Bank of Hawaii 10-K 2010
Commission File Number 1-6887
BANK OF HAWAII CORPORATION
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ý No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No ý
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 ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) 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 this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes o No ý
The aggregate market value of the registrant's outstanding voting common stock held by non-affiliates on June 30, 2009 (the last business day of the registrant's most recently completed second fiscal quarter), determined using the per share closing price on that date on the New York Stock Exchange of $35.83, was approximately $1,691,927,176. There was no non-voting common equity of the registrant outstanding on that date.
As of February 16, 2010, there were 48,010,982 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement relating to the Annual Meeting of Shareholders to be held on April 23, 2010, are incorporated by reference into Part III of this Report.
Bank of Hawaii Corporation (the "Parent") is a Delaware corporation and a bank holding company ("BHC") headquartered in Honolulu, Hawaii.
The Parent's principal and only operating subsidiary, Bank of Hawaii (the "Bank"), was organized on December 17, 1897 and is chartered by the State of Hawaii. The Bank's deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") and the Bank is a member of the Federal Reserve System.
The Bank provides a broad range of financial services and products primarily to customers in Hawaii and the Pacific Islands (Guam, nearby islands, and American Samoa). References to "we," "our," "us," or "the Company" refer to the holding company and its subsidiaries that are consolidated for financial reporting purposes.
The Bank's subsidiaries include Bank of Hawaii Leasing, Inc., Bankoh Investment Services, Inc., Pacific Century Life Insurance Corporation, BOH Wholesale Insurance Agency, Inc. (formerly known as Triad Insurance Agency, Inc.), and Bank of Hawaii Insurance Services, Inc. The Bank's subsidiaries are engaged in equipment leasing, securities brokerage, investment services, wholesale insurance, and insurance agency services. In 2009, the Company sold most of the assets and operations of its wholesale insurance agency and retail insurance brokerage subsidiaries, including the name of its wholesale insurance agency business, Triad Insurance Agency, Inc., to third parties.
We are aligned into four business segments for management reporting purposes: Retail Banking, Commercial Banking, Investment Services, and Treasury. See Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") and Note 13 to the Consolidated Financial Statements for more information.
Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports can be found free of charge on our website at www.boh.com as soon as reasonably practicable after such material is electronically filed with or furnished to the U.S. Securities and Exchange Commission (the "SEC"). The SEC maintains a website, www.sec.gov, which contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Our Corporate Governance Guidelines; charters of the Audit Committee, the Executive and Strategic Planning Committee, the Human Resources and Compensation Committee, and the Nominating and Corporate Governance Committee; and our Code of Business Conduct and Ethics are available on our website. Upon written request to the Corporate Secretary at 130 Merchant Street, Honolulu, Hawaii, 96813, this information is available in print form.
The Parent's other subsidiary is the BOHC Investment Fund, LLC (the "Fund"). The Fund was organized in September 2007, to invest in and hold securities of Qualified High Technology Businesses, as defined in the Hawaii Revised Statutes.
We have included the Chief Executive Officer and the Chief Financial Officer certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as Exhibits 31.1 and 31.2 of this report.
We are subject to substantial competition from banks, savings associations, credit unions, mortgage companies, finance companies, mutual funds, brokerage firms, insurance companies, and other providers of financial services, including financial service subsidiaries of commercial and manufacturing companies. We also compete with non-financial institutions that offer financial products and services. Some of our competitors are not subject to the same level of regulation and oversight that is required of banks and BHCs. As a result, some of our competitors may have lower cost structures. Also, some of our competitors, through alternative delivery channels such as the internet, may be based outside of the markets that we serve. Our extensive branch network, exceptional service levels, and knowledge of local trends and conditions contribute to our competitive advantage.
Supervision and Regulation
We are extensively regulated under both federal and state laws. The following information describes significant laws and regulations applicable to us. The description is qualified in its entirety by reference to the applicable laws and regulations. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and with the various bank regulatory agencies. The recent intervention into the banking system by the federal government to deal with the current financial crisis and its impact on the supervision and regulation of the banking and financial services industries may adversely affect our business, operations, and earnings. Changes in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on our business, operations, and earnings.
The Parent is registered as a BHC under the Bank Holding Company Act of 1956, as amended (the "BHC Act"), and is subject to the supervision of and to examination by the Board of Governors of the Federal Reserve Bank (the "FRB"). The Parent is also registered as a financial institution holding company under the Hawaii Code of Financial Institutions (the "Code") and is subject to the registration, reporting, and examination requirements of the Code.
The BHC Act prohibits, with certain exceptions, a BHC from acquiring beneficial ownership or control of more than 5% of the voting shares of any company, including a bank, without the FRB's prior approval. The Act also prohibits a BHC from engaging in any activity other than banking, managing or controlling banks or other subsidiaries authorized under the BHC Act, or furnishing services to or performing services for its subsidiaries.
Under FRB policy, a BHC is expected to serve as a source of financial and management strength to its subsidiary bank. A BHC is also expected to commit resources to support its subsidiary bank in circumstances where it might not do so absent such a policy. Under this policy, a BHC is expected to stand ready to provide adequate capital funds to its subsidiary bank during periods of financial adversity and to maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary bank.
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act, banks and bank holding companies from any state are permitted to acquire banks located in any other state, subject to certain conditions, including certain nationwide and state-imposed deposit concentration limits. The Bank also has the ability, subject to certain restrictions, to acquire branches outside its home state by acquisition or merger. The establishment of new interstate branches is also possible in those states with laws that expressly permit de novo branching. Because the Code permits de novo branching by out-of-state banks, those banks may establish new branches in Hawaii. Interstate branches are subject to certain laws of the states in which they are located.
Under the BHC Act, a BHC may elect to become a financial holding company and thereby engage in a broader range of financial and other activities than are permissible for traditional BHCs. In order to qualify for the election, all of the depository institution subsidiaries of the BHC must be well-capitalized and well-managed. Additionally, all of its insured depository institution subsidiaries must have achieved a rating of "satisfactory" or better under the Community Reinvestment Act (the "CRA"). Financial holding companies are permitted to engage in activities that are "financial in nature"; activities incidental to or complementary of the financial activities of traditional BHCs, as determined by the FRB. The Parent has not elected to become a financial holding company.
Bank of Hawaii
The Bank is subject to supervision and examination by the FRB of San Francisco and the State of Hawaii Department of Commerce and Consumer Affairs ("DCCA"), Division of Financial Institutions. The Bank is subject to extensive federal and state regulations that significantly affect business and activities. Regulatory bodies have broad authority to implement standards and to initiate proceedings designed to prohibit depository institutions from engaging in activities that represent unsafe and unsound banking practices or constitute violations of applicable laws, rules, regulations, administrative orders, or written agreements with regulators.
The standards relate generally to operations and management, asset quality, interest rate exposure, capital, and executive compensation. The agencies are authorized to take action against institutions that fail to meet such standards, including the assessment of civil monetary penalties, the issuance of cease-and-desist orders, and other actions.
Bankoh Investment Services, Inc., the broker dealer subsidiary of the Bank, is incorporated in Hawaii and is regulated by the Financial Industry Regulatory Authority, and the DCCA's Business Registration Division. The Bank's insurance subsidiaries, Bank of Hawaii Insurance Services, Inc. and BOH Wholesale Insurance Agency, Inc. are incorporated in Hawaii and are regulated by the DCCA's Division of Insurance. Pacific Century Life Insurance Corporation is incorporated in Arizona and is regulated by the State of Arizona Department of Insurance.
The federal bank regulatory agencies have issued substantially similar risk-based and leverage capital guidelines applicable to BHCs and the banks they supervise. Under the risk-based capital requirements, the Company and the Bank are each generally required to maintain a minimum ratio of total capital to risk-weighted assets of 8%. At least half of the total capital is to be composed of common equity, retained earnings, and qualifying perpetual preferred stock, less certain intangibles ("Tier 1 Capital"). The remainder may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of the allowance for loan and lease losses ("Tier 2 Capital") and, together with Tier 1 Capital, equals total capital ("Total Capital"). Risk weighted assets are calculated by taking assets and credit equivalent amounts of off-balance-sheet items and assigning them to one of several broad risk categories. The risk categories are assigned according to the obligor, or, if relevant, to the guarantor, or to the nature of the collateral. The aggregate dollar value of the amount in each category is then multiplied by the risk weight associated with that category.
BHCs and banks are also required to maintain minimum leverage ratios established by the federal bank regulatory agencies. These requirements provide for a minimum leverage ratio of Tier 1 Capital to adjusted quarterly average assets equal to 3% for BHCs and banks that have the highest regulatory rating and are not experiencing significant growth or expansion. All other BHCs and banks will generally be required to maintain a leverage ratio of at least 100 to 200 basis points above the stated minimum. See Note 11 to the Consolidated Financial Statements for capital ratios for the Company and the Bank.
The risk-based capital standards identify concentrations of credit risk and the risk arising from non-traditional banking activities, as well as an institution's ability to manage these risks, as important factors to be taken into account by the agencies in assessing an institution's overall capital adequacy. The capital guidelines also provide that exposure to a decline in the economic value of an institution's capital due to changes in interest rates is a factor to be considered in evaluating a bank's capital adequacy.
The Parent is a legal entity separate and distinct from the Bank. The Parent's principal source of funds to pay dividends on its common stock and to service its debt is dividends from the Bank. Various federal and state laws and regulations limit the amount of dividends the Bank may pay to the Parent without regulatory approval. The FRB is authorized to determine the circumstances when the payment of dividends would be an unsafe or unsound practice and to prohibit such payments. The right of the Parent, its shareholders, and creditors, to participate in any distribution of the assets or earnings of its subsidiaries, is also subject to the prior claims of creditors of those subsidiaries.
For information regarding the limitations on the Bank's ability to pay dividends to the Parent, see Note 11 to the Consolidated Financial Statements.
Transactions with Affiliates
Under federal law, the Bank is subject to restrictions that limit the transfer of funds or other items of value to the Parent, and any other non-bank affiliates in so-called "covered transactions." In general, covered transactions include loans, leases, other extensions of credit, investments and asset purchases, as well as other transactions involving the transfer of
value from the Bank to an affiliate or for the benefit of an affiliate. Unless an exemption applies, 1) covered transactions by the Bank with a single affiliate are limited to 10% of the Bank's capital and surplus, and 2) with respect to all covered transactions with affiliates in the aggregate, to 20% of the Bank's capital and surplus.
The Deposit Insurance Fund ("DIF") of the FDIC insures deposit accounts in the Bank up to a maximum amount per separately insured depositor. Beginning in October 2008, the FDIC temporarily increased FDIC deposit insurance coverage per separately insured depositor to $250,000 through December 31, 2013. On January 1, 2014, the standard coverage limit is scheduled to return to $100,000, per depositor, per insured bank, for all account ownership categories except certain retirement accounts, which will remain at $250,000 permanently per depositor, per insured bank.
FDIC-insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. In order to restore reserves and ensure that the DIF will be able to adequately cover losses from future bank failures, the FDIC approved new deposit insurance rules in November 2009. These rules modify the way the assessment system differentiates risks among insured institutions and implements changes in assessment rates, including base assessment rates, in order to increase assessment revenue. The FDIC's new deposit insurance rules required insured depository institutions to prepay their estimated quarterly risk-based assessments for all of 2010, 2011, and 2012. On December 30, 2009, the Bank prepaid its assessment in the amount of $42.3 million related to years 2010 through 2012. For purposes of calculating the prepayment amount, an institution's third quarter 2009 assessment base will be increased quarterly at a 5 percent annual growth rate through the end of 2012. In addition, the annual assessment rate will increase uniformly by 3 basis points beginning in 2011. Continuing declines in the DIF may result in the FDIC imposing additional assessments in the future, which could adversely affect the Company's capital levels and earnings.
In addition to DIF assessments, all FDIC-insured depository institutions must pay an annual assessment to provide funds for the repayment of debt obligations of the Financing Corporation. The Financing Corporation is a government-sponsored entity that was formed to borrow the money necessary to carry out the closing and ultimate disposition of failed thrift institutions by the Resolution Trust Corporation. As of January 1, 2010, the annualized assessment rate of risk-adjusted deposits, established by the FDIC for all DIF-assessable deposits was 1.06 basis points.
In October 2008, the FDIC introduced the Temporary Liquidity Guarantee Program (the "TLGP"), a program designed to improve the functioning of the credit markets and to strengthen capital in the financial system during this period of economic distress. The TLGP has two components: 1) a debt guarantee program, guaranteeing newly issued senior unsecured debt, and 2) a transaction account guarantee program, providing a full guarantee of noninterest-bearing deposit transaction accounts, Negotiable Order of Withdrawal (or "NOW") accounts paying less than 0.5% annual interest, and interest on Lawyers Trust Accounts, regardless of the amount. The Bank has not issued any senior unsecured debt to take advantage of the debt guarantee program, however, this program remains available to the Bank. The Bank participated in the transaction account guarantee program and, as such, all funds in covered accounts held through December 31, 2009 were covered with a full guarantee. In connection with this guarantee, a 10 basis point annual rate surcharge was assessed on amounts in covered accounts exceeding $250,000. Although the FDIC has extended the transaction account guarantee program through June 30, 2010, the Bank is not participating in this extension.
In the event of the liquidation or insolvency of an insured depository institution, the claims of depositors and the FDIC, where the FDIC succeeds to the claims of depositors or has been appointed as a receiver, will be afforded priority over other general unsecured claims against such an institution.
Other Safety and Soundness Regulations
Under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") the federal banking agencies possess broad powers to take prompt corrective action to resolve problems of insured depository institutions. FDICIA identifies
five capital categories for insured depository institutions: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." Under regulations established by the federal banking agencies, a "well capitalized" institution must have a Tier 1 Capital Ratio of at least 6%, a Total Capital Ratio of at least 10%, a Leverage Ratio of at least 5%, and not be subject to a capital directive order. As of December 31, 2009, the Bank was classified as "well capitalized." The classification of a depository institution under FDICIA is primarily for the purpose of applying the federal banking agencies' prompt corrective action provisions, and is not intended to be, nor should it be interpreted as, a representation of the overall financial condition or the prospects of any financial institution.
The federal banking agencies' prompt corrective action powers impose progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. These actions can include: requiring an insured depository institution to adopt a capital restoration plan guaranteed by the institution's parent company; placing limits on asset growth and restrictions on activities, including restrictions on transactions with affiliates; restricting the interest rates the institution may pay on deposits; prohibiting the payment of principal or interest on subordinated debt; prohibiting the holding company from making capital distributions without prior regulatory approval; and, ultimately, appointing a receiver for the institution.
As required by FDICIA, the federal banking agencies also have adopted guidelines prescribing safety and soundness standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation and benefits. The federal regulatory agencies may take action against a financial institution that does not meet such standards.
Community Reinvestment and Consumer Protection Laws
In connection with its lending activities, the Bank is subject to a number of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. These include the Equal Credit Opportunity Act, the Truth-in-Lending Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, and the CRA. In addition, federal banking regulators, pursuant to the Gramm-Leach-Bliley Act, have enacted regulations limiting the ability of banks and other financial institutions to disclose nonpublic consumer information to non-affiliated third parties. The regulations require disclosure of privacy policies and allow consumers to prevent certain personal information from being shared with non-affiliated parties.
The CRA requires the appropriate federal banking agency, in connection with its examination of a bank, to assess the bank's record in meeting the credit needs of the communities served by the bank, including low and moderate income neighborhoods. Under the CRA, institutions are assigned a rating of "outstanding," "satisfactory," "needs to improve," or "substantial non-compliance." The Bank received an "outstanding" rating in its most recent CRA evaluation.
Bank Secrecy Act / Anti-Money Laundering Laws
The Bank is subject to the Bank Secrecy Act and other anti-money laundering laws and regulations, including the USA PATRIOT Act of 2001. The USA PATRIOT Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by creating new laws, regulations, and penalties, imposing significant new compliance and due diligence obligations, and expanding the extra-territorial jurisdiction of the U.S. These laws and regulations require the Bank to implement policies, procedures, and controls to detect, prevent, and report money laundering and terrorist financing and to verify the identity of their customers. Violations of these requirements can result in substantial civil and criminal sanctions. In addition, provisions of the USA PATRIOT Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing bank mergers and BHC acquisitions.
As of January 31, 2010, we had approximately 2,400 employees.
business routinely encounters and addresses risks. There are a number of risks and uncertainties that could cause our financial results and condition to differ
materially from expected results.
Recent and pending legislation in response to market and economic conditions may significantly affect our operations, financial condition, and earnings.
Disruptions in the financial system since 2008 have resulted in significantly reduced business activity throughout the global and U.S. economies, which have the potential to significantly affect financial institutions. In response to this financial crisis affecting the banking system and financial markets, several programs have been initiated by the U.S. Treasury, the FRB, and the FDIC to stabilize the financial system.
There are uncertainties regarding the impact that these federal programs, and other liquidity, funding and economic stimulus initiatives of the federal government that may be initiated in the future will have on the financial markets or on the U.S. banking and financial services industries and the broader U.S. and global economies. These new laws, regulations, and changes may continue to increase our FDIC insurance premiums and may also increase our costs of regulatory compliance and of doing business, and otherwise affect our operations. They may significantly affect the markets in which we do business, the markets for and value of our investments, and our ongoing operations, costs, and profitability.
Changes in business and economic conditions, in particular those of Hawaii and the Pacific Islands (Guam, nearby islands, and American Samoa) could continue to lead to lower revenue, lower asset quality, and lower earnings.
Unlike larger national or other regional banks that are more geographically diversified, our business and earnings are closely tied to general business and economic conditions, particularly the economies of Hawaii and the Pacific Islands. These local economies are heavily influenced by tourism, real estate, government, and other service-based industries. Factors that could affect these local economies include declines in tourism, geopolitical risks, such as real or threatened acts of war or terrorism, higher energy costs, the availability of affordable air transportation, reduced consumer or corporate spending, natural disasters or adverse weather, public health issues, and the recent significant deterioration in general economic conditions. A sustained economic downturn, as we are experiencing in Hawaii and the Pacific Islands, could adversely affect the quality of our assets, credit losses, and the demand for our products and services, which could lead to lower revenue and lower earnings.
We continually monitor changes in the economy, including levels of visitor arrivals and spending, changes in housing prices, and unemployment rates. We also monitor the value of collateral, such as real estate, that secures loans we have made. A decline in the value of collateral could also reduce a customer's borrowing power.
Difficult market conditions have adversely affected our industry.
Dramatic declines in the U.S. Mainland housing market over the past two years, with falling home prices and increasing foreclosures and unemployment, have negatively impacted credit performance of residential mortgage loans and have resulted in significant write-downs of asset values by other financial institutions, including government-sponsored enterprises, as well as major commercial and investment banks. Real estate values in Hawaii continued to be somewhat more resilient than many markets on the U.S. Mainland over the past two years. However, there is no assurance that Hawaii real estate values will continue to be more resilient than U.S. Mainland markets. Many lenders and institutional investors have reduced, and in some cases, ceased providing funding to borrowers, including other financial institutions, reflecting concern about the stability of financial markets, generally, and the strength of counterparties, specifically. This market turmoil and tightening of credit has led to an increased level of commercial and consumer delinquencies for other financial institutions, a lack of confidence in the financial sector, and increased volatility in the financial markets. The resulting economic pressure on consumers and lack of confidence in the financial markets may adversely affect our business, financial condition, and results of operations.
Changes in interest rates could adversely impact our results of operations.
Our earnings are highly dependent on the spread between the interest earned on loans, leases, and investment securities and the interest paid on deposits and borrowings. Changes in market interest rates impact the rates earned on loans, leases, and investment securities and the rates paid on deposits and borrowings. In addition, changes to market interest rates could impact the level of loans, leases, investment securities, deposits, and borrowings, and the credit profile of our current borrowers. Interest rates are affected by many factors beyond our control, including general economic conditions, currency fluctuations, and the monetary and fiscal policies of various governmental and regulatory authorities. Changes in interest rates may negatively impact our ability to attract deposits, originate loans and leases, and achieve satisfactory interest rate spreads which could adversely affect our financial condition or results of operations.
Credit losses may continue to increase due to weaker economic conditions.
The risk of nonpayment of loans and leases is inherent in all lending activities. We maintain a reserve for credit losses to absorb estimated probable credit losses inherent in the loan, lease, and commitment portfolios as of the balance sheet date. Management makes various assumptions and judgments about the loan and lease portfolio, in determining the level of the reserve for credit losses. Many of these assumptions are based on current economic conditions. Volatility and deterioration in the broader economy may increase our risk of credit losses. If our assumptions are incorrect or economic conditions change, the reserve for credit losses may not be sufficient to cover losses, which could adversely affect our financial condition or results of operations.
Many of our loans are secured by real estate in Hawaii and Guam. As these locations experience softness in the economy, real estate values and customers' ability to repay could be adversely affected, and our loan and lease losses could exceed the estimates that are currently recorded in the reserve for credit losses.
Our operations are subject to extensive regulation.
Our operations are subject to extensive regulation by federal and state governmental authorities. The regulations are primarily intended to protect depositors, customers, and the banking system as a whole and not for the protection of shareholders. Failure to comply with applicable regulations could lead to penalties and damage to our reputation. Furthermore, the regulatory environment is constantly undergoing change and the impact of changes to laws and regulations, the interpretation of such laws or regulations, or other actions by regulatory agencies could make regulatory compliance more difficult or expensive. The ramifications and uncertainties of government regulatory reform of the banking and financial services industries could adversely affect the results of our operations. For example, a recent federal rule prohibits a financial institution from automatically enrolling customers in overdraft protection programs, on ATM and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service. This recent federal rule is likely to adversely affect the results of our operations.
Future legislative or regulatory actions responding to perceived financial and market problems could affect our rights against borrowers.
Recently, legislative and regulatory proposals have been discussed at the federal level that would limit an institution's ability to foreclose on the mortgage collateral of borrowers by reducing the amount borrowers are contractually obligated to pay under their mortgage loans. We could experience increased credit losses or increased expense in pursuing our remedies as a creditor, if proposals like these, or other proposals limiting our rights as a creditor, were implemented.
Competition may adversely affect our business.
Our future depends on our ability to compete effectively. We compete for deposits, loans, leases, and other financial services with a variety of competitors, including banks, thrifts, credit unions, mortgage companies, broker dealers, and insurance companies all of which may be based in or out of Hawaii and the Pacific Islands. Competition in our industry could intensify as a result of the increasing consolidation of financial services companies in
connection with current market conditions. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. Failures to effectively compete, innovate, and make effective use of available channels to deliver our products and services could adversely affect our financial condition or results of operations.
Our liquidity is dependent on dividends from the Bank.
The Parent is a separate and distinct legal entity from the Bank. The Parent receives substantially all of its cash in the form of dividends from the Bank. These dividends are the principal source of funds to pay dividends on the Parent's common stock. Various federal and state laws and regulations limit the amount of dividends that the Bank may pay to the Parent. If the amount of dividends paid by the Bank is further limited, the Parent's ability to meet its obligations, pay dividends to shareholders, or repurchase stock, may be further limited.
An interruption or breach in security of our information systems may result in financial losses or in a loss of customers.
We rely heavily on communications, electricity, and information systems to conduct our business. In addition, we rely on third parties to provide key components of our infrastructure, including loan, deposit and general ledger processing, internet connections, and network access. Any disruption in service of these key components could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our operations. Furthermore, security breaches of our information systems or data, whether managed by us or by third parties, could harm our reputation or cause a decrease in the number of customers that choose to do business with us. Security breaches could also subject the Bank to additional regulatory scrutiny and expose the Bank to civil litigation and possible financial liability.
Negative public opinion could damage our reputation and adversely impact our earnings and liquidity.
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
Changes in income tax laws or interpretations or in accounting standards could materially affect our financial condition or results of operations.
Changes in income tax laws could be enacted or interpretations of existing income tax laws could change causing an adverse effect to our financial condition or results of operations. Similarly, our accounting policies and methods are fundamental to how we report our financial condition and results of operations. Some of these policies require use of estimates and assumptions that may affect the value of our assets, liabilities, and financial results. Periodically, new accounting standards are imposed or existing standards are revised, changing the methods for preparing our financial statements.
Our performance depends on attracting and retaining key employees and skilled personnel to operate our business effectively.
Our success is dependent on our ability to recruit qualified and skilled personnel to operate our business effectively. Competition for these qualified and skilled people is intense. There are a limited number of qualified personnel in the markets we serve, so our success depends in part on the continued services of many of our current management and other key employees. Failure to retain our key employees and maintain adequate staffing of qualified personnel, could adversely impact our operations and our ability to compete.
The soundness of other financial institutions may adversely impact our financial condition or results of operations.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a
result of trading, clearing, lending, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, the Federal Home Loan Bank of Seattle (the "FHLB"), and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due us. Such losses could materially affect our financial condition or results of operations.
Changes in the equity markets could materially affect the level of assets under management and the demand for our other fee-based services.
Economic downturns could affect the volume of income from and demand for our fee-based services. Our investment management revenues depend in large part on the level of assets under management. Market volatility that leads customers to liquidate investments, as well as lower asset values can reduce our level of assets under management and thereby decreasing our investment management revenues.
Our mortgage banking income may experience significant volatility.
Our mortgage banking income is highly influenced by the level and direction of mortgage interest rates, and real estate and refinancing activity. In lower interest rate environments, the demand for mortgage loans and refinancing activity will tend to increase. This has the effect of increasing fee income, but could adversely impact the estimated fair value of our mortgage servicing rights as the rate of loan prepayments increase. In higher interest rate environments, the demand for mortgage loans and refinancing activity will generally be lower. This has the effect of decreasing fee income.
Our investment in FHLB stock may be subject to impairment charges in future periods if the financial condition of the FHLB declines further.
The Bank is a member of the FHLB, and as such, is required to hold FHLB stock as a condition of membership. As of December 31, 2009, the carrying value of our FHLB stock was $61.3 million and consisted of 612,924 shares valued at a par value of $100 per share. As of December 31, 2009, the Bank held 376,238 shares in excess of the minimum number of shares the Bank was required to hold as a condition of membership. Ownership is restricted and there is no market for these securities. In 2009, the FHLB's primary regulator, the Federal Housing Finance Agency, has chosen to treat the FHLB as if it was undercapitalized because of several factors, including the possibility that declines in the value of its private-label mortgage-backed securities could cause it to fall below its risk-based capital requirements. Due to this determination, the FHLB currently remains unable to repurchase or redeem capital stock or to pay dividends. If the FHLB's financial condition declines further, other-than-temporary impairment charges related to our investment in FHLB stock could occur in future periods. See discussion in MD&A related to our evaluation of impairment as of December 31, 2009.
The requirement to record certain assets and liabilities at fair value may adversely affect our financial results.
We report certain assets, including investment securities, at fair value. Generally, for assets that are reported at fair value we use quoted market prices or valuation models that utilize market data inputs to estimate fair value. Because we carry these assets on our books at their estimated fair value, we may incur losses even if the asset in question presents minimal credit risk. Given the continued disruption in the capital markets, we may be required to recognize other-than-temporary impairments in future periods with respect to investment securities in our portfolio. The amount and timing of any impairment recognized will depend on the severity and duration of the decline in fair value of our investment securities and our estimation of the anticipated recovery period.
Our principal offices are located in the Financial Plaza of the Pacific in Honolulu, Hawaii. We own and lease other branch offices and operating facilities located throughout Hawaii and the Pacific Islands.
We are involved in various legal proceedings arising from normal business activities. We do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of legal proceedings will have a material adverse effect on our financial position. However, we cannot presently determine whether or not any claims asserted against us or others to whom we may have indemnification obligations will have a material adverse effect on our results of operations in any future reporting period. See Note 18 related to commitments and contingencies for more information.
No matter was submitted during the fourth quarter of 2009 to a vote of security holders through solicitation of proxies or otherwise.
Executive Officers of the Registrant:
Listed below are executive officers of the Parent as of February 22, 2010.
R. Landon, 61
S. Ho, 44
T. Lucien, 56
A. Rossi, 61
E. Sellers, 53
J. Norris, 60
Market Information, Shareholders, and Dividends
Information regarding the historical market prices of the Parent's common stock and dividends declared on that stock are shown below.
The common stock of the Parent is traded on the New York Stock Exchange (NYSE Symbol: BOH) and quoted daily in leading financial publications. As of February 16, 2010, there were 7,315 common shareholders of record.
The Parent's Board of Directors considers on a quarterly basis the feasibility of paying a cash dividend to its shareholders. Under the Parent's general practice, dividends are declared upon completion of a quarter and are paid prior to the end of the subsequent quarter. Dividends declared consider future expected earnings. See "Dividend Restrictions" under "Supervision and Regulation" in Item 1 of this report and Note 11 to the Consolidated Financial Statements for more information.
The following graph shows the cumulative total return for the Parent's common stock compared to the cumulative total returns for the Standard & Poor's ("S&P") 500 Index and the S&P Banks Index. The graph assumes that $100 was invested on December 31, 2004 in the Parent's common stock, the S&P 500 Index, and the S&P Banks Index. The cumulative total return on each investment is as of December 31 of each of the subsequent five years and assumes reinvestment of dividends.
Summary of Selected Consolidated Financial Data
This report contains forward-looking statements concerning, among other things, the economic and business environment in our service area and elsewhere, credit quality, and other financial and business matters in future periods. Our forward-looking statements are based on numerous assumptions, any of which could prove to be inaccurate and actual results may differ materially from those projected because of a variety of risks and uncertainties, including, but not limited to: 1) general economic conditions either nationally, internationally, or locally may be less favorable than expected; 2) changes in the securities markets, public debt markets, and other capital markets in the U.S. and globally; 3) the increase in government oversight in the U.S. banking and financial services industries; 4) competitive pressure among financial services and products; 5) the impact of legislation and the regulatory environment; 6) fiscal and monetary policies of the markets in which we operate; 7) actual or alleged conduct which could harm our reputation; 8) changes in accounting standards; 9) changes in tax laws or regulations or the interpretation of such laws and regulations; 10) changes in our credit quality or risk profile that may increase or decrease the required level of our reserve for credit losses; 11) changes in market interest rates that may affect our credit markets and ability to maintain our net interest margin; 12) unpredicted costs and other consequences of legal or regulatory matters involving the Company; 13) changes to the amount and timing of proposed common stock repurchases; and 14) geopolitical risk, military or terrorist activity, natural disaster, adverse weather, public health, and other conditions impacting us and our customers' operations. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included under the section entitled "Risk Factors" in Part I of this report. Words such as "believes," "anticipates," "expects," "intends," "targeted," and similar expressions are intended to identify forward-looking statements but are not exclusive means of identifying such statements. We do not undertake an obligation to update forward-looking statements to reflect later events or circumstances.
Critical Accounting Estimates
Our Consolidated Financial Statements were prepared in accordance with U.S. generally accepted accounting principles and follow general practices within the industries in which we operate. The most significant accounting policies we follow are presented in Note 1 to the Consolidated Financial Statements. Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. Critical accounting estimates are defined as those that require assumptions or judgments to be made based on information available as of the date of the financial statements. Certain policies inherently have a greater reliance on the use of estimates. Those policies have a greater possibility of producing results that could be materially different than reported if there is a change to any of the estimates, assumptions, or judgments made by us. Based on the potential impact to the financial statements of the valuation methods, estimates, assumptions, and judgments used, we identified the determination of the reserve for credit losses, the valuation of mortgage servicing rights, the valuation of leased asset residual values, the valuation of pension and postretirement benefit obligations, and the determination of income tax expense and liability to be the accounting estimates that are the most subjective or judgmental.
Reserve for Credit Losses
A consequence of lending activities is that we may incur losses. The amount of such losses will vary, depending upon the risk characteristics of the loan and lease portfolio as affected by economic conditions, including rising interest rates, and the financial performance of borrowers. The reserve for credit losses consists of the Allowance for Loan and Lease Losses (the "Allowance") and a Reserve for Unfunded Commitments (the "Unfunded Reserve"). The reserve for credit losses provides for credit losses inherent in lending or commitments to lend and is based on loss estimates derived from a comprehensive quarterly evaluation, reflecting analyses of individual borrowers and historical loss experience, supplemented as necessary by credit judgment to address observed changes in trends,
conditions, and other relevant environmental and economic factors. The Allowance provides for probable and estimable losses inherent in our loan and lease portfolio. The Allowance is increased or decreased through the provisioning process. There is no exact method of predicting specific losses or amounts that ultimately may be charged-off on particular segments of the loan and lease portfolio.
Our determination of the amount of the reserve for credit losses is a critical accounting estimate as it requires the use of estimates and significant judgment as to the amount and timing of expected future cash flows on impaired loans, estimated loss rates on homogenous portfolios, and deliberation on economic factors and trends. On a quarterly basis, an evaluation of specific individual commercial borrowers is performed to identify impaired loans. See Note 4 to the Consolidated Financial Statements for more information on the reserve for credit losses.
Valuation of Mortgage Servicing Rights
When mortgage loans are sold with servicing rights retained, a servicing asset is established and accounted for based on estimated fair values. An estimated fair value is used because there is no quoted or established market for valuation of mortgage servicing rights. The estimated fair value is determined using discounted cash flow modeling techniques, which requires us to make estimates and assumptions regarding the amount and timing of expected future cash flows, loan repayment rates, costs to service, and interest rates that reflect the risks involved. Our estimates of the fair value of mortgage servicing rights are sensitive to changes in the underlying estimates and assumptions. Had we assumed lower interest rates and higher loan repayment rates, the estimated fair value of the mortgage servicing rights could have been lower than recorded in our Consolidated Statements of Condition. See Note 5 to the Consolidated Financial Statements for key assumptions used by management as well as a sensitivity analysis of changes in certain key assumptions.
Valuation of Leased Asset Residual Values
Lease financing receivables include a residual value component, which represents the estimated value of leased assets upon lease expiration. Our determination of residual value is derived from a variety of sources, including equipment valuation services, appraisals, and publicly available market data on recent sales transactions on similar equipment. The length of time until lease termination, the cyclical nature of equipment values, and the limited marketplace for re-sale of certain leased assets, are important variables considered in making this determination. We update our valuation analysis on an annual basis, or more often when events or circumstances warrant. When we determine that the fair value is lower than the expected residual value at lease expiration, the difference is recognized as an asset impairment in the period in which the analysis is completed. See Note 4 to the Consolidated Financial Statements for more information on the residual value of leased assets.
Pension and Postretirement Benefit Obligations
Our pension and postretirement benefit obligations and net periodic benefit cost are actuarially determined based on a number of key assumptions, including the discount rate, estimated future return on plan assets, and the health care cost trend rate. Our determination of the pension and postretirement benefit obligations and net periodic benefit cost is a critical accounting estimate as it requires the use of estimates and judgment related to the amount and timing of expected future cash out-flows for benefit payments and cash in-flows for maturities and return on plan assets. Changes in estimates and assumptions related to mortality rates and future health care costs could also have a material impact to our financial condition or results of operations. The discount rate is used to determine the present value of future benefit obligations and the net periodic benefit cost. The discount rate used to value the future benefit obligation as of each year-end is the rate used to determine the periodic benefit cost in the following year.
The estimated pension and postretirement net periodic benefit cost for 2010 is $3.2 million, based on an assumed discount rate of 6.00%. The following table presents a sensitivity analysis of a 25 basis point change in discount rates to the net periodic benefit cost and benefit obligation:
See Note 14 to the Consolidated Financial Statements for more information on our pension and postretirement benefit plans.
We determine our liabilities for income taxes based on current tax regulation and interpretations in tax jurisdictions where our income is subject to taxation. Currently, we file tax returns in 11 federal, state and local domestic jurisdictions, and four foreign jurisdictions. In estimating income taxes payable or receivable, we assess the relative merits and risks of the appropriate tax treatment considering statutory, judicial, and regulatory guidance in the context of each tax position. Accordingly, previously estimated liabilities are regularly reevaluated and adjusted, through the provision for income taxes.
Changes in the estimate of income taxes payable or receivable occur periodically due to changes in tax rates, interpretations of tax law, the status of examinations being conducted by various taxing authorities, and newly enacted statutory, judicial and regulatory guidance that impact the relative merits and risks of each tax position. These changes, when they occur, affect accrued income taxes and can be significant to our operating results. See Note 16 to the Consolidated Financial Statements for more information on income taxes.
Certain prior period information in Management's Discussion and Analysis of Financial Condition and Results of Operation ("MD&A") has been reclassified to conform to the 2009 presentation.
We are a regional financial services company serving businesses, consumers, and governments in Hawaii, American Samoa, and the West Pacific. Our main operating subsidiary, the Bank, was founded in 1897 and is the largest independent financial institution in Hawaii.
Our vision is "exceptional people building exceptional value for our customers, our island communities, our shareholders, and each other." Our governing objective is "maximizing shareholder value over time."
To achieve our vision and governing objective, our business plan is balanced between opportunities and risk management, and includes the flexibility to adjust. We have given increased priority to actions that result in strengthening measures of soundness including asset quality, reserve and capital levels, and liquidity.
During the fourth quarter of 2009, Hawaii's economy began to reflect some signs of stabilization. Visitor arrivals began to recover during the summer months and scheduled air seats for December 2009 through February 2010 are higher compared to a year ago. Visitor spending remains weak and declined 11.8% year-to-date through December 2009. The statewide unemployment rate improved slightly to a seasonally-adjusted 6.9% in December 2009 and remains better than the national average. Hawaiian Islands other than Oahu continue to experience higher levels of unemployment. The volume of home sales on Oahu for December 2009 was higher than a year ago, albeit at lower median prices, and months of inventory continue to decline.
Net income for 2009 was $144.0 million, a decrease of $48.2 million or 25% compared to 2008. Diluted earnings per share were $3.00 for 2009, a decrease of $0.99 or 25% compared to 2008. Our lower net income in 2009 was primarily due to the following:
Our actions in 2009 continued to be influenced by a weak economy as well as the uncertainties regarding the impact of government regulation. We continued to strengthen our balance sheet in 2009 with increased funding, reserves for credit losses, liquidity and capital.
mortgage-backed securities issued by the Government National Mortgage Association.
We also continued to reduce higher risk assets on our balance sheet in 2009 by liquidating our private-label mortgage-backed investment securities and by selling our position in six Shared National Credits to reduce future loss exposure. We also continued to maintain discipline in our loan underwriting.
We anticipate that the challenging economic environment may continue in 2010. We will address these challenges by focusing on our near-term objectives of maintaining high levels of liquidity, reserves for credit losses, and capital.
Analysis of Statements of Income
Average balances, related income and expenses, and resulting yields and rates are presented in Table 2. An analysis of the change in net interest income, on a taxable equivalent basis, is presented in Table 3.
Net Interest Income
Net interest income is affected by both changes in interest rates (rate) and the amount and composition of earning assets and interest-bearing liabilities (volume). Net interest margin is calculated as the yield on average earning assets minus the interest rate paid on average interest-bearing liabilities.
Due to the continued uncertainty regarding economic and industry conditions in 2009, we focused on building and maintaining liquidity. As government programs and other factors helped to reduce some of the uncertain industry conditions, we invested some of our liquidity into lower risk and relatively lower yielding investment securities.
Net interest income, on a taxable equivalent basis, decreased by $6.2 million or 1% in 2009 compared to 2008, primarily due to a $52.1 million decrease in interest income which was offset by a $45.9 million decrease in our funding costs. Net interest margin decreased by 61 basis points in 2009 compared to 2008. Yields on our loan and lease portfolio
decreased by 65 basis points in 2009 compared to 2008. Yields were 145 basis points lower in our commercial and industrial portfolio and 82 basis points lower in our home equity portfolio, as interest rates reset on these variable rate products. Although we made significant investments in our available-for-sale investment securities portfolio in 2009, yields decreased by 133 basis points in 2009 compared to 2008. Partially offsetting the decrease in yields earned on our average earning assets was a corresponding decrease in our funding costs. Rates paid on our interest-bearing deposits decreased by 59 basis points in 2009 compared to 2008, reflecting the full effects of a decreasing interest rate environment during 2009. Also contributing to our lower funding costs was a 106 basis point decrease in rates paid on securities sold under agreements to repurchase in 2009.
Average balances of our earning assets increased by $1.4 billion or 15% in 2009 compared to 2008, primarily due to strong growth in core deposits. Average deposit balances grew by $1.3 billion in 2009. Due to limited lending opportunities, our liquidity was mostly deployed in relatively lower yielding debt securities issued by the U.S. Treasury and in mortgage-backed securities issued by government agencies. Average balances of our available-for-sale investment securities portfolio increased by $1.3 billion in 2009. Average balances of our loan and lease portfolio decreased by $397.2 million in 2009 as a result of loan payoffs and reduced demand for loans and leases.
Net interest income, on a taxable equivalent basis, increased by $23.8 million or 6% in 2008 compared to 2007, primarily due to a $75.6 million decrease in funding costs which was partially offset by a $51.8 million decrease in interest income. Net interest margin increased by 25 basis points in 2008 compared to 2007, reflective of a steeper yield curve in 2008. Rates paid on interest-bearing deposits decreased by 95 basis points in 2008, reflective of a decreasing interest rate environment during 2008. Also contributing to our lower funding costs was a 138 basis point decrease in rates paid on securities sold under agreements to repurchase in 2008. The decrease in our funding costs was partially offset by a corresponding decrease in interest income from our earning assets. Yields on our loans and leases decreased by 83 basis points in 2008 compared to 2007. Yields were 190 basis points lower in our commercial and industrial portfolio and 166 basis points lower in our home equity portfolio, as interest rates reset on these variable rate products.
Average balances of our earning assets decreased by $16.9 million or less than 1% in 2008 from 2007. Average interest-bearing liabilities increased by $96.8 million or 1% in 2008 compared to 2007, primarily due to growth in interest-bearing demand and savings deposits as customers moved balances to more liquid accounts.
Provision for Credit Losses
The Provision for Credit Losses (the "Provision") reflects our judgment of the expense or benefit necessary to achieve the appropriate amount of the Allowance. We maintain the Allowance at levels adequate to cover our estimate of probable credit losses as of the end of the reporting period. The Allowance is determined through detailed quarterly analyses of our loan and lease portfolio. The Allowance is based on our loss experience and changes in the economic environment, as well as an ongoing assessment of our credit quality. We recorded a Provision of $107.9 million in 2009, $60.5 million in 2008, and $15.5 million in 2007. The Provision recorded in 2009 increased the Allowance to $143.7 million as of December 31, 2009, which was reflective of higher levels of net loans and leases charged-off and increased risk of further losses as the result of the slowdown in economic conditions. For further discussion on the Allowance, see the "Corporate Risk Profile Allowance for Loan and Lease Losses" section in MD&A.
Table 4 presents the major components of noninterest income for 2009, 2008, and 2007.
n.m. not meaningful.
Trust and asset management income is comprised of fees earned from the management and administration of trust and other customer assets. These fees are based upon the market value of the assets that we manage and the fee rate charged to customers. Total trust assets under administration were $9.9 billion as of December 31, 2009, $9.8 billion as of December 31, 2008, and $13.0 billion as of December 31, 2007. Trust and asset management income decreased by $10.8 million or 19% in 2009 compared to 2008 primarily due to a $7.3 million decrease in mutual fund management fees, which were adversely affected by increases in fee waivers in our money market mutual funds (due to low yields), a decline in average mutual fund holdings, combined with the continued decline in the average value of the equity markets during 2009. Also contributing to the decrease in trust and asset management income was a $1.0 million decrease in employee benefit trust and agency fees primarily due to the decrease in the market value of accounts and the average number of accounts under management. Finally, investment management fees decreased by $0.8 million primarily due to customers moving certain investment accounts to Bankoh Investment Services, Inc., the broker dealer subsidiary of the Bank, to take advantage of alternative investment options. Trust and asset management income decreased by $5.9 million or 9% in 2008 compared to 2007 primarily due to a $3.2 million decrease in investment advisory fees and a $2.7 million decrease in fees from accounts under management. Both decreases were affected by the decline in the equity markets during 2008.
Mortgage banking income is highly influenced by mortgage interest rates and the housing market activity. Mortgage banking income increased by $14.8 million or 182% in 2009 compared to 2008 primarily due to higher loan origination volume, the result of higher refinancing activity due to lower interest rates on conforming saleable mortgage-based products in 2009 compared to 2008. Residential mortgage loan originations were $1.2 billion in 2009, a $371.9 million or 43% increase from 2008. Residential mortgage loan sales were $1.0 billion in 2009, a $586.2 million or 128% increase from 2008. Mortgage banking income decreased by $3.6 million or 30% in 2008 compared to 2007. This decrease was primarily due to a $12.5 million decrease in income related to the estimated fair value of our mortgage servicing rights, net of the change in fair value of our designated trading securities. The decrease in our income from mortgage servicing rights was primarily due to higher loan repayment rate assumptions in 2008, as a result of lower interest rates on mortgage-based products and the resulting
increase in refinancing activity. This was partially offset by an $8.5 million increase in net gains on our derivative financial instruments in 2008 compared to 2007. The increase in net gains on our derivative financial instruments in 2008 compared to 2007 was primarily due to higher loan origination volume. Residential mortgage loan originations were $866.3 million in 2008, a $55.6 million or 7% increase from 2007. Residential mortgage loan sales were $456.8 million in 2008, a $114.4 million or 33% increase from 2007. Loan servicing income was $6.9 million in 2009, $6.3 million in 2008, and $6.1 million in 2007. Our portfolio of residential mortgage loans serviced for third parties was $3.1 billion as of December 31, 2009, $2.7 billion as of December 31, 2008, and $2.5 billion as of December 31, 2007.
Service charges on deposit accounts increased by $3.6 million or 7% in 2009 compared to 2008 primarily due to a $4.9 million increase in account analysis fees on analyzed business checking accounts as a result of lower earnings credit rates on customer accounts. This was partially offset by a $1.3 million decrease in monthly service fees primarily resulting from the introduction of our free checking product in July 2008. Service charges on deposit accounts increased by $4.6 million or 10% in 2008 compared to 2007 primarily due to a $4.4 million increase in account analysis fees on analyzed business checking accounts as a result of lower earnings credit rates on customer accounts. In addition, overdraft fees increased by $1.4 million primarily due to a fee increase implemented in May 2008. The increase was partially offset by a decrease in monthly service fees due to the introduction of our free checking product in July 2008 mentioned above.
Fees, exchange, and other service charges are primarily comprised of debit card income, fees from ATMs, merchant service activity, and other loan fees and service charges. Fees, exchange, and other service charges decreased by $1.9 million or 3% in 2009 compared to 2008 primarily due to a decrease in ATM fee income as well as lower merchant services income. This was the result of lower transaction volume during 2009 which was impacted by a slower economy in Hawaii and lower levels of visitor arrivals. Fees, exchange, and other service charges decreased by $0.2 million or less than 1% in 2008 compared to 2007.
Investment securities net gains were $25.8 million in 2009 compared to $0.5 million in 2008. This increase was largely due to sales of available-for-sale investment securities in the fourth quarter of 2009, including a complete liquidation of our investments in private-label mortgage-backed securities. We sold longer maturity available-for-sale investment securities in the fourth quarter of 2009 to reduce investment duration and to preserve capital levels in a potentially rising interest rate environment in future reporting periods.
Insurance income is comprised of commission income derived from our retail and wholesale insurance businesses. Insurance income decreased by $4.6 million or 19% in 2009 compared to 2008 primarily due to a $3.3 million decrease in commission and brokerage income and a $0.9 million decrease in income from annuity and life insurance products. Insurance income decreased in 2009 due to the sale of certain assets of our retail insurance brokerage operation, Bank of Hawaii Insurance Services, Inc. ("BOHIS") in June 2009, and our wholesale insurance business, BOH Wholesale Insurance Agency, Inc. (formerly known as Triad Insurance Agency, Inc.) in October 2009. These two Bank subsidiaries combined, earned $6.6 million in pre-tax income during 2009. Both sales were made to unrelated third parties. Insurance income increased by $1.4 million or 6% in 2008 compared to 2007 primarily due to a $1.2 million increase in income from fixed annuity and life insurance products and a $0.8 million increase in contingent commission income. This was partially offset by a $0.4 million decrease in income from life insurance premiums. The increase in income from fixed annuity products was a result of customers preferring conservative investment alternatives in light of equity market conditions in 2008.
Other noninterest income decreased by $16.7 million or 30% in 2009 compared to 2008 primarily due to the $13.7 million gain from the mandatory redemption of our Visa shares in 2008. Also contributing to the decrease was $3.3 million in lower unrealized gains recognized in 2009 related to our subordinated notes which were accounted for at fair value. We repaid our subordinated notes in March 2009. Other noninterest income increased by $22.3 million or 68% in 2008 compared to 2007 primarily due to the aforementioned mandatory redemption of our Visa shares and an $11.6 million gain on the sale of our equity interest in an aircraft leveraged lease in 2008.
Table 5 presents the major components of noninterest expense for 2009, 2008, and 2007.
Total salaries and benefits decreased by $3.4 million or 2% in 2009 compared to 2008 primarily due to decreases in incentive compensation, expense related to restricted stock grants, and lower base salaries (a result of fewer full-time equivalent employees). Partially offsetting these decreases in 2009 was an increase in retirement plan expense resulting from a change in assumptions and an increase in the amortization of actuarial losses in 2009. Total salaries and benefits increased by $11.1 million or 6% in 2008 compared to 2007 primarily due to cash for stock grants, broad-based incentive awards, and annual merit increases. The cash for stock grants related to a change in our practice of equity compensation for senior management. Senior officers, other than executive officers, received cash grants to encourage them to purchase our common stock in lieu of receiving restricted stock grants. Incentive compensation increased in 2008 compared to 2007 primarily due to $1.6 million in broad-based incentive awards which was designed to reward employees who helped us achieve solid financial performance despite the challenging economic environment in 2008. Partially offsetting these increases in 2008 were decreases in retirement plan expense, a result of assumption changes, and reduced executive retention expense.
Net occupancy decreased by $4.1 million or 9% in 2009 compared to 2008 primarily due to a
$2.1 million decrease in utilities expense caused by a reduction in energy costs. In addition, depreciation and amortization decreased by $0.9 million primarily due to a building being fully depreciated in 2008. Finally, net rental expense decreased by $0.9 million in 2009 primarily the result of paying rent for two Waikiki branch locations in 2008 during the construction of our new Waikiki branch. Net occupancy increased by $5.1 million or 13% in 2008 compared to 2007 primarily due to a $2.2 million increase in utilities expense as well as a $2.1 million increase in net rental expense. The increase in net rental expense was primarily related to the two Waikiki branch locations noted above and the opening of two new in-store branches in 2008. The increase in utilities expense in 2008 was primarily due to higher energy costs.
Professional fees increased by $0.9 million or 8% in 2009 compared to 2008 primarily due to higher legal fees. Professional fees remained relatively unchanged in 2008 compared to 2007.
FDIC insurance expense increased by $15.8 million in 2009 compared to 2008. The increase was primarily due to higher deposit balances, higher assessment rates, and our participation in the TLGP, coupled with the Company's $5.7 million share of an industry-wide assessment by the FDIC which was recorded in the second quarter of 2009. In 2008 and into 2009, we utilized credits from the Federal Deposit Insurance Reform Act of 2005 which were available to offset our deposit insurance assessments. We fully utilized these credits in March 2009. FDIC insurance expense increased nominally by $0.5 million in 2008 compared to 2007.
Other noninterest expense decreased by $5.6 million or 7% in 2009 compared to 2008 partially due to a $1.9 million decrease in our reserves for legal contingencies. Also contributing to the decrease was a combined $6.3 million decline in business development and travel, unrealized gains related to deferred compensation arrangements, delivery and postage services, donations, and advertising. In addition, we incurred a $1.0 million call premium expense in 2008 related to our Bancorp Hawaii Capital Trust I Capital Securities ("Capital Securities"). Partially offsetting these decreases was a $5.6 million reversal in 2008 of a previously recorded Visa contingency accrual. See Note 18 to the Consolidated Financial Statements for more information on the Visa legal matters. Other noninterest expense decreased by $4.4 million or 5% in 2008 compared to 2007 primarily due to the $5.6 million reversal of previously recorded Visa contingency accruals noted above. Also contributing to the decrease in other noninterest expense in 2008 was a $1.8 million fraud loss recorded in 2007. These items were partially offset by a $3.1 million increase in our reserves for legal contingencies, a $2.3 million increase in our contributions to the Bank of Hawaii Charitable Foundation and other charitable organizations, and the $1.0 million call premium related to our Capital Securities noted above.
Our provision for income taxes and effective tax rates for 2009, 2008, and 2007 were as follows:
The higher effective tax rate in 2009 from 2008 was primarily due to a $12.9 million credit to the provision for income taxes recorded in September 2008. This credit was the result of our acceptance of the settlement initiative from the IRS related to our Sale In-Lease Out ("SILO") transactions. Also favorably impacting our effective tax rate in 2008 was a pre-tax gain from the sale of our equity interest in an aircraft leveraged lease that would have resulted in an income tax expense of approximately $4.6 million, based on statutory income tax rates. However, due to the timing of the sale of our equity interest and the adjustment of previously recognized income tax liabilities, this transaction resulted in a $1.4 million net credit to the provision for income taxes. As a result, the total income tax benefit from this transaction was approximately $6.0 million.
As noted above, the lower effective tax rate in 2008 from 2007 was primarily due to the $12.9 million credit to the provision for income taxes recorded in September 2008 related to our SILO transactions as well as the $6.0 million total income tax benefit from the sale of our equity interest in an aircraft leveraged lease.
Analysis of Business Segments
Our business segments are Retail Banking, Commercial Banking, Investment Services, and Treasury.
Table 7 summarizes net income from our business segments for 2009, 2008, and 2007. Additional information about segment performance, including financial captions discussed below, is presented in Note 13 to the Consolidated Financial Statements.
Net income decreased by $35.9 million or 39% in 2009 compared to 2008 primarily due to an increase in the Provision and noninterest expense and lower net interest income. This was partially offset by higher noninterest income for the segment. The $29.5 million increase in the Provision was primarily due to higher net loan losses and risk in the segment's consumer real estate portfolios. The $4.8 million increase in noninterest expense was primarily due to higher FDIC base insurance assessments as well as our share of the industry-wide assessment by the FDIC. The $27.1 million decrease in net interest income was primarily due to lower earnings credits on the segment's deposit portfolio, partially offset by higher average deposit balances. The $5.1 million increase in noninterest income was primarily due to higher mortgage banking income, a result of higher origination and sale activity.
Net income decreased by $5.5 million or 6% in 2008 compared to 2007 primarily due to an increase in the Provision and noninterest expense. This was partially offset by higher net interest income and noninterest income. The $14.4 million increase in the Provision was primarily due to higher net loan losses and risk in the segment's consumer portfolios. The $8.7 million increase in noninterest expense was primarily due to an increase in debit card usage, occupancy, and salaries and benefits expense, as well as higher allocated expenses to the segment related to earnings-based incentive compensation. The $8.1 million increase in net interest income was primarily due to lower loan and deposit funding costs, which was partially offset by lower average deposit balances. The $6.4 million increase in noninterest income was primarily due to higher mortgage banking income, overdraft fees, and debit card income.
Net income decreased by $4.4 million or 8% in 2009 compared to 2008 primarily due to an increase in the Provision and noninterest expense. This was partially offset by higher net interest income and noninterest income. The $16.4 million increase in the Provision was primarily due to heightened risk in specific loan exposures and general risk from the weak economy in Hawaii and the U.S Mainland. The $3.9 million increase in noninterest expense was primarily due to higher FDIC base insurance assessments as well as our share of an industry-wide assessment by the FDIC. The $8.8 million increase in net interest income was primarily due to higher average deposit balances. The $0.8 million increase in noninterest income was primarily due to higher account analysis fees as a result of lower earnings credit rates on customer accounts.
Net income decreased by $11.9 million or 19% in 2008 compared to 2007 primarily due to an increase in the Provision and noninterest expense. This was partially offset by higher noninterest income and net interest income. The $30.3 million increase in the Provision was primarily due to heightened risk exposures in this segment's lending portfolio as noted above. The $1.1 million increase in noninterest expense was primarily due to higher allocated expenses to the segment. The $13.7 million increase in noninterest income was primarily due to the $11.6 million pre-tax gain on the sale of our equity interest in an aircraft leveraged lease and to higher account analysis fees as a result of lower earnings credit rates on customer accounts. The $0.9 million increase in net interest income was primarily due to lower funding costs, partially offset by the effects of the settlement of our SILO transactions.
Net income decreased by $6.7 million or 55% in 2009 compared to 2008 primarily due to a decrease in noninterest income and an increase in the Provision. This was partially offset by an increase in net interest income and a decrease in noninterest expense. The $11.7 million decrease in noninterest income was primarily due to lower fee income as a result of lower average asset values under trust administration, an increase in fee waivers in our money market mutual funds, and lower fee income related to our annuity products. The $1.0 million increase in the Provision was due to higher net charge-offs of loans in the segment. The $1.3 million increase in net interest income was primarily due to higher average deposit balances. The $0.8 million decrease in noninterest expense was primarily due to lower salaries expense.
Net income decreased by $4.3 million or 26% in 2008 compared to 2007 primarily due to a decrease in noninterest income and increases in noninterest expense and the Provision. This was partially offset by an increase in net interest income. The $6.1 million decrease in noninterest income was primarily due to lower fee income as a result of lower asset values under trust administration. The $1.2 million increase in noninterest expense was primarily due to higher salaries and allocated expenses. The $0.8 million increase in the Provision was due to higher net charge-offs of loans in the segment. The $1.4 million increase in net interest income was primarily due to lower funding costs on the segment's deposit balances.
Net income decreased by $1.3 million or 4% in 2009 compared to 2008 primarily due to a higher provision for income taxes. This was partially offset by higher net interest income and noninterest income and lower noninterest expense. The higher provision for income taxes in 2009 was primarily due to the $12.9 million credit to provision for income taxes related to our SILO transactions recorded in 2008. The $10.6 million increase in net interest income was primarily due to lower loan and deposit funding costs, higher deposit balances, an increase in the balance of our investment securities portfolio, lower levels of long-term debt, and lower costs associated with securities sold under agreements to repurchase. The $15.6 million increase in noninterest income was primarily due to net investment securities gains, partially offset by a $13.7 million gain from the mandatory redemption of our Visa shares in 2008. The $4.6 million decrease in noninterest expense was primarily due to lower allocated expenses.
Net income increased by $30.1 million in 2008 compared to 2007 primarily due to an increase in net interest income, a higher benefit for income taxes, and higher noninterest income. The $13.4 million increase in net interest income was primarily due to the net benefit from a reduction in loan rates and deposit funding costs, an increase in the balance of our investment securities portfolio, as well as decreases in the cost of funds purchased and securities sold under agreements to repurchase. The increase in the benefit for income taxes was primarily due to the $12.9 million credit related to our SILO transactions recorded in 2008. The $3.7 million increase in noninterest income was primarily due to a $13.7 million gain from the mandatory redemption of our Visa shares, partially offset by a $10.0 million net change in the estimated fair value of our mortgage servicing rights due to changes in valuation assumptions and the fair value of our designated trading securities.
Other organizational units (Technology, Operations, Marketing, Human Resources, Finance, Credit and Risk Management, and Corporate and Regulatory Administration) included in Treasury provide a wide-range of support to our other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process.
Analysis of Statements of Condition
Table 8 presents the contractual maturity distribution, weighted-average yield to maturity, and estimated fair value of our investment securities.
Our investment securities portfolio is managed to provide liquidity and interest income. Our portfolio is also used to offset interest rate risk positions and to provide collateral for various banking activities. The carrying amount of our investment securities was $5.5 billion as of December 31, 2009. This represents a $2.8 billion increase from December 31, 2008, exclusive of the trading securities we held as of that date. The increase in the carrying amount of our investment securities during 2009 was primarily due to investments made in debt securities issued by the U.S. Treasury and mortgage-backed securities issued by government agencies. These investments in high grade securities with relatively short duration, allows us to maintain flexibility to redeploy funds as such opportunities arise. During the fourth quarter of 2009, we sold our remaining investments in private-label mortgage-backed securities.
Our investment securities portfolio had gross unrealized gains of $68.5 million or 1% of total amortized cost as of December 31, 2009. Our investment securities portfolio also had gross unrealized losses of $21.8 million or less than 1% of total amortized cost as of December 31, 2009. The unrealized losses were primarily related to mortgage-backed securities issued by government agencies attributable to changes in interest rates, relative to when the investment securities were purchased. See Note 3 to the Consolidated Financial Statements for more information.
As of December 31, 2009, the par value, amortized cost, and fair value of our debt and mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were as follows:
As of December 31, 2009, we did not own any subordinated debt, or preferred or common stock of the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation.
Loans and Leases
Loans and leases remains our largest category of interest earning assets and the largest source of revenue. Total loans and leases were $5.8 billion as of December 31, 2009. Loans and leases decreased by $770.4 million or 12% from $6.5 billion as of December 31, 2008.
The commercial loan and lease portfolio is comprised of commercial and industrial loans, commercial mortgages, construction loans, and lease financing. Commercial and industrial loans are made primarily to corporations, middle market, and small businesses. Commercial mortgages and construction loans are offered to real estate investors, developers, and builders primarily domiciled in Hawaii. Commercial mortgages are secured by real estate. The source of repayment for investor property is cash flow from the property and for owner-occupied property is the operating cash flow from the business. Construction loans are for the purchase or construction of a property for which repayment will be generated by the property. Lease financing consists of direct financing leases and leveraged leases. Although our primary market is Hawaii, the commercial portfolio contains loans to some borrowers based on the U.S. Mainland, including some Shared National Credits.
Commercial loans and leases decreased by $258.7 million or 11% from $2.4 billion as of December 31, 2008. This was primarily due to a $258.6 million decrease in our commercial and industrial lending portfolio due to continued loan payoffs by corporate national customers and the sale of our position in six Shared National Credits totaling $37.0 million, given the potential downside risk of each credit. Our construction loan portfolio decreased by $45.6 million, consistent with the slow economy in Hawaii. Our lease financing portfolio decreased by $55.2 million, primarily a result of continued reduction in our leveraged lease portfolio. Partially offsetting the decrease in these commercial lending categories was a $100.7 million increase in our commercial mortgage portfolio. This increase was primarily due to one new commercial credit added during the second quarter of 2009 as well as our purchase of $47.5 million in seasoned loans, secured by real estate in Hawaii, in December 2009.
The consumer loan and lease portfolio is comprised of residential mortgage loans, home equity loans, personal credit lines, direct installment loans, and indirect auto loans and leases. These products are offered generally in the markets we serve through our branch network. Consumer loans and leases decreased by $511.7 million or 12% from $4.1 billion as of December 31, 2008. Balances in all
consumer lending categories decreased during 2009, due to reduced customer demand in a slow economy in Hawaii as well as our disciplined underwriting approach. While we continue to lend to credit worthy customers, we remain cautious in the current economic environment.
See Note 4 to the Consolidated Financial Statements for more information on our loan and lease portfolio.
Table 10 presents the geographic distribution of our loan and lease portfolio. Table 11 presents maturities and sensitivities of selected loans to changes in interest rates. This table excludes real estate loans (other than construction loans), lease financing, and consumer loans. See Note 4 to the Consolidated Financial Statements and the "Corporate Risk Profile Credit Risk" section of MD&A for more information.
Other assets were $496.9 million as of December 31, 2009, a $22.4 million or 5% increase from December 31, 2008. As of December 31, 2009, we had a total of $82.5 million in tax deposits placed with the IRS and State of Hawaii Department of Taxation. These deposits with the respective taxing authorities limits the potential accrual of additional interest based on our current estimate of our tax liabilities. The increase in other assets during 2009 was primarily due to a $42.3 million prepayment of our FDIC quarterly risk-based assessments for 2010, 2011, and 2012. This increase was partially offset by an $18.2 million decrease in the fair value of our derivative financial instruments recorded in other assets, primarily the estimated fair value of our customer-related interest rate swap accounts, which have off-setting amounts recorded in other liabilities. See Note 7 to the Consolidated Financial Statements for more information.
As of December 31, 2009, the carrying value of our FHLB stock was $61.3 million and consisted of 612,924 shares valued at a par value of $100 per share. Our investment in the FHLB is a condition of membership and, as such, is required to obtain credit and other services from the FHLB. The FHLB adopted a Capital Plan which among other things provided for the mandatory redemption of members' stock within five years of such request. In 2007, the Bank requested the redemption of 361,645 shares, which under the FHLB's Capital Plan would be redeemable in 2012.
In 2009, the FHLB's primary regulator, the Federal Housing Finance Agency, has chosen to treat the FHLB as if it was undercapitalized because of several factors, including the possibility that declines in the value of its private-label mortgage-backed securities could cause it to fall below its risk-based capital requirements. Due to this determination, the FHLB currently remains unable to repurchase or redeem capital stock or to pay dividends.
As of September 30, 2009, the FHLB had received requests to redeem 9.42 million shares of capital stock, including the Bank's request to redeem 361,645 shares of stock. The FHLB has accounted for these requests by recording a liability under the caption "mandatorily redeemable capital stock" on its balance sheet. In the Form 10-Q for third quarter of 2009, the FHLB stated that "the fair value of capital stock subject to mandatory redemption generally approximates par value as indicated by contemporaneous member purchases and transfers at par value."
The Bank continues to use and has access to the services of the FHLB. Management considers several factors in evaluating impairment including the commitment of the issuer to perform its obligations and to provide services to the Bank. Based upon the foregoing, management has not recorded an impairment of the carrying value of our FHLB stock as of December 31, 2009. See Note 1 to the Consolidated Financial Statements for information related to our accounting and impairment policy.
Goodwill was $31.5 million as of December 31, 2009, a $3.4 million or 10% decrease from December 31, 2008. The decrease in goodwill was the result of our sale of the assets of BOH Wholesale Insurance Agency, Inc., formerly known as Triad Insurance Agency, Inc., during the fourth quarter of 2009. As of December 31, 2009, we had no reporting units where there was a reasonable possibility of failing the Step 1 goodwill impairment test in accordance with GAAP. Step 1 of the goodwill impairment test is used to identify potential goodwill impairment by comparing the estimated fair value of a reporting unit with its carrying amount. See Note 1 to the Consolidated Financial Statements for more information on our goodwill impairment policy.
Total deposits were $9.4 billion as of December 31, 2009, a $1.1 billion or 13% increase from December 31, 2008. We experienced strong deposit growth from both our consumer and commercial customers throughout 2009. The increase was primarily due to a $796.2 million increase in our business money market savings accounts, a $511.9 million increase in our bonus rate savings products, and a $212.9 million increase in our analyzed business checking accounts. This was partially offset by a $231.4 million decrease in public interest-bearing demand accounts and a $176.1 million decrease in consumer time deposits of $100,000 or more.
Average time deposits of $100,000 or more was $742.0 million in 2009 and $946.0 million in 2008. See Note 8 to the Consolidated Financial Statements for more information.
Table 12 presents the components of our savings deposits as of December 31, 2009 and 2008.
Borrowings consisted of funds purchased and short-term borrowings, including commercial paper. Borrowings were $15.8 million as of December 31, 2009, a $4.8 million or 23% decrease from December 31, 2008. This decrease was due to a $6.8 million decrease in funds purchased, partially offset by a $2.0 million increase in short-term borrowings. We manage the level of our borrowings to ensure that we have adequate sources of liquidity. Due to our successful deposit gathering efforts and our increased capital levels, we reduced the level of borrowings as a source of funds. See Note 9 to the Consolidated Financial Statements for more information.
Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase were $1.6 billion as of December 31, 2009, a $589.9 million or 57% increase from December 31, 2008. This increase was primarily due to new placements to accommodate local government entities. A portion of the increase in securities sold under agreements to repurchase resulted from the withdrawal of public interest-bearing demand deposits in 2009. Securities sold under agreements to repurchase also provide us with a short-term source of liquidity. As many of our securities sold under agreements to repurchase are at variable rates, this provided us with a relatively inexpensive source of short-term funding in the current interest rate environment. Average rates paid on securities sold under agreements to repurchase were 2.06% in 2009, a 106 basis point decrease from 2008. See Note 9 to the Consolidated Financial Statements for more information.
Long-term debt, which represents a relatively more expensive source of funds for us, was $90.3 million as of December 31, 2009, a $113.0 million or 56% decrease from December 31, 2008. This decrease was primarily due to the repayment of $119.0 million in subordinated notes and $25.0 million in privately placed notes in the first quarter of 2009. This was partially offset by the recognition of $32.4 million in non-recourse debt on the balance sheet in the second quarter of 2009. The non-recourse debt was previously not recognized as a liability on the Company's balance sheet under leveraged lease accounting treatment for one of our commercial leases. See Note 10 to the Consolidated Financial Statements for more information.
Cross-border outstandings are defined as loans (including accrued interest), acceptances, interest-bearing deposits with other banks, other interest-bearing investments, and any other monetary assets which are denominated in dollars or other non-local currency. As of December 31, 2009, 2008 and 2007, we did not have cross-border outstandings to any foreign country which exceeded 0.75% of our total assets.
Corporate Risk Profile
Credit Risk is defined as the risk that borrowers or counter-parties will not be able to repay their obligations to us. Credit exposures reflect legally binding commitments for loans, leases, banker's acceptances, standby and commercial letters of credit, and deposit account overdrafts.
We manage and control risk in the loan and lease portfolio by adhering to well-defined underwriting criteria and account administration standards established by management. Written credit policies document underwriting standards, approval levels, exposure limits, and other limits or standards deemed necessary and prudent. Portfolio diversification at the obligor, industry, product, and/or geographic location
levels is actively managed to mitigate concentration risk. In addition, credit risk management also includes an independent credit review process that assesses compliance with commercial and consumer credit policies, risk ratings, and other critical credit information. In addition to implementing risk management practices that are based upon established and sound lending practices, we adhere to sound credit principles. We understand and evaluate our customers borrowing needs and capacity to repay, in conjunction with their character and history.
Commercial and industrial loans are made primarily for the purpose of financing equipment acquisition, expansion, working capital, and other general business purposes. Lease financing consists of direct financing leases and leveraged leases and are used by commercial customers to finance capital purchases ranging from computer equipment to transportation equipment. The credit decisions for these transactions are based upon an assessment of the overall financial capacity of the applicant. A determination is made as to the applicant's ability to repay in accordance with the proposed terms as well as an overall assessment of the risks involved. In addition to an evaluation of the applicant's financial condition, a determination is made of the probable adequacy of the primary and secondary sources of repayment, such as additional collateral or personal guarantees, to be relied upon in the transaction. Credit agency reports of the applicant's credit history supplement the analysis of the applicant's creditworthiness.
Commercial mortgages and construction loans are offered to real estate investors, developers, builders, and owner-occupants primarily domiciled in Hawaii. These loans are secured by first mortgages on real estate at loan-to-value ("LTV") ratios deemed appropriate based on the property type, location, overall quality, and sponsorship. Generally, these LTV ratios do not exceed 75%. The commercial properties are predominantly developments such as retail centers, apartments, industrial properties and, to a lesser extent, more specialized properties such as hotels. Substantially all of our commercial mortgage loans are secured by properties located in our primary market area.
In the underwriting of our commercial mortgage loans, we obtain appraisals for the underlying properties. Decisions to lend are based on the economic fundamentals of the property and the creditworthiness of the borrower. In evaluating a proposed commercial mortgage loan, we primarily emphasize the ratio of the property's projected net cash flows to the loan's debt service requirement. The debt service coverage ratio normally is not less than 120% and it is computed after deduction for a vacancy factor and property expenses as appropriate. In addition, a personal guarantee of the loan or a portion thereof is sometimes required from the principal(s) of the borrower. We normally require title insurance insuring the priority of our lien, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect our security interest in the underlying property. In addition, business interruption insurance or other insurance may be required.
Owner-occupant commercial mortgage loans are underwritten based upon the cash flow of the business provided that the real estate asset is utilized in the business operation. Real estate is evaluated independently as a secondary source of repayment. LTV ratios generally do not exceed 75%.
Construction loans are underwritten against projected cash flows derived from rental income, business income from an owner-occupant, or the sale of the property to an end-user. We may mitigate the risks associated with these types of loans by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.
We offer a variety of first mortgage and junior lien loans to consumers within our markets with residential home mortgages comprising our largest loan category. These loans are secured by a primary residence and are underwritten using traditional underwriting systems to assess the credit risks and financial capacity and repayment ability of the consumer. Decisions are primarily based on LTV ratios, debt-to-income ("DTI") ratios, liquidity, and credit score. LTV ratios generally do not exceed 80%, although higher levels are permitted with mortgage insurance. We offer variable rate mortgages with interest rates that are subject to change every year after the first, third, fifth, or seventh year, depending on the product and are based on the London Interbank Offered Rate ("LIBOR"). Variable rate mortgages are underwritten at fully-indexed interest rates. Non-traditional product offerings such as interest-only facilities are underwritten using a
fully amortizing payment. We do not offer payment-option facilities, sub-prime or Alt-A loans, or any product with negative amortization.
Automobile lending activities include loans and leases secured by new or used automobiles. We originate automobile loans and leases on an indirect basis through selected dealerships. Our procedures for underwriting automobile loans include an assessment of an applicant's overall financial capacity and repayment ability, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant's creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount. We require borrowers to maintain collision insurance on automobiles securing consumer loans, with us listed as loss payee.
Home equity loans are secured primarily by second mortgages on residential property of the borrower. The underwriting terms for the home equity product generally permits borrowing availability, in the aggregate, up to 75% of the appraised value of the collateral property at the time of origination. We offer fixed and variable rate home equity loans, with variable rate loans underwritten at indexed interest rates. Our procedures for underwriting home equity loans include an assessment of an applicant's overall financial capacity and repayment ability. Decisions are primarily based on LTV ratios, DTI ratios, liquidity, and credit scores. We do not offer home equity loan products with reduced documentation.
Our overall credit risk position is reflective of the continued weak economy in 2009, with increasing levels of non-performing assets compared to December 31, 2008. The decline in visitor arrivals appears to be stabilizing, however, visitor spending continues to be lower than recent years. The construction and real estate industries in Hawaii remain weak. Hawaii's seasonally adjusted unemployment rate has improved slightly but was higher in 2009 compared to 2008. The slower economy in Hawaii is resulting in higher delinquencies and loss rates in our loan and lease portfolio, with the primary impact in our commercial and industrial, construction, and mortgage-related consumer lending portfolios.
Table 13 summarizes the amount of our loan and lease portfolio that demonstrate a higher risk profile, based on our current assessment of risk characteristics.
Residential home building loans represent $60.3 million or 56% of our total commercial construction portfolio balance as of December 31, 2009. The higher risk exposure in our residential home building portfolio was $31.1 million as of December 31, 2009. This included $9.2 million in projects on Hawaiian islands other than Oahu of which $6.3 million was included in non-performing assets. The increase in our higher risk exposure in this portfolio segment in 2009 was primarily due to a single regional home builder with operations on Oahu that is largely experiencing difficulties in other markets.
Residential land loans in our residential mortgage portfolio often represent higher risk due to the volatility in the value of the underlying collateral. Our residential land loan portfolio was $37.9 million as of December 31, 2009, of which $32.5 million related to properties on Hawaiian islands other than Oahu.
The higher risk segment within our Hawaii home equity lending portfolio was $28.1 million or 3% of our total home equity loans outstanding as of December 31, 2009. The higher risk segment within our Hawaii home equity portfolio includes those loans originated in 2005 or later, with current monitoring credit scores below 600, and with original LTV ratios greater than 70%.
We also continue to have elevated risk in our air transportation portfolio. As of December 31, 2009, included in our commercial leasing portfolio were five leveraged leases on aircraft that were originated in the 1990's and prior. Outstanding credit exposure related to these leveraged leases was $38.4 million as of December 31, 2009 and $71.0 million as of December 31, 2008. The decrease in our air
transportation credit exposure in 2009 was primarily due to the sale of our equity interest in a cargo aircraft in the second quarter of 2009 and the fourth quarter charge-off of our equity interest in two leveraged leases to a lessee that filed for bankruptcy protection. The two leases that were charged-off in the fourth quarter of 2009 had been fully reserved for in the Allowance as of December 31, 2008. As of December 31, 2009, we also had a $7.9 million exposure related to one direct financing lease for an aircraft, whose intermediary and guarantor filed for and emerged from bankruptcy protection in the fourth quarter of 2009. Relative to our total loan and lease portfolio, domestic air transportation carriers continue to demonstrate a higher risk profile due to fuel costs, pension plan obligations, consumer demand, and marginal pricing power. We believe that volatile fuel costs, coupled with a weak economy, could place additional pressure on the financial health of air transportation carriers for the foreseeable future.
These higher risk loans and leases have been considered in our quarterly evaluation of the adequacy of the Allowance.
Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More
Table 14 presents a five-year history of non-performing assets and accruing loans and leases past due 90 days or more.
The following table presents the activity in Non-Performing Assets ("NPAs") for 2009:
NPAs are comprised of non-accrual loans and leases, non-accrual loans held for sale, foreclosed real estate, and other non-performing investments. Our NPAs were $48.3 million as of December 31, 2009, compared to $14.9 million as of December 31, 2008. This increase was primarily due to a $20.1 million increase in consumer NPAs, primarily in residential mortgage loans. Also contributing to the increase in NPAs was a $13.3 million increase in commercial NPAs, including non-accrual loans held for sale and foreclosed real estate, primarily in commercial construction loans. The ratio of our non-accrual loans and leases to total loans and leases was 0.73% as of December 31, 2009, compared to 0.22% as of December 31, 2008.
Residential mortgage loan NPAs increased by $16.0 million from December 31, 2008 to $19.9 million as of December 31, 2009. As of December 31, 2009, our residential mortgage loan NPAs were comprised of 92 loans with a weighted average current loan-to-value ratio of 70%.
Commercial construction NPAs, including non-accrual loans held for sale and foreclosed real estate, increased by $8.9 million from December 31, 2008 to $14.3 million as of December 31, 2009. As of December 31, 2009, we had four non-accrual construction project loans, two of which were partially charged-off. Also as of December 31, 2009, we had one commercial construction NPA, which was included in loans held for sale as we hold an executed letter of intent from the purchaser of the loan, and one construction project that has been foreclosed on.
Included in NPAs are loans that we consider impaired. Impaired loans are defined as those which we believe it is probable we will not collect all amounts due according to the contractual terms of the loan agreement, as well as those loans whose terms have been modified in a troubled debt restructuring ("TDR"). Impaired loans were $24.7 million as of December 31, 2009 and $8.3 million as of December 31, 2008. We had loans whose terms had been modified in a TDR of $9.2 million as of December 31, 2009, primarily in our consumer automobile and commercial and industrial portfolios. Loans modified in a TDR were primarily the result of the modification of interest rates to below market rates and the extensions of maturity dates.
Loans and leases that are 90 days or more past due, as to principal or interest, and still accruing interest are in this category because they are well secured and in the process of collection. Loans and leases past due 90 days or more and still accruing interest were $13.7 million as of December 31, 2009, a decrease of $0.5 million from December 31, 2008. The $6.3 million decrease in commercial loans in this category was primarily due to the refinance of two loans in our Pacific Islands Division in 2009 that were in the process of being refinanced as of December 31, 2008. This was partially offset by a $5.8 million increase in consumer loans in this category, primarily in the areas of residential mortgage and home equity lending.
If interest due on the balances of all non-accrual loans (including loans that were on non-accrual status during 2009 but not on non-accrual status as of December 31, 2009) had been accrued under the original terms, approximately $6.9 million in total interest income would have been recorded in 2009, compared to the $3.5 million recorded as interest income on those loans (including recoveries of interest income reversed in prior years).
Allowance for Loan and Lease Losses
Allowance allocations by loan and lease category are presented in Table 16.
Based on our ongoing assessment of credit quality of the loan and lease portfolio and the economic environment, our Allowance was $143.7 million as of December 31, 2009 and $123.5 million as of December 31, 2008. The ratio of the Allowance to total loans and leases outstanding was 2.49% as of December 31, 2009 compared to 1.89% as of December 31, 2008. The increase in the ratio of the Allowance to total loans and leases outstanding was consistent with the increase in our NPAs during 2009 as well as the overall weakness in the economy.
Net loans and leases charged-off was $87.7 million or 1.43% of total average loans and leases in 2009, an increase from $28.0 million or 0.43% of total average loans and leases in 2008. Net loans and leases charged-off increased in both the commercial and consumer lending portfolios during 2009. Commercial net charge-offs were $51.3 million in 2009, an increase of $42.6 million from 2008. This increase included $13.8 million related to our leveraged lease portfolio, $8.0 million related to our construction lending portfolio, and $16.2 million
related to positions we sold in five Shared National Credits which reduce our future loss exposure. Consumer net charge-offs were $36.5 million in 2009, an increase of $17.1 million from 2008. This increase included $9.9 million related to our home equity portfolio and $6.2 million related to our residential mortgage portfolio.
The components of the Allowance, including the allocation between commercial and consumer categories, reflect increasing credit risk during 2009 due to the weak economy. The allocation of the Allowance to our commercial portfolio decreased by $12.3 million from December 31, 2008, primarily due to a $15.4 million decrease in allocation to our leasing portfolio that resulted from $13.8 million in charge-offs related to our leveraged lease portfolio. The allocation of the Allowance to our consumer portfolio increased by $32.5 million from December 31, 2008, primarily due to a $24.1 million increase in allocation to our home equity portfolio and a $9.4 million increase in allocation to our residential mortgage portfolio. This was consistent with the increased risk of loss in these lending portfolios. See Note 4 to the Consolidated Financial Statements for more information on the Allowance.
Reserve for Unfunded Commitments
The Unfunded Reserve was $5.4 million and $5.2 million as of December 31, 2009 and December 31, 2008, respectively. The process used to determine the Unfunded Reserve is consistent with the process for determining the Allowance as adjusted for estimated funding probabilities or loan and lease equivalency factors. See Note 4 to the Consolidated Financial Statements for more information on the Unfunded Reserve.
Market risk is the potential of loss arising from adverse changes in interest rates and prices. We are exposed to market risk as a consequence of the normal course of conducting our business activities. Our market risk management process involves measuring, monitoring, controlling, and mitigating risks that can significantly impact our statements of income and condition. In this management process, market risks are balanced with expected returns in an effort to enhance earnings performance, while limiting volatility. The activities associated with these market risks are categorized into "trading" and "other than trading."
Our trading activities include foreign currency and foreign exchange contracts that expose us to a small degree of foreign currency risk. These transactions are primarily executed on behalf of customers. Our other than trading activities include normal business transactions that expose our balance sheet profile to varying degrees of market risk.
Our primary market risk exposure is interest rate risk.
Interest Rate Risk
The objective of our interest rate risk management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
The potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and repricing characteristics of financial instruments.
Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the U.S. and its agencies, particularly the FRB. The monetary policies of the FRB can influence the overall growth of loans, investment securities, and deposits and the level of interest rates earned on assets and paid for liabilities. The nature and impact of future changes in monetary policies are generally not predictable.
In managing interest rate risk, we, through the Asset/Liability Management Committee ("ALCO"), measure short and long-term sensitivities to changes in interest rates. The ALCO utilizes several
techniques to manage interest rate risk, which include:
The use of derivative financial instruments, as detailed in Note 17 to the Consolidated Financial Statements, has generally been limited. This is due to natural on-balance sheet hedges arising out of offsetting interest rate exposures from loans, investment securities with deposits, and other interest-bearing liabilities. In particular, the investment securities portfolio is utilized to manage the interest rate exposure and sensitivity to within the guidelines and limits established by ALCO. Natural and offsetting hedges reduce the need to employ off-balance sheet derivative financial instruments to hedge interest rate risk exposures. Expected movements in interest rates are also considered in managing interest rate risk. Thus, as interest rates change, we may use different techniques to manage interest rate risk.
A key element in our ongoing process to measure and monitor interest rate risk is the utilization of an asset/liability simulation model. The model is used to estimate and measure the balance sheet sensitivity to changes in interest rates. These estimates are based on assumptions on the behavior of loan and deposit pricing, repayment rates on mortgage-based assets, and principal amortization and maturities on other financial instruments. The model's analytics include the effects of standard prepayment options on mortgages and customer withdrawal options for deposits. While such assumptions are inherently uncertain, we believe that these assumptions are reasonable. As a result, the simulation model attempts to capture the dynamic nature of the balance sheet.
We utilize net interest income simulations to analyze short-term income sensitivities to changes in interest rates. Table 17 presents, for the next twelve months subsequent to December 31, 2009, 2008, and 2007, an estimate of the change in net interest income that would result from a gradual change in interest rates, moving in a parallel fashion over the entire yield curve, relative to the measured base case scenario. The base case scenario assumes the balance sheet and interest rates are generally unchanged. Based on the net interest income simulation as of December 31, 2009, net interest income sensitivity to changes in interest rates as of December 31, 2009 was more sensitive to changes in interest rates as compared to the sensitivity profiles as of December 31, 2008 and 2007, particularly in higher interest rate scenarios. Market conditions remain uncertain at the end of 2009, although they have improved since the end of 2008. Government intervention has caused interest rates to remain relatively low and has decreased market volatility. Credit spreads have narrowed in 2009 and are approaching pre-crisis levels. These factors have contributed to greater interest rate risk to the Company as of December 31, 2009.
To analyze the impact of changes in interest rates in a more realistic manner, non-parallel interest rate scenarios are also simulated. These non-parallel interest rate scenarios indicate that net interest income may decrease from the base case scenario should the yield curve flatten or become inverted for a period of time. Conversely, if the yield curve should steepen further from its mostly "normal" profile, net interest income may increase.
We also use the Market Value of Equity ("MVE") sensitivity analysis to estimate the net present value change in our net assets (i.e., assets, liabilities, and off-balance sheet instruments) from changes in interest rates. The MVE was approximately $2.1 billion, $1.3 billion, and $1.8 billion as of December 31, 2009, 2008, and 2007, respectively. During 2008, market credit spreads significantly increased and as a result the MVE as of December 31, 2008 was lower compared to the MVE as of December 31, 2009 and 2007. In addition, the MVE increased as of December 31, 2009 compared to December 31, 2008 due to strong deposit growth in 2009.
Table 18 presents, as of December 31, 2009, 2008, and 2007, an estimate of the change in the MVE that would result from an instantaneous 100 and 200 basis point increase or decrease in interest rates, moving in a parallel fashion over the entire yield curve. The MVE sensitivity decreased as of December 31, 2009 compared to December 31, 2008 as a result of interest rates increasing and credit spreads decreasing as of December 31, 2009, particularly in lower rate environments where a near 0% interest rate environment will have a marginally positive effect on the MVE. Conversely, higher rate scenarios will now have a negative impact to MVE.