30 to 89 days past due. All such loans are on nonaccrual status.
(3) Includes $0.2 million, $1.9 million, $1.6 million and $3.5 million of
performing loans on nonaccrual status at December 31, 1997, 1996, 1995
and 1994, respectively.
(4) Includes $3.9 million, $16.7 million, $7.3 million, $3.8 million and
$37.1 million of TDRs at December 31, 1997, 1996, 1995, 1994 and 1993,
respectively.
(5) Includes $15.4 million, $28.6 million, $21.7 million, $39.4 million and
$110.0 million of nonaccrual loans at December 31, 1997, 1996, 1995,
1994 and 1993, respectively.
(6) Net loans receivable are exclusive of the allowance for credit losses.
13
<PAGE> 15
The table below sets forth the Company's gross classified loan portfolio
as of December 31, 1997 (dollars are in thousands).
<TABLE>
<CAPTION>
CLASSIFIED LOANS
-------------------------------------------------
PERFORMING
NONPERFORMING (1) OTHER DELINQUENCIES (2) LOANS (3) TOTAL
------- ------- ------- ---------
<S> <C> <C> <C> <C>
SINGLE FAMILY
Estate $ 7,885 $ -- $ 6,423 $ 14,308
Conventional 2,865 4,315 13,722 20,902
INCOME PROPERTY
Multi-family -- -- 5,452 5,452
Commercial real estate -- -- 5,746 5,746
LAND 43 120 -- 163
SINGLE FAMILY CONSTRUCTION
Individual residences -- -- 719 719
Tract development -- -- 2,762 2,762
OTHER -- -- 1,189 1,189
------- ------- ------- -------
Total $10,793 $ 4,435 $36,013 $51,241
======= ======= ======= =======
</TABLE>
- ------------
(1) Loans 90 days or more past due. All such loans are on nonaccrual status.
(2) Loans delinquent 30 to 89 days. All such loans are on nonaccrual status.
(3) Includes $0.2 million of performing loans on nonaccrual status.
On January 1, 1995, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment
of a Loan," as amended by SFAS No. 118 ("Accounting by Creditors for Impairment
of a Loan - Income Recognition and Disclosures"). Under these statements, a loan
is considered impaired when it is probable that the creditor will be unable to
collect all contractual principal and interest payments under the terms of the
loan agreement. Pursuant to this statement, the Company generally measures
impaired loans based on the estimated fair value of the collateral, less
estimated selling costs, if foreclosure is probable. The Company measures the
impairment of a restructured loan by discounting the total expected future cash
flows at the loan's effective rate of interest in the original loan agreement.
The effect of initially adopting this statement was not material to the results
of operations or the financial position of the Company.
At December 31, 1997, the Company's gross impaired loans amounted to
$52.4 million and were comprised of the Company's $29.1 million of
non-delinquent TDRs and $11.6 million of delinquent loans (which include the
Company's $0.5 million of delinquent TDRs). At December 31, 1997, the Company's
impaired loans did not include $3.6 million of loans which were 30 to 89 days
past due and placed on nonaccrual status as a matter of policy and the $0.2
million of performing loans which were on nonaccrual status.
REO. REO is carried at the lower of cost or estimated fair value of the
property. Subsequent declines in fair value, if any, are accounted for through
the establishment of a specific reserve on the REO. The determination of the
REO's estimated fair value incorporates revenues projected to be realized from
disposal of the property, less construction and renovation costs, marketing and
transaction costs and holding costs (e.g., property taxes, insurance and
homeowners' association dues). For multiple-unit residential construction and
land developments, these projected cash flows are discounted utilizing a market
rate of return to determine their fair value.
14
<PAGE> 16
The following table summarizes the composition of the Company's REO at
the dates indicated (dollars are in thousands).
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1997 1996
-------- --------
<S> <C> <C>
SINGLE FAMILY - conventional $ 7,695 $ 9,777
INCOME PROPERTY
Multi-family 2,362 3,215
Commercial real estate -- 346
LAND 2,365 2,517
SINGLE FAMILY CONSTRUCTION - tract developments -- 16,156
-------- --------
GROSS INVESTMENT (1) 12,422 32,011
Reserves (2,563) (11,871)
-------- --------
NET INVESTMENT $ 9,859 $ 20,140
======== ========
</TABLE>
- ---------------
(1) Loan principal at foreclosure, plus post-foreclosure capitalized costs,
less cumulative charge-offs.
Reserves. Management establishes specific reserves for losses on
individual loans and REO when it has determined that recovery of the Company's
gross investment is not likely and when the amount of loss can be reasonably
determined. In making this determination, management considers (1) the status of
the asset, (2) the probable future status of the asset, (3) the value of the
asset or underlying collateral and (4) management's intent with respect to the
asset. In quantifying the loss, if any, associated with individual loans and
REO, management utilizes external sources of information (i.e. appraisals, price
opinions from real estate professionals, comparable sales data and internal
estimates). In establishing specific reserves, management estimates the revenues
expected to be generated from the disposal of the Company's collateral or owned
property, less construction and renovation costs (if any), holding costs and
transaction costs. For tract construction and land developments, the resulting
projected cash flows are discounted utilizing a market rate of return to
determine their value.
Management establishes general reserves against the Company's portfolio
of loans. Generally, such general reserves are established for each segment of
the Company's loan portfolio. In establishing general reserves, management
incorporates (1) the recovery rate for similar properties previously sold by the
Company, (2) valuations of groups of similar assets, (3) the probability of
future adverse events (i.e., performing loans which became nonperforming, loans
in default which proceed through foreclosure) and (4) guidelines published by
the OTS.
The table below sets forth the general and specific reserves for the
Company's loan and REO portfolios as of December 31, 1997 (dollars are in
thousands).
<TABLE>
<CAPTION>
LOANS
---------------------- REAL ESTATE
PERFORMING DELINQUENT (1) OWNED TOTAL
------- ------- ------- -------
<S> <C> <C> <C> <C>
AMOUNTS
Specific reserves $ 2,995 $ 883 $ 2,563 $ 6,441
General reserves 8,936 460 -- 9,396
------- ------- ------- -------
Total reserves $11,931 $ 1,343 $ 2,563 $15,837
======= ======= ======= =======
PERCENTAGES
% of total reserves to gross investment 1.4% 8.8% 20.6% 1.8%
% of general reserves to gross investment 1.1% 3.0% - % 1.1%
</TABLE>
- ---------------
(1) Delinquent loans are loans 30 to 89 days past due.
15
<PAGE> 17
The table below summarizes the activity in the Company's reserves for
the periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------====
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
LOANS
Average loans outstanding $ 745,197 $ 671,365 $ 578,766 $ 604,410 $ 756,023
========= ========= ========= ========= =========
Reserve balance at beginning of period $ 13,515 $ 15,192 $ 21,461 $ 46,629 $ 52,966
Provision for estimated losses 5,137 6,067 472 (24,449) (6,409)
Charge-offs:
Single family - conventional (3,472) (3,103) (2,894) (380) --
Income property
Multi-family (1,745) (4,641) (3,595) (339) --
Commercial real estate -- -- (70) -- --
Land (150) -- (48) -- --
Single family construction
Tract development -- -- (134) -- --
Other (11) -- -- -- --
Recoveries -- -- -- -- 72
--------- --------- --------- --------- ---------
Net charge-offs (5,378) (7,744) (6,741) (719) 72
--------- --------- --------- --------- ---------
Balance at end of period $ 13,274 $ 13,515 $ 15,192 $ 21,461 $ 46,629
========= ========= ========= ========= =========
Ratio of net charge-offs to average loans
outstanding during the period 0.72% 1.15% 1.16% 0.12% (0.01)%
REAL ESTATE OWNED
Reserve balance at beginning of period $ 11,871 $ 15,725 $ 32,609 $ 39,457 $ 15,173
Provision for estimated losses 913 4,933 18,973 29,747 35,818
Charge-offs (10,221) (8,787) (35,857) (36,595) (11,267)
Recoveries -- -- -- -- (267)
--------- --------- --------- --------- ---------
Balance at end of period $ 2,563 $ 11,871 $ 15,725 $ 32,609 $ 39,457
========= ========= ========= ========= =========
</TABLE>
16
<PAGE> 18
The following table sets forth the Company's loan loss reserves to total
loans in each of the categories listed (dollars are in thousands).
<TABLE>
<CAPTION>
December 31,
-----------------------------------------------------------------------------
1997 1996 1995
------------------------------- ----------------------------- -------
Percent of Percent of
Reserves Reserves
to Total Loans to Total Loans
Amount by Category Amount by Category Amount
------- --- ------- --- -------
<S> <C> <C> <C> <C> <C>
SINGLE FAMILY
Estate $ 1,975 1.1% $ 279 0.3% $ 118
Conventional 4,696 2.1% 6,197 2.7% 6,534
INCOME PROPERTY
Multi-family 2,000 0.9% 4,786 2.2% 7,815
Commercial real estate 2,252 2.0% 1,150 1.9% 259
LAND 162 0.4% 167 1.2% 361
SINGLE FAMILY CONSTRUCTION
Individual residences 503 0.4% 168 0.3% 83
Tract development 817 1.2% 338 1.0% 9
OTHER 226 2.3% -- -- % --
UNALLOCATED 643 -- % 430 -- % 13
------- ------- -------
TOTAL $13,274 1.4% $13,515 1.8% $15,192
======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------------------
1995 1994 1993
---- ------------------------- -------------------------------
Percent of Percent of Percent of
Reserves Reserves Reserves
to Total Loans to Total Loans to Total Loans
by Category Amount by Category Amount by Category
-------------- ------- -------------- ------- --------------
<S> <C> <C> <C> <C> <C>
SINGLE FAMILY
Estate 0.2% $ -- --% $ -- -- %
Conventional 2.0% 8,608 2.3% 12,812 3.0%
INCOME PROPERTY
Multi-family 3.6% 11,558 6.7% 17,461 9.0%
Commercial real estate 0.8% 150 1.9% 1,829 24.0%
LAND 6.5% 235 6.2% 7,961 35.9%
SINGLE FAMILY CONSTRUCTION
Individual residences 0.4% 375 11.5% 488 7.4%
Tract development 0.1% 535 8.9% 6,078 26.5%
OTHER -- % -- -- % -- --%
UNALLOCATED -- % -- -- % -- --%
------- -------
TOTAL 2.3% $21,461 3.8% $46,629 6.8%
======= =======
</TABLE>
17
<PAGE> 19
The following table sets forth the Company's reserves on REO to total
REO in each of the categories listed (dollars are in thousands).
<TABLE>
<CAPTION>
December 31,
----------------------------------------------------------------------------------------
1997 1996 1995
----------------------- ----------------------- -----------------------
Percent of Percent of Percent of
Reserves Reserves Reserves
to Total REO to Total REO to Total REO
Amount by Category Amount by Category Amount by Category
------- ----- ------- ----- ------- -----
<S> <C> <C> <C> <C> <C> <C>
SINGLE FAMILY
Estate $ -- --% $ -- --% $ -- --%
Conventional 1,523 19.8% 2,576 26.4% 2,902 19.0%
INCOME PROPERTY
Multi-family 18 0.8% 547 17.0% 4,806 25.5%
Commercial real estate -- --% 106 30.6% 105 30.3%
LAND 1,022 43.2% 1,242 49.3% 2,043 54.3%
SINGLE FAMILY CONSTRUCTION
Individual residences -- --% -- --% -- --%
Tract development -- --% 7,400 45.8% 5,869 38.1%
------- ------- -------
Total $ 2,563 20.6% $11,871 37.1% $15,725 29.3%
======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
December 31,
--------------------------------------------------------
1994 1993
----------------------- -----------------------
Percent of Percent of
Reserves Reserves
to Total REO to Total REO
Amount by Category Amount by Category
------- ----- ------- -----
<S> <C> <C> <C> <C>
SINGLE FAMILY
Estate $ -- --% $ -- --%
Conventional 5,229 31.4% 3,974 26.7%
INCOME PROPERTY
Multi-family 155 0.6% 4,597 31.5%
Commercial real estate 142 35.9% -- --%
LAND 5,868 51.2% 6,064 47.3%
SINGLE FAMILY CONSTRUCTION
Individual residences 417 29.1% -- --%
Tract development 20,798 54.6% 24,822 35.9%
------- -------
Total $32,609 34.2% $39,457 35.3%
======= =======
</TABLE>
18
<PAGE> 20
INVESTMENT SECURITIES
The Company has authority to invest in a variety of investment
securities, including United States Government and agency securities,
mortgage-backed securities and corporate securities. However, in recent years
the Company's strategy has been to grow through loan origination, rather than
purchases of investment securities. As a result, all of the Company's $57.4
million of mortgage-backed securities at December 31, 1994 matured or were sold
by the Company during 1995 and the Company's investment securities decreased
from $62.8 million at December 31, 1995 to $38.4 million at December 31, 1996.
During the first quarter of 1997, the Company purchased $40.0 million of U.S.
Government agency callable bonds, which was partially offset by sales of $12.5
million of U.S. Government securities during the second and third quarters of
1997. These bonds were ultimately called or sold during the fourth quarter of
1997. The Company classifies all securities acquired as available-for-sale under
generally accepted accounting principles, and thus are carried at fair value,
with unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity, net of taxes.
SOURCES OF FUNDS
General Strategy. The Company's principal sources of funds in recent
years have been deposits obtained on a retail basis through its branch offices
and, to a far lesser extent, advances from the FHLB and securities sold under
agreements to repurchase ("reverse repurchase agreements"). In addition, funds
have been obtained from maturities and repayments of loans and securities, and
sales of loans, securities and other assets, including real estate owned.
Deposits. The Company operates six retail banking locations, a decrease
from the twenty-one offices operated by the Company in mid-1993. Four of these
branches are located in the South Bay area of Los Angeles County. The Company's
retail branches carry average deposit balances of $133.3 million in retail
deposit accounts, which is substantially higher than most local banking
companies. The Company does not operate a money desk or otherwise solicit
brokered deposits.
The Company solicits deposits from the general public throughout its
service area. Generally, the Company competes for deposit funds with other
Southern California-based financial companies, including banks, savings
associations and thrift and loans. These companies generally compete with one
another based upon price, convenience and service.
Because the Company does not have a critical mass of retail banking
facilities, and because its smaller size does not afford it the economies of
scale to advertise its basic products to the extent of its principal
competitors, the Company generally competes on price and, to a lesser extent, on
service and convenience. Historically, these limitations have been moderated by
the loyalty afforded by, and the resistance to change of, the Company's primary
customer constituency, which include individuals over 55 years of age.
The Company has several types of deposit accounts principally designed
to attract short-term deposits. The following table sets forth the distribution
of average deposits and the weighted average interest rates paid thereon during
the periods indicated (dollars are in thousands). See NOTE G of the NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------------------------------------------------
1997 1996 1995
--------------------------- ----------------------------- --------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE PERCENT AVERAGE PERCENT AVERAGE PERCENT
INTEREST OF INTEREST OF INTEREST OF
AMOUNT (1) RATE TOTAL AMOUNT (1) RATE TOTAL AMOUNT (1) RATE TOTAL
------- --- ---- ------- --- ---- ------- --- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Checking/NOW $ 30,786 1.2% 4.1% $ 28,032 0.8% 4.0% $ 29,431 1.6% 4.4%
Passbook 22,084 1.8% 3.0 26,500 1.9% 3.8 29,831 0.7% 4.4
Money market 32,239 3.2% 4.3 26,254 1.4% 3.7 51,920 2.0% 7.7
Certificates of deposit 659,830 5.6% 88.6 621,050 5.6% 88.5 564,147 5.7% 83.5
------- ---- ------- ---- ------- ----
Total $744,939 5.2% 100.0% $701,836 5.1% 100.0% $675,329 5.0% 100.0%
======== ===== ======== ===== ======== =====
</TABLE>
- ------------------
(1) Amounts represent monthly averages.
19
<PAGE> 21
The table below sets forth the maturities of the Company's certificates
of deposit outstanding at the dates indicated (dollars are in thousands).
<TABLE>
<CAPTION>
DECEMBER 31, 1997
------------------------------------------------------------------------------------------
OVER OVER
THREE MONTHS SIX MONTHS
THREE MONTHS THROUGH THROUGH OVER
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL
--------------- --------------- ------------- ----------- -----------
<S> <C> <C> <C> <C> <C>
BALANCES LESS THAN $100,000
4.00% or less $ 1,660 $ 15 $ 26 $ 88 $ 1,789
4.01% - 5.00% 38,460 1,650 1,571 5,206 46,887
5.01% - 6.00% 119,283 111,758 176,146 16,890 424,077
6.01% - 7.00% 4,834 21,458 29,818 1,218 57,328
7.01% or more - - - 100 100
--------------- --------------- ------------- ----------- -----------
164,237 134,881 207,561 23,502 530,181
BALANCES GREATER OR EQUAL TO $100,000
4.00% or less - - - - -
4.01% - 5.00% 7,162 - 548 1,271 8,981
5.01% - 6.00% 38,734 30,306 57,313 4,129 130,482
6.01% - 7.00% 2,663 9,933 10,926 523 24,045
7.01% or more - - - - -
--------------- --------------- ------------- ----------- -----------
48,559 40,239 68,787 5,923 163,508
--------------- --------------- ------------- ----------- -----------
TOTAL $ 212,796 $ 175,120 $ 276,348 $ 29,425 $ 693,689
=============== =============== ============= =========== ===========
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1996
-----------------------------------------------------------------------------------------
OVER OVER
THREE MONTHS SIX MONTHS
THREE MONTHS THROUGH THROUGH OVER
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL
-------------- -------------- ------------- ----------- ---------------
<S> <C> <C> <C> <C> <C>
BALANCES LESS THAN $100,000
4.00% or less $ 2,581 $ 104 $ - $ 4 $ 2,689
4.01% - 5.00% 54,800 4,556 3,239 17,127 79,722
5.01% - 6.00% 108,271 91,529 93,528 52,373 345,701
6.01% - 7.00% 9,760 6,464 40,078 22,706 79,008
7.01% or more 234 - - 100 334
-------------- -------------- ------------- ----------- ---------------
175,646 102,653 136,845 92,310 507,454
BALANCES GREATER OR EQUAL TO $100,000
4.00% or less 104 - - - 104
4.01% - 5.00% 12,609 - 160 5,934 18,703
5.01% - 6.00% 29,449 25,322 30,697 11,224 96,692
6.01% - 7.00% 3,554 2,060 13,373 5,010 23,997
7.01% or more - 200 - 100 300
-------------- -------------- ------------- ----------- ---------------
45,716 27,582 44,230 22,268 139,796
-------------- -------------- ------------- ----------- ---------------
TOTAL $ 221,362 $ 130,235 $ 181,075 $ 114,578 $ 647,250
============== ============== ============= =========== ===============
</TABLE>
20
<PAGE> 22
Borrowings. The twelve district banks which comprise the FHLB System
function as a source of credit to member associations. The Company may apply for
advances from the FHLB secured by the capital stock of the FHLB owned by the
Company and certain of the Company's loans and other assets. 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 creditworthiness and other
relevant factors. At December 31, 1997, the Company had an approved line of
credit with the FHLB with a maximum advance of up to 35% of total assets (of
which 25% may be secured by mortgage collateral and 10% may be secured by
investment securities). At December 31, 1997, the Company had one $40.0 million
FHLB advance outstanding, which had an interest rate of 5.95% which matures in
June 1998.
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 within
specified periods, the NII generally will be negatively impacted by increasing
interest rates and positively impacted by decreasing interest rates during such
periods. Conversely, when the amount of rate-sensitive assets exceeds the amount
of rate-sensitive liabilities within specified periods, net interest income
generally will be positively impacted by increasing interest rates and
negatively impacted by decreasing interest rates during such periods. The speed
and velocity of the repricing of assets and liabilities will also contribute to
the effects on NII.
The Company utilizes two methods for measuring interest rate risk, gap
analysis and interest rate simulations. Gap analysis focuses on measuring
absolute dollar amounts subject to repricing within certain periods of time,
particularly the one-year maturity horizon.
Interest rate simulations provide the Company with an estimate of both
the dollar amount and percentage change in NII under various interest rate
scenarios. All assets and liabilities are subjected to tests of up 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 NPV of its
current balance sheet. From these results, the Company can then develop
alternatives to dealing with the tolerance thresholds.
During 1995, the Company initiated certain measures to reduce interest
rate risk. These measures included the sale of approximately $110.0 million in
fixed rate assets and the purchase of a $450.0 million interest rate cap on the
liability base subject to reprice within a six-month period. During 1996, the
Company continued to reduce interest rate risk exposure by making additional
fixed rate loan sales of approximately $35.0 million and sales of single family
11th DCOFI-indexed loans of approximately $45.0 million. The Company also
extended the duration of its liability base from six to nine months during the
course of 1996. During 1997, the Company continued to reduce its interest risk
exposure by selling its fixed-rate investment securities and extending the
duration of its liability base through the use of advances from the FHLB.
Since 1995, the Company has been utilizing interest rate floors to
mitigate the risk of interest margin compression on its new loans in a
decreasing interest rate environment. Typically, these floors represent the rate
at underwriting. Additionally, on most new income property loans, the Company
utilizes interest rate caps. These caps are life caps and are usually five
points above the rate at underwriting or at an amount that would still allow for
one-to-one debt service coverage at the maximum rate, thereby reducing the
likelihood of borrower default in a rising interest rate environment. The risk
to the Company that is associated with the interest rate caps is that interest
rates will exceed the maximum loan rates on such loans, and while the Company's
cost of funds continues to rise, the interest income derived from these loans
will be fixed, resulting in an overall compression on net interest income.
21
<PAGE> 23
The following table sets forth information concerning sensitivity of the
Company's interest-earning assets and interest-bearing liabilities as of
December 31, 1997. The amounts of assets and liabilities shown within a
particular period were determined in accordance with the contractual maturities
of the assets and liabilities, except that adjustable-rate loans are included in
the period in which they are first scheduled to adjust and not in the period in
which they mature. Such assets and liabilities are classified by the earlier of
maturity or repricing date (dollars are in thousands).
<TABLE>
<CAPTION>
Over Three Over Six Over One
Three Through Through Year Over
Months Six Twelve Through Five
Or less Months Months Five years Years Total
--------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING ASSETS
Cash and cash equivalents $ 42,250 $ -- $ -- $ -- $ -- $ 42,250
Investments and FHLB Stock 7,791 -- -- -- -- 7,791
Loans (1) 464,655 179,330 51,361 41,255 122,101 858,702
--------- --------- --------- --------- --------- ---------
Total interest-earning assets $ 514,696 $ 179,330 $ 51,361 $ 41,255 $ 122,101 $ 908,743
========= ========= ========= ========= ========= =========
INTEREST-BEARING LIABILITIES
Deposits
Non-certificates of deposit (2) $ 105,812 $ -- $ -- $ -- $ -- $ 105,812
Certificates of deposit 212,796 175,120 276,348 29,425 -- 693,689
FHLB advances -- 40,000 -- -- -- 40,000
Senior Notes -- -- -- -- 40,000 40,000
--------- --------- --------- --------- --------- ---------
Total interest-bearing liabilities $ 318,608 $ 215,120 $ 276,348 $ 29,425 $ 40,000 $ 879,501
========= ========= ========= ========= ========= =========
Interest rate sensitivity gap $ 196,088 $ (35,790) $(224,987) $ 11,830 $ 82,101 $ 29,242
Cumulative interest rate
sensitivity gap $ 196,088 $ 160,298 $ (64,689) $ (52,859) $ 29,242 $ 29,242
Cumulative interest rate
sensitivity gap as a percentage
of total interest-earning assets 21.6% 17.6% (7.1%) (5.8%) 3.2% 3.2%
</TABLE>
- ---------------
(1) Balances include nonaccrual loans of $15.4 million at December 31, 1997.
(2) Includes checking/NOW, passbook and money market accounts.
CAPITAL ADEQUACY
At December 31, 1997, the Company's stockholders' equity amounted to
$42.3 million or 4.56% of total assets. At December 31, 1997, the Bank was in
compliance with all applicable regulatory capital requirements and qualified as
a "well-capitalized" association under applicable laws and regulations. For
information relating to the Bank's compliance with these requirements, see ITEM
1. BUSINESS - CERTAIN REGULATORY MATTERS - SAVINGS ASSOCIATION REGULATION -
Regulatory Capital Requirements.
CERTAIN REGULATORY MATTERS
GENERAL
The Company is registered with the OTS as a savings and loan holding
company and is subject to regulation and examination as such by the OTS. The
Bank is a member of the FHLB and its deposits are insured by the FDIC. The Bank
is subject to examination and regulation by the OTS under the Home Owners' Loan
Act ("HOLA") and the FDIC under the Federal Deposit Insurance Act ("FDIA") with
respect to most of its business activities, including, among others, lending
activities, capital standards, general investment authority, deposit-taking and
borrowing authority, mergers and other business combinations, establishment of
branch offices, and permitted subsidiary investment and activities. The effect
of the statutes, regulations and other pronouncements and policies
22
<PAGE> 24
which govern the operations and activities of the Company and the Bank can be
significant, cannot be predicted with a high degree of certainty and can change
over time. Moreover, such statutes, regulations and other pronouncements and
policies are intended to protect depositors and the insurance funds administered
by the FDIC, and not stockholders or holders of indebtedness which is not
insured by the FDIC.
The following sections should be read in conjunction with MANAGEMENT'S
DISCUSSION and NOTES L and M of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
The description of the statutes and regulations applicable to the Company and
the Bank set forth below and elsewhere herein do not purport to be complete
descriptions of such statutes and regulations and their effects on the Company
and the Bank. Such descriptions also do not purport to identify every statute
and regulation that may apply to the Company or the Bank.
SAVINGS AND LOAN HOLDING COMPANY REGULATION
General. The Company is registered as a savings and loan holding company
under the HOLA and is subject to OTS regulation, examination, supervision and
reporting requirements. Because the Company has only one savings association
subsidiary, it is known as a "unitary" savings and loan holding company.
Activities Restrictions. There are generally no restrictions on the
activities of a unitary savings and loan holding company. However, if the
savings association subsidiary of a unitary holding company fails to meet the
qualified thrift lender ("QTL") test (see SAVINGS ASSOCIATION REGULATION -
Qualified Thrift Lender Test), then such unitary holding company is subject to
the activities restrictions applicable to multiple savings and loan holding
companies and, unless the savings association subsidiary requalifies as a QTL
within one year thereafter, shall register as, and become subject to the
restrictions applicable to, a bank holding company.
Among other things, no multiple savings and loan holding company or
subsidiary thereof which is not a savings association may commence or continue
for a limited period of time after becoming a multiple savings and loan holding
company or subsidiary thereof any business activity, upon prior notice to, and
no objection by the OTS, other than: (i) furnishing or performing management
services for a subsidiary savings association; (ii) conducting an insurance
agency or escrow business; (iii) holding, managing, or liquidating assets owned
by or acquired from a subsidiary savings association; (iv) holding or managing
properties used or occupied by a subsidiary savings association; (v) acting as
trustee under deeds of trust; (vi) those activities authorized by regulation as
of March 5, 1987 to be engaged in by multiple savings and loan holding
companies; or (vii) unless the OTS by regulation prohibits or limits such
activities for savings and loan holding companies, those activities authorized
by the Federal Reserve Board as permissible for bank holding companies. Those
activities described in (vii) above also must be approved by the OTS prior to
being engaged in by a multiple savings and loan holding company.
Restrictions on Acquisitions. Except under limited circumstances, savings
and loan holding companies are prohibited from acquiring, without prior approval
of the OTS, (i) control of any other savings association or savings and loan
holding company or substantially all the assets thereof or (ii) more than 5% of
the voting shares of a savings association or holding company thereof which is
not a subsidiary. Except with the prior approval of the OTS, no director or
officer of a savings and loan holding company or person owning or controlling by
proxy or otherwise more than 25% of such company's stock, may acquire control of
any savings association, other than a subsidiary savings association, or of any
other savings and loan holding company.
SAVINGS ASSOCIATION REGULATION
Qualified Thrift Lender Test. Any savings association that does not meet
the QTL test set forth in the HOLA and complementary regulations must either
convert to a national bank charter or be subject to restrictions specified in
the OTS regulations. Any such savings association that does not become a bank
would be: (i) prohibited from making any new investment or engaging in
activities that would not be permissible for national banks; (ii) prohibited
from establishing any new branch office in a location that would not be
permissible for a national bank in the association's home state; (iii)
ineligible to obtain new advances from any FHLB; and (iv) subject to limitations
on the payment of dividends comparable to the statutory and regulatory dividend
restrictions applicable to national banks. Also, beginning three years after the
date on which the savings association ceases to be a QTL, the savings
association would be prohibited from retaining any investment or engaging in any
activity not
23
<PAGE> 25
permissible for a national bank and would be required to repay any outstanding
advances to any FHLB. A savings association may requalify as a QTL if it
thereafter complies with the QTL test.
Any savings association is a QTL if (i) it qualifies as a domestic
building and loan association under Section 7701(a)(19) of the Internal Revenue
Code of 1986, as amended ("Code") (which generally requires that at least 60% of
the association's assets constitute housing-related and other qualifying
assets), or (ii) at least 65% of the association's "portfolio assets" (as
defined) consist of certain housing and consumer-related assets on a monthly
average basis in at least nine out of every 12 months. At December 31, 1997, the
Bank was in compliance with the QTL test.
Deposit Insurance. The FDIC administers two separate deposit insurance
funds. The Bank Insurance Fund ("BIF") generally insures the deposits of
commercial banks, and the SAIF generally insures the deposits of savings
associations.
Under FDIC regulations, associations are assigned to one of three capital
groups for insurance premium purposes - "well capitalized," "adequately
capitalized" and "undercapitalized" - which are defined in the same manner as
the regulations establishing the prompt corrective action system under Section
38 of the FDIA, as discussed under- Prompt Corrective Action Rules below. These
three groups are then divided into subgroups which are based on supervisory
evaluations by the association's primary federal regulator, resulting in nine
assessment classifications. Effective January 1, 1997, assessment rates for
SAIF-insured associations range from 0% of insured deposits for well-capitalized
associations with minor supervisory concerns to .27% of insured deposits for
undercapitalized associations with substantial supervisory concerns. In
addition, an additional assessment of 6.4 basis points and 1.3 basis points will
be added to the regular SAIF-assessment and to the regular BIF-assessment,
respectively, until December 31, 1999 in order to cover Financing Corporation
debt service payments.
Both the SAIF and the BIF are required by law to attain and thereafter
maintain a reserve ratio of 1.25% of insured deposits. The BIF has achieved the
required reserve ratio, and as a result, the FDIC reduced the average deposit
insurance premium paid by BIF-insured banks to a level substantially below the
average premium previously paid by savings associations. Banking legislation was
enacted September 30, 1996 to eliminate the premium differential between
SAIF-insured associations and BIF-insured associations. The legislation provided
that all insured depository associations with SAIF-assessable deposits as of
March 31, 1995 pay a special one-time assessment to recapitalize the SAIF.
Pursuant to this legislation, the FDIC promulgated a rule that established the
special assessment necessary to recapitalize the SAIF at 65.7 basis points of
SAIF-assessable deposits held by affected associations as of March 31, 1995.
Based upon its level of SAIF deposits as of March 31, 1995, the Company paid a
special assessment of $3.8 million. The assessment was accrued in the quarter
ended September 30, 1996.
Another component of the SAIF recapitalization plan provides for the
merger of the SAIF and the BIF on January 1, 1999, provided that no insured
depository association is a savings association on that date. If legislation is
enacted which requires the Bank to convert to a bank charter, the Company would
become a bank holding company subject to the more restrictive activity limits
imposed on bank holding companies unless special grandfather provisions are
included in such legislation. Based on its present activities, the Company does
not believe that its activities would be materially affected if it was required
to become a bank holding company.
Enforcement and Termination of Deposit Insurance. The OTS' enforcement
authority over savings associations and their holding companies includes, among
other things, the ability to assess civil money penalties, to issue cease and
desist orders, to initiate removal and prohibition orders against officers,
directors and certain other association-affiliated persons, and to appoint a
conservator or receiver for savings associations under appropriate
circumstances. In general, these enforcement actions may be initiated for
violations of laws and regulations, violations of cease and desist orders and
"unsafe or unsound" conditions or practices, which are not limited to cases of
inadequate capital.
The FDIC has authority to recommend that the OTS take authorized
enforcement action with respect to any savings associations. If the OTS does not
take the recommended action or provide an acceptable plan for addressing the
FDIC's concerns within 60 days after the receipt of the recommendation from the
FDIC, the FDIC may take such action if the FDIC Board of Directors determines
that the association is in an unsafe or unsound condition or that failure to
take such action will result in the continuation of unsafe or unsound practices
in
24
<PAGE> 26
conducting the business of the association. The FDIC may also take action prior
to the expiration of the 60-day time period in exigent circumstances after
notifying the OTS.
The FDIC may terminate the deposit insurance of any insured depository
association if the FDIC determines, after a hearing, that the association has
engaged or is engaging in unsafe or unsound practices which, as with the OTS'
enforcement authority, are not limited to cases of capital inadequacy, is in an
unsafe or unsound condition to continue operations or has violated any
applicable law, regulation or order or any condition imposed in writing by the
FDIC. In addition, FDIC regulations provide that any insured association that
falls below a 2% minimum leverage ratio (see below) will be subject to FDIC
deposit insurance termination proceedings unless it has submitted, and is in
compliance with, a capital plan with its primary federal regulator and the FDIC.
The FDIC may also suspend deposit insurance temporarily during the hearing
process if the association has no tangible capital. The FDIC is additionally
authorized by statute to appoint itself as conservator or receiver of an insured
association (in addition to the powers of the association's primary federal
regulatory authority) in cases, among others and upon compliance with certain
procedures, of unsafe or unsound conditions or practices or willful violations
of cease and desist orders.
Transactions with Affiliates. Under HOLA, all transactions between and
among a savings association and its affiliates, which include holding companies,
are subject to Sections 23A and 23B of the Federal Reserve Act. Generally, these
requirements limit these transactions to a percentage of the savings
association's capital and require all of them to be on terms at least as
favorable to the association as transactions with non-affiliates. In addition, a
savings association may not lend to any affiliate engaged in non-banking
activities not permissible for a bank holding company or acquire shares of any
affiliate that is not a subsidiary. The OTS is authorized to impose additional
restrictions on transactions with affiliates if necessary to protect the safety
and soundness of a savings association. The OTS regulations also set forth
various reporting requirements relating to transactions with affiliates.
Extensions of credit by a savings association to executive officers,
directors and principal shareholders are subject to Section 22(h) of the Federal
Reserve Act, which, among other things, generally prohibits loans to any such
individual where the aggregate amount exceeds an amount equal to 15% of an
association's unimpaired capital and surplus, plus an additional 10% of
unimpaired capital and surplus in the case of loans that are fully secured by
readily marketable collateral.
FHLB System. As a member of the FHLB system, the Bank is required to own
capital stock in its regional FHLB, the FHLB of San Francisco, in a minimum
amount determined at the end of each year based on the greater of (i) 1.0% of
the aggregate principal amount of its unpaid residential mortgage loans, home
purchase contracts and similar obligations, (ii) 5.0% of its outstanding
borrowings from the FHLB of San Francisco, or (iii) 0.3% of its total assets.
The Company was in compliance with this requirement, with an investment of $7.2
million in FHLB stock, at December 31, 1997. The FHLB of San Francisco serves as
a reserve or central bank for the member institutions within its assigned
region, the Eleventh FHLB District. It makes advances to members in accordance
with policies and procedures established by the Federal Housing Finance Board
and the Board of Directors of the FHLB of San Francisco.
Federal Reserve System. The Federal Reserve Board requires all
depository associations to maintain reserves against their transaction accounts
(primarily NOW and Super NOW checking accounts for savings associations) and
non-personal time deposits. At December 31, 1997, the Company was in compliance
with its reserve requirements.
Liquidity. OTS regulations currently require a savings association to
maintain a monthly average daily balance of liquid assets (including cash,
certain time deposits, bankers' acceptances and specified United States
Government, state or federal agency obligations) equal to at least 4.00% of the
average daily balance of its net withdrawable accounts and short-term borrowings
during the preceding calendar month. This liquidity requirement may be changed
from time to time by the OTS to any amount within the range of 4.00% to 10.00%
of such accounts and borrowings depending upon economic conditions and the
deposit flows of member associations. Monetary penalties may be imposed for
failure to meet this liquidity ratio requirement. The Company's liquidity for
the calculation period ended December 31, 1997, was 4.74%, which exceeded the
applicable requirements.
25
<PAGE> 27
Community Reinvestment Act. Under the Community Reinvestment Act ("CRA")
a savings association has a continuing and affirmative obligation consistent
with its safe and sound operation to help meet the credit needs of its entire
community, including low and moderate income neighborhoods. The CRA also
requires the OTS to assess an association's performance in meeting the credit
needs of its delineated communities, as part of its examination of the
association, and to take such assessments into consideration in reviewing
applications with respect to branches, mergers and other business combinations,
and savings and loan holding company acquisitions. An unsatisfactory CRA rating
may be the basis for denying such an application and community groups have
successfully protested applications on CRA grounds. The OTS assigns CRA ratings
of "outstanding", "satisfactory", "needs to improve" or "substantial
noncompliance". The Bank was rated "satisfactory" in its most recent CRA
examination (April 1996).
Regulatory Capital Requirements. HOLA and the capital regulations of the
OTS promulgated thereunder ("Capital Regulations") impose three capital
requirements on savings associations, including a "core capital requirement", a
"tangible capital requirement" and a "risk-based capital requirement".
Under the core capital requirement, a savings association must maintain
"core capital" of not less than 3.0% of adjusted total assets. "Core Capital"
generally includes common stockholders' equity, noncumulative perpetual
preferred stock, including any related surplus, and minority interests in the
equity accounts of fully consolidated subsidiaries. The amount of an
association's core capital is, in general, calculated in accordance with
generally accepted accounting principles ("GAAP"), but with certain exceptions.
Among other exceptions, adjustments to an association's GAAP equity accounts
that are required pursuant to FASB 115 to reflect changes in market value of
certain securities held by the association that are categorized as
"available-for-sale" are not to be included in the calculation of core capital
for regulatory capital purposes. Intangible assets (not including purchased
mortgage servicing rights, certain mortgage servicing rights with respect to
originated loans and purchased credit card relationships) must be deducted from
core capital. With certain exceptions, equity investments, including equity
investments in real estate, and that portion of land loans and nonresidential
construction loans in excess of an 80% loan-to-value ratio, must also be
deducted from capital. Core capital may include purchased mortgage servicing
rights, certain mortgage servicing rights with respect to originated loans and
purchased credit card relationships, subject to certain limitations.
Under the tangible capital requirement, a savings association must
maintain "tangible capital" in an amount not less than 1.5% of adjusted total
assets. "Tangible capital" means core capital less any intangible assets
(including supervisory goodwill), plus purchased mortgage servicing rights, and
certain mortgage servicing rights with respect to originated loans, subject to
certain limitations.
Under the risk-based capital requirement, a savings association must
maintain "total capital" equal to 8.0% of risk-weighted assets. "Total capital"
consists of core capital and supplementary capital. Supplementary capital
includes, among other things, certain types of preferred stock and subordinated
debt and, subject to certain limitations, general reserves up to 1.25% of
risk-weighted assets. A savings association's supplementary capital may be used
to satisfy the risk-based capital requirements only to the extent of that
association's core capital. Risk-weighted assets are the assets of the
association (including certain off-balance sheet items, including letters of
credit, and loans or other assets sold with subordination or recourse
arrangements) adjusted to reflect the degree of credit risk deemed to be
associated with such assets, ranging from 0% for low-risk assets such as U. S.
Government securities and GNMA securities to 100% for various types of loans and
other assets deemed to be higher risk. Single family mortgage loans having
loan-to-value ratios not exceeding 80% and meeting certain additional criteria,
as well as certain multi-family residential mortgage loans, qualify for a 50%
risk-weighted treatment.
The risk-based capital rules of the OTS, FDIC and other federal banking
agencies provide that an association must hold capital in excess of regulatory
minimums to the extent that examiners find either (i) significant exposure to
concentration of credit risk such as risks from higher interest rates,
prepayments, significant off-balance sheet items (especially standby letters of
credit), or risks arising from nontraditional activities or (ii) that the
association is not adequately managing these risks. For this purpose, however,
the agencies have stated that, in view of the statutory requirements relating to
permitted lending and investment activities of savings associations, the general
concentration by such associations in real estate lending activities would not,
by itself, be deemed to constitute an exposure to concentration of credit risk
that would require greater capital levels.
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<PAGE> 28
The following table summarizes the regulatory capital requirements under
HOLA for the Bank at December 31, 1997. As indicated in the table, the Bank's
capital levels exceeded all three of the minimum HOLA 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 $ 69,906 $ 69,906 $ 69,906
Adjustments
General reserves -- -- 8,554
Unrealized gains (6) (6) (6)
--------- ----------- --------- ----------- --------- -----------
Regulatory capital 69,900 7.55% 69,900 7.55% 78,454 11.48%
Required minimum 13,887 1.50 27,773 3.00 54,679 8.00
--------- ----------- --------- ----------- --------- -----------
Excess capital $ 56,013 6.05% $ 42,127 4.55% $ 23,775 3.48%
========= =========== ========= =========== ========= ===========
Adjusted assets (1) $ 925,783 $ 925,783 $ 683,491
========= ========= =========
</TABLE>
- -----------------------
(1) The term "adjusted assets" refers to (i) 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 (ii) the term
"risk-weighted assets" as defined in 12 C.F.R. Section 567.5 (d) for
purposes of the risk-based capital requirements.
In August 1993, the OTS adopted a final rule incorporating an
interest-rate risk component into the risk-based capital regulation. Under the
rule, an association with a greater than "normal" level of interest rate risk is
subject to a deduction of its interest rate risk component from total capital
for purposes of calculating its risk-based capital. As a result, such an
association is required to maintain additional capital in order to comply with
the risk-based capital requirement. The final rule was originally to be
effective as of January 1, 1994; however, its effectiveness has been delayed
several times. In August 1995, the OTS issued Thrift Bulletin No. 67, which
allows eligible associations to request an adjustment to their interest rate
risk component as calculated by the OTS, or to request to use their own models
to calculate their interest rate component. The OTS also indicated that it will
continue to delay the effectiveness of its interest rate risk rule requiring
associations with above normal interest rate risk exposure to adjust their
regulatory capital requirement until new procedures are implemented and
evaluated.
Prompt Corrective Action Rules. Under federal law, each federal banking
agency has implemented a system of prompt corrective action for associations
which it regulates. Under OTS regulations for prompt corrective action ("PCA
Rules"), an association is deemed to be (i) "well-capitalized" if it has total
risk-based capital of 10.0% or more, has a Tier 1 risk-based capital ratio of
6.0% or more, has a Tier 1 leverage capital ratio of 5.0% or more and is not
subject to any order or final capital directive to meet and maintain a specific
capital level for any capital measure; (ii) "adequately capitalized" if it has a
total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital
ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0%
under certain circumstances) and does not meet the definition of "well
capitalized," (iii) "undercapitalized" if it has a total risk-based capital
ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less
than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under
certain circumstances), (iv) "significantly undercapitalized" if it has a total
risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital
ratio that is less than 3.0% or a Tier 1 leverage capital ratio that is less
than 3.0%, and (v) "critically undercapitalized" if it has a ratio of tangible
equity to total assets that is equal to or less than 2.0%. Federal law
authorizes the OTS to reclassify a well capitalized association as adequately
capitalized and may require an adequately capitalized association or an
undercapitalized association to comply with supervisory actions as if it were in
the next lower category (except that the OTS may not reclassify a significantly
undercapitalized association as critically undercapitalized).
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<PAGE> 29
As of December 31, 1997, the most recent notification from the OTS
categorized the Bank as "well capitalized" under the regulatory framework for
prompt corrective action. The Bank's actual capital amounts and ratios and the
capital amounts and ratios required in order for an association to be well
capitalized and adequately capitalized are presented in the table below.
<TABLE>
<CAPTION>
TO BE CATEGORIZED AS TO BE CATEGORIZED AS
ADEQUATELY CAPITALIZED WELL CAPITALIZED
ACTUAL UNDER PCA RULES UNDER PCA RULES
--------------------- --------------------- ---------------------
AMOUNT RATIOS AMOUNT RATIOS AMOUNT RATIOS
------- ----- ------- ---- ------- -----
<S> <C> <C> <C> <C> <C> <C>
AS OF DECEMBER 31, 1997
Total Capital
(to Risk Weighted Assets) $78,454 11.48% $54,679 8.00% $68,349 10.00%
Core Capital
(to Adjusted Tangible Assets) 69,900 7.55% 27,773 3.00% 46,289 5.00%
Tangible Capital
(to Adjusted Tangible Assets) 69,900 7.55% 13,887 1.50% N/A N/A
Tier 1 Capital
(to Risk Weighted Assets) 69,900 10.23% N/A N/A 41,009 6.00%
</TABLE>
Under the PCA Rules, an association that is deemed to be
undercapitalized must submit a capital restoration plan and is subject to
mandatory restrictions on capital distributions (including cash dividends) and
management fees, increased supervisory monitoring by the OTS, growth
restrictions, restrictions on certain expansion proposals and capital
restoration plan submission requirements. If an association is deemed to be
significantly undercapitalized, all of the foregoing mandatory restrictions
apply, as well as a restriction on compensation paid to senior executive
officers. Furthermore, the OTS must take one or more of the following actions:
(i) require the association to sell shares (including voting shares) or
obligations; (ii) require the association to be acquired or merged (if one or
more grounds for the appointment of a conservator or receiver exists); (iii)
implement various restrictions on transactions with affiliates; (iv) restrict
interest rates on deposits; (v) impose further asset growth restrictions or
asset reductions; (vi) require the association or subsidiary to alter, reduce,
or terminate activities considered risky; (vii) order a new election of
directors; (viii) dismiss directors and/or officers who have held office more
than 180 days before the association became undercapitalized; (ix) require the
hiring of qualified executives; (x) prohibit correspondent bank deposits; (xi)
require the association to divest or liquidate a subsidiary in danger of
insolvency or a controlling company to divest any affiliate that poses a
significant risk, or is likely to cause a significant dissipation of assets or
earnings; (xii) require a controlling company to divest the association if it
improves the association's financial prospects; or (xiii) require any other
action the OTS determines fulfills the purposes of the PCA Rules.
The OTS may also impose on significantly undercapitalized associations
one or more of the mandatory restrictions applicable to critically
undercapitalized associations. The restrictions require prior regulatory
approval for any material transaction, to extend credit on a highly leveraged
transaction, to adopt charter or bylaws amendments, to make material accounting
changes, to engage in covered transactions with affiliates, to pay excessive
compensation, or to pay higher interest on new or renewing liabilities. A
critically undercapitalized association may not, beginning 60 days after
becoming critically undercapitalized, make any principal or interest payments on
subordinated debt not outstanding on July 15, 1991. The OTS is required, not
later than 90 days after a savings association becomes critically
undercapitalized to either (i) appoint a conservator or receiver or (ii) take
such other actions it determines would better achieve the purpose of the PCA
Rules. In any event, the OTS is required to appoint a receiver within 270 days
after the association becomes critically undercapitalized unless (i) with the
concurrence of the FDIC, the OTS determines the association has a positive net
worth, has been in substantial compliance with an approved capital restoration
plan, is profitable or has an upward trend in earnings which the OTS finds is
substantial, and is reducing the ratio of nonperforming loans to total loans and
(ii) the Director of the OTS and the Chairman of the FDIC both certify that the
association is viable and not expected to fail.
Dividends and Other Capital Distributions. OTS regulations impose
limitations on "capital distributions" by savings associations. Distributions
are defined to include, among other things, cash dividends and payments for the
repurchase or retirement of shares. The OTS retains the authority to prohibit
any capital distribution otherwise authorized under the regulation if the OTS
determines that the capital distribution would constitute an unsafe or
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<PAGE> 30
unsound practice. The regulation also states that the capital distribution
limitations apply to direct and indirect distributions to affiliates, including
those occurring in connection with corporation reorganizations.
A savings association that meets its capital requirements may make
capital distributions without prior OTS approval during a calendar year of up to
the greater of (i) 100% of its net income during the calendar year, plus the
amount that would reduce by not more than one-half its "surplus capital ratio"
at the beginning of the calendar year (the amount by which the association's
actual capital exceeded its capital requirements at that date) or (ii) 75% of
its net income over the most recent four-quarter period. An association that
does not meet its minimum regulatory capital requirements immediately prior to
or on a pro forma basis after giving effect to a proposed capital distribution
is not authorized to make any capital distributions unless it received prior
written approval from the OTS or the distributions are in accordance with the
express terms of an approved capital plan.
Savings associations generally are required to provide 30 days advance
notice of any proposed dividend. Any dividend declared within the notice period,
or without giving the prescribed notice, is invalid.
On December 5, 1994, the OTS published a notice of proposed rulemaking
to amend its capital distribution regulation. Under the proposal, savings
associations would be permitted to only make capital distributions that would
not result in their capital being reduced below the level required to remain
"adequately capitalized" as defined in the PCA Rules. The Bank would continue to
be required to provide notice to the OTS of its intent to make a capital
distribution.
Loans to One Borrower Limitation. With certain limited exceptions, the
maximum amount that a savings association may lend to one borrower (including
certain entities related to such borrower) is an amount equal to 15% of the
association's unimpaired capital and unimpaired surplus, plus an additional 10%
for loans fully secured by readily marketable collateral. Real estate is not
included within the definition of readily marketable collateral for this
purpose. Pursuant to the current regulation, the maximum amount which the Bank
could have loaned to any one borrower (and related entities) under the general
OTS loans to one borrower limit was $11.9 million as of December 31, 1997.
Other Lending Standards. The OTS and the other federal banking agencies
have jointly adopted uniform rules on real estate lending and related
Interagency Guidelines for Real Estate Lending Policies. The uniform rules
require that associations adopt and maintain comprehensive written policies for
real estate lending. The policies must reflect consideration of the Interagency
Guidelines and must address relevant lending procedures, such as loan-to-value
limitations, loan administration procedures, portfolio diversification standards
and documentation, approval and reporting requirements. Although the final rule
did not impose specific maximum loan-to-value ratios, the related Interagency
Guidelines state that such ratio limits established by individual associations'
board of directors should not exceed levels set forth in the Guidelines, which
range from a maximum of 65% for loans secured by raw land to 85% for improved
property. No limit is set for single family residence loans, but the Guidelines
state that such loans exceeding a 95% loan-to-value ratio should have private
mortgage insurance or some other form of credit enhancement. The Guidelines
further permit a limited amount of loans that do not conform to these criteria.
TAXATION
FEDERAL
The Company and the Bank currently file, and expect to continue to file,
a consolidated federal income tax return based on a fiscal year ended September
30. Consolidated returns have the effect of eliminating inter-company
transactions, including dividends, from the computation of taxable income.
For taxable years beginning prior to January 1, 1996, a savings
association such as the Company that met certain definitional tests relating to
the composition of its assets and the sources of its income (a "qualifying
savings association") was permitted to establish reserves for bad debts and to
claim annual tax deductions for additions to such reserves. A qualifying savings
association was permitted to make annual additions to such reserves based on the
association's loss experience under the "experience method". Alternatively, a
qualifying savings association could elect, on an annual basis, to use the
"percentage of taxable income" method to compute its addition to its bad debt
reserve on qualifying real property loans (generally, loans secured by an
interest in improved real estate). The percentage of taxable income method
permitted the association to deduct a specified percentage (8%) of its taxable
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<PAGE> 31
income before such deduction, regardless of the association's actual bad debt
experience, subject to certain limitations. In fiscal years 1997, 1996 and
1995, the Company utilized the experience method because that method produced a
greater deduction than the percentage method.
On August 20, 1996, President Clinton signed the Small Business Job
Protection Act (the "Act") into law. One provision of the Act repealed the
reserve method of accounting for bad debts for savings associations effective
for taxable years beginning after 1995 and provided for recapture of a portion
of the reserves existing at the close of the last taxable year beginning before
January 1, 1996. For its tax years beginning on or after January 1, 1996, a
savings association will be required to account for its bad debts under the
specific charge-off method. Under this method, deductions may be claimed only as
and to the extent that loans become wholly or partially worthless. A savings
association will be required to recapture its "applicable excess reserves,"
which are its federal tax bad debt reserves in excess of the base year reserve
amount, which are generally the balance of reserves as of December 31, 1987. The
Company does not have applicable excess reserves and thus will not be subject to
the recapture provisions. The base year reserves will continue to be subject to
recapture if: (1) the Company fails to qualify as a "bank" for federal income
tax purposes, (2) certain distributions are made with respect to the stock of
the Company, (3) the bad debt reserves are used for any purpose other than to
absorb bad debt losses or (4) there is a change in federal tax law. The
enactment of this legislation is expected to have no material impact on the
Company's operations or financial position.
In accordance with Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes," a deferred tax liability has not been recognized
for the tax bad debt base year reserves of the Company. At December 31, 1997,
the amount of those reserves was approximately $21.3 million. This reserve could
be recognized in the future under the conditions described in the preceding
paragraph.
Corporations, including qualifying savings associations, are subject to
an alternative minimum tax in addition to the regular corporate income tax. This
20% tax is computed based on the Company's taxable income (with certain
adjustments), as increased by its tax preference items and applies only if this
tax is larger than its regular tax. The adjustments include an addition to
taxable income of an amount equal to 75% of the excess of the Company's
"adjusted current earnings" over its regular taxable income. The tax preference
items common to savings associations include the excess, if any, of its annual
tax bad debt deduction over the deduction that would have been available under
the experience method. The Company did not incur a minimum tax liability in 1996
(as computed for federal income tax purposes).
For additional information regarding taxation, see NOTE I of the NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS.
STATE
The California franchise tax applicable to the Company is a
variable-rate tax. This rate is computed under a formula that results in a rate
higher than the rate applicable to nonfinancial corporations because it includes
an amount "in lieu" of local personal property and business license taxes paid
by such corporations (but not paid by banks or financial institutions such as
the Company). For the taxable years 1997 and 1996, the maximum rate was set at
approximately 11%. Under California regulations, financial corporations are
permitted to claim bad debt deductions using a reserve method, with the reserve
level being determined by past experience or current facts and circumstances.
RISK FACTORS
ASSET QUALITY
At December 31, 1997, the Company's nonperforming assets amounted to
$20.7 million, or 2.2% of total assets, and consisted of $10.8 million of loans
which were 90 days or more past due ("nonperforming loans") and $9.9 million of
real estate acquired by foreclosure or deed-in-lieu thereof, net of writedowns
and reserves ("real estate owned"). In addition to its nonperforming assets, at
December 31, 1997, the Company had (1) $4.4 million of loans which were
delinquent 30 to 89 days, which the Company placed on nonaccrual status as a
matter of policy, and (2) $36.0 million of performing loans, which the Company
had classified as substandard or lower in accordance with OTS regulations
because they were TDRs or contained one or more defined weaknesses, of which
$0.2 million were on
30
<PAGE> 32
nonaccrual status. The Company's $61.1 million of classified assets at December
31, 1997 were primarily attributable to loans originated during the late 1980s
and early 1990s by prior management of the Company, which generally emphasized
loans to construct single-family residential tract developments, individual
single-family residences and apartment buildings, as well as permanent loans
secured by the properties built with the Company's construction loans. For a
variety of reasons, including the Company's prior underwriting practices,
management of the Company believes that the loans originated by the Company
prior to 1995 generally involve greater risk of loss than the loans originated
by the Company thereafter. Management of the Company has devoted, and continues
to devote, substantial time and resources to the identification, collection and
workout of the Company's problem assets, which has resulted in a significant
decrease in the Company's nonperforming assets from a high of $151.2 million, or
17.2% of total assets, at December 31, 1993. There can be no assurance, however,
that the Company's nonperforming assets will not increase in future periods,
either as a result of (1) loans in the Company's loan portfolio originated prior
to 1995 or (2) loans in such portfolio originated subsequent to such date,
which generally have performed in accordance with their terms but involve the
risks set forth under "NEW BUSINESS GENERATION- ASSET QUALITY" above and have
not been outstanding long enough to be considered mature, seasoned loans.
ADEQUACY OF ALLOWANCES FOR LOSSES
The Company believes that it has established adequate allowances for
losses for its loan portfolio and real estate owned, which respectively amounted
to $13.3 million, or 1.6%, of net loans (exclusive of the allowance for loan
losses) and $2.6 million, or 20.6% of gross real estate owned at December 31,
1997. Notwithstanding the foregoing, material future additions to the allowance
for loan losses may be necessary due to changes in economic conditions, the
performance of the Company's loan portfolio, particularly loans originated after
1994, and increases in loans. Future additions to the allowance for losses on
real estate owned may be necessary to reflect changes in the economics and
markets for real estate in which the Company's real estate owned is located and
other factors which may result in adjustments which are necessary to ensure that
the Company's real estate owned is carried at the lower cost or fair value, less
estimated costs to dispose of the properties. In addition, the OTS, as an
integral part of its examination process, periodically reviews the Company's
allowances for losses and the carrying values of its assets. The Company was
most recently examined by the OTS in this regard as of June 30, 1997. Increases
in the provision for losses on loans and real estate owned would adversely
affect the Company's results of operations. See "NEW BUSINESS GENERATION- ASSET
QUALITY"
LIMITATIONS ON USE OF TAX LOSS CARRYFORWARDS
As of December 31, 1997, the Company had federal net operating loss
carryforwards of $12.5 million which expire in 2010 through 2011 and may be used
to reduce taxable income of the Company in future years. The Company also has
federal alternative minimum tax credit carryforwards of $1.0 million as of
December 31, 1997. In addition, at the same date the Company had state net
operating loss carryfowards of $4.2 million and $8.1 million which expire in
2000 and 2001, respectively. The Company's net operating loss and alternative
minimum tax credit carryforwards would be subject to significant limitation
under Section 382 of the Code, if the Company underwent an ownership change (as
defined below, and "Ownership Change"). In event of an Ownership Change, Section
382 of the Code imposes an annual limitation on the amount of taxable income a
corporation may offset with net operating losses, credit carryforwards and
certain recognized built-in-losses. The limitation imposed by Section 382 of the
Code for any post-change year would be determined by multiplying the value of
the Company's stock (including both Common Stock and Preferred Stock)
outstanding at the time of Ownership Change by the applicable long-term tax
exempt rate (which was 5.23% for December 1997). Any unused annual limitation
may be carried over to later years, and the limitation may under certain
circumstances be increased by the built-in gains in assets held by the Company
at the time of the change that are recognized in the five-year period after the
change. Under current conditions, if an Ownership Change were to occur, the
Company's annual net operating loss utilization would be limited to a maximum of
approximately $3.3 million.
The Company would undergo an Ownership Change if, among other things,
the stockholders who own or have owned, directly or indirectly, 5% or more of
the Common Stock or are otherwise treated as 5% stockholders or a "higher tier
entity" under Section 382 of the Code and the regulations promulgated thereunder
("5% Stockholders") increase their aggregate percentage ownership of such stock
by more than 50 percentage points over the lowest percentage of such stock owned
by such stockholders at any time during a specified testing period (generally
the preceding three years). Because events which are beyond the control of the
Company could result in an Ownership Change, there can be no assurance that an
Ownership Change will not occur in the future and thereby limit the
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<PAGE> 33
Company's ability to utilize its net operating loss carryforwards to reduce
taxable income in future periods. For a description of the possible limitations
on the ability of the Company to utilize its remaining income tax benefits, see
"OPERATING RESULTS" below.
INTEREST RATE RISK
The Company's operating results depend to a large extent on its net
interest income, which is the difference between the interest income earned on
interest-earning assets and the interest expense incurred in connection with its
interest-bearing liabilities. Changes in the general level of interest rates can
affect the Company's net interest income by affecting the spread between the
Company's interest-earning assets and interest-bearing liabilities. This may be
due to the disparate maturities or period to repricing of the Company's
interest-earning assets and interest-bearing liabilities, as well as in the case
of an increase in the general level of interest rates, periodic caps which limit
the interest rate change on many of the Company's adjustable-rate mortgage
loans. In addition to its effect on the Company's interest rate spread, changes
in the general level of interest rates also affect, among other things, the
ability of the Company to originate loans; the ability of borrowers to make
payments on loans; the value of the Company's interest-earning assets and its
ability to realize gains from the sale of such assets; the average life of the
Company's interest-earning assets; the value of the Company's mortgage servicing
rights; and the average life of the Company's ability to obtain deposits in
competition with other available investment alternatives. Interest rates are
highly sensitive to many factors, including governmental monetary policies,
domestic and international economic and political conditions and other factors
beyond the control of the Company. See "INTEREST RATE RISK MANAGEMENT".
ECONOMIC CONDITIONS
The success of the Company is dependent to a certain extent upon general
economic conditions, particularly in the areas of Southern California in which
it conducts its business activities. Adverse changes in the economic conditions
of these areas may impair the ability of the Company to collect loans and would
otherwise have an adverse effect on its business, including the demand for new
loans, the ability of customers to repay loans and the value of both real estate
which secures its loans and its real estate owned. Moreover, earthquakes and
other natural disasters could have similar effects. Although such disasters have
not significantly adversely affected the Company to date, the ability of
borrowers to acquire insurance for such disasters in California is severely
limited. As a result, the properties which secure the Company's loans generally
are not covered by such insurance.
COMPETITION
The Company experiences substantial competition both in attracting and
retaining deposits and in making loans. Its most direct competition for deposits
historically has come from other thrift associations, commercial banks and
credit unions doing business in its market areas in Southern California. In
addition, as with all banking organizations, the Company has experienced
increasing competition from nonbanking sources. For example, the Company also
competes for funds with full service and discount broker-dealers and with other
investment alternatives, such as mutual funds and corporate and governmental
debt securities. The Company's competition for loans comes principally from
other thrift associations, commercial banks, mortgage banking companies,
consumer finance companies, insurance companies and other institutional lenders.
A number of associations with which the Company competes for deposits and loans
have significantly greater assets, capital and other resources than the Company.
In addition, many of the Company's competitors are not subject to the same
extensive federal regulation that governs savings and loan holding companies
such as the Company and federally-chartered and federally-insured savings
associations such as the Bank. As a result, many of the Company's competitors
have advantages over the Company in conducting certain businesses and providing
certain services.
REGULATION
Both the Company, as a savings and loan holding company, and the Bank,
as a federally-chartered savings association, are subject to significant
government supervision and regulation, which is intended primarily for the
protection of depositors. Statutes and regulations affecting the Company and the
Bank may be changed at any time, and the interpretation of these statutes and
regulations by examining authorities also is subject to change. There can be no
assurance that future changes in applicable statutes and regulations or in their
interpretation will not adversely affect the business of the Company. The
Company is subject to regulation and examination by the OTS, and the Bank is
subject to examination by the OTS, as its chartering authority and primary
regulator, and by the FDIC, as the insurer of
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<PAGE> 34
its deposits through the SAIF administered by it. There can be no assurance that
the OTS or the FDIC will not, as a result of such regulation and examination,
impose various requirements or regulatory sanctions upon the Company or the
Bank, as applicable. In addition to governmental supervision and regulation,
both the Company and the Bank are subject to changes in federal and state laws,
including changes in tax laws, which could materially affect the real estate
industry. See "CERTAIN REGULATORY MATTERS."
DEPENDENCE ON CHIEF EXECUTIVE OFFICER
Scott A. Braly, President and Chief Executive Officer of the Company,
has had, and will continue to have, a significant role in the development and
management of the Company's business, including in particular its lending
operations. The loss of his services could have an adverse effect on the
Company. The Company and Mr. Braly are not parties to an employment agreement,
and the Company currently does not maintain key man life insurance relating to
Mr. Braly or any of its other officers.
EMPLOYEES
The Company employed 210 persons at December 31, 1997. Employees are not
represented by a union or collective bargaining group and the Company considers
its employee relations to be satisfactory. Employees are provided retirement,
savings incentive and other benefits, including life, health, accident and
hospital insurance.
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ITEM 2. PROPERTIES.
As of December 31, 1997, the Company had seven leased facilities and
owned the land and improvements of two branch offices. The leased facilities
included its corporate headquarters, four branch offices (with respect to which
the Company leased only the land), a loan production office and a warehouse. All
of the properties owned or leased by the Company are in Southern California.
The principal terms and the net book values of leasehold improvements
relating to premises leased by the Company are detailed below. None of the
leases contain any unusual terms and all are "net" or "triple net" leases.
<TABLE>
<CAPTION>
EXPIRATION RENEWALS MONTHLY SQUARE
FACILITY OF TERM OPTIONS RENTAL FEET NET BOOK VALUE
--------- ------------ ------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
El Segundo Corporate 11/30/00 One 5-yr $ 40,092 42,202 $ 785,559
Torrance Branch 12/31/01 One 5-yr 17,036 7,343 188,451
Westlake Branch 03/31/00 None 11,828 7,600 21,522
Manhattan Beach Branch 10/31/10 Four 5-yr 4,590 4,590 48,357
Tarzana Branch 01/31/00 Five 5-yr 3,283 3,352 93,473
Warehouse 09/30/99 One 2-yr 2,916 6,480 -
------------- --------------
$ 79,745 $ 1,137,362
============= ==============
</TABLE>
At December 31, 1997, the net book values of the Company's office real
property and improvements owned, and furniture, fixtures and equipment were $0.8
million and $2.3 million, respectively. See NOTE F of the NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS. The Company believes that all of the above facilities are
in good condition and are adequate for the Company's present operations.
The Company remains obligated on the lease of a discontinued branch
until July 31, 2001. All current obligations under this lease are reflected
under operating costs.
The Company's lease on its Irvine loan production office expired on
April 30, 1997. The Company exercised its option to extend the lease for six
months and currently has a month-to-month lease.
34
<PAGE> 36
ITEM 3. LEGAL PROCEEDINGS.
On September 6, 1996, the Company and the Bank were named as defendants
in a class action lawsuit entitled Stanley D. Mosler and Eileen C. Mosler vs.
Hawthorne Savings and Loan Association, Hawthorne Financial Corporation, et.
al., filed in the Superior Court of the State of California as Case No. BC154729
(the "Action"). The plaintiffs had previously filed an individual action
alleging the same matters contained in the class action complaint. Plaintiffs
contend they were entitled to a notice of availability of foreclosure
counseling, which they allege they did not receive, before the Bank foreclosed.
Plaintiffs contend that the alleged failure to provide counseling notices and
the underbidding by the Bank of the loan amount at foreclosure resulted in
damages to the purported class in an amount in excess of $40 million. The
Company has been named and alleged to have liability based upon its relationship
as trustee on the Deed of Trust securing the Bank's loans. The Company and the
Bank filed responsive pleadings to the Action alleging that the complaint is
defective on its face and that the plaintiffs are not proper representatives of
the purported class. The court granted the Company and Bank's motion and
dismissed the plaintiffs' case. The Appellate Court heard oral argument in July
1997 and upheld the trial court's dismissal of the Action. The plaintiffs sought
a review by the California Supreme Court. The Supreme Court denied plaintiff's
request for review. The remaining causes of action in this lawsuit are the same
as contained in the previously filed individual action. Trial in the individual
action is scheduled for May 11, 1998.
The Bank is a defendant in an action entitled Takaki vs. Hawthorne
Savings and Loan Association, filed in the Superior Court of the State of
California, Los Angeles, as Case No. YC021815. The plaintiffs were owners of
real property which they sold in early 1992 to a third party. The Bank provided
escrow services in connection with the transaction. A substantial portion of the
consideration paid to the plaintiffs took the form of a deed of trust secured by
another property then owned by an affiliate of the purchaser. The value of the
collateral securing this deed of trust ultimately proved to be inadequate. The
plaintiffs alleged that the bank knew, or should have known, that the security
for the plaintiffs' loan was inadequate and should have so advised them. In late
June 1997, a trial jury found for the plaintiffs and awarded compensatory and
punitive damages totaling $9.1 million. In late July 1997, the trial judge
reduced the combined award to $3.3 million. The plaintiffs accepted the reduced
judgment. The Bank has filed a Notice of Appeal from the judgment and has posted
an Appeal Bond with the court to stay plaintiffs enforcement of the judgment
pending the Appellate Court's decision. Based upon its view that the law in
California is unambiguous that there is no duty which attaches to escrow
providers to advise parties to an escrow, the Bank believes that its position
will ultimately be upheld on appeal and accordingly, that no amounts will be
paid by the Bank to the plaintiffs in this matter. There can be no assurances
that this will be the case, however. The defendant's appellate brief and the
plaintiff's appellate brief have been filed with the Court. The defendent's
response is due April 6, 1998. Thereafter, hearing for oral arguments will be
scheduled by the Court.
The Company is involved in a variety of other litigation matters. In the
opinion of management, none of these cases will have a materially adverse effect
on the Bank's or the Company's financial condition or operations.
35
<PAGE> 37
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of stockholders during the last
quarter of 1997.
ITEM 4A. EXECUTIVE OFFICERS.
The executive officers of the Company are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION WITH THE COMPANY AND PRIOR BUSINESS EXPERIENCE
---- --- -------------------------------------------------------
<S> <C> <C>
Scott A. Braly 44 President and Chief Executive Officer of Hawthorne
Financial and Hawthorne Savings since July 1993. Director of
Citadel Holding Corporation and Fidelity Federal Bank from
April 1992 to July 1993.
Norman A. Morales 37 Executive Vice President and Chief
Financial Officer of Hawthorne Financial and
Hawthorne Savings since February 1995. Executive
Vice President and Chief Financial Officer of SC
Bancorp and Southern California Bank from July 1987
to January 1995.
James D. Sage 59 Senior Vice President, Corporate Secretary and General Counsel
of Hawthorne Financial and Hawthorne Savings since August
1993. Special Litigation Consultant to Great Western Bank from
September 1990 to November 1993.
</TABLE>
The above officers serve at the discretion of the Board of Directors.
36
<PAGE> 38
P A R T II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS.
(a) MARKET PRICES OF STOCK
The common stock, par value $0.01 per share, of the Company is traded on
the Nasdaq National Market. The following table sets forth the high and low
sales prices as reported by the Nasdaq for the common stock of the Company for
the periods indicated.
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1997 HIGH LOW
------------ ---------
<S> <C> <C>
First quarter $ 11 3/4 $ 7 3/4
Second quarter 12 1/4 9 1/4
Third quarter 18 12 1/4
Fourth quarter 24 17 1/2
YEAR ENDED
DECEMBER 31, 1996 HIGH LOW
------------ ---------
First quarter $ 5 5/8 $ 4 3/8
Second quarter 9 4 7/8
Third quarter 9 1/4 6 3/4
Fourth quarter 8 1/8 6 5/8
</TABLE>
(b) STOCKHOLDERS
At the close of business on February 28, 1998, the Company had 3,156,596
shares of common stock outstanding and 489 holders of record of the common stock
of the Company.
(C) DIVIDENDS
It is the present policy of the Company to retain earnings to provide
funds for use in its business. The Company has not paid cash dividends on its
Common Stock during the past several years and does not anticipate doing so in
the foreseeable future.
37
<PAGE> 39
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial data presented below at and for each
of the years in the five-year period ended December 31, 1997 are derived from
the audited consolidated financial statements of the Company.
<TABLE>
<CAPTION>
AT OR FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA
Total assets $ 928,197 $ 847,195 $ 753,583 $ 743,793 $ 881,641
Cash and cash equivalents 51,620 93,978 14,015 18,063 42,901
Investment securities 578 38,371 62,793 30,190 52,425
Mortgage-backed securities -- -- -- 57,395 28,891
Loans receivable, net 838,251 672,401 617,328 537,020 623,450
Real estate owned, net 9,859 20,140 37,905 62,613 72,234
Deposits 799,501 717,809 698,008 649,382 829,809
Senior notes due 2004 40,000 -- -- -- --
Senior notes due 2000 -- 12,307 12,006 -- --
Other borrowings 40,000 50,000 -- 47,141 --
Stockholders' equity 42,319 43,922 38,966 40,827 43,949
Gross nonperforming assets (1) 20,652 36,783 49,203 80,716 151,183
Allowance for credit losses 13,274 13,515 15,192 21,461 46,629
STATEMENT OF OPERATIONS DATA
Interest revenues $ 75,616 $ 65,354 $ 50,994 $ 49,571 $ 58,798
Interest costs 43,825 39,960 34,486 30,443 36,692
--------- --------- --------- --------- ---------
Net interest income 31,791 25,394 16,508 19,128 22,106
Provision for credit losses 5,137 6,067 472 (24,449) (6,409)
--------- --------- --------- --------- ---------
Net interest income after provision for
credit losses 26,654 19,327 16,036 43,577 28,515
Noninterest revenues, net
Operating 3,599 1,927 1,311 1,973 3,295
(Losses) gains on sales of securities (11) 248 2,954 -- --
Net gain (loss) from disposition
of deposits and premises -- 6,413 (117) 2,835 (4,066)
Other revenues (expenses) 112 (3,366)(2) 864 -- --
General and administrative costs 22,009 21,046 20,339 23,911 21,162
(Income) loss from real estate
operations, net (229) 2,378 14,309 27,314 43,840
--------- --------- --------- --------- ---------
Total noninterest expenses 21,780 23,424 34,648 51,225 65,002
--------- --------- --------- --------- ---------
Earnings (loss) before income tax benefit
(expense) and extraordinary item 8,574 1,125 (13,600) (2,840) (37,258)
Income tax benefit (expense) 2,577 6,382 (617) (123) 7,648
--------- --------- --------- --------- ---------
Earnings (loss) before extraordinary item 11,151 7,507 (14,217) (2,963) (29,610)
Extraordinary item (1,534)(3) -- -- -- --
--------- --------- --------- --------- ---------
Net earnings (loss) $ 9,617 $ 7,507 $ (14,217) $ (2,963) $ (29,610)
========= ========= ========= ========= =========
Net earnings (loss) available for
Common Stock $ 7,162 $ 5,070 $ (14,334) $ (2,963) $ (29,610)
========= ========= ========= ========= =========
</TABLE>
38
<PAGE> 40
<TABLE>
<CAPTION>
AT OR FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------
1997 1996 1995 1994 1993
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
PER SHARE AMOUNTS
Basic earnings (loss) per share before
extraordinary item $ 3.02 $ 1.95 $ (5.52) $ (1.14) $ (11.39)
Basic earnings (loss) per share after
extraordinary item 2.49 1.95 (5.52) (1.14) (11.39)
Diluted earnings (loss) per share before
extraordinary item 1.66 1.17 (5.52) (1.14) (11.39)
Diluted earnings (loss) per share after
extraordinary item 1.37 1.17 (5.52) (1.14) (11.39)
Dividends per share of Common
Stock N/A N/A N/A N/A 0.50
YIELDS AND COSTS (FOR THE PERIOD)
Interest-earning assets 9.00% 8.43% 7.62% 6.63% 6.44%
Interest-bearing liabilities 5.44% 5.29% 5.01% 3.91% 4.12%
Interest rate spread (4) 3.56% 3.14% 2.61% 2.72% 2.32%
Net interest margin (5) 3.78% 3.28% 2.47% 2.56% 2.42%
PERFORMANCE RATIOS (6)
Return on average asset 1.11% 0.93% (1.96)% (0.36)% (3.09)%
Return on average common stockholders'
equity 19.83% 17.75% (47.57)% (6.99)% (50.80)%
Average stockholders' equity to average assets 5.60% 5.24% 4.11% 5.12% 6.08%
Efficiency ratio (7) 62.19% 77.03% 114.14% 113.32% 83.31%
BANK CAPITAL RATIOS (END OF PERIOD)(8)
Tangible 7.55% 6.27% 5.80% 5.15% 4.61%
Core 7.55% 6.27% 5.80% 5.15% 4.61%
Risk-based 11.48% 11.11% 10.27% 9.36% 8.18%
ASSET QUALITY DATA(1)
Gross nonperforming assets 20,652 36,783 49,203 80,716 151,183
Nonperforming assets to total assets
at end of period 2.22% 4.34% 6.53% 10.85% 17.15%
Nonperforming loans to total loans at
end of period 1.27% 2.43% 1.79% 3.24% 11.78%
Allowance for credit losses to loans at
end of period 1.56% 1.97% 2.40% 3.84% 6.96%
Allowance for credit losses to nonperforming
loans at end of period 122.99% 81.21% 134.47% 118.55% 59.06%
</TABLE>
(1) Nonperforming assets consists of loans delinquent 90 days or more and
REO, net of applicable write downs and reserves.
(2) Includes a one-time charge on all deposits insured by the SAIF as of
March 31, 1995 to recapitalize the SAIF.
(3) Relates to the accelerated write off of unamortized issue costs and
original issue discount associated with Senior Notes due 2000 which
were issued by the Company in December 1995 and repaid in full in
December 1997 with a portion of the proceeds from the offering of
Senior Notes due 2004.
(4) Interest rate spread represents the difference between the weighted
average yield on interest-earning assets and the weighted average cost
of interest-bearing liabilities.
(5) Net interest income divided by average interest-earning assets.
(6) With the exception of end period ratios, all ratios are based on
average monthly balances during the periods.
(7) Represents general and administrative costs divided by net interest
income before provision for credit losses and operating noninterest
revenues.
(8) The tangible and core capital ratios are calculated as a percent of
adjusted tangible assets and the risk-based capital ratio is calculated
as a percent of total risk-weighted assets.
39
<PAGE> 41
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OPERATING RESULTS
GENERAL
For 1997, the Company reported net earnings of $11.2 million before the
effect of an extraordinary item related to the early extinguishment of debt, or
$1.66 per share. During the year ended December 31, 1996, the Company reported
net earnings of $7.5 million, or $1.17 per share, as compared with a net loss of
$14.2 million, or $5.52 per share, during the year ended December 31, 1995. Net
earnings for the full year of 1997, after giving effect to the extraordinary
item, were $9.6 million, or $1.37 per share. The extraordinary item results from
the accelerated write-off of unamortized issue costs and the original issue
discount associated with the Company's Senior Notes, due 2000, issued in
December 1995, which were prepaid in full and at par value in December 1997. The
Company's results for 1996 included a pretax gain of $6.4 million on the sale of
the Company's San Diego deposit franchise and a pretax charge of $3.8 million
for the special assessment levied industry-wide to recapitalize the SAIF. The
per share amounts have been calculated on a diluted basis.
The table below isolates the principal components which have led to the
substantial, three-year growth trend in the Bank's core earnings and in the
Company's net earnings (dollars are in thousands).
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Net interest income $ 33,770 $ 27,315 $ 16,600
Provision for credit losses (5,137) (6,067) (472)
-------- -------- --------
Net interest income 28,633 21,248 16,128
Operating revenues 3,599 1,927 1,311
General and administrative costs (22,009) (21,046) (20,339)
-------- -------- --------
CORE EARNINGS (LOSS) 10,223 2,129 (2,900)
Nonrecurring gains (losses)
Sale of deposits and premises -- 6,413 (117)
Sale of securities (11) 248 2,954
SAIF assessment -- (3,813) --
Real estate operations, net 229 (2,378) (14,309)
Other, net 112 447 864
Other items
Interest on Senior Notes (1,979) (1,921) (92)
Income tax benefit (provision) 2,577 6,382 (617)
-------- -------- --------
928 5,378 (11,317)
-------- -------- --------
NET EARNINGS (LOSS) BEFORE
EXTRAORDINARY ITEM $ 11,151 $ 7,507 $(14,217)
======== ======== ========
</TABLE>
During the three-year period ended December 31, 1997, the Company's core
earnings, which measure the operating performance of the Bank's core business,
have improved from a loss of $2.9 million in 1995 to earnings of $10.2 million
in 1997. This improvement is directly traceable to (1) growth in the Bank's
gross interest margin (to 3.78% for 1997 as compared with 2.47% for 1995), (2)
growth in the Bank's average earning assets (to $840.3 million in 1997 from
$668.9 million in 1995), (3) improvement in the Bank's average interest-earning
gap (to a positive $35.1 million in 1997 from a negative $19.2 million in 1995),
and (4) substantial reductions in the Bank's nonperforming and nonaccruing
assets (to $25.1 million at the end of 1997 from $98.5 million at the end of
1994). These substantial improvements in the Bank's key operating measures have
been accomplished with only a modest increase to the Company's general and
administrative costs (to $22.0 million in 1997 from $20.3 million in 1995, a
cumulative increase of 8.4%).
40
<PAGE> 42
] The substantial improvement in the Company's and the Bank's operating
measures resulted from, among other factors, the accomplishments summarized
below:
- For the three-year period ended December 31, 1997, the Bank
originated new loan commitments, virtually all of which were
held in the Bank's loan portfolio following their origination,
of over $1.0 billion ($495.0 million in 1997, $332.3 million
in 1996 and $197.4 million in 1995). Though many of the Bank's
loans possess very short durations, this volume of new loan
originations pushed the Bank's net loan portfolio to $838.3
million by the end of 1997, an increase of $301.2 million, or
56.1%, from the end of 1994.
- Because the Bank's loans generally have yields well in excess
of those generally available to providers of traditional
mortgage credit secured by residential properties, the
substantial growth in the Bank's loan portfolio has been
accompanied by a similar increase to the overall yield on the
Bank's loan portfolio, which increased to 9.40% during 1997
from 7.84% during 1995.
- The Bank has been able to draw upon its remaining six retail
banking locations (down from 21 locations in mid-1993) to fund
virtually all of the growth in the Bank's loan portfolio and
in its total assets, while maintaining the integrity of its
deposit cost structure (the Bank's deposit cost of funds
increased only 26 basis points during the three-year period
ended December 31, 1997, while total deposits increased by
$150.1 million, or 23.1%, and total deposits housed in the
Bank's current six-branch network increased by $294.9 million,
or 59.2%, during this same period).
On December 31, 1997, the Company issued $40.0 million of 12.5% Senior
Notes, due 2004, in a private placement. The proceeds from this new issue of
Senior Notes were used, in part, to prepay all the Company's outstanding Senior
Notes, due 2000, which carried a coupon interest rate of 12.0%, and to redeem
all of its outstanding Cumulative Perpetual Preferred Stock, Series A, which
carried a dividend rate of 18.0%. The Senior Notes and Preferred Stock, were
retired at par plus accrued interest and dividends, which approximated $27.2
million. The refinancing has the effect, on a fully-taxable basis, of reducing
the Company's cost of capital by approximately 1,100 basis points while
providing approximately $10.4 million of net proceeds for general corporate
purposes, including supporting the planned business activities of the Bank.
NET INTEREST INCOME
The operations of the Company are substantially dependent on its net
interest income, which is the difference between the interest income received
from its interest-earning assets and the interest expense paid on its
interest-bearing liabilities. The Company's net interest margin is its net
interest income divided by its average interest-earning assets. These percentage
measures are 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 relationship between repricing or maturity
of the Company's adjustable-rate and fixed-rate loans and short-term investment
securities and its deposits and borrowings, and (3) the magnitude of the
Company's nonaccrual loans and REO.
41
<PAGE> 43
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, during the periods indicated (dollars in
thousands).
<TABLE>
<CAPTION>
1997 1996
-------------------------------------- ---------------------------------------
AVERAGE REVENUES/ YIELD/ AVERAGE REVENUES/ YIELD/
BALANCE COSTS COST BALANCE COSTS COST
----------- ---------- ---------- ----------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
ASSETS
Interest-earning assets
Loans $ 745,197 $ 70,012 9.40% $ 671,365 $ 59,722 8.90%
Cash and cash equivalents 33,747 1,776 5.26% 65,094 3,425 5.26%
Investment securities 54,420 3,403 6.25% 32,014 1,814 5.67%
Investment in capital
stock of Federal Home Loan Bank 6,980 425 6.09% 6,577 393 5.98%
Mortgage-backed securities - - - - - -
---------- --------- ---------- ---------
Total interest-earning assets 840,344 75,616 9.00% 775,050 65,354 8.43%
--------- ---------- --------- ---------
Noninterest-earning assets 25,403 31,675
---------- ----------
Total assets $ 865,747 $ 806,725
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities
Deposits $ 744,165 38,920 5.23% $ 701,836 35,568 5.07%
Borrowings 48,621 2,926 6.02% 41,138 2,471 6.01%
Senior notes 12,473 1,979 15.87% 12,150 1,921 15.81%
---------- --------- ---------- ---------
Total interest-bearing liabilities 805,259 43,825 5.44% 755,124 39,960 5.29%
---------- --------- ---------- ---------- --------- ---------
Other liabilities 11,997 9,310
Stockholders' equity 48,491 42,291
---------- ----------
Total liabilities & stockholders' equity $ 865,747 $ 806,725
========== ==========
Net interest income $ 31,791 $ 25,394
========= =========
Interest rate spread 3.56% 3.14%
========== ==========
Net interest margin 3.78% 3.28%
========== ==========
</TABLE>
<TABLE>
<CAPTION>
1995
------------------------------------------
AVERAGE REVENUES/ YIELD/
BALANCE (1) COSTS COST
----------- ---------- ----------
<S> <C> <C> <C>
ASSETS
Interest-earning assets
Loans $ 578,766 $ 45,386 7.84%
Cash and cash equivalents 21,128 1,446 6.84%
Investment securities 11,727 626 5.34%
Investment in capital
stock of Federal Home Loan Bank 6,473 327 5.05%
Mortgage-backed securities 50,777 3,209 6.32%
---------- ---------
Total interest-earning assets 668,871 50,994 7.62%
--------- ----------
Noninterest-earning assets 56,118
----------
Total assets $ 724,989
==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities
Deposits $ 675,329 33,593 4.97%
Borrowings 12,153 801 6.59%
Senior notes 625 92 14.72%
---------- ---------
Total interest-bearing liabilities 688,107 34,486 5.01%
---------- --------- ----------
Other liabilities 6,997
Stockholders' equity 29,885
----------
Total liabilities & stockholders' equity $ 724,989
==========
Net interest income $ 16,508
=========
Interest rate spread 2.61%
==========
Net interest margin 2.47%
==========
</TABLE>
(1) Amounts for 1995 represent monthly averages. All other periods
are calculated on daily balances.
The Company's interest income (net of interest due on nonaccrual loans)
increased by $10.3 million or 15.7% during 1997 as compared to the same period
in 1996, and increased by $14.4 million or 28.2% during 1996, as compared to
1995. These increases were primarily attributable to increases in the average
balance of loans outstanding and, to a lesser extent, increases in the weighted
average yield earned thereon, which reflect the Company's substantial lending
activities during the three years ended December 31, 1997.
The increase in the average balance of loans outstanding during 1997 and
1996, along with the reduction in real estate owned during these periods,
contributed to an improvement in the ratio of interest-earning assets (which
include balances attributable to loans on nonaccrual status) to interest-bearing
liabilities during such periods. This ratio increased to 104.4% for 1997, as
compared with 102.6% during 1996 and 97.2% during 1995.
The increase in interest income during 1997 was partially offset by a
$3.9 million, or 9.7%, increase in interest expense, as compared to the same
period in the prior year, which was primarily due to an increase in the average
balances of the Company's deposits and borrowings and an increase in the
weighted average rate paid on the Company's deposits. The increase in interest
income during 1996 more than offset a $5.5 million, or 15.9%, increase in
interest expense during the period, as compared to 1995, which was primarily
attributable to an increase in the average balances of the Company's deposits
and borrowings and the issuance of Senior Notes due 2000 in December 1995.
As a result of the foregoing, the Company's net interest income
increased by $8.9 million, or 53.8%, from $16.5 million during 1995 to $25.4
million during 1996, and the Company's net interest margin (net interest income
divided by average interest-earning assets) increased by 81 basis points, or
32.8%, from 2.47% to 3.28% during the same respective periods. During 1997, the
Company's net interest income increased by $6.4 million or 25.2%, as compared to
the same period in the prior year, and the Company's net interest margin
increased by 50 basis points, or 15.2%, from 3.28% to 3.78% during the same
respective periods.
42
<PAGE> 44
The table below shows the components of the changes in the Company's
interest revenues and costs for 1997 and 1996, as compared with the preceding
year (dollars are in thousands).
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 AND 1996
-------------------------------------------------------------
INCREASE (DECREASE)
DUE TO CHANGE IN
-------------------------------------------
RATE AND NET
VOLUME RATE VOLUME (1) CHANGE
-------- -------- -------- --------
<S> <C> <C> <C> <C>
INTEREST REVENUES
Loans (2) $ 6,567 $ 3,354 $ 369 $ 10,290
Cash and cash equivalents (1,649) -- -- (1,649)
Investment securities 1,269 188 132 1,589
Investment in capital stock of
Federal Home Loan Bank 25 7 -- 32
Mortgage-backed securities -- -- -- --
-------- -------- -------- --------
6,212 3,549 501 10,262
-------- -------- -------- --------
INTEREST COSTS
Deposits 2,042 1,235 75 3,352
Borrowings 442 11 2 455
Senior notes 46 12 -- 58
-------- -------- -------- --------
2,530 1,258 77 3,865
-------- -------- -------- --------
NET INTEREST INCOME $ 3,682 $ 2,291 $ 424 $ 6,397
======== ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1996 AND 1995
--------------------------------------------------------------
INCREASE (DECREASE)
DUE TO CHANGE IN
--------------------------------------------
RATE AND NET
VOLUME RATE VOLUME (1) CHANGE
-------- -------- -------- --------
<S> <C> <C> <C> <C>
INTEREST REVENUES
Loans (2) $ 7,243 $ 6,117 $ 976 $ 14,336
Cash and cash equivalents 3,009 (334) (696) 1,979
Investment securities 1,083 38 67 1,188
Investment in capital stock of
Federal Home Loan Bank 5 60 1 66
Mortgage-backed securities (3,209) -- -- (3,209)
-------- -------- -------- --------
8,131 5,881 348 14,360
-------- -------- -------- --------
INTEREST COSTS
Deposits 1,319 630 26 1,975
Borrowings 1,910 (66) (174) 1,670
Senior notes 1,697 7 125 1,829
-------- -------- -------- --------
4,926 571 (23) 5,474
-------- -------- -------- --------
NET INTEREST INCOME $ 3,205 $ 5,310 $ 371 $ 8,886
======== ======== ======== ========
</TABLE>
- -------------------
(1) Calculated by multiplying change in rate by change in volume.
(2) Interest on loans is net of interest on nonaccrual loans.
43
<PAGE> 45
PROVISIONS FOR CREDIT LOSSES
Provisions for credit losses amounted to $5.1 million, $6.1
million and $0.5 million for 1997, 1996 and 1995, respectively. The provisions
for credit losses during 1996 and 1995 were primarily attributable to losses
related to the Company's pre-1995 loan portfolio. An increasing proportion of
the Company's loan loss provisions during 1997 and to a lesser extent during
1996 represent general reserves allocated to the Company's post-1994
originations. At December 31, 1997, the Company's allowance for loan losses
amounted to $13.3 million, of which $9.4 million were general reserves. See "NEW
BUSINESS GENERATION - ASSET QUALITY RESERVES".
NONINTEREST REVENUES
Recurring noninterest operating revenues increased to $3.6 million
during 1997, as compared with $1.9 million in 1996 and $1.3 million in 1995. The
growth in such revenues is directly attributable to the Company's reemergence as
a prominent lender within its local markets. Loan-related fees consist of
prepayment penalties, extension and modification fees, and exit fees. As
described elsewhere herein, the Company generally charges borrowers a fee, in
the form of a penalty, if their loan is prepaid within a defined period of time,
generally from one-to-three years, following origination. In addition, the
Company is able to charge its borrowers a fee, payable upon repayment of the
loan, in selected instances where the Company's loan provides the borrower with
a period of time, generally not in excess of one year, to dispose of the
Company's collateral. These prepayment and exit fees totaled 47.2%, 35.5% and
6.2% of loan-related fees in 1997, 1996 and 1995, respectively.
Other recurring noninterest revenues are generated from the Company's
retail banking operations, and do not tend to fluctuate materially from
year-to-year.
As described elsewhere herein, the Company realized substantial one-time
noninterest revenue and costs during 1996 and 1995, attributable to (1) sales of
branch deposits and facilities, in particular the sale during 1996 of the Bank's
San Diego County deposit franchise, (2) sales of loans and securities, and (3)
the one-time special assessment to recapitalize the SAIF.
During 1995, the Company sold $19.2 million of loans for a nominal gain.
During 1996, the Company sold $129.5 million of loans for a gain of $0.4
million. The majority of the loans sold during 1996 consisted of seasoned loans
secured primarily by single family homes, with approximately $43.0 million of
total sales represented by loans originated subsequent to 1994 and secured by
income-producing properties.
During 1995, the Company sold $94.8 million of investment securities,
producing a net gain of $3.0 million, primarily to augment the Bank's capital
ratios. During 1996, the Company sold an additional $35.0 million in U.S.
Treasury Securities for a net gain of $0.2 million. These securities were
designated as available-for-sale and were sold primarily to augment the Bank's
capital ratios. During 1997, the Company sold $37.6 million in U.S. Treasury
Securities at a nominal loss. These securities were designated as
available-for-sale and were sold primarily to provide cash for loan fundings.
44
<PAGE> 46
The table below sets forth information concerning the Company's
noninterest revenues for the periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
OPERATING
Loan related fees $ 2,718 $ 1,223 $ 515
Other 881 704 796
------- ------- -------
$ 3,599 $ 1,927 $ 1,311
======= ======= =======
NON-OPERATING
GAIN (loss) on sale of securities $ (11) $ 248 $ 2,954
Disposition of deposits and premises -- 6,413 (117)
Other 112 (3,366) 864
------- ------- -------
$ 101 $ 3,295 $ 3,701
======= ======= =======
</TABLE>
NONINTEREST EXPENSES
GENERAL AND ADMINISTRATIVE COSTS
The table below details the Company's general and administrative costs
for periods indicated (dollars are in thousands).
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Employee $10,606 $ 9,507 $ 9,859
Operating 5,101 4,858 3,798
Occupancy 3,106 2,890 2,841
Professional 1,907 1,615 1,579
SAIF insurance premium and OTS assessment 1,289 2,152 2,213
Goodwill amortization -- 24 49
------- ------- -------
$22,009 $21,046 $20,339
======= ======= =======
</TABLE>
EMPLOYEE COSTS
The Company currently retains the service of a staff of senior and
middle managers to effect the Company's strategic and operational initiatives,
including management and staff which have responsibility for the Company's
financing activities, retail banking operations and corporate staff and
administrative functions. Over the past two years, management has redeployed
resources previously allocated to problem asset resolution and the Company's
branching activities into the principal financing activities. During the
three-year period ended December 31, 1997, total full-time equivalent employees
increased to 198 in 1997 from 159 in 1995, or 24.5%, while total salary costs
increased to $9.3 million in 1997 from $7.4 million in 1995. The growth in
compensation costs reflects the Bank's reliance upon relatively few, highly
skilled and compensated professionals in the conduct of its various specialized
business pursuits.
OPERATING COSTs
Operating costs principally include (1) data processing service charges
from outside vendors, (2) premiums for corporate liability insurance, (3) the
cost of corporate telecommunications and supplies, (4) the cost of advertising
and promotion, (5) transaction service charges from outside vendors and (6) the
amortization of prepaid offering costs arising
45
<PAGE> 47
from the 1995 recapitalization of the Company. During 1996, the Company
significantly expanded its community outreach and marketing activities, which
contributed to an increase in operating costs of approximately $0.5 million in
1996 as compared with 1995. Within the same year, the Company also amortized
approximately $0.2 million of issue costs which had their genesis with the
December 1995 sale of investment units. The increase in costs of approximately
$0.2 million incurred during 1997 as compared to 1996 was principally related to
an increase in parent company corporate taxes.
OCCUPANCY COSTs
Occupancy costs consist of the expenses related to the operation of the
Company's corporate facilities, as well as its six branch deposit network. The
Company has experienced an overall increase in occupancy costs of about 10%
during the three-year period ended December 31, 1997, representing nominal
increases to rental rates and occupancy charges.
PROFESSIONAL FEES
Professional fees are paid to outside lawyers, who represent the Company
in a variety of legal matters, the Company's independent accountants, and to
various other vendors that provide employee search and miscellaneous consulting
services to the Company. A significant portion of the professional fees paid in
1995 and 1996 were legal costs due to the magnitude of the Company's
foreclosures and related actions against borrowers. Commencing in mid-1997, the
Company implemented a series of initiatives to increase the depth of its lending
management group and to hire programming and supplemental management talent in
anticipation of converting the Company's core technology to a client server
platform from an outsourced, mainframe provider. The platform conversion,
including Year 2000 compliance initiatives, are expected to be substantially
completed by the middle of 1998. A majority of the new personnel hired by the
company were sourced through executive search firms, the cost of which is
included in general and administrative costs for 1997.
SAIF PREMIUMs
The Company pays premiums to the SAIF based upon the dollar amount of
deposits it holds and the assessment rate charged by the FDIC, which is based
upon the Company's financial condition, its capital ratios and the rating it
receives in connection with annual regulatory examinations by the OTS. Because
of the Company's improved financial condition, the assessment rate charged by
the FDIC has decreased from $0.31 per $100 of deposits for 1995 and the first
half of 1996, to $0.29 per $100 of deposits through the first half of 1997, to
$.09 for the last half of 1997.
EXPENSES ASSOCIATED WITH REAL ESTATE OPERATIONS
The table below details the revenues and costs associated with the
Company's REO for the periods indicated (dollars are in
thousands).
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
EXPENSES ASSOCIATED WITH REAL ESTATE OWNED
Property taxes $ 119 $ 135 $ 35
Repairs, maintenance and renovation 222 160 475
Insurance 188 258 132
-------- -------- --------
Total 529 553 642
NET RECOVERIES FROM SALE OF PROPERTIES (1,282) (1,769) (2,467)
PROPERTY OPERATIONS, NET (389) (1,339) (2,839)
PROVISION FOR ESTIMATED LOSSES ON
REAL ESTATE OWNED 913 4,933 18,973
-------- -------- --------
(INCOME) LOSS FROM
REAL ESTATE OPERATIONS, NET $ (229) $ 2,378 $ 14,309
======== ======== ========
</TABLE>
Net recoveries from property sales represent the difference between the
proceeds received from property disposal and the carrying value of such
properties upon disposal. The decline in such net recoveries is proportional to
the decline in the volume of foreclosures and property sales during the
three-year period ended December 31, 1997.
46
<PAGE> 48
During 1993, 1994 and 1995, the Company acquired via foreclosure over
100 apartment buildings. This accumulated portfolio of apartment buildings was
operated by the Company during an extended holding period, during which
management renovated and retenanted each building, and operated the stabilized
property for its cash flow return. Commencing in late 1995, and continuing
throughout 1996 and into early 1997, the Company disposed of its accumulated
portfolio of buildings through retail channels. Accordingly, the net revenues
received by the Company from this portfolio has declined steadily during the
three-year period ended December 31, 1997.
During 1995, 1996 and 1997, the Company recorded additional provisions
for estimated losses on REO of $19.0 million, $4.9 million and
$0.9 million, respectively, principally in connection with the completion and
liquidation of certain tract developments. At December 31, 1997, the
Company had liquidated all of its investments in these tract developments.
INCOME TAXES
The Company recognized $2.6 million and $6.4 million of income tax
benefits in 1997 and 1996, respectively, and income tax expense of $0.6 million
in 1995. The $2.6 million of income tax benefit recognized during the year ended
December 31, 1997, was due to a $5.9 million increase in the Company's deferred
tax asset as a result of the reduction in the valuation allowance against
deferred tax assets. Partially reducing this benefit was an expected liability
of $3.3 million attributable to the Company's profitable operations.
At December 31, 1996, the Company had approximately $8.8 million of
accumulated income tax benefits, consisting primarily of net operating loss
carryforwards and future tax deductions which had not been recognized. The
recognition of these accumulated income tax benefits is subject to limitations
for generally accepted accounting principles and for regulatory capital
purposes. The primary factor affecting the timing and magnitude of recognition
of these accumulated income tax benefits is the current and future profitability
of the Company. Additionally, no more than 10% of the Bank's regulatory capital
can be represented by a deferred tax asset created pursuant to anticipated
future utilization of an institution's income tax benefits.
At December 31, 1997 the Company had $2.8 million of unrecognized income
tax benefits which are available to be utilized during 1998 and beyond, subject
to the Company's continuing ability to generate earnings. Should the Company
cease to be profitable, or should the Company record substantial operating
losses in the future, all or a portion of the deferred tax asset established to
date may need to be reversed. Management believes that the Company's income tax
accounting practices fully comport with generally accepted accounting principles
and have been and are appropriate in the circumstances.
47
<PAGE> 49
FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY AND ASSET QUALITY
The table below sets forth the Company's consolidated assets,
liabilities and stockholders' equity and the percentage distribution of these
items at the dates indicated (dollars are in thousands).
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------
1997 1996
-------------------- --------------------
BALANCE PERCENT BALANCE PERCENT
-------- ----- -------- -----
<S> <C> <C> <C> <C>
ASSETS
Cash and cash equivalents $ 51,620 5.6% $ 93,978 11.1%
Investment securities available-for-sale 578 0.1 38,371 4.5
Loans receivable, net (1) 838,251 90.2 672,401 79.4
Real estate owned 9,859 1.1 20,140 2.4
Other assets (2) 27,889 3.0 22,305 2.6
-------- ----- -------- -----
Total assets $928,197 100.0% $847,195 100.0%
======== ===== ======== =====
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits $799,501 86.1% $717,809 84.7%
Short-term borrowings 40,000 4.3 50,000 5.9
Senior notes 40,000 4.3 12,307 1.5
Accounts payable and other liabilities 6,377 0.7 23,157 2.7
-------- ----- -------- -----
885,878 95.4 803,273 94.8
Stockholders' equity 42,319 4.6 43,922 5.2
-------- ----- -------- -----
Total liabilities and stockholders' equity $928,197 100.0% $847,195 100.0%
======== ===== ======== =====
</TABLE>
- ---------------
(1) Includes nonaccrual loans of $15.4 million and $28.6 million for 1997
and 1996, respectively. See ASSET QUALITY.
(2) Includes fixed assets, accrued interest receivable, FHLB stock and
other assets.
ASSETS
Total assets increased by $81.0 million from year-end 1996 to year-end
1997. This increase was primarily due to a net increase in loans receivable of
$165.9 million, which was partially offset by decreases in cash and cash
equivalents and investment securities of $42.4 million and $37.8 million,
respectively.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, deposits at
correspondent banks and Federal funds sold. Cash and cash equivalents at
year-end 1997 were $51.6 million, a decrease of $42.4 million, from $94.0
million at year-end 1996. At year-end 1996, the Company concluded two loan sales
of approximately $76.0 million which produced the high levels of cash and cash
equivalents. The funds were subsequently redeployed in investment securities and
new loan originations.
INVESTMENT SECURITIES
Investment securities consist of securities classified as
available-for-sale. Investment securities decreased by $37.8 million from
year-end 1996 to year-end 1997. At year-end 1996,
48
<PAGE> 50
the Company had $38.4 million in investment securities classified as
available-for-sale. See NOTE C of the NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS.
LOAN PORTFOLIO
The Company's loan portfolio is almost exclusively secured by real
estate concentrated in Southern California. Net loans outstanding increased from
$672.4 million to $838.3 million, or 24.7%, from year-end 1996 to year-end 1997.
The largest increases were centered in residential construction, single family
estate and commercial real estate lending. SEE NEW BUSINESS GENERATION AND NOTE
D OF THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
REAL ESTATE OWNED
Real estate acquired in satisfaction of loans is transferred to REO 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 REO after the date of transfer are recorded through the
establishment of, or additions to specific reserves. The Company's investment in
REO decreased from $20.1 million to $9.9 million, or 51.0%, from year-end 1996
to year-end 1997.
OTHER ASSETS
Other assets at year-end 1997 totaled $27.9 million, the principal
components comprising of the Bank's investment in capital stock of the FHLB
($7.2 million), a deferred tax asset ($6.8 million) and accrued interest
receivable ($5.3 million). This compares to year-end 1996's amount of $22.3
million, with allocations of $6.8 million, $4.2 million and $4.8 million,
respectively, for the same components.
LIABILITIES
GENERAL
The Company derives funds principally from deposits and, to a far lesser
extent, from borrowings from the FHLB. In addition, recurring cash flows are
generated from loan repayments and payoffs and, to a lesser extent, 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.
DEPOSITS
The Company operates six retail branches, with an average of
approximately $133.3 million per location. Total deposits at December 31, 1997
were $799.5 million, an increase of 11.4%, from $717.8 million at December 31,
1996. See NOTE G of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
SHORT-TERM BORROWINGS
The Company considers advances from the FHLB system its primary source
of borrowings. The Company may apply for advances from the FHLB secured by the
capital stock of the FHLB owned by the Company and certain of the Company's
mortgages and other assets (principally obligations issued or guaranteed by the
U.S. Government or agencies thereof). Advances can be requested for any business
purpose in which the Company is authorized to engage. The Company had
outstanding at year-end 1997 one borrowing from the FHLB of $40.0 million at an
interest rate of 5.95% and a maturity in June 1998. See NOTE H of the NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
SENIOR NOTES
At year-end 1996, the Company had $12.3 million outstanding of Senior
Notes due 2000. Interest expense and the accretion of the original issue
discount during 1997 totaled $2.0 million. On December 31, 1997, the Company
completed the issuance of new Senior Notes, in the amount of $40.0 million due
2004, which, in part, repaid the existing Senior Notes and redeemed the
Company's existing Preferred Stock Series A. The Senior Notes due 2004 carry an
interest
49
<PAGE> 51
rate of 12.5%, and are not callable for five years from the issue date. Interest
is required to be paid semiannually at the stated interest rate.
ACCOUNTS PAYABLE AND OTHER LIABILITIES
Accounts payable and other liabilities totaled $6.4 million and $23.2
million at December 31, 1997 and 1996, respectively. At year end 1996, the
Company had recorded a liability of approximately $15.0 million relating to the
repurchase of certain loans sold in December. After year-end, the Company agreed
to repurchase these loans and included them in total loans receivable in the
Company's consolidated balance sheets. This amount represented the cash to be
paid for the loans repurchased, which amount was paid in February 1997.
STOCKHOLDERS' EQUITY
The Company's capital structure at December 31, 1997 is comprised of
common stockholders' equity, which amounted to $42.3 million. The capital
structure as of December 31, 1996, was comprised of common stockholders' equity
and Cumulative Preferred Stock Series A, which amounted to $43.9 million. The
decrease in equity of $1.6 million in 1997 from 1996 was due to the redemption
of the Series A Preferred, which had a book value of $11.6 million, offset by
consolidated net earnings of $9.6 million.
CAPITAL RESOURCES AND LIQUIDITY
The parent company had $9.9 million of cash on hand at December 31,
1997. The parent company is a holding company with no significant business
operations outside of the Bank. Its requisite obligations in relation to its
debt and operations are dependent upon its sole source of funds from dividends
of the Bank.
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 association to
maintain a monthly average daily balance of liquid assets equal to 4.0% of the
average daily balance of its net withdrawable accounts and short-term borrowings
during the preceding calendar month. The Bank had liquidity ratios of 4.74% and
11.05% as of December 31, 1997 and 1996, respectively.
The Company's current primary funding resources are deposit accounts,
principal payments on loans, proceeds from sales of REO, advances from the FHLB
and cash flows from operations. Other possible sources of liquidity available to
the Company include 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 Company 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 REO.
YEAR 2000 COMPLIANCE
Hawthorne Savings recognizes that the arrival of the new millennium
poses a unique challenge to equipment and systems to recognize the date change
from December 31, 1999 to January 1, 2000 and, like most other companies, has
assembled a project team to identify Year 2000 issues. The Company is in the
process of converting from a service bureau main frame system to an in-house
client server system, which is Year 2000 compliant. The conversion has been in
the strategic plans since 1995 to facilitate a need to enhance the systems and
provide superior customer service, and not as a result of the year 2000
compliance issue. The Company is also in the process of obtaining assurances
from external service providers that they are taking appropriate actions to
remedy their Year 2000 issues.
The Company has identified all critical systems and the total cost to
the Company for the Year 2000 compliance activities has not been and is not
anticipated to be material to its financial position or results of operations
in any given year. The costs to complete the Year 2000 modification and testing
processes are based on management's best estimates.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
The Bank's profitability is dependent to a large extent upon its net
interest income, which is the difference between is interest income on
interest-earning assets, such as loans and securities, and its interest expense
on interest-bearing liabilities, such as deposits and borrowings. The Bank,
like other financial associations, is subject to interest rate risk to the
degree that its interest-earning assets reprice differently than its
interest-bearing liabilities. The Bank manages its mix of assets and
liabilities with the goals of limiting its exposure to interest rate risk,
ensuring adequate liquidity, and coordinating its sources and uses of funds.
Specific strategies have included shortening the amortized maturity of
fixed-rate loans and increasing the volume of adjustable rate loans to reduce
the average maturity of the Bank's interest-earning assets. FHLB advances are
used in an effort to extend the effective duration of interest-bearing
liabilities to better match the repricing sensitivity of interest-earning
assets.
The Bank seeks to control its interest rate risk exposure in a manner
that will allow for adequate levels of earnings and capital over a range of
possible interest rate environments. The Bank has adopted formal policies and
practices to monitor and manage interest rate risk exposure. As part of this
effort, the Bank uses the market value ("MV") methodology, a type of sensitivity
analysis, to gauge interest rate risk exposure.
Generally, MV is the discounted present value of the difference between
incoming cash flows on interest-earning assets and other assets and outgoing
cash flows on interest-bearing liabilities and other liabilities. The
application of the methodology attempts to quantify interest rate risk as the
change in the MV which would result from changes in market interest rates in
theoretical increments of 100 basis points, up to 400 basis points in either
direction.
At December 31, 1997, it was estimated that the Bank's MV would
decrease 8.8% and 18.0% in the event of 200 and 400 basis point increases in
market interest rates, respectively. The Bank's MV at the same date would
increase 9.3% and 19.4% in the event of 200 and 400 basis point decreases in
market rates, respectively.
Presented below, as of December 31, 1997, is an analysis of the Bank's
MV interest rare risk as measured by changes in MV for instantaneous and
sustained parallel shifts of 200 and 400 basis point increments in market
interest rates (dollars are in thousands).
<TABLE>
<CAPTION>
Market Value
Change --------------------------------------------
in Rates $ Amount $ Change % Change
-------- -------- --------- --------
<S> <C> <C> <C>
+400 bp $65,860 $(14,479) (18.02%)
+200 bp 73,246 (7,093) (8.83%)
0 bp 80,339 -- --%
-200 bp 87,782 7,443 9.26%
-400 bp 95,897 15,558 19.37%
</TABLE>
Management believes that the MV methodology overcomes three
shortcomings of the typical maturity gap methodology. First, it does not use
arbitrary repricing intervals and accounts for all expected future cash flows;
weighting each by its appropriate discount factor. Second, because the MV
method projects cash flows of each financial instrument under different
interest-rate environments, it can incorporate the effect of embedded options
on an association's interest rate risk exposure. Third, it allows interest
rates on different instruments to change by varying amounts in response to a
change in market interest rates, resulting in more accurate estimates of cash
flows.
However, as with any method of measuring interest rate risk, there are
certain shortcomings inherent to the MV methodology. The model assumes interest
rate changes are instantaneous parallel shifts in the yield curve. In reality,
rate changes are rarely instantaneous. The use of the simplifying assumption
that short-term and long-term rates change by the same degree may also misstate
historic rate patterns, which rarely show parallel yield curve shifts. Further,
the model assumes that certain assets and liabilities of similar maturity or
period to repricing will react the same to changes in rates. In reality, certain
types of financial instruments may react in advance of changes in market rates,
while the reaction of other types of financial instruments may lag behind the
change in general market rates. Additionally, the MV methodology may not reflect
the full impact of annual and life-time restrictions on changes in rates for
certain assets, such as adjustable-rate mortgage loans, or the effect of
prepayment penalties. When interest rates change, actual loan prepayments and
actual early withdrawals from certificates may deviate significantly from
assumptions used in the model. Finally, this methodology does not measure or
reflect the impact that higher rates may have on adjustable-rate loan customers'
ability to service their debt. All of these factors are considered in monitoring
the Bank's exposure to interest rate risk.
50
<PAGE> 52
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
See Index included in Item 14 below and the Financial Statements which
begin on the first page following the Signature Page.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not Applicable
P A R T III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required in ITEM 10 is hereby incorporated by reference
to the Company's definitive Proxy Statement to be filed with the Securities and
Exchange Commission for the 1998 Annual Meeting of Stockholders ("Proxy
Statement") under the captions "NOMINATION AND ELECTION OF DIRECTORS" and
"COMPENSATION OF EXECUTIVE OFFICERS DURING 1997."
ITEM 11. EXECUTIVE COMPENSATION.
The information required in ITEM 11 is hereby incorporated by reference
to the Proxy Statement under the captions "COMPENSATION OF EXECUTIVE OFFICERS
DURING 1997" and "REPORT ON EXECUTIVE COMPENSATION."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required in ITEM 12 is hereby incorporated by reference
to the Proxy Statement under the caption "SECURITY OWNERSHIP OF PRINCIPAL
STOCKHOLDERS AND MANAGEMENT; AFFILIATE TRANSACTIONS."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required in ITEM 13 is hereby incorporated by reference
to the Proxy Statement under the caption "SECURITY OWNERSHIP OF PRINCIPAL
STOCKHOLDERS AND MANAGEMENT; AFFILIATE TRANSACTIONS."
51
<PAGE> 53
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(A) The following documents are filed as part of this report:
(1) Financial Statements.
INDEPENDENT AUDITORS' REPORT
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Financial Condition as of December
31, 1997 and 1996.
Consolidated Statements of Operations for the years ended
December 31, 1997, 1996 and 1995.
Consolidated Statements of Stockholders' Equity for the years
ended December 31, 1997, 1996 and 1995.
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995.
Notes to Consolidated Financial Statements for the years ended
December 31, 1997, 1996 and 1995.
MANAGEMENT'S ASSERTION REPORT
INDEPENDENT ACCOUNTANTS' REPORT
(2) Financial Statement Schedules.
Schedules are omitted because the conditions requiring their
filing are not applicable or because the required information is
provided in the Consolidated Financial Statements, including the
Notes thereto.
(3) Exhibits.
EXHIBIT NO. DESCRIPTION OF DOCUMENT
(3.1) Certificate of Incorporation and Bylaws. The
Company's Certificate of Incorporation and Bylaws
are attached as Exhibits 4(a) and 4(b) to the
Company's Registration Statement on Form S-8
(Registration No. 33-74800) filed on
February 3, 1994.
(3.2) Amendment of Certificate of Incorporation. Filed as
Exhibit 3 to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 1995.
(3.3) Certificate of Designations and Preferences of the
Cumulative Preferred Stock, Series A. Filed with
Form 8-K dated February 7, 1996.
(4.1) Specimen Stock Certificate for the Company's Common
Stock. Filed as Exhibit 4 to the Company's Annual
Report on Form 10-K for the year ended December 31,
1985.
(4.2) Form of Senior Notes due 2000. Filed as an exhibit
to the Form 8-K dated February 7, 1996.
52
<PAGE> 54
EXHIBIT NO. DESCRIPTION OF DOCUMENT
(10.1) Stock Option Plan. Filed as an exhibit to
the Form S-8 (Registration No. 33-74800)
dated February 3, 1994 and updated filing on
Form S-8 (Registration No. 333-23587) dated
March 19, 1997.
(10.2) Employment Agreement between the Company and Scott
Braly. Filed as Exhibit 10 to the Company's Annual
Report on Form 10-K for the year ended December 31,
1993.
(10.3) Lease of corporate headquarters. Filed as Exhibit
10 to the Company's Annual Report on Form 10-K for
the year ended December 31, 1996.
(10.4) Unit Purchase Agreement between the Company and the
investors named therein. Filed as an exhibit to the
Form 8-K dated February 7, 1996.
(10.5) Form of Warrant to purchase 2.4 million shares of
common stock. Filed as an exhibit to the Form 8-K
dated February 7, 1996.
(10.6) Registration Rights Agreement between the Company
and certain investors as named therein. Filed as an
exhibit to the Form 8-K dated February 7, 1996.
(11.1) Statement re: Computation of Per Share Earnings
(see Note A of the Notes to Consolidated Financial
Statements).
(21.1) Subsidiaries of the Registrant. Filed as Exhibit 22
to the Company's Annual Report on Form 10-K for the
year ended December 31, 1994.
(23.1) Independent Auditors' Consent.
(27.1) Financial Data Schedules.
(B) Reports on Form 8-K
No current reports on Form 8-K were filed for the three months ended
December 31, 1997.
53
<PAGE> 55
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
DATED: MARCH 25, 1998 HAWTHORNE FINANCIAL CORPORATION
BY: /s/ SCOTT A. BRALY
----------------------------------
SCOTT A. BRALY, PRESIDENT
AND CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE DATE
- --------- ----
<S> <C>
/s/ SCOTT A. BRALY March 25, 1998
- --------------------------------------------
SCOTT A. BRALY, PRESIDENT AND
CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
/s/ NORMAN A. MORALES March 25, 1998
- --------------------------------------------
NORMAN A. MORALES, EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)
/s/ MARILYN G. AMATO March 25, 1998
- ------------------------------------
MARILYN G. AMATO, DIRECTOR
/s/ TIMOTHY R. CHRISMAN March 25, 1998
- --------------------------------------------
TIMOTHY R. CHRISMAN, CHAIRMAN OF THE BOARD
/s/ R. MICHAEL HALL March 25, 1998
- --------------------------------------------
R. MICHAEL HALL, DIRECTOR
/s/ ANTHONY W. LIBERATI March 25, 1998
- --------------------------------------------
ANTHONY W. LIBERATI, DIRECTOR
/s/ HARRY F. RADCLIFFE March 25, 1998
- --------------------------------------------
HARRY F. RADCLIFFE, DIRECTOR
/s/ HOWARD E. RITT March 25, 1998
- --------------------------------------------
HOWARD E. RITT, DIRECTOR
</TABLE>
54
<PAGE> 56
FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
AS OF DECEMBER 31, 1997 AND 1996
THREE YEARS ENDED DECEMBER 31, 1997
F-1
<PAGE> 57
C O N T E N T S
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
INDEPENDENT AUDITORS' REPORT F-3
CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION F-4
CONSOLIDATED STATEMENTS OF OPERATIONS F-6
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY F-7
CONSOLIDATED STATEMENTS OF CASH FLOWS F-8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS F-10
MANAGEMENT'S ASSERTION REPORT F-47
INDEPENDENT ACCOUNTANTS' REPORT F-49
</TABLE>
F-2
<PAGE> 58
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
Hawthorne Financial Corporation
El Segundo, California:
We have audited the accompanying consolidated statements of financial
condition of Hawthorne Financial Corporation and Subsidiary (the "Company") as
of December 31, 1997 and 1996 and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1997. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based upon our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial condition of Hawthorne Financial
Corporation and Subsidiary as of December 31, 1997 and 1996, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
January 30, 1998
Los Angeles, California
F-3
<PAGE> 59
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS ARE IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1997 1996
-------- --------
<S> <C> <C>
Cash and cash equivalents (NOTE B) $ 51,620 $ 93,978
Investment securities available-for-sale, at fair value (NOTE C) 578 38,371
Loans receivable (net of allowance for
estimated credit losses of $13,274 in 1997
and $13,515 in 1996) (NOTE D) 838,251 672,401
Real estate owned (net of allowance for
estimated losses of $2,563 in 1997
and $11,871 in 1996) (NOTE E) 9,859 20,140
Accrued interest receivable 5,298 4,781
Investment in capital stock of Federal
Home Loan Bank - at cost 7,213 6,788
Office property and equipment - at cost,
net (NOTE F) 4,200 4,729
Deferred tax asset, net (NOTE I) 6,820 4,243
Other assets 4,358 1,764
-------- --------
$928,197 $847,195
======== ========
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE> 60
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS ARE IN THOUSANDS)
LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1997 1996
--------- ---------
<S> <C> <C>
Liabilities
Deposits (NOTE G) $ 799,501 $ 717,809
Short-term borrowings (NOTE H) 40,000 50,000
Accounts payable and other liabilities 6,377 23,157
Senior notes (NOTE L) 40,000 12,307
--------- ---------
885,878 803,273
Commitments and contingencies (NOTE N)
Stockholders' equity (NOTES L and M)
Preferred stock - $0.01 par value; authorized 10,000,000 shares
Cumulative preferred stock, series A: liquidation preference,
$50 per share; authorized, 270 shares; outstanding, no shares (1997)
and 270 shares (1996) -- --
Common stock - $0.01 par value; authorized, 20,000,000 shares;
issued and outstanding, 3,095,996 shares (1997) and 2,604,675 shares (1996) 31 26
Capital in excess of par value - cumulative preferred stock, series A -- 11,592
Capital in excess of par value - common stock 10,402 7,745
Unrealized gain (loss) on available-for-sale securities 6 (132)
Retained earnings 32,020 24,858
--------- ---------
42,459 44,089
Less
Treasury stock, at cost - 5,400 shares (48) (48)
Loan to Employee Stock Ownership Plan (NOTE K) (92) (119)
--------- ---------
42,319 43,922
--------- ---------
$ 928,197 $ 847,195
========= =========
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE> 61
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS ARE IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Interest revenues
Loans, net of nonaccrual income $ 70,012 $ 59,722 $ 45,386
Investments 5,604 5,632 2,399
Mortgage-backed securities -- -- 3,209
-------- -------- --------
Total interest revenues 75,616 65,354 50,994
-------- -------- --------
Interest costs
Deposits (NOTE G) 38,920 35,568 33,593
Short-term borrowings (NOTE H) 2,926 2,471 801
Senior notes 1,979 1,921 92
-------- -------- --------
Total interest costs 43,825 39,960 34,486
-------- -------- --------
Net interest income 31,791 25,394 16,508
Provision for credit losses (NOTE D) 5,137 6,067 472
-------- -------- --------
Net interest income after provision for
credit losses 26,654 19,327 16,036
Noninterest revenues, net
Operating 3,599 1,927 1,311
(Loss) gain on sale of securities (11) 248 2,954
Disposition of deposits and premises (NOTE J) -- 6,413 (117)
Other non-operating 112 (3,366) 864
Noninterest expenses
General and administrative costs
Employee 10,606 9,507 9,859
Operating 5,101 4,858 3,798
Occupancy 3,106 2,890 2,841
Professional 1,907 1,615 1,579
SAIF premium and OTS assessment 1,289 2,152 2,213
Goodwill -- 24 49
-------- -------- --------
Total general and administrative costs 22,009 21,046 20,339
(Income) loss from real estate operations, net (NOTE E) (229) 2,378 14,309
-------- -------- --------
Total noninterest expenses 21,780 23,424 34,648
-------- -------- --------
Earnings (loss) before income taxes and extraordinary item 8,574 1,125 (13,600)
Income tax benefit (expense) (NOTE I) 2,577 6,382 (617)
-------- -------- --------
Earnings (loss) before extraordinary item 11,151 7,507 (14,217)
Extraordinary item (NOTE L) (1,534) -- --
-------- -------- --------
Net earnings (loss) $ 9,617 $ 7,507 $(14,217)
======== ======== ========
Net earnings (loss) available for Common $ 7,162 $ 5,070 $(14,334)
======== ======== ========
Basic earnings (loss) per share before extraordinary
item (NOTE A) $ 3.02 $ 1.95 $ (5.52)
======== ======== ========
Basic earnings (loss) per share (NOTE A) $ 2.49 $ 1.95 $ (5.52)
======== ======== ========
Diluted earnings (loss) per share before extraordinary
item (NOTE A) $ 1.66 $ 1.17 $ (5.52)
======== ======== ========
Diluted earnings (loss) per share (NOTE A) $ 1.37 $ 1.17 $ (5.52)
======== ======== ========
Weighted average basic shares outstanding 2,883 2,599 2,599
======== ======== ========
Weighted average diluted shares outstanding 5,235 4,341 2,599
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE> 62
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
Capital in
Excess of Capital in Unrealized
Cumulative Par Value- Excess of Gain (Loss)
Preferred Preferred Par Value- on Available-
Stock, Common Stock, Common for-Sale Retained
Series A Stock Series A Stock Securities,net Earnings
---- -------- ------ -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1995 $ -- $ 2,605 $ -- $ 2,921 $ 1,393 $ 34,122
Change in par value of common
stock -- (2,579) -- 2,579 -- --
Issuance of preferred stock -- -- 12,760 -- -- --
Issuance of warrants -- -- -- 2,245 -- --
Offering costs -- -- (1,168) -- -- --
Unrealized gains (losses) -- -- -- -- (1,387) --
Net earnings (loss) -- -- -- -- -- (14,217)
Accrued dividends on preferred
stock -- -- -- -- -- (117)
Repayments -- -- -- -- -- --
---- -------- -------- -------- -------- --------
Balance at December 31, 1995 -- 26 11,592 7,745 6 19,788
Unrealized gains (losses) -- -- -- -- (138) --
Net earnings (loss) -- -- -- -- -- 7,507
Accrued dividends on preferred
stock -- -- -- -- -- (2,437)
Repayments -- -- -- -- -- --
---- -------- -------- -------- -------- --------
Balance at December 31, 1996 -- 26 11,592 7,745 (132) 24,858
Exercised stock options -- 1 -- 295 -- --
Unrealized gains (losses) -- -- -- -- 138 --
Net earnings (loss) -- -- -- -- -- 9,617
Dividends paid on preferred
stock -- 4 -- 4,270 -- --
Accrued dividends on preferred
stock -- -- -- -- -- (2,455)
Redemption of preferred stock -- -- (11,592) (1,908) -- --
Repayments -- -- -- -- -- --
---- -------- -------- -------- -------- --------
Balance at December 31, 1997 $ -- $ 31 $ -- $ 10,402 $ 6 $ 32,020
==== ======== ======== ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
Loan to
Employee
Stock Total
Treasury Ownership Stockholders'
Stock Plan Equity
-------- -------- --------
<S> <C> <C> <C>
Balance at January 1, 1995 $ (48) $ (166) $ 40,827
Change in par value of common
stock -- -- --
Issuance of preferred stock -- -- 12,760
Issuance of warrants -- -- 2,245
Offering costs -- -- (1,168)
Unrealized gains (losses) -- -- (1,387)
Net earnings (loss) -- -- (14,217)
Accrued dividends on preferred
stock -- -- (117)
Repayments -- 23 23
-------- -------- --------
Balance at December 31, 1995 (48) (143) 38,966
Unrealized gains (losses) -- -- (138)
Net earnings (loss) -- -- 7,507
Accrued dividends on preferred
stock -- -- (2,437)
Repayments -- 24 24
-------- -------- --------
Balance at December 31, 1996 (48) (119) 43,922
Exercised stock options -- -- 296
Unrealized gains (losses) -- -- 138
Net earnings (loss) -- -- 9,617
Dividends paid on preferred
stock -- -- 4,274
Accrued dividends on preferred
stock -- -- (2,455)
Redemption of preferred stock -- -- (13,500)
Repayments -- 27 27
-------- -------- --------
Balance at December 31, 1997 $ (48) $ (92) $ 42,319
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these statements.
F-7
<PAGE> 63
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
NET CASH FROM OPERATING ACTIVITIES
Net earnings (loss) $ 9,617 $ 7,507 $ (14,217)
Adjustments
Income tax benefit (2,752) (4,257) --
Provision for estimated credit losses on loans 5,137 6,067 472
Provision for estimated credit losses
on real estate owned 913 4,933 18,973
Net (gain) loss on sale of deposits and facilities -- (6,413) 117
Net loss (gain) on sale of securities 11 (248) (2,954)
Net recoveries from sale of real estate owned (1,282) (1,769) (2,467)
Net loss (gain) from sale of other assets 7 (462) (68)
Loss on early extinguishment of debt 1,534 -- --
Loan fee and discount accretion (3,987) (3,537) (2,061)
Depreciation and amortization 1,819 1,654 1,441
FHLB dividends (425) (393) (332)
Goodwill amortization -- 24 49
(Increase) decrease in:
Accrued interest receivable (517) (1,275) (41)
Income tax assets -- -- 2,630
Other assets (3,215) (485) (468)
(Decrease) increase other liabilities (14,447) 14,616 (1,840)
Other, net -- (219) 81
--------- --------- ---------
Net cash (used) provided by operating activities (7,587) 15,743 (685)
--------- --------- ---------
NET CASH FLOWS FROM INVESTING ACTIVITIES
Investment securities
Purchases (40,571) (139,779) (62,792)
Maturities 40,795 129,576 --
Sales proceeds 37,570 34,857 44,333
Mortgage-backed securities
Principal amortization -- 33 7,007
Sale proceeds -- -- 50,459
Loans
New loans funded (229,433) (204,914) (143,236)
Construction disbursements (140,783) (61,676) (16,799)
Payoffs 202,999 72,897 27,760
Sales proceeds 1,370 130,413 19,282
Principal amortization 30,134 21,056 16,494
Other, net (44,523) (13,137) 503
Real estate
Sale proceeds 32,791 26,674 41,176
Capitalized costs (8,842) (12,015) (15,209)
Other, net 166 (4) --
Redemption of FHLB stock -- -- 1,015
Office property and equipment
Sales proceeds 9 4,566 795
Additions (726) (441) (1,767)
--------- --------- ---------
Net cash used by investing activities (119,044) (11,894) (30,979)
--------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these statements.
F-8
<PAGE> 64
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS-CONTINUED
(DOLLARS ARE IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
NET CASH FLOWS FROM FINANCING ACTIVITIES
Cash received from sale of deposits -- (178,884) (16,807)
Other deposit activity, net 81,692 204,973 65,698
Net change in borrowings (10,000) 50,000 (47,141)
Net proceeds from exercise of options 296 -- --
Collection of ESOP loan 27 25 23
Net proceeds from issuance of senior notes 40,000 -- 12,006
Redemption of senior notes (13,500) -- --
Net proceeds from issuance of preferred stock -- -- 11,592
Redemption of preferred stock (13,500) -- --
Net proceeds from issuance of warrants -- -- 2,245
Cash dividends paid on preferred stock (742) -- --
--------- --------- ---------
Net cash provided by financing activities 84,273 76,114 27,616
--------- --------- ---------
(DECREASE) INCREASE IN CASH
AND CASH EQUIVALENTS (42,358) 79,963 (4,048)
CASH AND CASH EQUIVALENTS
AT BEGINNING OF YEAR 93,978 14,015 18,063
--------- --------- ---------
CASH AND CASH EQUIVALENTS
AT END OF YEAR $ 51,620 $ 93,978 $ 14,015
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF
CASH FLOW INFORMATION
Cash paid during the year for
Interest $ 43,937 $ 39,672 $ 34,815
Income taxes, net -- 175 --
Non-cash investing and financing activities
Real estate acquired in settlement of loans 21,360 21,486 38,275
Loans originated to finance sales of real estate owned 5,157 18,141 15,996
Net change in unrealized gains/(losses) on
available-for-sale securities 138 (138) (1,387)
Accrued dividends on preferred stock 2,455 2,437 117
Transfer of held-to-maturity securities to
available-for-sale, prior to SFAS 115 -- -- 30,168
Reclassification of held-to-maturity securities
to available-for-sale per SFAS 115 -- -- 48,287
Loan activity
Total commitments and permanent fundings $ 494,931 $ 332,325 $ 197,376
Less:
Change in undisbursed funds on construction
commitments (62,846) (31,914) (16,095)
Loans originated to finance property sales (5,157) (18,141) (15,996)
Non-cash portion of refinanced loans (6,300) -- --
Undisbursed portion of new lines of credit (50,412) (15,680) (5,250)
--------- --------- ---------
Net construction disbursements and loans funded $ 370,216 $ 266,590 $ 160,035
========= ========= =========
</TABLE>
The accompanying notes are an integral part of these statements.
F-9
<PAGE> 65
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE A - SUMMARY OF ACCOUNTING POLICIES
A summary of the significant accounting policies applied in the preparation of
the accompanying consolidated financial statements are set forth in the sections
which follow.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include accounts of Hawthorne Financial
Corporation ("Company") and its wholly-owned subsidiary, Hawthorne Savings,
F.S.B. ("Bank"). All material intercompany transactions and accounts have been
eliminated.
NATURE OF OPERATIONS
The Company is principally engaged in the business of attracting deposits from
the general public and using those deposits, together with borrowings and other
funds, to originate residential and income property real estate loans. The
Company's principal sources of revenue are interest earned on mortgage loans and
investment securities, and fees received in connection with various deposit
account services and miscellaneous loan processing activities. The Company's
principal expenses are interest paid on deposit accounts and the costs necessary
to operate the Company.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Significant estimates include
estimates of the allowance for loan losses, valuation of real estate owned, fair
value of stock options and fair values of financial instruments.
CASH AND CASH EQUIVALENTS
The Bank, in accordance with regulations, must maintain qualifying liquid assets
at an average monthly balance of not less than 4% of the average of all deposits
and other borrowings due in less than one year. Liquid assets consists primarily
of cash, certificates of deposit and overnight investments. In addition,
bankers' acceptances, and certain U.S. Government securities, corporate notes
and mortgage-backed securities are liquid assets for regulatory purposes.
In the consolidated statements of financial condition and cash flows, cash and
cash equivalents include cash, amounts due from banks, interest-bearing
deposits, certificates of deposit and overnight investments.
INVESTMENT SECURITIES
The Company classifies debt and equity securities upon acquisition as
available-for-sale. Debt and equity securities are classified as
available-for-sale securities and reported at fair value, with unrealized gains
and losses excluded from earnings and reported in a separate component of
stockholders' equity.
F-10
<PAGE> 66
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE A - SUMMARY OF ACCOUNTING POLICIES - CONTINUED
LOANS RECEIVABLE
The Company defers all loan fees, net of certain direct costs associated with
originating loans, and amortizes these net deferred fees into interest revenue
as a yield adjustment over the lives of the loans using the interest method for
permanent loans and the straight-line method for construction loans. When a loan
is paid off, any unamortized net deferred fees are recognized in interest
income.
Interest on loans, including impaired loans, is recognized in revenue as earned
and is accrued only if deemed collectible. Loans one or more payments delinquent
are placed on nonaccrual status, meaning that the Company stops accruing
interest on such loans and reverses any interest previously accrued but not
collected. A nonaccrual loan may be restored to accrual status when delinquent
principal and interest payments are brought current and future monthly principal
and interest payments are expected to be collected.
All loans are classified as held-to-maturity as the Company has the current
intent and ability to hold these loans in portfolio until maturity.
REAL ESTATE OWNED
Properties acquired through foreclosure, or deed in lieu of foreclosure ("real
estate owned"), are carried at the lower of cost or estimated fair value of the
property. Subsequent declines in fair value, if any, are accounted for through
the establishment of a specific reserve on the property. The determination of a
property's estimated fair value incorporates (1) revenues projected to be
realized from disposal of the property, less (2) construction and renovation
costs, (3) marketing and transaction costs and (4) holding costs (e.g., property
taxes, insurance and homeowners' association dues). For multiple-unit
residential construction and land developments, these projected cash flows are
discounted utilizing a market rate of return to determine their fair value.
In many instances following foreclosure, these properties require significant
time for the completion of construction and their marketing and eventual sale.
During this period, estimates of future revenues and costs can, and do, vary,
requiring changes in the amount of specific reserves allocated to individual
properties.
For multiple-unit, for-sale housing developments, the actual loss incurred from
the sale of individual units is charged against previously established specific
reserves when all of the foreclosed units within the project have been sold. For
individual assets, the actual loss is charged against previously established
specific reserves when the property is sold.
Based upon periodic analysis of future recoverability, changes in specific
reserves established for the Company's real estate owned portfolio are charged
to real estate operations.
F-11
<PAGE> 67
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE A - SUMMARY OF ACCOUNTING POLICIES - CONTINUED
ALLOWANCE FOR ESTIMATED CREDIT LOSSES
The Company establishes specific reserves for losses on individual real estate
loans when it has determined that recovery of the Company's gross investment is
not probable and when the amount of loss can be reasonably determined. In making
this determination, the Company considers (1) the current status of the asset,
(2) the probable future status of the asset, (3) the value of the asset or
underlying collateral, and (4) the Company's intent with respect to the asset.
In quantifying the loss, if any, associated with individual loans, the Company
utilizes external sources of information (i.e., appraisals, price opinions from
real estate professionals, comparable sales data and internal estimates). In
establishing specific reserves, the Company estimates the revenues expected to
be generated from disposal of the Company's collateral, less construction and
renovation costs (if any), holding costs and transaction costs. For
multiple-unit residential construction and land developments, the resulting
projected net cash flows are discounted utilizing a market rate of return to
determine their fair value.
The Company establishes general reserves against the Company's portfolio of
loans. Generally, such reserves are established for each segment of the
Company's loan portfolio, including loans secured by single family residences,
multi-family residences, commercial properties, residential construction
developments and land parcels. In establishing general reserves, the Company
incorporates (1) the recovery rate for similar properties previously sold by the
Company, (2) valuations of groups of similar assets, (3) the probability of
future adverse events (i.e., performing loans which become nonperforming, loans
in default which proceed through to foreclosure) and (4) guidelines published by
the Office of Thrift Supervision ("OTS").
A loan is impaired when it is probable that the creditor will be unable to
collect all contractual principal and interest payments under the terms of the
loan agreement. The Company measures impaired loans based on the present value
of expected future cash flows discounted at the loan's effective interest rate
or, as an expedient, the fair value of the collateral (less estimated selling
costs if foreclosure is probable) if the loan is collateral-dependent.
DEPRECIATION AND AMORTIZATION
Depreciation is provided in amounts sufficient to relate the cost of depreciable
assets to operations over their estimated service lives, on a straight-line
basis. Buildings are depreciated over their estimated useful lives ranging from
twenty to thirty years on a straight-line basis. Leasehold improvements are
amortized over the lives of their respective leases or the service lives of the
improvements, whichever is shorter. Original issuance costs of $1.2 million, as
of December 1995, associated with the Senior Notes were capitalized and were
being amortized over the life of the debt, which was five years. The Senior
Notes were repaid in 1997 and the remaining unamortized costs of $0.8 million
were expensed as an extraordinary item.
INCOME TAXES
The Company and its subsidiary file a consolidated federal income tax return and
a combined state franchise tax return on a fiscal year ending September 30.
F-12
<PAGE> 68
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
Deferred tax assets and liabilities represent the tax effects, calculated at
currently effective tax rates, of future deductible or taxable amounts
attributable to events that have been recognized on a cumulative basis in the
financial statements. If it is more likely than not that any of a deferred tax
asset will not be realized, a valuation allowance is recorded.
EXCESS OF COST OVER FAIR VALUE OF NET ASSETS ACQUIRED
In 1994, the Company recorded excess of cost over fair value of $0.2 million as
goodwill resulting from the acquisition of one branch facility. The amount was
being amortized over five years. However the facility was sold in 1996, at which
time the remaining balance was offset against the gain on sale.
STOCK BASED COMPENSATION PLANS
The Company applies APB Opinion No. 25 and related Interpretations in accounting
for its plans. In 1996, the FASB issued SFAS No. 123, "Accounting for
Stock-Based Compensation", which encourages companies to account for stock
compensation awards based on the fair value at the date the awards are granted.
This statement does not require the application of the fair value method and
allows the continuance of the current accounting method, which requires
accounting for stock compensation awards based on their intrinsic value as of
the grant date. However, SFAS No. 123 requires pro forma disclosure of net
income and, if presented, earnings per share, as if the fair value based method
of accounting defined in this statement had been applied. See NOTE K.
IMPAIRMENT OF LONG-LIVED ASSETS
On January 1, 1996, the Bank adopted SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of."
This statement requires that long-lived assets, certain identifiable
intangibles, and goodwill related to those assets to be held and used be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. Furthermore, this statement
requires that certain long-lived assets and identifiable intangibles to be
disposed of be reported at the lower of historical cost or fair value less cost
to sell. The adoption of SFAS No. 121 did not have a material impact on
operations.
FINANCIAL ASSETS AND LIABILITIES
In June 1996, the Financial Accounting Standards Board issued SFAS No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities." This statement provides accounting and reporting standards for
transfers and servicing of financial assets and extinguishment of liabilities,
and is applied prospectively to financial statements for fiscal years beginning
after December 31, 1996. In 1996, the FASB also issued SFAS No. 127, "Deferral
of the Effective Date of Certain Provisions of FASB Statement No. 125," which
defers for one year the effective date of certain provisions within SFAS No.
125. The Company does not believe that adoption of SFAS Nos. 125 and 127 had a
material impact on its operations and financial position in 1997.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
effective for the fiscal years beginning after December 15, 1997. This statement
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. This statement further requires that a company display an amount
representing total comprehensive income for the period in that financial
statement. This statement also requires that a company classify items of other
comprehensive income by their nature in a financial statement. Reclassification
of financial statements for earlier periods, provided for comparative purposes,
is required. Based on current accounting standards, this statement is not
expected to have a material impact on the Company's consolidated financial
statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," effective for financial statements for
periods beginning after December 15, 1997. This statement establishes standards
for reporting information about operating segments in annual financial
statements and requires that the Company report selected information about
operating segments in interim financial reports issued to stockholders. It also
establishes standards for related disclosures about products and services,
geographic areas and major customers. The Company has not yet determined its
reporting segments.
RECLASSIFICATIONS
Certain amounts in the 1996 and 1995 consolidated financial statements have been
reclassified to conform to the 1997 presentation.
F-13
<PAGE> 69
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997 (DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE A - SUMMARY OF ACCOUNTING POLICIES - CONTINUED
EARNINGS PER SHARE CALCULATION
In 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which
establishes standards for computing and presenting earnings per share. The table
below sets forth the Company's earnings per share calculations for the years
ended December 31, 1997, 1996 and 1995. The Diluted and Basic Methods were used
for all three years as prescribed under Generally Accepted Accounting Principles
("GAAP"). 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, (2) Options refers to the outstanding stock
options granted (see Note K) and (3) Preferred Stock refers to the Cumulative
Perpetual Preferred Stock issued by the Company in December 1995, and redeemed
in December 1997, which carried an annual dividend equal to 18% of the face
amount of the Preferred Stock, permitted dividends thereon to be paid, under
certain circumstances, in equivalent value of the Company's common stock and had
an initial dividend payment in June 1997.
F-14
<PAGE> 70
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE A - SUMMARY OF ACCOUNTING POLICIES - CONTINUED
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
SHARES OUTSTANDING
Basic 2,883 2,599 2,599
Warrants 2,376 2,376 --
Options 657 686 --
Less Treasury shares(1)(2) (681) (1,320) --
-------- -------- --------
Diluted 5,235 4,341 2,599
======== ======== ========
STOCKHOLDERS' EQUITY
Basic $ 42,319 $ 32,330 $ 27,374
Warrants 5,346 5,346 --
Options 5,073 3,482 --
Less Treasury shares(1)(2) (9,012) (8,790) --
-------- -------- --------
Diluted $ 43,726 $ 32,368 $ 27,374
======== ======== ========
NET EARNINGS (LOSS)
Earnings before
extraordinary item $ 11,151 $ 7,507 $(14,217)
Preferred stock dividends (2,455) (2,437) (117)
-------- -------- --------
Earnings available for Common
before extraordinary item 8,696 5,070 (14,334)
Extraordinary item (1,534) -- --
-------- -------- --------
Net earnings available
for Common $ 7,162 $ 5,070 $(14,334)
======== ======== ========
BASIC BOOK VALUE PER SHARE $ 14.68 $ 12.44 $ 10.53
======== ======== ========
BASIC EARNINGS (LOSS) PER SHARE $ 2.49 $ 1.95 $ (5.52)
======== ======== ========
DILUTED BOOK VALUE PER SHARE $ 8.35 $ 7.46 $ 10.53
======== ======== ========
DILUTED EARNINGS (LOSS) PER SHARE $ 1.37 $ 1.17 $ (5.52)
======== ======== ========
</TABLE>
(1) Under the Diluted Method, it is assumed that the Company will use
proceeds from the proforma exercise of the Warrants and Options to
acquire the actual shares currently outstanding (Treasury shares).
(2) Treasury shares were assumed to be repurchased at the average closing
stock price for the period.
F-15
<PAGE> 71
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE B - CASH AND CASH EQUIVALENTS
Cash and cash equivalents at December 31 consist of the following:
<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
Cash $ 9,520 $82,578
Certificates of deposit -- 100
Federal funds sold 42,100 11,300
------- -------
$51,620 $93,978
======= =======
</TABLE>
NOTE C - INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The cost basis and estimated fair value of investment securities
available-for-sale at December 31 are summarized as follows:
<TABLE>
<CAPTION>
1997
--------------------------------------------------------------------------
GROSS UNREALIZED ESTIMATED
AMORTIZED ------------------------------ FAIR
COST GAINS LOSSES VALUE
---------------- ----------- -------------- ----------------
<S> <C> <C> <C> <C>
Mutual Fund $ 572 $ 6 $ -- $ 578
---------------- ----------- -------------- ----------------
$ 572 $ 6 $ -- $ 578
================ =========== ============== ================
</TABLE>
<TABLE>
<CAPTION>
1996
--------------------------------------------------------------------------
GROSS UNREALIZED ESTIMATED
AMORTIZED ------------------------------ FAIR
COST GAINS LOSSES VALUE
---------------- ----------- -------------- ----------------
<S> <C> <C> <C> <C>
U.S. Government $ 38,503 $ -- $ 132 $ 38,371
---------------- ----------- -------------- ----------------
$ 38,503 $ -- $ 132 $ 38,371
================ =========== ============== ================
</TABLE>
Within the available-for-sale amounts at December 31, 1996 are restricted U.S.
Government securities purchased with proceeds from the recapitalization of the
Company in December 1995. See NOTE L. These proceeds represented prefunded
interest expense associated with the Senior Notes and had both a cost basis and
fair value of $3.2 million at December 31, 1996.
F-16
<PAGE> 72
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE C - INVESTMENT SECURITIES AVAILABLE-FOR-SALE - CONTINUED
The cost basis and estimated fair value of investment securities
available-for-sale at December 31, 1997 are summarized by contractual maturity
as follows:
<TABLE>
<CAPTION>
ESTIMATED
FAIR
COST BASIS VALUE YIELD
----------- -------------- ------------
<S> <C> <C> <C>
Due in less than one year $ 572 $ 578 6.38%
---------- -------------- ------------
$ 572 $ 578 6.38%
========== ============== ============
</TABLE>
NOTE D - LOANS RECEIVABLE
Loans receivable at December 31 are summarized as follows:
<TABLE>
<CAPTION>
1997 1996
--------- ---------
<S> <C> <C>
SINGLE FAMILY
Estate $ 173,764 $ 107,891
Conventional 224,006 231,306
INCOME PROPERTY
Multi-family 225,738 220,707
Commercial real estate 114,293 60,388
LAND 39,475 14,513
SINGLE FAMILY CONSTRUCTION
Individual residences 112,899 56,306
Tract development 68,653 33,791
OTHER 9,698 15,684
--------- ---------
GROSS LOANS RECEIVABLE (1) 968,526 740,586
LESS
Participants' share (1,141) (1,413)
Undisbursed funds (108,683) (46,646)
Deferred fees and credits, net (7,177) (6,611)
Reserves (13,274) (13,515)
--------- ---------
NET LOANS RECEIVABLE $ 838,251 $ 672,401
========= =========
</TABLE>
- ------------
(1) Gross loans receivable includes outstanding balance plus undisbursed
construction commitments.
F-17
<PAGE> 73
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D - LOANS RECEIVABLE - CONTINUED
The table below summarizes the maturities for fixed-rate loans and the repricing
intervals for adjustable-rate loans as of December 31, 1997:
<TABLE>
<CAPTION>
PRINCIPAL BALANCE
--------------------------------------
FIXED ADJUSTABLE
INTERVAL RATE RATE TOTAL
-------- -------- --------
<S> <C> <C> <C>
1 to 3 months $ 1,529 $572,950 $574,479
greater than 3 to 6 months 1,522 177,808 179,330
greater than 6 to 12 months 14,113 37,248 51,361
greater than 1 to 2 years 14,043 -- 14,043
greater than 2 to 5 years 27,212 -- 27,212
greater than 5 to 10 years 8,103 -- 8,103
greater than 10 to 20 years 18,060 -- 18,060
More than 20 years 95,938 -- 95,938
-------- -------- --------
$180,520 $788,006 $968,526
======== ======== ========
</TABLE>
The contractual weighted average interest rates on loans at December 31, 1997
and 1996 were 8.96% and 8.75%, respectively.
The table below summarizes nonaccrual loans at December 31 by type of loan:
<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
SINGLE FAMILY
Estate $ 7,885 $ 2,824
Conventional 7,348 14,184
INCOME PROPERTY - multi-family -- 11,172
LAND 163 432
OTHER -- 12
------- -------
$15,396 $28,624
======= =======
</TABLE>
The interest income recognized on nonaccrual loans for 1997, 1996 and 1995 was
$0.9 million, $1.9 million and $1.0 million, respectively. If these loans had
been performing for the entire year the income recognized would have been $1.4
million, $2.8 million and $1.5 million for 1997, 1996 and 1995, respectively.
F-18
<PAGE> 74
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D - LOANS RECEIVABLE - CONTINUED
The table below summarizes the amounts of interest revenue that would have been
recognized on troubled debt restructurings had borrowers paid at the original
loan interest rate throughout each of the years below, the interest revenue that
would have been recognized based upon the modified interest rate, and the
interest revenue that was included in the consolidated statements of operations
for the periods indicated. For this purpose, troubled debt restructurings
("TDRs") include loans with respect to which (1) the original interest rate was
changed for a defined period of time, (2) the loan's maturity was extended,
and/or (3) principal or interest payments were suspended for a defined period of
time.
<TABLE>
<CAPTION>
PRINCIPAL ORIGINAL MODIFIED RECOGNIZED
BALANCE INTEREST INTEREST INTEREST
------- ------- ------- -------
<S> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1997
Permanent loans $29,562 $ 2,908 $ 2,665 $ 2,505
------- ------- ------- -------
$29,562 $ 2,908 $ 2,665 $ 2,505
======= ======= ======= =======
YEAR ENDED DECEMBER 31, 1996
Construction loans $ 389 $ 43 $ 43 $ 18
Permanent loans 38,695 3,716 3,511 3,088
------- ------- ------- -------
$39,084 $ 3,759 $ 3,554 $ 3,106
======= ======= ======= =======
YEAR ENDED DECEMBER 31, 1995
Permanent loans $24,029 $ 1,929 $ 1,707 $ 1,707
------- ------- ------- -------
$24,029 $ 1,929 $ 1,707 $ 1,707
======= ======= ======= =======
</TABLE>
The table below summarizes the activity within the allowance for estimated
credit losses on loans for the years ended December 31:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Balance at beginning of year $ 13,515 $ 15,192 $ 21,461
Provision for credit losses 5,137 6,067 472
Charge-offs (5,378) (7,744) (6,741)
-------- -------- --------
$ 13,274 $ 13,515 $ 15,192
======== ======== ========
</TABLE>
During the past several years, the Company's lending areas, which are
concentrated in Southern California, experienced adverse economic conditions,
including declining real estate values. These factors adversely affected the
ability of certain borrowers to repay loans according to their stated terms.
Although the Company believes the level of allowance for estimated credit losses
on loans is adequate to absorb losses inherent in the loan portfolio, continuing
weakness in the local economy may result in increasing loan losses that cannot
be reasonably predicted at December 31, 1997.
F-19
<PAGE> 75
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE D - LOANS RECEIVABLE - CONTINUED
The recorded investment in loans considered to be impaired under SFAS No. 114 at
December 31 was as follows:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Impaired loans without specific loss reserves $ 27,970 $ 43,209 $50,157
Impaired loans with specific loss reserves 24,476 8,728 13,159
Specific loss reserves allocated to impaired loans (2,815) (2,185) (3,426)
-------- -------- -------
Total impaired loans, net of specific loss reserves $ 49,631 $ 49,752 $59,890
======== ======== =======
Average investment in impaired loans $ 50,400 $ 57,100 $78,600
Interest income recognized on impaired loans $ 4,202 $ 3,607 $ 4,356
</TABLE>
The table below reconciles the principal balance of impaired loans and TDRs at
December 31, as follows:
<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C>
Total impaired loans $ 52,446 $ 51,937
Impaired loans 90 days or more delinquent (10,793) (16,643)
-------- --------
Performing impaired loans 41,653 35,294
Impaired loans which are not TDRs (12,193) --
-------- --------
Performing TDRs 29,460 35,294
TDRs which are 90 days or more delinquent 102 3,790
-------- --------
Total TDRs $ 29,562 $ 39,084
======== ========
</TABLE>
F-20
<PAGE> 76
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE E - REAL ESTATE OWNED
Real estate owned at December 31 is summarized as follows:
<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C>
SINGLE FAMILY
Conventional $ 7,695 $ 9,777
INCOME PROPERTY
Multi-family 2,362 3,215
Commercial -- 346
LAND 2,365 2,517
CONSTRUCTION- tract development -- 16,156
-------- --------
GROSS INVESTMENT 12,422 32,011
Reserves (2,563) (11,871)
-------- --------
NET INVESTMENT $ 9,859 $ 20,140
======== ========
</TABLE>
The table below summarizes the allowance for estimated losses on real estate
owned for the years ended December 31:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Balance at beginning of year $ 11,871 $ 15,725 $ 32,609
Provision for estimated losses 913 4,933 18,973
Charge-offs (10,221) (8,787) (35,857)
-------- -------- --------
Balance at end of year $ 2,563 $ 11,871 $ 15,725
======== ======== ========
</TABLE>
Real estate operations for the years ended December 31 are summarized as
follows:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Expenses associated with real estate owned
Property taxes $ 119 $ 135 $ 35
Repairs, maintenance and renovation 222 160 475
Insurance 188 258 132
-------- -------- --------
529 553 642
Net recoveries from sales of properties (1,282) (1,769) (2,467)
Rental income, net (389) (1,339) (2,839)
Provision for estimated losses on real estate owned 913 4,933 18,973
-------- -------- --------
(Income) loss from real estate operations, net $ (229) $ 2,378 $ 14,309
======== ======== ========
</TABLE>
F-21
<PAGE> 77
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE F - OFFICE PROPERTY AND EQUIPMENT - AT COST
Office property and equipment at December 31 consists of the following:
<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
Office buildings $ 1,140 $ 1,140
Furniture and equipment 4,844 4,191
Leasehold improvements 2,305 2,290
------- -------
8,289 7,621
Less
Accumulated depreciation and amortization (4,279) (3,082)
------- -------
4,010 4,539
Land 190 190
------- -------
$ 4,200 $ 4,729
======= =======
</TABLE>
The Company recognized $1.2 million, $1.1 million and $1.0 million of
depreciation expense for the years 1997, 1996 and 1995, respectively.
NOTE G - DEPOSITS
The table below summarizes the balances of and weighted average interest rates
("WAIR") for deposits at December 31:
<TABLE>
<CAPTION>
1997 1996
------------------------------ -----------------------------------
WAIR BALANCE WAIR BALANCE
-------- --------------- ---------- ---------------
<S> <C> <C> <C> <C>
Checking/NOW 1.23% $ 36,755 0.99% $ 28,879
Passbook 1.64% 20,139 1.68% 22,887
Money market 3.94% 48,918 1.46% 18,793
Certificates of deposit
4.00% or less 1,789 2,793
4.01% - 5.00% 55,868 98,425
5.01% - 6.00% 554,559 442,393
6.01% - 7.00% 81,373 103,005
7.01% or more 100 634
--------- ---------
5.28% $ 799,501 5.10% $ 717,809
========= =========
</TABLE>
F-22
<PAGE> 78
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
Interest expense on deposits, by type of account, for the years ended December
31 is summarized as follows:
<TABLE>
<CAPTION>
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Checking/NOW $ 381 $ 212 $ 484
Passbook 403 508 205
Money market 1,018 365 1,024
Certificates of deposit 37,118 34,483 31,880
------- ------- -------
$38,920 $35,568 $33,593
======= ======= =======
</TABLE>
F-23
as'ldf'sd
<PAGE> 79
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE G - DEPOSITS - CONTINUED
The table below sets forth the maturities of the Company's certificates of
deposit outstanding at December 31:
<TABLE>
<CAPTION>
1997
-------------------------------------------------------------------------
OVER OVER
THREE MONTHS SIX MONTHS
THREE MONTHS THROUGH THROUGH OVER
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL
------------ ------------ ---------- -------- --------
<S> <C> <C> <C> <C> <C>
BALANCES less than $100,000
4.00% or less $ 1,660 $ 15 $ 26 $ 88 $ 1,789
4.01% - 5.00% 38,460 1,650 1,571 5,206 46,887
5.01% - 6.00% 119,283 111,758 176,146 16,890 424,077
6.01% - 7.00% 4,834 21,458 29,818 1,218 57,328
7.01% or more - - - 100 100
-------- -------- -------- -------- --------
164,237 134,881 207,561 23,502 530,181
BALANCES greater than or equal to $100,000
4.00% or less - - - - -
4.01% - 5.00% 7,162 - 548 1,271 8,981
5.01% - 6.00% 38,734 30,306 57,313 4,129 130,482
6.01% - 7.00% 2,663 9,933 10,926 523 24,045
7.01% or more - - - - -
-------- -------- -------- -------- --------
48,559 40,239 68,787 5,923 163,508
-------- -------- -------- -------- --------
TOTAL $212,796 $175,120 $276,348 $ 29,425 $693,689
======== ======== ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
1996
-------------------------------------------------------------------------
OVER OVER
THREE MONTHS SIX MONTHS
THREE MONTHS THROUGH THROUGH OVER
OR LESS SIX MONTHS ONE YEAR ONE YEAR TOTAL
------------ ------------ ---------- -------- --------
<S> <C> <C> <C> <C> <C>
BALANCES less than $100,000
4.00% or less $ 2,581 $ 104 $ - $ 4 $ 2,689
4.01% - 5.00% 54,800 4,556 3,239 17,127 79,722
5.01% - 6.00% 108,271 91,529 93,528 52,373 345,701
6.01% - 7.00% 9,760 6,464 40,078 22,706 79,008
7.01% or more 234 - - 100 334
-------- -------- -------- -------- --------
175,646 102,653 136,845 92,310 507,454
BALANCES greater than or equal to $100,000
4.00% or less 104 - - - 104
4.01% - 5.00% 12,609 - 160 5,934 18,703
5.01% - 6.00% 29,449 25,322 30,697 11,224 96,692
6.01% - 7.00% 3,554 2,060 13,373 5,010 23,997
7.01% or more - 200 - 100 300
-------- -------- -------- -------- --------
45,716 27,582 44,230 22,268 139,796
-------- -------- -------- -------- --------
TOTAL $221,362 $130,235 $181,075 $114,578 $647,250
======== ======== ======== ======== ========
</TABLE>
F-24
<PAGE> 80
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE H - SHORT-TERM BORROWINGS
A primary alternate funding source for the Company is a credit line with the
FHLB of San Francisco of up to 35% of the Company's total assets. The FHLB
system functions as a source of credit to savings institutions which are members
of a Federal Home Loan Bank. Advances are typically secured by the Company's
real estate 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 of San Francisco considers
a member's creditworthiness and other relevant factors.
The balance and rate of FHLB advances at December 31 are summarized as follows:
<TABLE>
<CAPTION>
1997 1996
------------------------------ -----------------------------
ORIGINAL TERM PRINCIPAL RATE PRINCIPAL RATE
- ------------------- ---------------- ---------- --------------- ---------
<S> <C> <C> <C> <C>
9 Months $ - - % $ 25,000 5.99%
12 Months 40,000 5.95% 25,000 6.24%
-------- --------
$ 40,000 5.95% $ 50,000 6.12%
======== ========
</TABLE>
The following schedule summarizes information relating to the Company's FHLB
advances for the periods presented:
<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C>
Average balance during the year $ 48,600 $ 41,138
Average interest rate during the year 6.00% 6.01%
Maximum month-end balance during the year 75,000 100,000
Loans underlying the agreements at year end 446,204 360,829
</TABLE>
F-25
<PAGE> 81
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE I - INCOME TAXES
Benefit (provision) for income taxes for the years ended December 31 consists of
the following:
<TABLE>
<CAPTION>
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Current
Federal $ - $ 2,139 $ (615)
State - - (2)
------- ------- -------
- 2,139 (617)
------- ------- -------
Deferred
Federal 2,346 3,087 -
State 231 1,156 -
------- ------- -------
2,577 4,243 -
------- ------- -------
$ 2,577 $ 6,382 $ (617)
======= ======= =======
</TABLE>
The components of the net deferred income tax asset (liability) at December 31
are summarized as follows:
<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C>
Deferred income tax liabilities
Loan fees $ (2,690) $ (1,234)
FHLB stock (1,380) (1,170)
Depreciation (444) (740)
Other (1,249) (1,158)
-------- --------
(5,763) (4,302)
-------- --------
Deferred income tax assets
Bad debts 6,974 8,140
State NOL carryforward 1,301 703
Federal AMT credit carryforward 1,041 936
Federal NOL carryforward 4,240 5,166
Delinquent interest - 684
Other 1,841 1,672
-------- --------
15,397 17,301
-------- --------
Valuation allowance (2,814) (8,756)
-------- --------
Net deferred income tax assets $ 6,820 $ 4,243
======== ========
</TABLE>
F-26
<PAGE> 82
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE I - INCOME TAXES - CONTINUED
At December 31, 1997, the Company had (1) a federal net operating loss
carryforward of $12.5 million expiring in 2010 through 2011, (2) state net
operating loss carryforwards of $4.2 million and $8.1 million expiring in 2000
and 2001, respectively and (3) a federal alternative minimum tax credit
carryover of $1.0 million which can be carried forward indefinitely.
The income tax receivable (liability) at December 31 consists of the following:
<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
Deferred
Federal
Income tax asset $ 6,517 $ 8,997
Valuation allowance (1,084) (5,910)
State
Income tax asset 3,117 4,002
Valuation allowance (1,730) (2,846)
------- -------
$ 6,820 $ 4,243
======= =======
</TABLE>
The table below summarizes the differences between the statutory income tax and
the Company's effective tax for the years ended December 31:
<TABLE>
<CAPTION>
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Federal income (tax) benefit $(2,464) $ (393) $ 4,760
Reduction (addition) resulting from
Change in valuation allowance 5,942 6,090 (4,743)
Goodwill amortization and charge-off - (13) 163
California franchise tax, net of federal income taxes (737) 763 -
Other (164) (65) (797)
------- ------- -------
$ 2,577 $ 6,382 $ (617)
======= ======= =======
</TABLE>
F-27
<PAGE> 83
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE J - DISPOSITION OF DEPOSITS AND PREMISES
During 1996 and 1995, the Company sold certain of its branch deposits and sold
or closed the related branch facilities, consolidated deposits from certain
branches and sold the related facilities, and sold its two owned corporate
office buildings. The table below sets forth the composition of the net gain or
loss realized from these transactions for the years ended December 31:
<TABLE>
<CAPTION>
1996 1995
--------- ---------
<S> <C> <C>
Deposits sold $ 186,573 $ 17,072
========= =========
Net premium received from sales of deposits $ 6,305 $ 265
Net gain (loss) on disposition of premises
Proceeds received 1,826 743
Net book value at disposition (1,479) (922)
Provision for loss on disposition - (203)
--------- ---------
Net gain (loss) from disposition of premises 347 (382)
Other sale-related expenses (239) -
--------- ---------
Net gain (loss) $ 6,413 $ (117)
========= =========
</TABLE>
F-28
<PAGE> 84
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE K - EMPLOYEE BENEFIT PLANS
The Company has an Employee Stock Ownership Plan ("ESOP") that previously
covered substantially all employees over 21 years of age who met minimum service
requirements. As of December 15, 1995, the Company froze the ESOP and all
accounts became fully vested and nonforfeitable. At December 31, 1997, the ESOP
owned 132,751 shares of the Company's common stock. As of December 31, 1997, the
Company had a loan receivable from the ESOP of $92,000 collateralized by 5,833
shares of common stock owned by the ESOP.
Effective April 1, 1996, the ESOP was amended to include a 401(k) plan. The
Company makes a matching contribution equal to 100% of the amount each
participant elects to defer up to a maximum of 3% of the participant's
compensation for the calendar quarter. Employees are eligible to participate if
they were employed by the Company on March 1, 1996 or have been employed for 6
months, worked at least 500 hours, and over 21 years of age.
The Company had a retirement income plan ("Retirement Plan") that previously
covered substantially all employees over 21 years of age who met minimum service
requirements. The Company terminated the Retirement Plan as of July 1997.
The Company has two stock option plans ("Option Plans"), one of which provides
for the issuance of stock options to all employees of the Company and the other
of which provides for the issuance of stock options to all employees other than
certain executive officers of the Company. The purpose for both plans is the
rewarding of exemplary performance by officers and employees of the Company as
well as the recruiting and retaining of officers and employees. At December 31,
1997, the Option Plans provide for the issuance of an aggregate of a maximum of
840,854 shares of common stock of the Company upon exercise of options. The
exercise price of any option may not be less than the fair market value of the
common stock on the date of grant and the term of any option may not exceed 10
years.
F-29
<PAGE> 85
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE K - EMPLOYEE BENEFIT PLANS - CONTINUED
A summary of the status of the Option Plans as of December 31, and changes
during the years ended on those dates, is presented below:
<TABLE>
<CAPTION>
1997 1996
------------------------- -------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
SHARES PRICE SHARES PRICE
------- -------- ------- --------
<S> <C> <C> <C> <C>
Outstanding at beginning of year 686,000 $ 5.08 696,000 $ 4.95
Granted 120,000 16.77 36,000 7.81
Exercised (60,200) 4.92 - -
Terminated (24,000) 5.26 (46,000) 5.26
------- -------
Outstanding at end of year 721,800 7.03 686,000 5.08
======= =======
Options exercisable at year end 372,934 226,050
======= =======
</TABLE>
The following table summarizes information about stock options outstanding at
December 31, 1997:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
REMAINING
EXERCISE NUMBER CONTRACTUAL NUMBER
PRICE OUTSTANDING LIFE EXERCISABLE
-------- ----------- ----------- -----------
<S> <C> <C> <C>
$ 4.65 322,000 5.10 203,334
5.26 243,800 5.28 169,600
7.81 36,000 7.50 -
10.50 20,000 7.00 -
18.02 100,000 7.00 -
------- -------
7.03 721,800 5.57 372,934
======= =======
</TABLE>
If compensation costs for the Option Plans had been determined based on the fair
value at the grant date for awards in 1997, 1996 and 1995 consistent with the
provisions of SFAS No. 123, the Company's net earnings and net earnings per
share would have been reduced to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1997 1996 1995
------- ------- --------
<S> <C> <C> <C>
Net earnings (loss) - as reported $ 9,617 $ 7,507 $(14,217)
======= ======= ========
Net earnings (loss) - pro forma $ 8,880 $ 6,646 $(14,270)
======= ======= ========
Basic earnings (loss) per share - as reported $ 2.49 $ 1.95 $ (5.52)
======= ======= ========
Basic earnings (loss) per share - pro forma $ 2.23 $ 1.62 $ (5.54)
======= ======= ========
Diluted earnings (loss) per share - as reported $ 1.37 $ 1.17 $ (5.52)
======= ======= ========
Diluted earnings (loss) per share - pro forma $ 1.23 $ 0.97 $ (5.54)
======= ======= ========
</TABLE>
F-30
<PAGE> 86
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
The fair value of options granted under the Option Plans were estimated on the
date of grant using the Black-Scholes option-pricing model. In 1997, the
following weighted average assumptions were used: no dividend yield, expected
volatility of 123%, risk free interest rate of 5.7% and expected lives of 3 to 5
years. In 1996 and 1995, the following weighted average assumptions were used:
no dividend yield, expected volatility of 124%, risk free interest rate of 5.6%
and expected lives of 3-5 years.
NOTE L - CAPITAL AND DEBT OFFERINGS
In December 1995, the Company sold $27.0 million of "investment units" at a
price of $500,000 per unit in a private placement offering (the "1995
Offering"). Each investment unit consisted of $250,000 principal amount of the
Company's senior notes due 2000 ("1995 Senior Notes"), five shares of the
Company's cumulative preferred stock, series A ("Series A Preferred"), and one
warrant to purchase 44,000 shares of the Company's common stock ("Warrants").
The Company contributed $19.0 million of the net proceeds of the Offering as
qualifying Tier 1 capital to the Bank during December to satisfy the
capital-raising provisions of a Prompt Corrective Action Directive ("PCA")
issued in June 1995 by the OTS.
The Company recorded the 1995 Senior Notes, with a face amount of $13.5 million,
at $12.0 million. Interest was payable semiannually at a rate of 12.0% per annum
on the face amount and had an effective annual cost of 15.87% during 1997 after
recording the effect of the Original Issue Discount ("OID") of $1.5 million. The
accretion of the OID was to be recognized using the constant yield method over
the five-year term of the Senior Notes. During 1997, 1996 and 1995, the Company
recorded $350,000, $301,000 and $11,000, respectively, of OID as part of its
interest expense.
The Company also recorded the receipt of $12.8 million from the issuance of 270
shares of Series A Preferred with a par value of $.01 as Capital in Excess of
Par Value - Cumulative Preferred Stock, Series A. The Series A Preferred
provided for cumulative dividends, payable quarterly commencing June 1997 at an
annual rate of 18% on the $13.5 million liquidation preference of the stock.
The Company recorded $2.2 million of the proceeds from the sale of the units to
the Warrants as additional paid in capital. The Warrants entitle the holders to
purchase up to an aggregate of 2.4 million shares of Common Stock for $2.25 per
share at any time after December 15, 1998. The Warrants will terminate in
December 2005.
On December 31, 1997, the Company sold $40.0 million of 12.5% Senior Notes due
2004 ("1997 Senior Notes") in a private placement (the "1997 Offering"), which
included registration rights. Concurrent with the completion of the 1997
Offering, the Company prepaid all of its 1995 Senior Notes and redeemed all of
its Series A Preferred. The 1995 Senior Notes and Series A Preferred were
retired at par plus accrued interest and dividends, which approximated $27.2
million. This repayment and redemption resulted in the write-off of the
remaining OID ($0.8 million) and prepaid offering costs ($0.7 million) as an
extraordinary item. Net proceeds after the offering costs and the prepayment of
the 1995 Senior Notes and Series A Preferred amounted to approximately $10.4
million, funds which became available to the Company for general corporate
purposes, inclusive of supporting the planned business activities of the Bank.
Interest on the 1997 Senior Notes will be payable semiannually commencing on
June 30, 1998. On or after December 31, 2002, the 1997 Senior Notes will be
redeemable at any time at the option of the Company, in whole or in part, at the
redemption price of 106.25% for the twelve-month period beginning December 31,
2002, and 103.125% for the twelve-month period beginning December 31, 2003, and
thereafter until maturity.
NOTE M - STOCKHOLDERS' EQUITY
Retained earnings, which include bad debt deductions of approximately $25.5
million for federal income tax purposes at December 31, 1997, are restricted and
may be used only for the absorption of losses on loans and real estate acquired
through foreclosure. They are not subject to federal income tax unless used for
other purposes. The
F-31
<PAGE> 87
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE M - STOCKHOLDERS' EQUITY - CONTINUED
Company has not provided for federal income tax on these amounts, since it is
not contemplated that such amounts will be used for purposes other than to
absorb such losses.
The Home Owners' Loan Act ("HOLA") and the capital regulations of the OTS
promulgated thereunder ("Capital Regulations") impose three capital requirements
on savings associations, including a "core capital requirement", a "tangible
capital requirement" and a "risk-based capital requirement".
Under the core capital requirement, a savings association must maintain "core
capital" of not less than 3.0% of adjusted total assets. "Core Capital"
generally includes common stockholders' equity, noncumulative perpetual
preferred stock, including any related surplus, and minority interests in the
equity accounts of fully consolidated subsidiaries. The amount of an
association's core capital is, in general, calculated in accordance with GAAP,
but with certain exceptions. Among other exceptions, adjustments to an
association's GAAP equity accounts that are required pursuant to SFAS 115 to
reflect changes in market value of certain securities held by the association
that are categorized as "available-for-sale" are not to be included in the
calculation of core capital for regulatory capital purposes. Intangible assets
(not including purchased mortgage servicing rights, certain mortgage servicing
rights with respect to originated loans and purchased credit card relationships)
must be deducted from core capital. With certain exceptions, equity investments,
including equity investments in real estate, and that portion of land loans and
nonresidential construction loans in excess of an 80% loan-to-value ratio, must
also be deducted from capital. Core capital may include purchased mortgage
servicing rights, certain mortgage servicing rights with respect to originated
loans and purchased credit card relationships, subject to certain limitations.
Under the tangible capital requirement, a savings association must maintain
"tangible capital" in an amount not less than 1.5% of adjusted total assets.
"Tangible capital" means core capital less any intangible assets (including
supervisory goodwill), plus purchased mortgage servicing rights, and certain
mortgage servicing rights with respect to originated loans, subject to certain
limitations.
Under the risk-based capital requirement, a savings association must maintain
"total capital" equal to 8.0% of risk-weighted assets. "Total capital" consists
of core capital and supplementary capital. Supplementary capital includes, among
other things, certain types of preferred stock and subordinated debt and,
subject to certain limitations, general reserves up to 1.25% of risk-weighted
assets. A savings association's supplementary capital may be used to satisfy the
risk-based capital requirements only to the extent of that association's core
capital. Risk-weighted assets are the assets of the association (including
certain off-balance sheet items, including letters of credit, and loans or other
assets sold with subordination or recourse arrangements) adjusted to reflect the
degree of credit risk deemed to be associated with such assets, ranging from 0%
for low-risk assets such as U. S. Government securities and GNMA securities to
100% for various types of loans and other assets deemed to be higher risk.
Single family mortgage loans having loan-to-value ratios not exceeding 80% and
meeting certain additional criteria, as well as certain multi-family residential
mortgage loans, qualify for a 50% risk-weighted treatment.
The risk-based capital rules of the OTS, FDIC and other federal banking agencies
provide that an association must hold capital in excess of regulatory minimums
to the extent that examiners find either (i) significant exposure to
concentration of credit risk such as risks from higher interest rates,
prepayments, significant off-balance sheet items (especially standby letters of
credit), or risks arising from nontraditional activities or (ii) that the
association is not adequately managing these risks. For this purpose, however,
the agencies have stated that, in view of the statutory requirements relating to
permitted lending and investment activities of savings associations, the general
concentration by such associations in real estate lending activities would not,
by itself, be deemed to constitute an exposure to concentration of credit risk
that would require greater capital levels.
F-32
<PAGE> 88
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE M - STOCKHOLDERS' EQUITY -CONTINUED
In August 1993, the OTS adopted a final rule incorporating an interest-rate risk
component into the risk-based capital regulation. Under the rule, an association
with a greater than "normal" level of interest rate risk is subject to a
deduction of its interest rate risk component from total capital for purposes of
calculating its risk-based capital. As a result, such an association is required
to maintain additional capital in order to comply with the risk-based capital
requirement. The final rule was originally to be effective as of January 1,
1994; however, its effectiveness has been delayed several times. In August 1995,
the OTS issued Thrift Bulletin No. 67, which allows eligible associations to
request an adjustment to their interest rate risk component as calculated by the
OTS, or to request to use their own models to calculate their interest rate
component. The OTS also indicated that it will continue to delay the
effectiveness of its interest rate risk rule requiring associations with above
normal interest rate risk exposure to adjust their regulatory capital
requirement until new procedures are implemented and evaluated.
Under federal law, each federal banking agency has implemented a system of
prompt corrective action for associations which it regulates. Under OTS
regulations for prompt corrective action ("PCA Rules"), an association is deemed
to be (i) "well-capitalized" if it has total risk-based capital of 10.0% or
more, has a Tier 1 risk-based capital ratio of 6.0% or more, has a Tier 1
leverage capital ratio of 5.0% or more and is not subject to any order or final
capital directive to meet and maintain a specific capital level for any capital
measure; (ii) "adequately capitalized" if it has a total risk-based capital
ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and a
Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances)
and does not meet the definition of "well capitalized," (iii) "undercapitalized"
if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1
risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital
ratio that is less than 4.0% (3.0% under certain circumstances), (iv)
"significantly undercapitalized" if it has a total risk-based capital ratio that
is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a
Tier 1 leverage capital ratio that is less than 3.0%, and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. Federal law authorizes the OTS to reclassify a well
capitalized association as adequately capitalized and may require an adequately
capitalized association or an undercapitalized association to comply with
supervisory actions as if it were in the next lower category (except that the
OTS may not reclassify a significantly undercapitalized association as
critically undercapitalized).
Under the PCA Rules, an association that is deemed to be undercapitalized must
submit a capital restoration plan and is subject to mandatory restrictions on
capital distributions (including cash dividends) and management fees, increased
supervisory monitoring by the OTS, growth restrictions, restrictions on certain
expansion proposals and capital restoration plan submission requirements. If an
association is deemed to be significantly undercapitalized, all of the foregoing
mandatory restrictions apply, as well as a restriction on compensation paid to
senior executive officers. Furthermore, the OTS must take one or more of the
following actions: (i) require the association to sell shares (including voting
shares) or obligations; (ii) require the association to be acquired or merged
(if one or more grounds for the appointment of a conservator or receiver
exists); (iii) implement various restrictions on transactions with affiliates;
(iv) restrict interest rates on deposits; (v) impose further asset growth
restrictions or asset reductions; (vi) require the association or subsidiary to
alter, reduce, or terminate activities considered risky; (vii) order a new
election of directors; (viii) dismiss directors and/or officers who have held
office more than 180 days before the association became undercapitalized; (ix)
require the hiring of qualified executives; (x) prohibit correspondent bank
deposits; (xi) require the association to divest or liquidate a subsidiary in
danger of insolvency or a controlling company to divest any affiliate that poses
a significant risk, or is likely to cause a significant dissipation of assets or
earnings; (xii) require a controlling company to divest the association if it
improves the association's financial prospects; or (xiii) require any other
action the OTS determines fulfills the purposes of the PCA Rules.
The OTS may also impose on significantly undercapitalized associations one or
more of the mandatory restrictions applicable to critically undercapitalized
associations. The restrictions require prior regulatory approval for any
F-33
<PAGE> 89
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE M - STOCKHOLDERS' EQUITY - CONTINUED
material transaction, to extend credit on a highly leveraged transaction, to
adopt charter or bylaws amendments, to make material accounting changes, to
engage in covered transactions with affiliates, to pay excessive compensation,
or to pay higher interest on new or renewing liabilities. A critically
undercapitalized association may not, beginning 60 days after becoming
critically undercapitalized, make any principal or interest payments on
subordinated debt not outstanding on July 15, 1991. The OTS is required, not
later than 90 days after a savings association becomes critically
undercapitalized to either (i) appoint a conservator or receiver or (ii) take
such other actions it determines would better achieve the purpose of the PCA
Rules. In any event, the OTS is required to appoint a receiver within 270 days
after the association becomes critically undercapitalized unless (i) with the
concurrence of the FDIC, the OTS determines the association has a positive net
worth, has been in substantial compliance with an approved capital restoration
plan, is profitable or has an upward trend in earnings which the OTS finds is
substantial, and is reducing the ratio of nonperforming loans to total loans and
(ii) the Director of the OTS and the Chairman of the FDIC both certify that the
association is viable and not expected to fail.
As of December 31, 1997 and 1996, the most recent notification from the OTS
categorized the Bank as well capitalized under the regulatory framework for PCA
Rules. There are no conditions or events since that notification that management
believes have changed the Bank's category. The following table sets forth as of
December 31, 1997 and 1996, the Bank's actual regulatory capital amounts and
ratios and the regulatory capital amounts and ratios for the Bank to be
"adequately capitalized" and "well capitalized."
<TABLE>
<CAPTION> TO BE CATEGORIZED
AS WELL CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
---------------------- --------------------- -----------------------
AMOUNT RATIO AMOUNT RATIOS AMOUNT RATIOS
-------- ----- -------- ------ -------- ------
<S> <C> <C> <C> <C> <C> <C>
AS OF DECEMBER 31, 1997:
Total Capital
(to Risk Weighted Assets) $ 78,454 11.48% $ 54,679 8.00% $ 68,349 10.00%
Core Capital
(to Adjusted Tangible Assets)(1) 69,900 7.55% 27,773 3.00% 46,289 5.00%
Tangible Capital
(to Adjusted Tangible Assets)(1) 69,900 7.55% 13,887 1.50% N/A N/A
Tier 1 Capital
(to Risk Weighted Assets) 69,900 10.23% N/A N/A 41,009 6.00%
AS OF DECEMBER 31, 1996
Total Capital
(to Risk Weighted Assets) $ 59,560 11.11% $ 42,879 8.00% $ 53,599 10.00%
Core Capital
(to Adjusted Tangible Assets)(1) 52,803 6.27% 25,267 3.00% 42,106 5.00%
Tangible Capital
(to Adjusted Tangible Assets)(1) 52,803 6.27% 12,634 1.50% N/A N/A
Tier 1 Capital
(to Risk Weighted Assets) 52,803 9.85% N/A N/A 32,159 6.00%
</TABLE>
- ----------------
(1) The term "adjusted tangible 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 refers to the term
"risk-weighted assets" as defined in 12 C.F.R. Section 567.1(b) for
purposes of risk-based capital requirements.
F-34
<PAGE> 90
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE N - COMMITMENTS AND CONTINGENCIES
LITIGATION
On September 6, 1996, the Company and the Bank were named as defendants in a
class action lawsuit entitled Stanley D. Mosler and Eileen C. Mosler vs.
Hawthorne Savings and Loan Association, Hawthorne Financial Corporation, et.
al., filed in the Superior Court of the State of California as Case No. BC154729
(the "Action"). The plaintiffs had previously filed an individual action
alleging the same matters contained in the class action complaint. Plaintiffs
contend they were entitled to a notice of availability of foreclosure
counseling, which they allege they did not receive, before the Bank foreclosed.
Plaintiffs contend that the alleged failure to provide counseling notices and
the underbidding by the Bank of the loan amount at foreclosure resulted in
damages to the purported class in an amount in excess of $40 million. The
Company has been named and alleged to have liability based upon its relationship
as trustee on the Deed of Trust securing the Bank's loans. The Company and
F-35
<PAGE> 91
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE N - COMMITMENTS AND CONTINGENCIES - CONTINUED
the Bank filed responsive pleadings to the Action alleging that the complaint is
defective on its face and that the plaintiffs are not proper representatives of
the purported class. The court granted the Company and Bank's motion and
dismissed the plaintiffs' case. The Appellate Court heard oral argument in July
1997 and upheld the trial court's dismissal of the Action. The plaintiffs sought
a review by the California Supreme Court. The Supreme Court denied plaintiff's
request for review. The remaining causes of action in this lawsuit are the same
as contained in the previously filed individual action. Trial in the individual
action is scheduled for May 11, 1998.
As previously reported, the Bank is a defendant in an action entitled Takaki vs.
Hawthorne Savings and Loan Association, filed in the Superior Court of the State
of California, Los Angeles, as Case No. YC021815. The plaintiffs were owners of
real property which they sold in early 1992 to a third party. The Bank provided
escrow services in connection with the transaction. A substantial portion of the
consideration paid to the plaintiffs took the form of a deed of trust secured by
another property then owned by an affiliate of the purchaser. The value of the
collateral securing this deed of trust ultimately proved to be inadequate. The
plaintiffs alleged that the Bank knew, or should have known, that the security
for the plaintiffs' loan was inadequate and should have so advised them. In late
June 1997, a trial jury found for the plaintiffs and awarded compensatory and
punitive damages totaling $9.1 million. In late July 1997, the trial judge
reduced the combined award to $3.3 million. The plaintiffs accepted the reduced
judgment. The Bank has filed a Notice of Appeal from the judgment and has posted
an Appeal Bond with the court to stay plaintiffs enforcement of the judgment
pending the Appellate Court's decision. Based upon its view that the law in
California is unambiguous that there is no duty which attaches to escrow
providers to advise parties to an escrow, the Bank believes that its position
will ultimately be upheld on appeal and accordingly, that no amounts will be
paid by the Bank to the plaintiffs in this matter. There can be no assurances
that this will be the case, however. The defendant's appellate brief and the
plaintiff's appellate brief have been filed with the Court. The defendant's
response is due April 6, 1998. Thereafter, hearing for oral arguments will be
scheduled by the Court.
The Company is involved, in the normal course of business, in a variety of other
litigation matters. 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 or
operations.
LENDING COMMITMENTS
At December 31, 1997, the Company had outstanding commitments to originate loans
of $31.7 million, commitments to fund the undisbursed portion of existing
construction and land loans of $107.6 million and commitments to fund the
undisbursed portion of existing lines of credit of $14.0 million.
ERRORS AND OMISSIONS INSURANCE
The Company had a mortgagee's errors and omissions insurance policy as of
December 31, 1997. The Company did not have errors and omissions insurance on
other aspects of its operation.
F-36
<PAGE> 92
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
LEASES
The Company has entered into agreements to lease certain office facilities under
operating leases which expire at various dates to the year 2010. The leases
generally provide that the Company pay property taxes, insurance and other
items. Current rental commitments for the remaining terms of these noncancelable
leases as of December 31, 1997 are as follows:
<TABLE>
<CAPTION>
AMOUNT
--------
<S> <C>
1998 $ 1,223
1999 1,293
2000 1,076
2001 378
2002 55
Thereafter 431
-------
$ 4,456
=======
</TABLE>
Lease expense for office facilities was $1.0 million for each of the
years ended December 31, 1997, 1996 and 1995.
NOTE O - ESTIMATED FAIR VALUE INFORMATION
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, "Disclosures about
Fair Value of Financial Instruments." The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. However, considerable judgment is required to interpret
market data to develop the estimates of fair value. Accordingly, the estimates
presented herein are not necessarily indicative of the amounts the Company could
realize in a current market exchange. The use of different market assumptions
and or estimation methodologies may have a material effect on the estimated fair
value amounts.
F-37
<PAGE> 93
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
<TABLE>
<CAPTION>
1997 1996
---------------------- ----------------------
ESTIMATED ESTIMATED
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Assets
Cash and cash equivalents $ 51,620 $ 51,620 $ 93,978 $ 93,978
Investment securities 578 578 38,371 38,371
Loans receivable 838,251 848,989 672,401 683,622
Investment in FHLB Stock 7,213 7,123 6,788 6,788
Liabilities
Deposits
Money market $ 48,918 $ 48,918 $ 18,793 $ 18,793
Passbook 20,139 20,139 22,887 22,887
Checking/NOW 30,177 30,177 24,954 24,954
Certificates of deposit 693,689 693,887 647,250 646,766
Noninterest bearing demand 6,578 6,578 3,925 3,925
FHLB advances 40,000 40,106 50,000 50,136
Senior Notes 40,000 40,000 12,307 12,307
</TABLE>
The methods and assumptions used to estimate the fair value of each class of
financial instruments for which it is practicable to estimate that value are
explained below.
For cash and cash equivalents, the carrying amount is considered to be their
estimated fair value.
For investment securities, fair values are based on quoted market prices
obtained from an independent pricing service (NOTES A and C).
For FHLB stock, the carrying amount approximates fair value, as the stock may
be sold back to the FHLB at the carrying value.
The carrying amount of loans receivable is their contractual amounts outstanding
reduced by net deferred loan origination fees and the allowance for loan losses
(NOTE D). Adjustable rate loans consist primarily of loans whose interest rates
float with changes in either a specified bank's reference rate or the FHLB
eleventh district cost of funds index.
The fair value of both adjustable and fixed rate loans was estimated by
discounting the remaining contractual cash flows using the estimated current
rate at which similar loans would be made to borrowers with similar credit risk
characteristics over the same remaining maturities, reduced by net deferred loan
origination fees and the allocable portion of the allowance for the loan losses.
The estimated current rate for discounting purposes was not adjusted for any
change in borrowers' credit risks since the origination of such loans. Rather,
the allocable portion of the allowance for loan losses is considered to provide
for such changes in estimating fair value.
The fair value of nonaccrual loans (NOTE D) has been estimated at the carrying
amount of these loans, as it is not practicable to reasonably assess the credit
risk adjustment that would be applied in the market place for such loans.
The withdrawable amounts for checking accounts are considered to be stated at
their estimated fair value. The fair value of passbook accounts and
fixed-maturity certificates of deposit is estimated using the rates currently
offered for deposits of similar remaining maturities.
F-38
<PAGE> 94
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
The fair value of FHLB advances is estimated using the rates currently offered
on similar instruments with similar terms.
The fair value of senior notes in 1997 is at carrying value since the debt was
issued on December 31, 1997. In 1996, it was not practicable for the Company to
estimate the fair value of the senior notes because they were not rated nor
registered, and a quoted market price was not available. The notes had an
effective interest rate of 15.9% and a maturity date of December 31, 2000.
The fair value estimates presented herein are based on pertinent information
available to management as of December 31, 1997 and 1996. Although management is
not aware of any factors that would significantly affect the estimated fair
value amounts, such amounts have not been comprehensively revalued for purposes
of these financial statements since that date and, therefore, current estimates
of fair value may differ significantly from the amounts presented above.
F-39
<PAGE> 95
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE P - SEPARATE PARENT COMPANY FINANCIAL STATEMENTS
STATEMENTS OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1997 1996
-------- --------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 9,944 $ 1,222
Investment securities - 3,203
Investment in subsidiary 69,906 53,490
Other assets 2,501 987
-------- --------
$ 82,351 $ 58,902
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and other liabilities $ 32 $ 2,673
Senior notes 40,000 12,307
-------- --------
40,032 14,980
Stockholders' equity
Preferred stock - $0.01 par value; authorized 10,000,000 shares
Cumulative preferred stock, series A: liquidation preference,
$50 per share; authorized, 270 shares; outstanding, no shares
(1997) and 270 shares (1996) - -
Common stock - $0.01 par value; authorized 20,000,000 shares;
issued and outstanding, 3,095,996 shares (1997) and 2,604,675
shares (1996) 31 26
Capital in excess of par value - cumulative preferred stock, series A - 11,592
Capital in excess of par value - common stock 10,402 7,745
Unrealized gain (loss) on available-for-sale securities 6 (132)
Retained earnings 32,020 24,858
-------- --------
42,459 44,089
Less
Treasury stock, at cost - 5,400 shares (48) (48)
Loan to Bank ESOP (92) (119)
-------- --------
42,319 43,922
-------- --------
$ 82,351 $ 58,902
======== ========
</TABLE>
F-40
<PAGE> 96
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE P - SEPARATE PARENT COMPANY FINANCIAL STATEMENTS - CONTINUED
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Interest revenues
Loans $ - $ - $ 49
Investments 95 246 13
From subsidiary 10 16 12
-------- -------- --------
Total interest revenues 105 262 74
Interest costs 1,979 1,921 92
-------- -------- --------
Net interest income (1,874) (1,659) (18)
Noninterest revenues, net
Operating 21 13 49
Loss on sale of securities (10) - -
Other non-operating (1) (1) (89)
Operating costs (882) (910) (515)
Loss from real estate operations, net - - (102)
-------- -------- --------
Loss before income taxes, equity in subsidiary,
and extraordinary item (2,746) (2,557) (675)
Income tax expense - - (37)
-------- -------- --------
Loss before equity in subsidiary and extraordinary item (2,746) (2,557) (712)
Equity in earnings (loss) of subsidiary 13,897 10,064 (13,505)
-------- -------- --------
Earnings (loss) before extraordinary item 11,151 7,507 (14,217)
Extraordinary item (1,534) - -
-------- -------- --------
Net earnings (loss) $ 9,617 $ 7,507 $(14,217)
======== ======== ========
Net earnings (loss) available for Common $ 7,162 $ 5,070 $(14,334)
======== ======== ========
Basic earnings (loss) per share before extraordinary item $ 3.02 $ 1.95 $ (5.52)
======== ======== ========
Basic earnings (loss) per share $ 2.49 $ 1.95 $ (5.52)
======== ======== ========
Diluted earnings (loss) per share before extraordinary item $ 1.66 $ 1.17 $ (5.52)
======== ======== ========
Diluted earnings (loss) per share $ 1.37 $ 1.17 $ (5.52)
======== ======== ========
Weighted average shares 5,235 4,341 2,599
======== ======== ========
</TABLE>
F-41
<PAGE> 97
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE P - SEPARATE PARENT COMPANY FINANCIAL STATEMENTS - CONTINUED
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities
Net earnings (loss) $ 9,617 $ 7,507 $(14,217)
Adjustments
Equity in undistributed (earnings) loss of subsidiary (13,897) (10,064) 13,505
Depreciation and amortization 582 479 112
Decrease (increase) in interest receivable 16 (2) (13)
Loss on early extinguishment of debt 1,534 - -
Loss on sale of investments 10 - -
Loss on sale of REOs - - 80
Increase in other assets (2,451) - (1,178)
Decrease (increase) in accounts payable and other liabilities (79) (228) 14
-------- -------- --------
Net cash used by operating activities (4,668) (2,308) (1,697)
-------- -------- --------
Cash flows from investing activities
Purchases of securities - - (4,845)
Maturities of securities 795 1,677 -
Proceeds from sale of securities 2,414 - -
Proceeds from sales of loans receivable - - 760
Collection of loans receivable - - 16
Net proceeds from real estate owned - - 671
-------- -------- --------
Net cash provided (used) by investing activities 3,209 1,677 (3,398)
-------- -------- --------
Cash flows from financing activities
Net proceeds from exercise of options 296 - -
Net collection of ESOP loan 27 24 23
Cash contribution to subsidiary (3,400) - (20,000)
Cash dividends received 1,000 - -
Net proceeds from issuance of senior notes 40,000 - 11,994
Redemption of senior notes (13,500) - -
Net proceeds from issuance of preferred stock - - 12,760
Redemption of preferred stock (13,500) - -
Net proceeds from issuance of warrants - - 1,078
Cash dividends paid on preferred stock (742) - -
-------- -------- --------
Net cash provided by financing activities 10,181 24 5,855
-------- -------- --------
Increase (decrease) in cash 8,722 (607) 760
Cash at beginning of year 1,222 1,829 1,069
-------- -------- --------
Cash at end of year $ 9,944 $ 1,222 $ 1,829
======== ======== ========
Non-cash investing and financing items
Net change in unrealized gain (loss) on available-for-sale
securities 19 $ (25) $ 6
Accrued dividends on preferred stock 2,455 2,437 117
</TABLE>
F-42
<PAGE> 98
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE Q - QUARTERLY INFORMATION (UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------
MAR 31, JUN 30, SEP 30, DEC 31,
-------- ------- -------- --------
<S> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1997
Interest revenues $ 17,007 $ 18,748 $ 19,382 $ 20,479
Interest costs 10,155 10,826 11,275 11,569
-------- -------- -------- --------
Net interest income 6,852 7,922 8,107 8,910
Provision for credit losses 1,220 1,019 1,500 1,398
-------- -------- -------- --------
Net interest income after provision
for credit losses 5,632 6,903 6,607 7,512
Noninterest revenues, net
Operating 732 832 1,126 909
Loss on sale of securities - (10) (1) -
Other non-operating (13) 10 220 (105)
Noninterest expenses
Operating costs 5,424 5,244 5,202 6,139
Loss (income) from real estate operations, net 260 2 (489) (2)
-------- -------- -------- --------
Total noninterest expenses 5,684 5,246 4,713 6,137
Earnings before income taxes and
extraordinary item 667 2,489 3,239 2,179
Income tax benefit (expense) 692 935 (25) 975
-------- -------- -------- --------
Earnings before extraordinary item 1,359 3,424 3,214 3,154
Extraordinary item - - - (1,534)
-------- -------- -------- --------
Net earnings $ 1,359 $ 3,424 $ 3,214 $ 1,620
======== ======== ======== ========
Net earnings available for Common $ 750 $ 2,815 $ 2,606 $ 994
======== ======== ======== ========
Basic earnings per share before
extraordinary item $ 0.29 $ 1.02 $ 0.85 $ 0.82
======== ======== ======== ========
Basic earnings per share $ 0.29 $ 1.02 $ 0.85 $ 0.32
======== ======== ======== ========
Diluted earnings per share before
extraordinary item $ 0.16 $ 0.57 $ 0.47 $ 0.45
======== ======== ======== ========
Diluted earnings per share $ 0.16 $ 0.57 $ 0.47 $ 0.18
======== ======== ======== ========
Weighted average shares outstanding 4,794 4,959 5,507 5,622
======== ======== ======== ========
</TABLE>
F-43
<PAGE> 99
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE Q - QUARTERLY INFORMATION (UNAUDITED) - CONTINUED
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------
MAR 31, JUN 30, SEP 30, DEC 31,
-------- -------- -------- --------
<S> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1996
Interest revenues $ 14,801 $ 16,044 $ 16,420 $ 18,089
Interest costs 9,409 9,899 9,722 10,930
-------- -------- -------- --------
Net interest income 5,392 6,145 6,698 7,159
Provision for credit losses 1,410 2,255 2,570 (168)
-------- -------- -------- --------
Net interest income after provision
for credit losses 3,982 3,890 4,128 7,327
Noninterest revenues, net
Operating 440 491 626 370
Gain on sale of securities - - - 248
Disposition of deposits and premises - 6,413 - -
Other non-operating 346 (80) (3,829) 197
Operating costs 5,111 5,344 5,139 5,452
(Income) loss from real estate operations, net (651) 629 827 1,573
-------- -------- -------- --------
Total operating costs 4,460 5,973 5,966 7,025
Earnings (loss) before income taxes 308 4,741 (5,041) 1,117
Income tax benefit 2,253 1,230 2,885 14
-------- -------- -------- --------
Net earnings (loss) $ 2,561 $ 5,971 $ (2,156) $ 1,131
======== ======== ======== ========
Net earnings (loss) available for Common $ 1,953 $ 5,365 $ (2,764) $ 523
======== ======== ======== ========
Basic earnings (loss) per share $ 0.75 $ 2.06 $ (1.06) $ 0.20
======== ======== ======== ========
Diluted earnings (loss) per share $ 0.49 $ 1.23 $ (1.06) $ 0.12
======== ======== ======== ========
Weighted average shares outstanding (1) 3,949 4,346 4,578 4,522
======== ======== ======== ========
</TABLE>
- --------------------
(1) Calculated using actual shares outstanding for the quarter ended
September 30, 1996. Inclusion of options and warrants would have been
antidilutive.
F-44
<PAGE> 100
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE R - CONSOLIDATING SCHEDULES
<TABLE>
<CAPTION>
HAWTHORNE HAWTHORNE
SAVINGS FINANCIAL ELIMINATIONS CONSOLIDATED
--------- --------- ------------ ------------
<S> <C> <C> <C> <C>
ASSETS
Cash and cash equivalents $ 51,620 $ 9,944 $ (9,944) $ 51,620
Investment securities 578 - - 578
Investment in subsidiary - 69,906 (69,906) -
Loans receivable, net 838,242 - 9 838,251
Real estate owned, net 9,859 - - 9,859
Accrued interest receivable 5,298 - - 5,298
FHLB stock 7,213 - - 7,213
Office property and equipment 4,200 - - 4,200
Other assets 8,773 2,501 (96) 11,178
--------- --------- --------- ---------
$ 925,783 $ 82,351 $ (79,937) $ 928,197
========= ========= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits $ 809,445 $ - $ (9,944) $ 799,501
Borrowings 40,000 - - 40,000
Accounts payable and other liabilities 6,432 32 (87) 6,377
Senior debt - 40,000 - 40,000
--------- --------- --------- ---------
855,877 40,032 (10,031) 885,878
Stockholders' equity
Preferred Stock - - - -
Capital stock 150 31 (150) 31
Capital in excess of par
value - preferred stock - - - -
Capital in excess of par
value - common stock 24,165 10,402 (24,165) 10,402
Unrealized gain (loss) on available-
for-sale securities 6 6 (6) 6
Retained earnings 45,585 32,020 (45,585) 32,020
--------- --------- --------- ---------
69,906 42,459 (69,906) 42,459
Less
Treasury stock - (48) - (48)
Loan to Bank ESOP - (92) - (92)
--------- --------- --------- ---------
69,906 42,319 (69,906) 42,319
--------- --------- --------- ---------
$ 925,783 $ 82,351 $ (79,937) $ 928,197
========= ========= ========= =========
</TABLE>
F-45
<PAGE> 101
HAWTHORNE FINANCIAL CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE YEARS ENDED DECEMBER 31, 1997
(DOLLAR AMOUNTS IN TABLES ARE IN THOUSANDS)
NOTE R - CONSOLIDATED SCHEDULES - CONTINUED
<TABLE>
<CAPTION>
HAWTHORNE HAWTHORNE
SAVINGS FINANCIAL ELIMINATIONS CONSOLIDATED
--------- --------- ------------ ------------
<S> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1997
Interest revenues
Loans $ 70,013 $ - $ (1) $ 70,012
Investments 5,509 105 (10) 5,604
-------- -------- -------- --------
75,522 105 (11) 75,616
Interest costs
Deposits 38,930 - (10) 38,920
Borrowings 2,926 - - 2,926
Senior notes - 1,979 - 1,979
-------- -------- -------- --------
41,856 1,979 (10) 43,825
-------- -------- -------- --------
Net interest income 33,666 (1,874) (1) 31,791
Loan provision for credit losses 5,137 - - 5,137
-------- -------- -------- --------
Net interest income after provision
for credit losses 28,529 (1,874) (1) 26,654
Noninterest revenues, net
Operating 3,728 21 (150) 3,599
Loss on sale of securities (1) (10) - (11)
Other non-operating 112 (1) 1 112
Noninterest expenses
General and administrative costs
Employee 10,606 - - 10,606
Operating 4,468 783 (150) 5,101
Occupancy 3,106 - - 3,106
Professional 1,808 99 - 1,907
SAIF Premium and OTS assessment 1,289 - - 1,289
-------- -------- -------- --------
21,277 882 (150) 22,009
Income from real estate operations, net (229) - - (229)
-------- -------- -------- --------
Total noninterest expenses 21,048 882 (150) 21,780
-------- -------- -------- --------
Earnings (loss) before income taxes,
equity in subsidiary, and extraordinary item 11,320 (2,746) - 8,574
Income tax benefit 2,577 - - 2,577
-------- -------- -------- --------
Income (loss) before equity in
subsidiary and extraordinary item 13,897 (2,746) - 11,151
Equity in subsidiary - 13,897 (13,897) -
-------- -------- -------- --------
Earnings before extraordinary item 13,897 11,151 (13,897) 11,151
Extraordinary item - (1,534) - (1,534)
-------- -------- -------- --------
Net earnings (loss) $ 13,897 $ 9,617 $(13,897) $ 9,617
======== ======== ======== ========
</TABLE>
F-46
<PAGE> 102
MANAGEMENT'S ASSERTION REPORT
January 30, 1998
To our Stockholders:
FINANCIAL STATEMENTS
The management of Hawthorne Financial Corporation ("Company") and its
subsidiary, Hawthorne Savings, F.S.B. is responsible for the preparation,
integrity, and fair presentation of its published financial statements and all
other information presented in this annual report. The financial statements have
been prepared in accordance with generally accepted accounting principles
("GAAP") and, as such, include amounts based on judgments and estimates made by
management.
The financial statements have been audited by an independent accounting firm,
which was given unrestricted access to all financial records and related data,
including minutes of all meetings of stockholders, the Board of Directors and
committees of the Board. Management believes that all representations to the
independent auditors during their audit were valid and appropriate.
INTERNAL CONTROL
Management is responsible for establishing and maintaining an effective internal
control over financial reporting, presented in conformity with both GAAP and the
Office of Thrift Supervision ("OTS") instructions for the Thrift Financial
Report ("TFR"). The Company's internal control contains monitoring mechanisms,
and actions are taken to correct deficiencies identified.
There are inherent limitations in the effectiveness of any internal control,
including the possibility of human error and the circumvention or overriding of
controls. Accordingly, even effective internal controls can provide only
reasonable assurance with respect to financial statement preparation. Further,
because of changes in conditions, the effectiveness of internal controls may
vary over time.
Management assessed the Company's internal controls over financial reporting
presentation in conformity with both GAAP and TFR instructions as of December
31, 1997. The assessment was based on criteria for effective internal control
over financial reporting described in Internal Control - Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on this assessment, management believes that the Company maintained
effective internal controls over financial reporting presented in conformity
with both GAAP and TFR instructions, as of December 31, 1997.
The Audit Committee of the Board of Directors is comprised entirely of outside
directors who are independent of management; it includes members with banking or
related management experience, has access to its own outside counsel, and does
not include any large customers of the Company. The Audit Committee is
responsible for recommending to the Board of Directors the selection of
independent auditors. It meets periodically with management, the independent
auditors, and the internal auditors to ensure that they are carrying out their
responsibilities. The Audit Committee is also responsible for performing an
oversight role by reviewing the Company's financial reports. The independent
auditors and the internal auditors have full and free access to the Audit
Committee, with or without the presence of management, to discuss the adequacy
of internal controls for financial reporting and any other matter which they
believe should be brought to the attention of the Audit Committee.
F-47
<PAGE> 103
COMPLIANCE WITH LAWS AND REGULATIONS
Management is also responsible for ensuring the compliance with federal laws and
regulations concerning loans to insiders and federal and state laws and
regulations concerning dividend restrictions, both of which are designated by
the FDIC as safety and soundness standards.
Management assessed its compliance with the designated safety and soundness laws
and regulations and has maintained records of its determinations and assessments
as required by the OTS. Based on this assessment, Management believes that the
Company has complied, in all material respects, with the designated safety and
soundness laws and regulations for the year ended December 31, 1997.
/s/ SCOTT A. BRALY /s/ NORMAN A. MORALES
- ------------------------------ ------------------------------
Scott A. Braly Norman A. Morales
President and Executive Vice President and
Chief Executive Officer Chief Financial Officer
F-48
<PAGE> 104
INDEPENDENT ACCOUNTANTS' REPORT
To the Audit Committee
Hawthorne Financial Corporation
El Segundo, California
We have examined management's assertion that, as of December 31, 1997,
Hawthorne Financial Corporation ("the Company") and its subsidiary, Hawthorne
Savings, F.S.B. maintained effective internal control over financial reporting
presented in conformity with both generally accepted accounting principles and
the Office of the Thrift Supervision Instructions for Thrift Financial Reports
included in the accompanying management's report on internal controls.
Our examination was made in accordance with standards established by the
American Institute of Certified Public Accountants, and, accordingly, included
obtaining an understanding of the internal control over financial reporting,
testing and evaluating the design and operating effectiveness of the internal
control over financial reporting, and such other procedures as we considered
necessary in the circumstances. We believe that our examination provides a
reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements
due to error or fraud may occur and not be detected. Also, projections of any
evaluation of the internal control over financial reporting to future periods
are subject to the risk that the internal control may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, management's assertion that, as of December 31, 1997,
the Company maintained an effective internal control over financial reporting
presented in conformity with both generally accepted accounting principles and
the Office of Thrift Supervision Instructions for Thrift Financial Reports is
fairly stated, in all material respects, based on the criteria established in
Internal Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
DELOITTE & TOUCHE LLP
January 30, 1998
Los Angeles, California
F-49
<PAGE> 1
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement Nos.
33-74800 and 333-23587 of Hawthorne Financial Corporation on Form S-8 of our
report dated January 30, 1998, appearing in this Annual Report on Form 10-K of
Hawthorne Financial Corporation for the year ended December 31, 1997.
/s/ DELOITTE & TOUCHE LLP
March 30, 1998
Los Angeles, California
F-50
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