(Exact
name of registrant as specified in its charter)
Commonwealth
of Puerto Rico
66-0608955
(State
or other jurisdiction of
(I.R.S.
Employer
incorporation
or organization)
Identification
No.)
270
Muñoz Rivera Avenue, San Juan, Puerto Rico 00918
(Address
of principal executive offices, including zip code)
(787)
751-7340
(Registrant’s
telephone number, including area
code)
Securities
registered pursuant to Section 12(b) of the Act:
Common
Stock, par value
$0.01
per share
Securities
registered pursuant to Section 12(g) of the Act:
None
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined
in
Rule 405 of the Securities Act.
Yes
o
No x
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 x
Indicate
by check mark whether the registrant: (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements
for
the past 90 days.
Yes
x
No o
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment of
this
Form 10-K. o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer o
Accelerated
filer x
Non-
accelerated filer o
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).
Yes
o
No x
As
of
June 30, 2006, the last business day of the registrant’s most recently completed
second fiscal quarter, the aggregate market value of the shares of Common Stock
held by non-affiliates, based on the closing price of the Common Stock on the
Nasdaq National Market System on such date, was approximately $72.7
million.
The
number of shares outstanding of the issuer’s Common Stock as of March 16, 2007
was 19,374,683 shares.
Documents
Incorporated by Reference
Portions
of the Company’s Proxy Statement relating to the 2006 Annual Meeting of
Stockholders, which will be filed within 120 days after December 31, 2006,
are
incorporated by reference into Part III, Items 10-14 of this Form 10-K.
EUROBANCSHARES,
INC.
INDEX
PAGE
PART
I
1
SPECIAL
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING INFORMATION
1
ITEM
1. BUSINESS.
1
ITEM
1A. RISK FACTORS.
28
ITEM
1B. UNRESOLVED STAFF COMMENTS.
34
ITEM
2. PROPERTIES.
34
ITEM
3. LEGAL PROCEEDINGS.
37
ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
37
PART
II
37
ITEM
5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.
37
ITEM
6. SELECTED FINANCIAL DATA.
38
ITEM
7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION.
40
ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK.
74
ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
74
ITEM
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND
FINANCIAL DISCLOSURE.
76
ITEM
9A. CONTROLS AND PROCEDURES.
77
ITEM
9B. OTHER INFORMATION.
79
PART
III
80
ITEM
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
80
ITEM
11. EXECUTIVE COMPENSATION.
80
ITEM
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND
RELATED STOCKHOLDER MATTERS.
80
ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
80
ITEM
14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
80
PART
IV
80
ITEM
15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
80
i
PART
I
SPECIAL
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING INFORMATION
Statements
contained in this Annual Report on Form 10-K that are not purely historical
are
forward-looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended, including our expectations, intentions,
beliefs, or strategies regarding the future. Any
statements in this document about expectations, beliefs, plans, objectives,
assumptions or future events or performance are not historical facts and
are
forward-looking statements. These statements are often, but not always, made
through the use of words or phrases such as “may,” “should,” “could,” “predict,”
“potential,” “believe,” “will likely result,” “expect,” “will continue,”
“anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and
“outlook,” and similar expressions. Accordingly, these statements involve
estimates, assumptions and uncertainties, which could cause actual results
to
differ materially from those expressed in them. Any forward-looking statements
are qualified in their entirety by reference to the factors discussed throughout
this document. All
forward-looking statements concerning economic conditions, rates of growth,
rates of income or values as may be included in this document are based on
information available to us on the dates noted, and we assume no obligation
to
update any such forward-looking statements. It is important to note that
our
actual results may differ materially from those in such forward-looking
statements due to fluctuations in interest rates, inflation, government
regulations, economic conditions, customer disintermediation and competitive
product and pricing pressures in the geographic and business areas in which
we
conduct operations, including our plans, objectives, expectations and intentions
and other risk factors, as detailed below.
The
following risk factors could cause actual results or outcomes to differ
materially from those expressed in any forward-looking statements made by
us,
and you should not place undue reliance on any such forward-looking statements.
Any forward-looking statement speaks only as of the date on which it is made
and
we do not undertake any obligation to update any forward-looking statement
or
statements to reflect events or circumstances after the date on which such
statement is made or to reflect the occurrence of unanticipated events. New
factors emerge from time to time, and it is not possible for us to predict
which
will arise. In addition, we cannot assess the impact of each factor on our
business or the extent to which any factor, or combination of factors, may
cause
actual results to differ materially from those contained in any forward-looking
statements.
Our
business operations, financial condition and results of operations are subject
to certain risks. For further information on these risks, see Item 1A - Risk
Factors of this Annual Report on Form 10-K.
ITEM
1. Business.
Overview
EuroBancshares,
Inc. (the “Company,” “we,” “us,” “our,” or “ EuroBancshares” hereafter) is a
diversified financial holding company headquartered in San Juan, Puerto Rico,
offering a broad array of financial services through our wholly-owned banking
subsidiary, Eurobank, and our wholly-owned insurance agency subsidiary,
EuroSeguros. As of December 31, 2006, we had, on a consolidated basis, total
assets of $2.5 billion, net loans and leases of $1.7 billion, total deposits
of
$1.9 billion, and stockholders’ equity of $169.9 million.
Eurobank
is a full-service Puerto Rico commercial bank with 23 branches located
throughout the island. The Bank is engaged in substantially all of the business
operations customarily conducted by independent financial institutions in
Puerto
Rico and the United States, including the acceptance of checking, savings
and
time deposits and the making of commercial and consumer loans, mortgage loans,
real estate loans, lease financing, and other installment and term loans.
Eurobank also offers trust and wealth management services. As a traditional
commercial bank, Eurobank earns interest on loans, leases and investment
securities that are funded by customer deposits, borrowings, retained earnings
and equity. The difference between the interest received and the interest
paid
has historically comprised the majority of our earnings.
We
are a
relationship-driven financial services company focused on providing personalized
banking services. We established our position in the small and middle market
business community as a secondary alternative to our larger competitors,
who we
believed were under-serving the market. Today, we compete head to head with
all
Puerto Rico commercial banks for the primary banking relationship of these
customers. Our personalized customer service and experienced and focused
management team are at the core of our strategy. While we have grown in size,
we
remain focused on providing services with a personal touch. Additionally,
we
have sought to further develop our footprint throughout the entire island
by
opening branches along the main vehicular arteries that circle Puerto Rico.
By
the year 2007, we intend to have a branch located within a convenient drive
of
approximately 80% of the population of Puerto Rico. We believe this is
achievable with a 26 branch network.
1
Our
niche
is to provide one-on-one services to small and mid-sized commercial businesses
in Puerto Rico. Most of these businesses are involved in service industries,
wholesale and retail distribution, dairy farming, construction, manufacturing,
transportation and professional services, and have annual sales between $2.0
and
$40.0 million. However, we also provide responsive customer service and
convenient banking products to smaller companies with sales ranging from
$500,000 to $2.0 million, consisting primarily of lawyers, healthcare providers,
CPAs, engineers, small contractors and other professionals. While we do not
mass
market to the retail segment, we do provide retail banking services to the
owners and families of our targeted commercial and small business customers,
their employees and individuals who reside or work near our branch offices.
These customers are usually also depositors of Eurobank. We seek to provide
all
of our customers with quick, responsive service and foster a culture in which
customers are valued and respected.
We
target
experienced real estate developers and provide them with acquisition,
development, and construction loans. We place particular emphasis on
single-family homes, townhouses, and walk-up developments throughout the
Island.
We also finance commercial real estate development and construction projects,
particularly if they are owner-occupied, ideally limiting our maximum credit
exposure between $7.5 million and $10.0 million for these types of credits.
Under the tradename “EuroMortgage,” we support these activities by providing
financing to the purchasers of these real estate units. In addition, through
a
staff of salespeople, today we also provide mortgages to our branch customers
and the general public. On a selective basis, we provide financing to
owner-occupied properties and to a lesser extent to income producing
properties.
In
1999,
under the tradename “EuroLease,” we began providing open-end lease financing
pursuant to which the lessee is responsible for the residual value, if any,
of
the leased asset. This short to medium-term fixed rate financing blends well
with our primarily floating rate commercial loan portfolio.
Long-term,
it is our objective to leverage our relationships with our primary customers
by
cross-selling a complete array of banking products and services directly
or
through third-party providers. Through our trust department and EuroSeguros,
we
seek to assist our customers with a full array of wealth management products
and
services.
Our
Strategic Plan
Our
primary business objectives are to enhance our profitability and to establish
Eurobank as the premier small and middle market commercial bank in Puerto
Rico.
Our core customers are small and mid-sized businesses, real estate development
companies and the owners, executives and employees of these businesses. Our
success is largely based on our personalized service philosophy. We specifically
target customers who want to deal directly with people they know and trust.
As
convenience remains an overriding factor in customer choice, we have continued
to establish de novo branches throughout the island to provide such convenience,
and at the same time we have continued to enhance our technology
platform.
We
have
developed a strategy that focuses on providing superior service through
highly-qualified and relationship-oriented employees who are committed to
their
respective communities. Through this strategy we intend to grow our business,
expand our customer base and improve profitability. The key elements of our
strategy are:
●
Focus
on Our Targeted Customers.
We
focus our time and resources on the following types of customers:
small
and mid-sized businesses, real estate development companies and
the
owners, executives and employees of these businesses. In this regard,
we
seek to leverage our business banking relationships by cross-selling
to
the personal financial needs of these business owners, executives
and
employees.
●
Provide
Superior and Convenient Service to Our Customers.
We
strive to provide superior customer service through convenient
access to
Eurobank’s branches and personalized relationship banking. We have 23
branch offices strategically located throughout Puerto Rico. Eurobank
intends to open three additional branches by the end of 2007. After
the
addition of these new branch offices, we will have a branch office
located
within a convenient drive of approximately 80% of the island’s population.
Under our business model, we provide each commercial customer with
its own
relationship manager for all its banking needs. These relationship
managers and our executive management team regularly visit customers
at
their places of business.
2
●
Hire
and Retain Well-Trained and Qualified Employees.
We
are continuing to grow our franchise by providing superior customer
service through committed, qualified and relationship-oriented
employees.
We seek to hire experienced and qualified employees that prefer
our
relationship banking approach. These employees are specifically
incented
through our compensation program to leverage our commercial relationships
by cross-selling our products and services to the owners, executives
and
employees of our business
customers.
●
Use
the Lease Financing Business to Mitigate Interest Rate
Risk.
We
use our lease financing business to mitigate our interest rate
risk by
offsetting the variable rate nature of our commercial loan portfolio
with
a short to medium-term fixed rate
product.
●
De
Novo Branching and Acquisitions.
We
seek to increase our presence throughout the island through selective
acquisitions and the opening of de novo branches in attractive
locations.
Our de novo expansion outside of the San Juan metropolitan market
has
followed Puerto Rico’s primary traffic arteries to areas that have been
growing.
●
Maximize
Growth of our International Banking Entities (IBE).
Because EBS Overseas, Eurobank’s IBE subsidiary, and EBS International
Bank, a division of Eurobank, are generally not subject to federal
or
Puerto Rico income tax, we will seek to maximize the growth of
these IBEs
as interest rates and applicable law
permit.
Our
De Novo Branch and Acquisition Strategy
Our
growth strategy is concentrated on increasing our banking presence throughout
the island of Puerto Rico. Our expansion has been the result of internal
growth,
acquisitions and the opening of de novo branch offices. Consistent with our
operating philosophy and growth strategy, we regularly evaluate opportunities
to
acquire other banks or bank branches, expand our market coverage and share
through de novo branching and enhance our product and service offerings.
Eurobank’s expansion out of the San Juan metropolitan area has followed Puerto
Rico’s primary traffic arteries to new locations poised for growth. We believe
that the Puerto Rico banking environment, which is dominated by large banks,
has
afforded us a continuing opportunity to gain new customer relationships and
to
expand existing relationships. The growth in our branch network has expanded
our
presence throughout the Island and increased our customer base. Each branch
now
has the ability to sell not only traditional products such as commercial
credit,
leasing, construction, mortgages, consumer credit and personal secured loans,
but also to cross-sell our entire product line, including insurance through
EuroSeguros, and investment products through our trust department account
representatives.
De
Novo Branches
Between
2003 and 2006, we opened four new banking offices in Aguadilla, Canóvanas,
Hatillo and Mayagüez. We are currently planning to open branches in the
following municipalities: Fajardo, Cabo Rojo, Yauco and Cayey. Our newer
branches are located along the major vehicular arteries that encircle the
island
of Puerto Rico. By the year 2007, we expect to have a branch located within
a
convenient drive of approximately 80% of the population of Puerto
Rico.
Mergers
and Acquisitions
Since
1997, we have completed acquisitions of three banks in Puerto Rico with combined
assets of approximately $679.4 million. The following is a summary of our
latest
material acquisitions.
BankTrust
Acquisition
On
May 3,
2004, we acquired all of the capital stock of BankTrust; a Puerto Rico chartered
commercial bank, through the merger of BankTrust with and into Eurobank.
The
aggregate purchase price for the capital stock of BankTrust was $23.4 million,
and consisted of the issuance of 683,304 shares of our common stock, 430,537
shares of our Series A Preferred Stock, and $6.5 million in cash. There were
no
changes in our Board of Directors or our senior management team as a result
of
the BankTrust acquisition. We funded a portion of the purchase price with
proceeds we received from the issuance of 733,316 shares of our common stock
at
$8.13 per share in a private placement of our common stock to our existing
stockholders and option holders. In connection with the private placement
and
the acquisition of BankTrust, our Board of Directors engaged an independent
third-party financial advisor, Feldman Financial Advisors, Inc., to determine
the fairness, from a financial point of view, to our stockholders of the
merger
consideration paid to BankTrust’s stockholders and the terms of the private
placement. The acquisition was accounted for using the purchase method of
accounting under generally accepted accounting principles.
3
BankTrust
provided a broad range of financial products and services to its customers,
including commercial, mortgage and personal loans, financial leases, checking
and savings accounts, asset management and trust services. BankTrust operated
five branch offices - two were located in San Juan and the other three were
located in Guaynabo, Mayagüez and Ponce. BankTrust also had one loan production
office in San Juan and operated an IBE under the name “BT International.” As of
June 1, 2004, we had closed four of the five BankTrust branches, as well
as the
loan production office, and consolidated these operations into our existing
branch network. Eurobank continued to operate BT International as a division
of
Eurobank under the tradename of EBS International Bank and the Guaynabo branch
office as a branch of Eurobank. On the closing date, the estimated fair value
of
the assets acquired was $522.0 million and the estimated fair value of the
deposits and other liabilities assumed was $492.9 million.
Banco
Financiero de Puerto Rico Acquisition
On
December 15, 2002, we acquired all of the issued and outstanding capital
stock
of Banco Financiero de Puerto Rico for an aggregate purchase price of $1.5
million, consisting of the issuance of common stock valued at $1.2 million
and
$326,000 in cash. Banco Financiero was merged with and into Eurobank. Banco
Financiero operated through three branch offices in Ponce, Puerto Rico. The
acquisition was accounted for using the purchase method of accounting under
generally accepted accounting principles. The estimated fair value of the
assets
acquired and liabilities assumed of $2.8 million exceeded the acquisition
price
of $1.8 million including additional cost associated with the acquisition
of
$214,000. The Banco Financiero acquisition was accretive to our earnings
for the
year ended December 31, 2003, as we reduced the pre-closing level of noninterest
expense associated with its operations by more than 75.0% within the first
60
days after closing.
Products
and Services
Eurobank
is engaged in substantially all of the business operations customarily conducted
by independent financial institutions in Puerto Rico, including the acceptance
of checking, savings and time deposits and the making of commercial and consumer
loans, mortgage loans, real estate loans, lease financing, and other installment
and term loans. Eurobank also offers trust and wealth management services.
We
provide our customers with internet banking, electronic funds transfers through
ACH services, cash management, vault services, and loan and deposit sweep
accounts. While we offer a wide variety of financial services to our customers,
our primary products and services are grouped in the following categories:
commercial banking, leasing (“EuroLease”), mortgage banking (“EuroMortgage”),
and trust and wealth management. In addition, we provide automobile, property
and casualty, and guaranteed auto protection insurance to customers in our
market area through our other wholly-owned subsidiary, EuroSeguros. The
following provides a summary description of our core products and
services:
Commercial
Banking
Eurobank
markets commercial banking products and services primarily to small and
mid-sized businesses located in Puerto Rico. Commercial banking products
and
services offered include commercial loans, residential construction loans
and,
to a lesser extent, consumer credit and personal secured loans, as well as
a
broad range of deposit products and other non-deposit banking services,
including internet banking and cash management services tailored to meet
the
needs of these businesses.
While
we
market a wide range of commercial banking products and services, emphasis
is
placed on our loan products. Each commercial lending branch has senior
management with extensive lending experience. These managers exercise
substantial authority over credit presentation and pricing initiatives, subject
to centralized loan approvals for all unsecured credits and secured credits
over
$100,000. This decentralized management approach for secured credits, coupled
with continuity of service by the same staff members, enables us to develop
long-term customer relationships, maintain high quality service and respond
quickly to customer needs. The centralized approval process, however, provides
credit control. We believe that our emphasis on local relationship banking,
together with a conservative approach to lending, are important factors in
our
success and growth.
4
We
centralize most credit and support functions in order to achieve credit quality
consistency and cost efficiencies in the delivery of products and services
by
each banking office. The central office provides services such as data
processing, bookkeeping, accounting, treasury management, credit approval,
loan
review, compliance, risk management and internal auditing to enhance our
delivery of quality service. We also provide overall direction in the areas
of
credit policy and administration, strategic planning, marketing, investment
portfolio management and other financial and administrative services. The
branch
offices work closely with our central office to develop new products and
services needed by our customers and to introduce enhancements to existing
products and services.
Commercial
and Construction Loans
In
the
commercial banking area, Eurobank focuses on providing commercial and
construction loans to local businesses. These businesses generally have annual
sales ranging from $2.0 million to $40.0 million, and financing requirements
between $1.0 million and $10.0 million.
At
December 31, 2006, commercial loans totaled $1.0 billion, or 59.16% of our
gross
loan and lease portfolio, which included $736.6 million in commercial loans
secured by real estate. Commercial loans include lines of credit and commercial
term loans to finance operations and to provide working capital for specific
purposes, such as to finance the purchase of assets, equipment or inventory.
Since a borrower’s cash flow from operations is generally the primary source of
repayment, our analysis of the credit risk focuses heavily on the borrower’s
debt repayment capacity.
Lines
of
credit are extended to businesses based on the financial strength and integrity
of the borrower and are secured primarily by real estate, accounts receivable
and inventory, and have a maturity of one year or less. Such lines of credit
bear an interest rate that floats with our base rate, the prime rate, LIBOR
or
another established index.
Commercial
term loans are typically made to finance the acquisition of fixed assets,
provide permanent working capital or to finance the purchase of businesses.
Commercial term loans generally have terms from one to five years. They may
be
collateralized by the asset being acquired or other available assets and
bear
interest rates that either float with Eurobank’s base rate, prime rate, LIBOR or
another established index or is fixed for the term of the loan.
At
December 31, 2006, construction loans totaled $126.2 million, or 7.23% of
our
gross loan and lease portfolio. We seek to market our construction loans
to
experienced developers who develop residential units throughout the island
and
whose peak maximum credit needs for a particular project generally are between
$7.5 million and $10.0 million. Construction loans generally have terms of
18
months, with options to extend for additional periods to complete construction
and sale of the units. We usually require a 20.0% equity capital investment
by
the developer and loan-to-value ratios of not more than 80.0% of anticipated
completion value.
Over
the
last four years, our commercial and construction loans have grown 27.77%
on a
compounded basis. The following table shows end of period balances of commercial
and construction loans for the periods indicated below:
As
of December 31,
2006
2005
2004
2003
2002
(In
thousands)
$1,160,308
$
967,049
$
786,438
$
525,251
$
435,322
Our
portfolio of commercial and construction loans is subject to certain risks,
including: (1) a possible downturn in the Puerto Rico economy; (2) interest
rate
increases; (3) the deterioration of a borrower’s or guarantor’s financial
capabilities; and (4) environmental risks, including natural disasters. We
attempt to reduce the exposure to such risks through: (1) reviewing each
loan
request and renewal individually; (2) utilizing a centralized approval system
for all unsecured loans and secured loans in excess of $100,000; (3) strictly
adhering to written loan policies; and (4) conducting an independent credit
review. In addition, loans based on short-term asset values are monitored
on a
monthly or quarterly basis. In general, we receive and review financial
statements of borrowing customers on an ongoing basis during the term of
the
relationship and respond to any deterioration noted.
5
Consumer
Loans
Although
Eurobank focuses on marketing commercial loans to local businesses, it also
provides consumer credit and personal secured loans to the owners and employees
of these businesses. At December 31, 2006, consumer loans totaled $61.5 million,
or 3.51% of our gross loan and lease portfolio, which included $782,000 in
consumer loans secured by real estate. Our consumer loan portfolio is subject
to
certain risks, including: (1) amount of credit offered to consumers in the
market; (2) interest rate increases; and (3) consumer bankruptcy laws which
allow consumers to discharge certain debts. We attempt to reduce the exposure
to
such risks through the direct approval of all consumer loans by: (1) reviewing
each loan request and renewal individually; (2) utilizing a centralized approval
system for loans in excess of $25,000; (3) strictly adhering to written credit
policies; and (4) conducting an independent credit review.
The
only
major consumer loan category acquired from BankTrust not previously marketed
by
Eurobank was BankTrust’s boat financing portfolio, which amounted to $37.4
million as of December 31, 2006.
Leasing
Activities
We
entered the leasing business in order to assist us in managing our interest
rate
risk. We determined that a short to medium-term fixed rate product, such
as
lease financings, was needed to mitigate our interest rate risk resulting
from
our high volume of variable rate commercial loans. Our entry into the lease
financing market was facilitated by our ability to attract a veteran management
team, low entry costs and the opportunity to gain market share.
Under
the
tradename “EuroLease,” Eurobank offers open-ended leases pursuant to which the
lessee is responsible for the residual value of the leased unit. At December
31,
2006, we held $443.3 million in leases, representing 25.38% of our gross
loan
and lease portfolio. During 2006, approximately 96.14% of all originations
were
automobile leases. The remaining originations were primarily medical equipment
and construction equipment leases. While the granting of leases is governed
by
many aspects of our general credit policies and procedures, due to the nature
of
the exposure, additional specific parameters are applied to leases. Our
automobile leasing is done by way of finance leases, where the lessee is
responsible for any residual at the end of the lease term. Practically all
automobile leasing in Puerto Rico is done in this manner and the large majority
of banks compete in this market. Although we believe that the risk in this
product is generally higher than commercial lending, we believe the higher
risks
are acceptable due to the obligation of the lessee for the residual value
and
the numerous risk mitigation parameters that we utilize in the credit
underwriting process. All lease requests are reviewed by our credit department
and are subjected to numerous credit tests. There are varying levels of credit
approval authority within the department, although none is as high as the
approval authority of the senior leasing officer, who has the authority to
approve aggregate credit extensions of up to $175,000 to any one borrower.
We
apply the same “total to one borrower” concept in the commercial lending area as
well. Additional risk mitigation is practiced through a series of parameters
and
controls, which include but are not limited to, minimum dollar amounts on
new
vehicle leases, maximum amounts on residuals, maximum terms, obligatory
insurance, minimum income parameters, maximum debt service-to-income parameters,
certain credit history parameters, down payments and employment history
parameters.
On
a
monthly basis, we review the existing lease portfolio to determine the repayment
performance of borrowers displaying subprime lending characteristics. This
analysis contemplates the segregation of the lease portfolio in two
different categories, sub-prime and prime, based on
the characteristics of each borrower. The review includes the
segregation of the monthly delinquency report into these categories to
compare the percentage of the outstanding balance for each category in different
delinquent stratas. For 2006, the analysis revealed there was a
similar repayment performance for both categories. This review
enables us to have a better monitoring system and control sub-prime
borrowers and to reduce risk of repossessions and future losses.
During
2006, approximately 65.17% of our new automobile leases were financed on
a no
residual value basis because the automobiles would be transferred to the
lessee
at the end of the lease term. For those that do have a residual value, the
lessee is contractually responsible for the full residual amount at the end
of
the lease term. We do not have the risk of fluctuations in automobile values
relative to residual value. Instead, our risk is a credit risk regarding
whether
the lessee will perform on its obligation to purchase the automobile at the
end
of the contract at residual value. In addition, in some instances EuroLease
will
refinance the automobile purchased at the residual value.
6
New
automobile leases are offered for terms of up to 72 months. Leases with terms
of
72 months will be financed based on no residual value. Lessees may also choose
a
60-month lease term, in which case we offer financing with a maximum of a
35%
residual value. This higher residual value product is usually offered mostly
on
high-end European and Japanese automobiles based on historical used automobile
resale values.
Under
current Puerto Rican law, the lessee is deemed to be the title holder of
a
leased automobile and therefore is responsible for all tort liability associated
with the operation and possession of the automobile.
We
have
developed procedures designed to facilitate our lease financing business.
Our
account executives generate the leases at the automobile dealer level. We
are
selective with respect to our customers, and are aided in this selection
by
referrals from the automobile dealers. We also market this service to our
targeted customers. While most of our leases are for automobiles, in some
cases
we have been willing to provide equipment lease financing for our commercial
customers.
We
believe the collection process is an integral component to a successful leasing
business. Our collection efforts with respect to leases start 10 days after
the
due date of each lease. A
collections staff of twelve internal collectors and
ten outside collectors is managed by a Collections Department Head,
one Collections Manager and two supervisors. To reinforce
outside collectors, additional resources are obtained by hiring external
collection agencies that provide support on certain accounts.
Our
internal collectors are responsible for all efforts to collect on leases
under
30 days past due. If a customer cannot be reached by phone, the account is
then
assigned to the outside collector’s staff. When the account reaches 60 days past
due, repossession efforts are started. If a customer does not deliver the
automobile voluntarily, the case is referred to our outside collections lawyers.
Most of our repossessions are voluntary. Court proceedings for repossession
take
approximately 60 days. Once repossessed, vehicles and equipment are initially
recorded at the lower of net realizable value or book value at the date of
repossession, establishing a new cost basis. Any resulting loss is charged
to
the allowance for loan and lease losses. A valuation of repossessed assets
is
made quarterly after its repossession. Additional declines in value after
repossession, if any, are charged to current operations. Gains or losses
on
disposition of repossessed assets and related maintenance expenses are included
in current operations.
The
following table sets forth the dollar volume of leases originated by Eurobank
and the end of period balances of leases for the periods indicated
below:
As
of or for the Year Ended December 31,
2006
2005
2004
2003
2002
(In
thousands)
Originations
$
147,352
$
230,985
$
257,808
$
185,321
$
138,922
End
of period balance
$
443,311
$
487,863
$
459,251
$
315,935
$
256,087
Eurobank
intends to maintain its lease origination volume at current levels and focus
on
improving the overall quality of the portfolio and service to its network
of
dealers. In doing so, we also intend to provide dealers, on a selective basis,
with floor plan financing. We seek to avoid an excess concentration of leases
as
a percentage of interest-earning assets. Typically, we retain the right to
service the leases we sell. During 2005, we sold approximately $29.9 million
in
leases, compared to $30.0 million in leases sold during 2004. There was no
sale
of lease financing contracts during 2006. For more information regarding
the
accounting treatment of these servicing assets, see “Management’s
Discussion and Analysis of Financial Condition and Results of Operations
—
Critical Accounting Policies — Servicing Assets,”
and
“Note
2 — Summary of Significant Accounting Policies”
to
our
consolidated financial statements.
Mortgage
Banking
Under
the
tradename “EuroMortgage,” Eurobank offers Federal National Mortgage Association,
or FNMA, Veterans Affairs, or VA, and Federal Housing Administration, or
FHA,
and Freddie Mac loans, as well as conforming and non-conforming mortgage
loans.
We are an approved seller/servicer for FNMA and Freddie Mac. Eurobank has
continued to make inroads in the market by providing for the efficient and
expeditious turnaround of new loan applications and by establishing certain
strategic relationships that allow access to secondary mortgage markets on
a
best price basis. At December 31, 2006, residential mortgage loans totaled
$76.3
million, representing 4.37% of our gross loan and lease portfolio.
7
Our
targeted market for mortgage banking is the financing of the homes on the
island
or units financed by our construction lending department. We also provide
mortgage banking services to our retail customers and to the owners, executives
and employees of our targeted commercial customers. In addition, our salespeople
engage in marketing and direct selling efforts to the general community.
All
mortgages originated by Eurobank are fixed-rate mortgages with a maximum
term of
30 years. Part of the mortgage loans we originate are sold to other financial
institutions with servicing released. We have been authorized by FNMA, Freddie
Mac, and recently by GNMA to create mortgage loan pools to be sold in the
secondary market. However, as of December 31, 2006, we had not created any
such
pool. It is our intention to create such pools in the future.
The
following table sets forth the dollar volume of residential mortgage
originations by Eurobank and the end of period balances of residential mortgages
for the periods indicated below:
As
of or for the Year Ended December
31,
2006
2005
2004
2003
2002
(In
thousands)
Originations
$
55,097
$
21,112
$
28,028
$
53,880
$
32,635
End
of period balance
$
76,277
$
44,841
$
51,730
$
15,941
$
34,198
Our
portfolio of mortgage loans is subject to certain risks, including: (1) a
possible downturn in the Puerto Rico economy affecting real estate values;
(2)
interest rate increase; (3) the deterioration of a borrower’s or guarantor’s
financial capabilities; and (4) environmental risks, including natural
disasters. We attempt to reduce the exposure to such risks through: (1)
reviewing each loan request and renewal individually; (2) utilizing a
centralized approval system for loans in excess of $500,000; (3) strictly
adhering to written loan policies; and (4) conducting an independent credit
review. In general, we receive and review financial statements of borrowing
customers on an ongoing basis during the term of the relationship and respond
to
any deterioration noted.
Trust
and Wealth Management
We
established Eurobank’s trust and wealth management to cross-sell retirement
benefits, personal and corporate trust and wealth management services to
the
owners, executives and employees of our customer base. As of December 31,
2006,
Eurobank had approximately $235.3 million in trust assets under management,
primarily acquired in the BankTrust merger.
We
offer
a full array of investment products and services guided by an experienced
and
specialized team focused on serving our customers’ financial needs. This is part
of our strategy of creating financial centers in which each customer may
access
a variety of integrated financial products and services. Investment products
are
offered through an association with National Financial Services, LLC, a
registered broker-dealer. We offer financial planning and investment management
services to individuals and corporate customers. During 2006, 2005 and 2004,
we
traded approximately $17.4 million, $36.2 million and $18.9 million,
respectively, in investment securities for our customers.
Insurance
EuroSeguros
primarily offers automobile, property and casualty, and guaranteed auto
protection insurance to customers in our market area. EuroSeguros represents
several insurance companies in Puerto Rico and is licensed and regulated
by the
Office of the Commissioner of Insurance of Puerto Rico.
EuroSeguros’
goals for the year 2007 are to expand to offer life insurance products and
to
continue to work closely with Eurobank’s mortgage customers, leasing customers
and branch professionals, while continuing to enhance personalized service
to
all of these customers.
8
International
Banking Entities
During
the first six months of 2004, we transferred all of the assets and liabilities
of Eurobank International, an IBE that operated as a division of Eurobank,
to an
IBE subsidiary of Eurobank, EBS Overseas, Inc. We also have an IBE that operates
as a division of Eurobank under the name EBS International Bank. This IBE
was
acquired under the name of BT International in connection with the acquisition
of BankTrust and changed to EBS International Bank on September 27, 2005.
We
have continued to operate EBS International Bank as a division of Eurobank
and
do not have immediate plans to transfer its assets to our subsidiary, EBS
Overseas, Inc.
IBEs
are
limited under the IBE Act with respect to the types of activities they can
undertake. In general, IBEs may accept deposits or borrow money from other
IBEs
and from “foreign persons.” For purposes of the IBE Act, a “foreign person” is
defined as anyone who is not a resident of Puerto Rico. IBEs are also permitted
to engage in any activity that is financial in nature outside of Puerto Rico
that is permissible for a bank holding company or a foreign office or subsidiary
of a United States bank under applicable United States law. Typically, we
borrow
funds in the United States in the form of repurchase obligations or brokered
deposits (considered foreign under the IBE Act) and invest those funds primarily
in United States Treasury Obligations, U.S. Government Agencies Obligations,
U.S. Government Sponsored Agencies Obligations, Mortgage Back Securities
issued
or guaranteed by U.S. Government Agencies or U.S. Government Sponsored Agencies
and obligations issued by U.S. Corporations. The income earned from this
activity is tax exempt. For more information regarding the regulation of
IBEs,
see the section of this Annual Report on Form 10-K captioned “Supervision
and Regulation — International Banking Center Regulatory
Act.”
EBS
Overseas, Inc. is authorized to invest in notes and bonds issued by the
U.S. government, the Commonwealth of Puerto Rico, other foreign governments
and their agencies, and U.S. and foreign corporations. As of December 31,
2006,
EBS Overseas’ investment portfolio consisted of the following: $248.0 million,
or 53.9%, in mortgage-backed securities issued or guaranteed by government
or
government sponsored agencies, $150.7 million, or 32.8%, in U.S. government
agency obligations, $56.4 million, or 12.3%, in mortgage-backed securities
issued by U.S. corporations, and $5.1 million, or 1.1%, in Puerto Rico
Public Authorities.
We
have
structured EBS Overseas’ investment portfolio in an effort to improve our net
interest margin in the future. The maturities on debt obligations in EBS
Overseas’ investment portfolio range from 2 to 6.5 years with an estimated
average maturity as of December 31, 2006 of 2.8 years. The original
estimated average maturities of mortgage-backed securities in the portfolio
also
range from 2 to 7 years, with an average maturity as of December 31, 2006
of
approximately 3.3 years.
As
of
December 31, 2006, EBS Overseas had total assets of approximately
$464.8 million, repurchase obligations of approximately
$317.2 million, borrowings from EBS International Bank of approximately
$98.0 million and stockholders’ equity of approximately $47.0 million.
Further, as of December 31, 2006, EBS International Bank had total assets
of
approximately $313.2 million, deposits of approximately
$284.9 million, and repurchase agreements of approximately
$26.0 million.
Eurobank
Statutory Trust I and II
On
November 11, 2001, Eurobank Statutory Trust I, a special purpose statutory
trust
subsidiary of EuroBancshares, was formed for the purpose of issuing $25.0
million in trust preferred securities, which were issued on December 18,
2001
with a
liquidation amount of $1,000 per security, with option to redeem in five
years.
In an
effort to improve our net interest margin, on December 18, 2006, these trust
preferred securities were redeemed resulting in the write-off of approximately
$626,000 in unamortized placement costs.
On
December 10, 2002, Eurobank Statutory Trust II, a special purpose statutory
trust subsidiary of EuroBancshares was formed for the purpose of issuing
$20.0
million in trust preferred securities, which were issued on December 19,
2002.
On
March
1, 2005 the Federal Reserve Board adopted the final rule that allows the
continued limited inclusion of trust-preferred securities in the Tier 1 capital
of bank holding companies (BHCs). Under the final rule, trust preferred
securities and other restricted core capital elements are subject to stricter
quantitative limits. The Federal Reserve Board’s final rule limits restricted
core capital elements to 25% of all core capital elements, net of goodwill
less
any associated deferred tax liability. Amounts of restricted core capital
elements in excess of these limits generally may be included in Tier 2 capital.
The final rule provides a five-year transition period, ending March 31, 2009,
for application of the quantitative limits.
9
For
more
detail on notes payable to statutory trusts please refer to “Note
17 - Notes Payable to Statutory Trusts”
to our
consolidated financial statements.
Market
We
consider our primary market area to be the island of Puerto Rico. We serve
this
market through our main office and branches in the greater metropolitan area
of
San Juan and our branches in Aguadilla, Bayamón, Caguas, Carolina, Canóvanas,
Cidra, Condado, Guaynabo, Hatillo, Ponce, Humacao, Luquillo, San Lorenzo,
Manatí
and Mayagüez, Puerto Rico. Puerto Rico is the fourth largest of the Caribbean
Islands and is located approximately 1,100 miles southeast of Miami. It is
approximately 100 miles long and 35 miles wide.
Puerto
Rico came under United States sovereignty in 1898 and obtained commonwealth
status in 1952. Puerto Ricans have been citizens of the United States since
1917. The United States and Puerto Rico share a common defense, market and
currency. The Commonwealth of Puerto Rico exercises virtually the same control
over its internal affairs as do the fifty states. Most federal taxes, except
those such as Social Security taxes which are imposed by mutual consent,
are not
levied in Puerto Rico. No federal income tax is collected from Puerto Rico
residents on income earned in Puerto Rico, except for certain federal employees
who are subject to taxes on their salaries. According to the United
States Census Bureau,
the
population of Puerto Rico was 3.8 million in 2000, compared to 3.5 million
in
1990. As of 2005, the population of San Juan, the island’s capital and largest
city, was estimated in approximately 429,000.
The
economy of Puerto Rico is closely linked to that of the United States. As
such,
factors affecting the United States economy usually have a significant impact
on
the performance of the Puerto Rico economy. These include exports, direct
investment, the amount of federal transfer payments, the level of interest
rates, the level of oil prices, and the rate of inflation and tourist
expenditures. In the past, the economy of Puerto Rico had usually followed
the
trends of the United States economy. The economic slowdown in the United
States
in 2001 and 2002 and the subsequent recovery in 2003, which continued in
2004
and 2005, were also reflected in the Puerto Rico economy, in somewhat of
a more
limited extent, but lagging behind the growth in the United States for fiscal
2006. In January 2006, the Planning Board of Puerto Rico (“the Planning Board”)
estimated that in 2006 and 2007, the Gross National Product (“GNP”) growth rates
would not exceed 2.2% and 2.5%, respectively. On June 30, 2006, the Planning
Board announced that the agency revised the estimate of macroeconomic variables
for fiscal year 2006 and the projection for fiscal year 2007 and estimated
the
GNP growth at 1.2% and 0.6% for those same periods, respectively. For 2005
and
2004, the GNP growth was 2.0% and 2.8%, respectively.
Between
May 1 and May 17, 2006, Puerto Rico experienced a partial government shutdown
caused by the inability of the Legislature and Governor to agree on a budget,
which resulted in an estimated $740 million budget shortfall. This government
shutdown forced the closure of approximately 43 public agencies, including
Puerto Rico’s public schools, leaving an estimate of 90,000 government employees
out of work. In response to this economic crisis, several bills were approved
by
the Puerto Rico legislature
to
impose additional taxes, some of which were applicable to the banking industry,
resulting in an increase in our effective tax rate. For more information
relating to the risks surrounding our economic environment and the additional
taxes imposed to the banking industry, see the sections captioned “Risks
Relating to the Economic Environment”
and
“Provision
for Income Taxes”
in Item
1A - Risk Factors and Item 7 - Management’s Discussion and Analysis of Financial
Condition and Results of Operations, respectively, of this Annual Report
on Form
10-K.
Recent
increases in the price of gasoline and several basic services and utilities
are
negatively affecting the purchasing power of local consumers, which undoubtedly
have been the key driver of the Puerto Rico economy in recent years. Considering
prices as of year 2000, the GNP grew to $44.9 billion in 2005, from $44.0
billion in fiscal year 2004. According to the Puerto Rico Department of Labor
and Human Resources, the average unemployment rate in Puerto Rico was 10.6%
in
2005, compared to 11.4% in 2004. As of September 30, 2006, the unemployment
rate
was estimated at 11.3%, representing an increase of 0.2% when compared to
the
same period in 2005. The employment rate decreased to 42.3% as of September
30,
2006, from 43.8% for the same period in 2005.
The
dominant sectors of the Puerto Rico economy are manufacturing and services.
The
manufacturing sector has undergone fundamental changes over the years as
a
result of increased emphasis on higher wages, high technology industries,
such
as pharmaceuticals, biotechnology, electronics, computers, microprocessors,
professional and scientific instruments and certain high technology machinery
and equipment. The services sector, including finance, insurance, real estate,
wholesale and retail trade and tourism, also plays a major role in the economy.
It ranks second only to manufacturing in contribution to the gross domestic
product and leads all sectors in providing employment. The other material
sectors of the Puerto Rican economy include government, transportation and
agriculture.
10
As
of
December 31, 2006, there were 14 FDIC-insured commercial bank and trust
companies operating in Puerto Rico. Total assets of these institutions as
of
December 31, 2006 were $89.2 billion. As of December 31, 2006, there were
32
International Banking Entities operating in Puerto Rico licensed to conduct
offshore banking transactions, with total assets of $76.3 billion. As of
December 31, 2006, Eurobank held 3.52% of the deposits held by FDIC insured
financial institutions in Puerto Rico.
Environmental
Compliance
In
addition to our obligations under environmental laws with respect to property
that we own, there are several federal and state statutes that govern the
rights
and obligations of financial institutions with respect to environmental issues.
In addition to being directly liable under these statutes for its own conduct,
a
financial institution may also be held liable under certain circumstances
for
the actions of borrowers or other third parties on property that collateralizes
a loan held by the institution. This potential liability may far exceed the
original amount of the loan made by the financial institution, which is secured
by the property. Currently, we are not a party to any legal proceedings
involving potential liability under applicable environmental laws.
Employees
We
had
approximately 509 full-time equivalent employees as of December 31, 2006.
Our
future success will depend in part on our ability to attract, retain and
motivate highly qualified management and other personnel. We provide health,
life and disability coverage for our employees and make contributions on
behalf
of eligible employees under a plan intended to qualify as a simplified employee
pension plan under the Puerto Rico Internal Revenue Code. Our employees are
not
represented by a collective bargaining agreement and we have never experienced
a
strike or similar work stoppage. We consider our relationship with our employees
to be good.
Available
Information
Our
Internet website address is www.eurobankpr.com.
We make
available free of charge on or through our website our annual reports on
Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all
amendments to those reports filed or furnished pursuant to Section 13(a)
or
15(d) of the Securities and Exchange Act of 1934, as amended, as soon as
reasonably practicable after such material is electronically filed with or
furnished to the Securities and Exchange Commission. You may also read and
copy
any materials we file with the Securities and Exchange Commission at the
SEC’s
Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549-0102.
You
may obtain information on the operation of the SEC’s Public Reference Room by
calling at 1-800-SEC-0220. The SEC maintains an internet site that contains
reports, proxy and information statements, and other information regarding
issuers that file electronically with the SEC at www.sec.gov. However, the
information found on our website is not part of this or any other
report.
SUPERVISION
AND REGULATION
This
following is a summary description of the relevant laws, rules and regulations
governing banks and bank and financial holding companies. The descriptions
of,
and references to, the statutes and regulations below are brief summaries
and do
not purport to be complete. The descriptions are qualified in their entirety
by
reference to the specific statutes and regulations discussed.
General
The
supervision and regulation of bank holding companies and their subsidiaries
are
intended primarily for the protection of depositors, the deposit insurance
funds
of the FDIC and the banking system as a whole, and not for the protection
of the
bank holding company stockholders or creditors. The banking agencies have
broad
enforcement power over bank holding companies and banks, including the power
to
impose substantial fines and other penalties for violations of laws and
regulations.
11
Legislation
is from time to time introduced in Congress and Puerto Rico’s legislature,
including proposals to overhaul the bank regulatory system, expand the powers
of
depository institutions and limit the investments that depository institutions
may make with insured funds. Such legislation may change applicable statutes
and
the operating environment of EuroBancshares and Eurobank in substantial and
unpredictable ways. We cannot determine the ultimate effect that future
legislation or implementing regulations would have upon the financial condition
and results of operations of EuroBancshares or Eurobank, or any of their
subsidiaries.
On
March
13, 2007, EuroBancshares’ subsidiary bank, Eurobank, entered into a Stipulation
and Consent Order with the FDIC agreeing to the issuance of a Cease and Desist
Order. The Cease and Desist Order was based upon examination results which
indicated that the Bank’s Bank Secrecy Act/Anti-Money Laundering Program was not
fully in compliance with the requirements of the BSA laws, regulations, and
guidance. For additional information, see the sections of this report captioned
“Recent
Developments”
on page
27.
EuroBancshares
EuroBancshares
is a financial holding company registered under the Bank Holding Company
Act,
and is subject to supervision, regulation and examination by the Federal
Reserve
Board. The Bank Holding Company Act and other federal laws subject bank holding
companies to particular restrictions on the types of activities in which
they
may engage, and to a range of supervisory requirements and activities, including
regulatory enforcement actions for violations of laws and
regulations.
Regulatory
Restrictions on Dividends; Source of Strength
EuroBancshares
is regarded as a legal entity separate and distinct from its other subsidiaries.
The principal source of our revenue is dividends received from Eurobank.
Various
federal and state statutory provisions limit the amount of dividends Eurobank
can pay to EuroBancshares without regulatory approval. It is the policy of
the
Federal Reserve Board that bank holding companies should pay cash dividends
on
common stock only out of income available over the past year and only if
prospective earnings retention is consistent with the organization’s expected
future needs and financial condition. The policy provides that bank holding
companies should not maintain a level of cash dividends that undermines the
bank
holding company’s ability to serve as a source of strength to its banking
subsidiaries.
Under
Federal Reserve Board policy, a bank holding company is expected to act as
a
source of financial strength to each of its banking subsidiaries and commit
resources to their support. Such support may be required at times when, absent
this Federal Reserve Board policy, a holding company may not be inclined
to
provide it. As discussed below, a bank holding company, in certain
circumstances, could be required to guarantee the capital plan of an
undercapitalized banking subsidiary.
In
the
event of a bank holding company’s bankruptcy under Chapter 11 of the United
States Bankruptcy Code, the trustee will be deemed to have assumed, and is
required to cure immediately, any deficit under any commitment by the debtor
holding company to any of the federal banking agencies to maintain the capital
of an insured depository institution, and any claim for breach of such
obligation will generally have priority over most other unsecured
claims.
Activities
“Closely Related” to Banking
The
Bank
Holding Company Act prohibits a bank holding company, with certain limited
exceptions, from acquiring direct or indirect ownership or control of any
voting
shares of any company which is not a bank or from engaging in any activities
other than those of banking, managing or controlling banks and certain other
subsidiaries, or furnishing services to or performing services for its
subsidiaries. One principal exception to these prohibitions allows the
acquisition of interests in companies whose activities are found by the Federal
Reserve Board, by order or regulation, to be so closely related to banking
or
managing or controlling banks, as to be a proper incident thereto. These
activities include, among other things, numerous services and functions
performed in connection with lending, investing, and financial counseling
and
tax planning. In approving acquisitions by bank holding companies of companies
engaged in banking-related activities, the Federal Reserve Board considers
a
number of factors, and weighs the expected benefits to the public (such as
greater convenience and increased competition or gains in efficiency) against
the risks of possible adverse effects (such as undue concentration of resources,
decreased or unfair competition, conflicts of interest, or unsound banking
practices). The Federal Reserve Board is also empowered to differentiate
between
activities commenced de
novo and
activities commenced through acquisition of a going concern.
The
Gramm-Leach-Bliley Financial Modernization Act of 1999, revised and expanded
the
provisions of the Bank Holding Company Act by including a new section that
permits a bank holding company to elect to become a financial holding company
to
engage in a full range of activities that are “financial in nature.” The
qualification requirements and the process for a bank holding company that
elects to be treated as a financial holding company require that all of the
subsidiary banks controlled by the bank holding company at the time of election
to become a financial holding company must be and remain at all times
“well-capitalized” and “well managed.” EuroBancshares made an election to become
a financial holding company on September 20, 2002.
The
Gramm-Leach-Bliley Act further requires that, in the event that the bank
holding
company elects to become a financial holding company, the election must be
made
by filing a written declaration with the appropriate Federal Reserve Bank
that:
●
states
that the bank holding company elects to become a financial holding
company;
●
provides
the name and head office address of the bank holding company and
each
depository institution controlled by the bank holding
company;
●
certifies
that each depository institution controlled by the bank holding
company is
“well-capitalized” as of the date the bank holding company submits its
declaration;
●
provides
the capital ratios for all relevant capital measures as of the
close of
the previous quarter for each depository institution controlled
by the
bank holding company; and
●
certifies
that each depository institution controlled by the bank holding
company is
“well managed” as of the date the bank holding company submits its
declaration.
The
bank
holding company must have also achieved at least a rating of “satisfactory
record of meeting community credit needs” under the Community Reinvestment Act
during the institution’s most recent examination.
Financial
holding companies may engage, directly or indirectly, in any activity that
is
determined to be:
●
financial
in nature;
●
incidental
to such financial activity; or
●
complementary
to a financial activity provided it “does not pose a substantial risk to
the safety and soundness of depository institutions or the financial
system generally.”
The
Gramm-Leach-Bliley Act specifically provides that the following activities
have
been determined to be “financial in nature”: lending, trust and other banking
activities; insurance activities; financial or economic advisory services;
securitization of assets; securities underwriting and dealing; existing bank
holding company domestic activities; existing bank holding company foreign
activities and merchant banking activities. In addition, the Gramm-Leach-Bliley
Act specifically gives the Federal Reserve Board the authority, by regulation
or
order, to expand the list of “financial” or “incidental” activities, but
requires consultation with the United States Treasury Department, and gives
the
Federal Reserve Board authority to allow a financial holding company to engage
in any activity that is “complementary” to a financial activity and does not
“pose a substantial risk to the safety and soundness of depository institutions
or the financial system generally.”
Privacy
Policies
Under
the
Gramm-Leach-Bliley Act, all financial institutions are required to adopt
privacy
policies, restrict the sharing of nonpublic customer data with nonaffiliated
parties and establish procedures and practices to protect customer data from
unauthorized access. EuroBancshares and its subsidiaries have established
policies and procedures to assure our compliance with all privacy provisions
of
the Gramm-Leach-Bliley Act.
13
Safe
and Sound Banking Practices
Bank
holding companies are not permitted to engage in unsafe and unsound banking
practices. The Federal Reserve Board’s Regulation Y, for example, generally
requires a holding company to give the Federal Reserve Board prior notice
of any
redemption or repurchase of its own equity securities, if the consideration
to
be paid, together with the consideration paid for any repurchases or redemptions
in the preceding year, is equal to 10% or more of the company’s consolidated net
worth. The Federal Reserve Board may oppose the transaction if it believes
that
the transaction would constitute an unsafe or unsound practice or would violate
any law or regulation. Depending upon the circumstances, the Federal Reserve
Board could take the position that paying a dividend would constitute an
unsafe
or unsound banking practice.
The
Federal Reserve Board has broad authority to prohibit activities of bank
holding
companies and their nonbanking subsidiaries which represent unsafe and unsound
banking practices or which constitute violations of laws or regulations,
and can
assess civil money penalties for certain activities conducted on a knowing
and
reckless basis, if those activities caused a substantial loss to a depository
institution. The penalties can be as high as $1 million for each day the
activity continues.
Annual
Reporting; Examinations
We
are
required to file annual reports with the Federal Reserve Board, and such
additional information as the Federal Reserve Board may require pursuant
to the
Bank Holding Company Act. The Federal Reserve Board may examine a bank holding
company or any of its subsidiaries, and charge the company for the cost of
such
the examination.
Capital
Adequacy Requirements
The
Federal Reserve Board has adopted a system using risk-based capital guidelines
to evaluate the capital adequacy of certain large bank holding companies.
Prior
to March 30, 2006, these capital guidelines were applicable to all bank holding
companies having $150 million or more in assets on a consolidated basis.
However, effective March 30, 2006, the Federal Reserve Board amended the
asset
size threshold to $500 million for purposes of determining whether a bank
holding company is subject to the capital adequacy guidelines. EuroBancshares
currently has consolidated assets in excess of $500 million and is therefore
subject to the Federal Reserve Board’s capital adequacy guidelines.
Under
the
guidelines, specific categories of assets are assigned different risk weights,
based generally on the perceived credit risk of the asset. These risk weights
are multiplied by corresponding asset balances to determine a “risk-weighted”
asset base. The guidelines require a minimum total risk-based capital ratio
of
8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements).
Total capital is the sum of Tier 1 and Tier 2 capital. To be considered
“well-capitalized,” a bank holding company must maintain, on a consolidated
basis, (i) a Tier 1 risk-based capital ratio of at least 6.0%, and (ii) a
total
risk-based capital ratio of 10.0% or greater. As of December 31, 2006, our
Tier
1 risk-based capital ratio was 10.25% and its total risk-based capital ratio
was
11.25%. Thus, EuroBancshares is considered “well-capitalized” for regulatory
purposes.
In
addition to the risk-based capital guidelines, the Federal Reserve Board
uses a
leverage ratio as an additional tool to evaluate the capital adequacy of
bank
holding companies. The leverage ratio is a company’s Tier 1 capital divided by
its average total consolidated assets. Certain highly-rated bank holding
companies may maintain a minimum leverage ratio of 3.0%, but other bank holding
companies are required to maintain a leverage ratio of at least 4.0%. As
of
December 31, 2006, our leverage ratio was 7.92%.
The
federal banking agencies’ risk-based and leverage ratios are minimum supervisory
ratios generally applicable to banking organizations that meet certain specified
criteria. The federal bank regulatory agencies may set capital requirements
for
a particular banking organization that are higher than the minimum ratios
when
circumstances warrant. Federal Reserve Board guidelines also provide that
banking organizations experiencing internal growth or making acquisitions
will
be expected to maintain strong capital positions, substantially above the
minimum supervisory levels, without significant reliance on intangible
assets.
14
Imposition
of Liability for Undercapitalized Subsidiaries
Bank
regulators are required to take “prompt corrective action” to resolve problems
associated with insured depository institutions whose capital declines below
certain levels. In the event an institution becomes “undercapitalized,” it must
submit a capital restoration plan. The capital restoration plan will not
be
accepted by the regulators unless each company having control of the
undercapitalized institution guarantees the subsidiary’s compliance with the
capital restoration plan up to a certain specified amount. Any such guarantee
from a depository institution’s holding company is entitled to a priority of
payment in bankruptcy.
The
aggregate liability of the holding company of an undercapitalized bank is
limited to the lesser of 5% of the institution’s assets at the time it became
undercapitalized or the amount necessary to cause the institution to be
“adequately capitalized.” The bank regulators have greater power in situations
where an institution becomes “significantly” or “critically” undercapitalized or
fails to submit a capital restoration plan. For example, a bank holding company
controlling such an institution can be required to obtain prior Federal Reserve
Board approval of proposed dividends, or might be required to consent to
a
consolidation or to divest the troubled institution or other
affiliates.
Acquisitions
by Bank Holding Companies
The
Bank
Holding Company Act requires every bank holding company to obtain the prior
approval of the Federal Reserve Board before it may acquire all, or
substantially all, of the assets of any bank, or ownership or control of
any
voting shares of any bank, if after such acquisition it would own or control,
directly or indirectly, more than 5% of the voting shares of such bank. In
approving bank acquisitions by bank holding companies, the Federal Reserve
Board
is required to consider the financial and managerial resources and future
prospects of the bank holding company and the banks concerned, the convenience
and needs of the communities to be served, and various competitive
factors.
Control
Acquisitions
The
Change in Bank Control Act prohibits a person or group of persons from acquiring
“control” of a bank holding company unless the Federal Reserve Board has been
notified and has not objected to the transaction. Under a rebuttable presumption
established by the Federal Reserve Board, the acquisition of 10% or more
of a
class of voting stock of a bank holding company with a class of securities
registered under Section 12 of the Exchange Act would, under the circumstances
set forth in the presumption, constitute acquisition of control.
In
addition, any company is required to obtain the approval of the Federal Reserve
Board under the Bank Holding Company Act before acquiring 25% (5% in the
case of
an acquiror that is a bank holding company) or more of the outstanding common
stock of the company, or otherwise obtaining control or a “controlling
influence” over the company.
Cross-guarantees
Under
the
Federal Deposit Insurance Act, or FDIA, a depository institution (which
definition includes both banks and savings associations), the deposits of
which
are insured by the FDIC, can be held liable for any loss incurred by, or
reasonably expected to be incurred by, the FDIC in connection with (1) the
default of a commonly controlled FDIC-insured depository institution or (2)
any
assistance provided by the FDIC to any commonly controlled FDIC-insured
depository institution “in danger of default.” “Default” is defined generally as
the appointment of a conservator or a receiver and “in danger of default” is
defined generally as the existence of certain conditions indicating that
default
is likely to occur in the absence of regulatory assistance. In some
circumstances (depending upon the amount of the loss or anticipated loss
suffered by the FDIC), cross-guarantee liability may result in the ultimate
failure or insolvency of one or more insured depository institutions in a
holding company structure. Any obligation or liability owed by a subsidiary
bank
to its parent company is subordinated to the subsidiary bank’s cross-guarantee
liability with respect to commonly controlled insured depository institutions.
Eurobank is currently the only FDIC-insured depository institution subsidiary
of
EuroBancshares.
Because
EuroBancshares is a legal entity separate and distinct from Eurobank, its
right
to participate in the distribution of assets of any subsidiary upon the
subsidiary’s liquidation or reorganization will be subject to the prior claims
of the subsidiary’s creditors. In the event of a liquidation or other resolution
of Eurobank, the claims of depositors and other general or subordinated
creditors of Eurobank would be entitled to a priority of payment over the
claims
of holders of any obligation of Eurobank to its shareholders, including any
depository institution holding company (such as EuroBancshares) or any
shareholder or creditor of such holding company.
15
Anti-Terrorism
Legislation
In
the
wake of the tragic events of September 11th, on October 26, 2001, the President
signed into law the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act of 2001. Also known
as
the “Patriot Act,” the law enhances the powers of the federal government and law
enforcement organizations to combat terrorism, organized crime, and money
laundering. The Patriot Act significantly amends and expands the application
of
the Bank Secrecy Act, including enhanced measures regarding customer identity,
new suspicious activity reporting rules, and enhanced anti-money laundering
programs.
Under
the
Patriot Act, financial institutions are subject to prohibitions against
specified financial transactions and account relationships as well as enhanced
due diligence and “know your customer” standards in their dealings with foreign
financial institutions and customers. For example, the enhanced due diligence
policies, procedures, and controls generally require financial institutions
to
take reasonable steps:
·
to
conduct enhanced scrutiny of account relationships to guard against
money
laundering and report any suspicious transaction;
·
to
ascertain the identity of the nominal and beneficial owners of,
and the
source of funds deposited into, each account as needed to guard
against
money laundering and report any suspicious
transactions;
·
to
ascertain for any foreign bank, the shares of which are not publicly
traded, the identity of the owners of the foreign bank, and the
nature and
extent of the ownership interest of each such owner; and
·
to
ascertain whether any foreign bank provides correspondent accounts
to
other foreign banks and, if so, the identity of those foreign banks
and
related due diligence information.
Under
the
Patriot Act, financial institutions must also establish anti-money laundering
programs. The Patriot Act sets forth minimum standards for these programs,
including: (i) the development of internal policies, procedures and
controls; (ii) the designation of a compliance officer; (iii) an
ongoing employee training program; and (iv) an independent audit function
to
test the adequacy of such programs.
In
addition, the Patriot Act requires bank regulatory agencies to consider the
record of a bank in combating money laundering activities in their evaluation
of
bank and bank holding company merger or acquisition transactions. Regulations
proposed by the U.S. Department of the Treasury to effect certain provisions
of
the Patriot Act provide that all transaction or other correspondent accounts
held by a U.S. financial institution on behalf of any foreign bank must be
closed within 90 days after the final regulations are issued, unless the
foreign
bank has provided the U.S. financial institution with a means of verification
that the institution is not a “shell bank.” Proposed regulations interpreting
other provisions of the Patriot Act continue to be issued.
Under
the
authority of the Patriot Act, the Secretary of the Treasury adopted rules
on
September 26, 2002 increasing the cooperation and information sharing among
financial institutions, regulators, and law enforcement authorities regarding
individuals, entities and organizations engaged in, or reasonably suspected
based on credible evidence of engaging in, terrorist acts or money laundering
activities. Under those rules, a financial institution is required to:
·
expeditiously
search its records to determine whether it maintains or has maintained
accounts, or engaged in transactions with individuals or entities,
listed
in a request submitted by the Financial Crimes Enforcement Network
(“FinCEN”);
·
notify
FinCEN if an account or transaction is identified;
·
designate
a contact person to receive information requests;
16
·
limit
use of information provided by FinCEN to (i) reporting to FinCEN,
(ii)
determining whether to establish or maintain an account or engage
in a
transaction, and (iii) assisting the financial institution in complying
with the Bank Secrecy Act; and
·
maintain
adequate procedures to protect the security and confidentiality
of FinCEN
requests.
Under
the
new rules, a financial institution may also share information regarding
individuals, entities, organizations, and countries for purposes of identifying
and, as appropriate, reporting activities that it suspects may involve possible
terrorist activity or money laundering. Such information-sharing is protected
under a safe harbor if the financial institution: (i) notifies FinCEN of
its intention to share information, even when sharing with an affiliated
financial institution; (ii) takes reasonable steps to verify that, prior to
sharing, the financial institution or association of financial institutions
with
which it intends to share information has submitted a notice to FinCEN;
(iii) limits the use of shared information to identifying and reporting on
money laundering or terrorist activities, determining whether to establish
or
maintain an account or engage in a transaction, or assisting it in complying
with the Bank Security Act; and (iv) maintains adequate procedures to
protect the security and confidentiality of the information. Any financial
institution complying with these rules will not be deemed to have violated
the
privacy requirements discussed above.
The
Secretary of the Treasury also adopted a rule on September 26, 2002 intended
to
prevent money laundering and terrorist financing through correspondent accounts
maintained by U.S. financial institutions on behalf of foreign banks. Under
the
rule, financial institutions: (i) are prohibited from providing
correspondent accounts to foreign shell banks; (ii) are required to obtain
a certification from foreign banks for which they maintain a correspondent
account stating the foreign bank is not a shell bank and that it will not
permit
a foreign shell bank to have access to the U.S. account; (iii) must
maintain records identifying the owner of the foreign bank for which they
may
maintain a correspondent account and its agent in the United States designated
to accept services of legal process; and (iv) must terminate correspondent
accounts of foreign banks that fail to comply with or fail to contest a lawful
request of the Secretary of the Treasury or the Attorney General of the United
States, after being notified by the Secretary or Attorney General.
On
March
13, 2007, EuroBancshares’ subsidiary bank, Eurobank, entered into a Stipulation
and Consent Order with the FDIC agreeing to the issuance of a Cease and Desist
Order. The Cease and Desist Order was based upon examination results which
indicated that the Bank’s Bank Secrecy Act/Anti-Money Laundering Program was not
fully in compliance with the requirements of the BSA laws, regulations, and
guidance. For additional information, see the sections of this report captioned
“Recent
Developments”
on page
27.
Sarbanes-Oxley
Act of 2002
In
July 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002,
or the Sarbanes-Oxley Act, which implemented legislative reforms intended
to
address corporate and accounting fraud. The Sarbanes-Oxley Act contains reforms
of various business practices and numerous aspects of corporate governance.
Most
of these requirements have been implemented pursuant to regulations issued
by
the SEC. The following is a summary of certain key provisions of the
Sarbanes-Oxley Act.
In
addition to the establishment of a new accounting oversight board that enforces
auditing, quality control and independence standards and is funded by fees
from
all registered public accounting firms and publicly traded companies, the
Sarbanes-Oxley Act places restrictions on the scope of services that may
be
provided by accounting firms to their public company audit clients. Any
non-audit services being provided to a public company audit client requires
pre-approval by the client’s audit committee. Also, the Sarbanes-Oxley Act makes
certain changes to the requirements for partner rotation after a period of
time.
The Sarbanes-Oxley Act requires chief executive officers and chief financial
officers, or their equivalent, to certify to the accuracy of periodic reports
filed with the SEC, subject to civil and criminal penalties if they knowingly
or
willingly violate this certification requirement. Furthermore, counsel is
required to report evidence of a material violation of securities laws or
a
breach of fiduciary duties to the company’s chief executive officer or its chief
legal officer, and, if such officer does not appropriately respond, to report
such evidence to the audit committee or other similar committee of the board
of
directors or the board itself.
Under
this law, longer prison terms apply to corporate executives who violate federal
securities laws; the period during which certain types of suits can be brought
against a company or its officers is extended and bonuses issued to top
executives prior to restatement of a company’s financial statements are now
subject to disgorgement if such restatement was due to corporate misconduct.
Executives are also prohibited from insider trading during retirement plan
“blackout” periods, and loans to company executives (other than loans by
financial institutions permitted by federal rules or regulations) are
restricted. In addition, the legislation accelerates the time frame for
disclosures by public companies, as they must immediately disclose any material
changes in their financial condition or operations. Directors and executive
officers required to report changes in ownership in a company’s securities must
now report any such change within two business days of the change.
17
The
Sarbanes-Oxley Act increases responsibilities and codifies certain requirements
relating to audit committees of public companies and how they interact with
the
company’s registered public accounting firm. Audit committee members must be
independent and are barred from accepting consulting, advisory or other
compensatory fees from the company. In addition, companies are required to
disclose whether at least one member of the committee is a “financial expert”
(as such term is defined by the SEC) and if not, why not. A company’s registered
public accounting firm is prohibited from performing statutorily mandated
audit
services for a company if the company’s chief executive officer, chief financial
officer, controller, chief accounting officer or any person serving in
equivalent positions had been employed by such firm and participated in the
audit of such company during the one-year period preceding the audit initiation
date. The Sarbanes-Oxley Act also prohibits any officer or director of a
company
or any other person acting under their direction from taking any action to
fraudulently influence, coerce, manipulate or mislead any independent public
or
certified accountant engaged in the audit of the company’s financial statements
for the purpose of rendering the financial statements materially misleading.
The
Sarbanes-Oxley Act also has provisions relating to inclusion of certain internal
control reports and assessments by management in the annual report to
stockholders. Commencing with this annual report, EuroBancshares is required
to
include an internal control report containing management’s assertions regarding
the effectiveness of its internal control structure and procedures over
financial reporting. The internal control report must include statements
regarding management’s responsibility for establishing and maintaining adequate
internal control over financial reporting; management’s assessment as to the
effectiveness of the company’s internal control over financial reporting, based
on management’s evaluation of it as
of
year-end; and of the framework used as criteria for evaluating the effectiveness
of the company’s internal control over financial reporting. The law also
requires the company’s registered public accounting firm that issues the audit
report to attest to, and report on, management’s assessment of the company’s
internal controls over financial reporting in accordance with standards for
attestation engagements issued or adopted by the Public Company Accounting
Oversight Board.
Eurobank
Eurobank
is subject to extensive regulation and examination by the Commissioner of
Financial Institutions of Puerto Rico and the FDIC, which insures its deposits
to the maximum extent permitted by law, and is subject to certain Federal
Reserve Board regulations of transactions with its affiliates. The federal
and
Puerto Rico laws and regulations which are applicable to Eurobank, regulate,
among other things, the scope of its business, its investments, its reserves
against deposits, the timing of the availability of deposited funds and the
nature and amount of and collateral for certain loans. In addition to the
impact
of such regulations, commercial banks are affected significantly by the actions
of the Federal Reserve Board as it attempts to control the money supply and
credit availability in order to influence the economy.
Transactions
with Affiliates
There
are
various statutory and regulatory limitations, including those set forth in
sections 23A and 23B of the Federal Reserve Act and Regulation W, governing
the
extent to which Eurobank will be able to purchase assets from or securities
of
or otherwise finance or transfer funds to EuroBancshares or its nonbanking
subsidiaries. Among other restrictions, such transfers by Eurobank to
EuroBancshares or any of its nonbanking subsidiaries generally will be limited
to 10.0% of Eurobank’s capital and surplus and, with respect to EuroBancshares
and all such nonbanking subsidiaries, to an aggregate of 20.0% of Eurobank’s
subsidiary’s capital and surplus. Furthermore, loans and extensions of credit
are required to be secured in specified amounts and are required to be on
terms
and conditions consistent with safe and sound banking practices.
In
addition, any transaction by a bank with an affiliate and any sale of assets
or
provision of services to an affiliate generally must be on terms that are
substantially the same, or at least as favorable, to the bank as those
prevailing at the time for comparable transactions with nonaffiliated
companies.
18
Loans
to Insiders
Sections
22(g) and (h) of the Federal Reserve Act and its implementing regulation,
Regulation O, place restrictions on loans by a bank to executive officers,
directors, and principal stockholders. Under Section 22(h), loans to a director,
an executive officer and to a greater than 10% stockholder of a bank and
certain
of their related interests, or insiders, and insiders of affiliates, may
not
exceed, together with all other outstanding loans to such person and related
interests, the bank’s loans-to-one-borrower limit (generally equal to 15% of the
institution’s unimpaired capital and surplus). Section 22(h) also requires that
loans to insiders and to insiders of affiliates be made on terms substantially
the same as offered in comparable transactions to other persons, unless the
loans are made pursuant to a benefit or compensation program that (i) is
widely
available to employees of the bank and (ii) does not give preference to insiders
over other employees of the bank. Section 22(h) also requires prior Board
of
Directors approval for certain loans, and the aggregate amount of extensions
of
credit by a bank to all insiders cannot exceed the institution’s unimpaired
capital and surplus. Furthermore, Section 22(g) places additional restrictions
on loans to executive officers.
Dividends
The
ability of Eurobank to pay dividends on its common stock is restricted by
the
Puerto Rico Banking Act of 1933, as amended, the FDIA and FDIC regulations.
In
general terms, the Puerto Rico Banking Act provides that when the expenditures
of a bank are greater than receipts, the excess of expenditures over receipts
shall be charged against the undistributed profits of the bank and the balance,
if any, shall be charged against the required reserve fund of the bank. If
there
is no sufficient reserve fund to cover such balance in whole or in part,
the
outstanding amount shall be charged against the bank’s capital account. The
Puerto Rico Banking Act provides that until said capital has been restored
to
its original amount and the reserve fund to 20% of the original capital,
the
bank may not declare any dividends. In general terms, the FDIA and the FDIC
regulations restrict the payment of dividends when a bank is undercapitalized,
when a bank has failed to pay insurance assessments, or when there are safety
and soundness concerns regarding a bank.
The
payment of dividends by Eurobank may also be affected by other regulatory
requirements and policies, such as maintenance of adequate capital. If, in
the
opinion of the regulatory authority, a depository institution under its
jurisdiction is engaged in, or is about to engage in, an unsafe or unsound
practice (that, depending on the financial condition of the depository
institution, could include the payment of dividends), such authority may
require, after notice and hearing, that such depository institution cease
and
desist from such practice. The Federal Reserve Board has issued a policy
statement that provides that insured banks and bank holding companies should
generally pay dividends only out of operating earnings for the current and
preceding two years. In addition, all insured depository institutions are
subject to the capital-based limitations required by the Federal Deposit
Insurance Corporation Improvement Act of 1991.
FDIC
Capital Requirements
Eurobank
is also subject to certain restrictions on the payment of dividends as a
result
of the requirement that it maintain adequate levels of capital in accordance
with guidelines promulgated from time to time by applicable
regulators.
The
FDIC
and the Commissioner of Financial Institutions of Puerto Rico monitor the
capital adequacy of Eurobank by using a combination of risk-based guidelines
and
leverage ratios. The agencies consider the bank’s capital levels when taking
action on various types of applications and when conducting supervisory
activities related to the safety and soundness of individual banks and the
banking system.
Under
the
risk-based capital guidelines, a risk weight factor of 0% to 100% is assigned
to
each category of assets based generally on the perceived credit risk of the
asset class. The risk weights are then multiplied by the corresponding asset
balances to determine a “risk-weighted” asset base. At least half of the
risk-based capital must consist of core (Tier 1) capital, which is comprised
of:
●
common
stockholders’
equity (includes common stock and any related surplus, undivided
profits,
disclosed capital reserves that represent a segregation of undivided
profits, and foreign currency translation adjustments; less net
unrealized
losses on marketable equity
securities);
●
certain
noncumulative perpetual preferred stock and related surplus;
and
19
●
minority
interests in the equity capital accounts of consolidated subsidiaries,
and
excludes goodwill and various intangible
assets.
The
remainder, supplementary (Tier 2) capital, may consist of:
●
allowance
for loan and lease losses, up to a maximum of 1.25% of risk-weighted
assets;
●
certain
perpetual preferred stock and related surplus;
●
hybrid
capital instruments;
●
perpetual
debt;
●
mandatory
convertible debt securities;
●
term
subordinated debt;
●
intermediate-term
preferred stock; and
●
certain
unrealized holding gains on equity securities.
“Total
risk-based capital” is determined by combining core capital and supplementary
capital.
Under
the
regulatory capital guidelines, Eurobank must maintain a total risk-based
capital
to risk-weighted assets ratio of at least 8.0%, a Tier 1 capital to
risk-weighted assets ratio of at least 4.0%, and a Tier 1 capital to adjusted
total assets ratio of at least 4.0% (3.0% for banks receiving the highest
examination rating) to be considered adequately capitalized. See discussion
in
the section below captioned “The
FDIC Improvement Act.”
FIRREA
The
Financial Institutions Reform, Recovery and Enforcement Act of 1989, or FIRREA,
includes various provisions that affect or may affect Eurobank. Among other
matters, FIRREA generally permits bank holding companies to acquire healthy
thrifts as well as failed or failing thrifts. FIRREA removed certain
cross-marketing prohibitions previously applicable to thrift and bank
subsidiaries of a common holding company. Furthermore, a multi-bank holding
company may now be required to indemnify the federal deposit insurance fund
against losses it incurs with respect to such company’s affiliated banks, which
in effect makes a bank holding company’s equity investments in healthy bank
subsidiaries available to the FDIC to assist such company’s failing or failed
bank subsidiaries.
In
addition, pursuant to FIRREA, any depository institution that has been chartered
less than two years, is not in compliance with the minimum capital requirements
of its primary federal banking regulator, or is otherwise in a troubled
condition must notify its primary federal banking regulator of the proposed
addition of any person to the Board of Directors or the employment of any
person
as a senior executive officer of the institution at least 30 days before
such
addition or employment becomes effective. During such 30-day period, the
applicable federal banking regulatory agency may disapprove of the addition
of
employment of such director or officer. Eurobank is not subject to any such
requirements.
FIRREA
also expanded and increased civil and criminal penalties available for use
by
the appropriate regulatory agency against certain “institution-affiliated
parties” primarily including (i) management, employees and agents of a financial
institution, as well as (ii) independent contractors such as attorneys and
accountants and others who participate in the conduct of the financial
institution’s affairs and who caused or are likely to cause more than minimum
financial loss to or a significant adverse affect on the institution, who
knowingly or recklessly violate a law or regulation, breach a fiduciary duty
or
engage in unsafe or unsound practices. Such practices can include the failure
of
an institution to timely file required reports or the submission of inaccurate
reports. Furthermore, FIRREA authorizes the appropriate banking agency to
issue
cease and desist orders that may, among other things, require affirmative
action
to correct any harm resulting from a violation or practice, including
restitution, reimbursement, indemnifications or guarantees against loss.
A
financial institution may also be ordered to restrict its growth, dispose
of
certain assets or take other action as determined by the ordering agency
to be
appropriate.
20
The
FDIC Improvement Act
The
Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA,
made a
number of reforms addressing the safety and soundness of the deposit insurance
system, supervision of domestic and foreign depository institutions, and
improvement of accounting standards. This statute also limited deposit insurance
coverage, implemented changes in consumer protection laws and provided for
least-cost resolution and prompt regulatory action with regard to troubled
institutions.
FDICIA
requires every bank with total assets in excess of $500 million to have an
annual independent audit made of the bank’s financial statements by a certified
public accountant to verify that the financial statements of the bank are
presented in accordance with generally accepted accounting principles and
comply
with such other disclosure requirements as prescribed by the FDIC.
FDICIA
also places certain restrictions on activities of banks depending on their
level
of capital. FDICIA divides banks into five different categories, depending
on
their level of capital. Under regulations adopted by the FDIC, a bank is
deemed
to be “well-capitalized” if it has a total Risk-Based Capital Ratio of 10.0% or
more, a Tier 1 Capital Ratio of 6.0% or more and a Leverage Ratio of 5.0%
or
more, and the bank is not subject to an order or capital directive to meet
and
maintain a certain capital level. Under such regulations, a bank is deemed
to be
“adequately capitalized” if it has a total Risk-Based Capital Ratio of 8.0% or
more, a Tier 1 Capital Ratio of 4.0% or more and a Leverage Ratio of 4.0%
or
more (unless it receives the highest composite rating at its most recent
examination and is not experiencing or anticipating significant growth, in
which
instance it must maintain a Leverage Ratio of 3.0% or more). Under such
regulations, a bank is deemed to be “undercapitalized” if it has a total
Risk-Based Capital Ratio of less than 8.0%, a Tier 1 Capital Ratio of less
than
4.0% or a Leverage Ratio of less than 4.0%. Under such regulations, a bank
is
deemed to be “significantly undercapitalized” if it has a Risk-Based Capital
Ratio of less than 6.0%, a Tier 1 Capital Ratio of less than 3.0% and a Leverage
Ratio of less than 3.0%. Under such regulations, a bank is deemed to be
“critically undercapitalized” if it has a Leverage Ratio of less than or equal
to 2.0%. In addition, the FDIC has the ability to downgrade a bank’s
classification (but not to “critically undercapitalized”) based on other
considerations even if the bank meets the capital guidelines. According to
these
guidelines, Eurobank was classified as “well-capitalized” as of December 31,
2006.
In
addition, if a state non-member bank is classified as undercapitalized, the
bank
is required to submit a capital restoration plan to the FDIC. Pursuant to
FDICIA, an undercapitalized bank is prohibited from increasing its assets,
engaging in a new line of business, acquiring any interest in any company
or
insured depository institution, or opening or acquiring a new branch office,
except under certain circumstances, including the acceptance by the FDIC
of a
capital restoration plan for the bank.
Furthermore,
if a state non-member bank is classified as undercapitalized, the FDIC may
take
certain actions to correct the capital position of the bank; if a bank is
classified as significantly undercapitalized or critically undercapitalized,
the
FDIC would be required to take one or more prompt corrective actions. These
actions would include, among other things, requiring: sales of new securities
to
bolster capital; improvements in management; limits on interest rates paid;
prohibitions on transactions with affiliates; termination of certain risky
activities and restrictions on compensation paid to executive officers. If
a
bank is classified as critically undercapitalized, FDICIA requires the bank
to
be placed into conservatorship or receivership within ninety days, unless
the
FDIC determines that other action would better achieve the purposes of FDICIA
regarding prompt corrective action with respect to undercapitalized
banks.
The
capital classification of a bank affects the frequency of examinations of
the
bank and impacts the ability of the bank to engage in certain activities
and
affects the deposit insurance premiums paid by such bank. Under FDICIA, the
FDIC
is required to conduct a full-scope, on-site examination of every bank at
least
once every twelve months. An exception to this rule is made, however, that
provides that banks (i) with assets of less than $100 million, (ii) are
categorized as “well-capitalized,” (iii) were found to be well managed and its
composite rating was outstanding and (iv) has not been subject to a change
in
control during the last twelve months, need only be examined by the FDIC
once
every eighteen months.
Brokered
Deposits
Under
FDICIA, banks may be restricted in their ability to accept brokered deposits,
depending on their capital classification. “Well-capitalized” banks are
permitted to accept brokered deposits, but all banks that are not
well-capitalized are not permitted to accept such deposits. The FDIC may,
on a
case-by-case basis, permit banks that are adequately capitalized to accept
brokered deposits if the FDIC determines that acceptance of such deposits
would
not constitute an unsafe or unsound banking practice with respect to the
bank.
Deposits obtained from financial intermediaries, so-called “brokered deposits,”
represented approximately 64.35% of Eurobank’s total deposits as of December 31,
2006. As previously mentioned, Eurobank is currently well-capitalized and
therefore is not subject to any limitations with respect to its brokered
deposits.
21
Federal
Limitations on Activities and Investments
The
equity investments and activities as a principal of FDIC-insured state-chartered
banks such as Eurobank are generally limited to those that are permissible
for
national banks. Under regulations dealing with equity investments, an insured
state bank generally may not directly or indirectly acquire or retain any
equity
investment of a type, or in an amount, that is not permissible for a national
bank.
FDIC
Deposit Insurance Assessments
In
addition, under FDICIA, the Federal Deposit Insurance Corporation, or FDIC,
is
authorized to assess insurance premiums on a bank’s deposits at a variable rate
depending on the probability that the deposit insurance fund will incur a
loss
with respect to the bank. (Under prior law, the deposit insurance
assessment was a flat rate, regardless of the likelihood of loss.) In this
regard, the FDIC has issued regulations that provide for a transitional
risk-based deposit assessment that determines the deposit insurance assessment
rates on the basis of the bank’s capital classification and supervisory
evaluations. Each of these categories has three subcategories, resulting
in nine assessment risk classifications. The three subcategories with
respect to capital are “well-capitalized,” “adequately capitalized” and “less
than adequately capitalized” (which would include “undercapitalized,”
“significantly undercapitalized” and “critically undercapitalized” banks).
The three subcategories with respect to supervisory concerns are
“healthy,” “supervisory concern” and “substantial supervisory concern.” A
bank is deemed “healthy” if it is financially sound with only a few minor
weaknesses. A bank is deemed subject to “supervisory concern” if it has
weaknesses that, if not corrected, could result in significant deterioration
of
the bank and increased risk to the Bank Insurance Fund, or BIF. A bank is
deemed subject to “substantial supervisory concern” if it poses a substantial
probability of loss to the BIF.
On
June
30, 1996, the Deposit Insurance Funds Act of 1996, or DIFA, was enacted and
signed into law as part of the Economic Growth and Regulatory Paperwork
Reduction Act of 1996. DIFA established the framework for the eventual merger
of
the BIF and the Savings Association Insurance Fund, or SAIF, into a single
Deposit Insurance Fund. It repealed the statutory minimum premium and, under
implementing FDIC regulations promulgated in 1997, premiums assessed by both
the
BIF and the SAIF are to be assessed using the matrix described above at a
rates
between 0 cents and 27 cents per $100 of deposits.
DIFA
also
separated, effective January 1, 1997, the Financing Corporation, or FICO,
assessment to service the interest on its bond obligations from the BIF and
SAIF
assessments. The amount assessed on individual institutions by the FICO would
be
in addition to the amount, if any, paid for deposit insurance according to
the
FDIC’s risk-related assessment rate schedules. The FICO rate could be adjusted
quarterly to reflect changes in assessment bases for the BIF and the SAIF.
Accordingly, Eurobank could be subject to two separate premiums (for servicing
interest on bond obligations and for the BIF/SAIF insurance), if such premiums
were assessed. The FDIC acts as collection agent for the FICO.
In
addition, DIFA authorized the FICO to asses both BIF and SAIF insured deposits,
and required the BIF rate to equal one-fifth the SAIF rate through year-end
1999, or until insurance funds were merged, whichever occurred first. On
March
31, 2006, the BIF and SAIF were merged into a newly created Deposit Insurance
Fund (DIF).
In
October 2006, as required by the Federal Deposit Insurance Reform Act of
2005,
the FDIC issued a final rule to implement the one-time deposit insurance
assessment credit. Beginning in 2007, the FDIC will apply an eligible
institution's assessment credit (less any portion of the credit transferred
to
another institution) against the institution's future assessments to the
maximum
extent allowed by the statute. The one-time assessment credit cannot be applied
to reduce FICO payments. The one time assessment credit for Eurobank, our
wholly owned banking subsidiary, amounted to approximately $670,000 and will
be
used to reduce the FDIC’s new insurance premium assessment during 2007, as
further explained below.
22
In
November 2006, the FDIC adopted a final rule amending its assessment regulations
to improve and modernize its operational systems for deposit insurance
assessments. Beginning in 2007, the FDIC will categorize each insured
institution into one of four risk categories following a two-step process,
which
will evaluate first the capital ratios of the insured institution and then,
other relevant information. The FDIC’s new insurance premium rates will
range between 5 and 43 cents per $100 in accessible deposits.
The
FDIC
may terminate the deposit insurance of any insured depository institution,
including Eurobank, if it determines after a hearing that the institution
has
engaged or is engaging in unsafe or unsound practices, is in an unsafe or
unsound condition to continue operations, or has violated any applicable
law,
regulation, order or any condition imposed by an agreement with the FDIC.
It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has
no
tangible capital. If insurance of accounts is terminated, the accounts at
the institution at the time of the termination, less subsequent withdrawals,
shall continue to be insured for a period of six months to two years, as
determined by the FDIC. Management is aware of no existing circumstances
which would result in termination of Eurobank’s deposit insurance.
Check
Clearing for the 21st
Century Act
On
October 28, 2003, President Bush signed into law the Check Clearing for the
21st
Century
Act, also known as Check 21. The new law, which was not effective until October
28, 2004, gives “substitute checks,” such as a digital image of a check and
copies made from that image, the same legal standing as the original paper
check. Some of the major provisions include:
●
allowing
check truncation without making it
mandatory;
●
demanding
that every financial institution communicate to accountholders
in writing
a description of its substitute check processing program and their
rights
under the law;
●
legalizing
substitutions for and replacements of paper checks without agreement
from
consumers;
●
retaining
in place the previously mandated electronic collection and return
of
checks between financial institutions only when individual agreements
are
in place;
●
requiring
that when accountholders request verification, financial institutions
produce the original check (or a copy that accurately represents
the
original) and demonstrate that the account debit was accurate and
valid;
and
●
requiring
recrediting of funds to an individual’s account on the next business day
after a consumer proves that the financial institution has
erred.
This
new
legislation will likely affect bank capital spending as many financial
institutions assess whether technological or operational changes are necessary
to stay competitive and take advantage of the new opportunities presented
by
Check 21.
Community
Reinvestment Act
Under
the
Community Reinvestment Act, or CRA, as implemented by the Congress in 1977,
a
financial institution has a continuing and affirmative obligation, consistent
with its safe and sound operation, to help meet the credit needs of its entire
community, including low and moderate income neighborhoods. The CRA does
not
establish specific lending requirements or programs for financial institutions
nor does it limit an institution’s discretion to develop the types of products
and services that it believes are best suited to its particular community,
consistent with the CRA. The CRA requires federal examiners, in connection
with
the examination of a financial institution, to assess the institution’s record
of meeting the credit needs of its community and to take such record into
account in its evaluation of certain applications by such institution. The
CRA
also requires all institutions to make public disclosure of their CRA ratings.
EuroBancshares has a Compliance Committee, which oversees the planning of
products, and services offered to the community, especially those aimed to
serve
low and moderate income communities. The FDIC rated Eurobank as “satisfactory”
in meeting community credit needs under the CRA at its most recent examination
for CRA performance.
23
Consumer
Laws and Regulations
In
addition to the laws and regulations discussed herein, Eurobank is also subject
to certain consumer laws and regulations that are designed to protect consumers
in transactions with banks. While the list set forth herein is not exhaustive,
these laws and regulations include the Truth in Lending Act, the Truth in
Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability
Act, the Equal Credit Opportunity Act, and the Fair Housing Act, among others.
These laws and regulations mandate certain disclosure requirements and regulate
the manner in which financial institutions must deal with customers when
taking
deposits or making loans to such customers. Eurobank must comply with the
applicable provisions of these consumer protection laws and regulations as
part
of its ongoing customer relations.
Interstate
Branching
Effective
June 1, 1997, the Riegle-Neal Interstate Banking and Branching Efficiency
Act of
1994 amended the FDIA and certain other statutes to permit state and national
banks with different home states to merge across state lines, with approval
of
the appropriate federal banking agency, unless the home state of a participating
bank had passed legislation prior to May 31, 1997 expressly prohibiting
interstate mergers. Under the Riegle-Neal Act amendments, once a state or
national bank has established branches in a state, that bank may establish
and
acquire additional branches at any location in the state at which any bank
involved in the interstate merger transaction could have established or acquired
branches under applicable federal or state law. If a state opts out of
interstate branching within the specified time period, no bank in any other
state may establish a branch in the state which has opted out, whether through
an acquisition or de novo.
For
purposes of the Riegle-Neal Act’s amendments to the FDIA, Eurobank is treated as
a state bank and is subject to the same restrictions on interstate branching
as
other state banks. However, for purposes of the International Banking Act
of
1978, Eurobank is considered to be a foreign bank and may branch interstate
by
merger or de novo to the same extent as a domestic bank in Eurobank’s home
state. It is not yet possible to determine how these statutes will be
harmonized, with respect either to which federal agency will approve interstate
transactions or to which “home state” determination rules will
apply.
Eurobank
currently does not have any branches outside Puerto Rico.
Federal
Home Loan Bank System
The
FHLB
system, of which Eurobank is a member, consists of 12 regional FHLBs governed
and regulated by the Federal Housing Finance Board. The FHLBs serve as reserve
or credit facilities for member institutions within their assigned regions.
They
are funded primarily from proceeds derived from the sale of consolidated
obligations of the FHLB system. They make loans (i.e.,
advances) to members in accordance with policies and procedures established
by
the FHLB and the boards of directors of each regional FHLB.
As
a
system member, Eurobank is entitled to borrow from the FHLB of New York,
or
FHLB-NY, and is required to own capital stock in the FHLB-NY in an amount
equal
to the greater of 1% of the aggregate of the unpaid principal of its home
mortgage loans, home purchase contracts, and similar obligations at the
beginning of each fiscal year, which for this purpose is deemed to be not
less
than 30% of assets or 5% of the total amount of advances by the FHLB-NY to
Eurobank. Eurobank is in compliance with the stock ownership rules described
above with respect to such advances, commitments and letters of credit and
home
mortgage loans and similar obligations. All loans, advances and other extensions
of credit made by the FHLB-NY to Eurobank are secured by a portion of its
mortgage loan portfolio, certain other investments and the capital stock
of the
FHLB-NY held by Eurobank.
Mortgage
Banking Operations
Eurobank
is subject to the rules and regulations of FHA, VA, FNMA, FHLMC and GNMA
with
respect to originating, processing, selling and servicing mortgage loans
and the
issuance and sale of mortgage-backed securities. Those rules and regulations,
among other things, prohibit discrimination and establish underwriting
guidelines which include provisions for inspections and appraisals, require
credit reports on prospective borrowers and fix maximum loan amounts and,
with
respect to VA loans, fix maximum interest rates. Mortgage origination activities
are subject to, among others, the Equal Credit Opportunity Act, Federal
Truth-in-Lending Act and the Real Estate Settlement Procedures Act and the
regulations promulgated thereunder which, among other things, prohibit
discrimination and require the disclosure of certain basic information to
mortgagors concerning credit terms and settlement costs. Eurobank is also
subject to regulation by the Commissioner of Financial Institutions of Puerto
Rico, with respect to, among other things, the establishment of maximum
origination fees on certain types of mortgage loan products.
24
Puerto
Rico Regulation
As
a
commercial bank organized under the laws of Puerto Rico, Eurobank is subject
to
the supervision, examination and regulation
of the
Commissioner of Financial Institutions of Puerto Rico, pursuant to the Puerto
Rico Banking Act of 1933, as amended. Certain of those activities are described
in this “Supervision
and Regulation” section
above.
Puerto
Rico Banking Law
Section
12 of the Puerto Rico Banking Law requires the prior approval of the
Commissioner of Financial Institutions of Puerto Rico with respect to a transfer
of capital stock of a bank that results in a change of control of the bank.
Under Section 12, a change of control is presumed to occur if a person or
group
of persons acting in concert, directly or indirectly, acquires more than
5.0% of
the outstanding voting capital stock of the bank. The Commissioner of Financial
Institutions of Puerto Rico has interpreted the restrictions of Section 12
as
applying to acquisitions of voting securities of entities controlling a bank,
such as a bank holding company. Under the Puerto Rico Banking Law, the
determination of the Commissioner of Financial Institutions of Puerto Rico
whether to approve a change of control filing is final and non-
appealable.
Section
16 of the Puerto Rico Banking Law requires every bank to maintain a legal
reserve which shall not be less than 20% of its demand liabilities, except
government deposits (federal, state and municipal) which are secured by actual
collateral. The reserve is required to be composed of any of the following
securities or combination thereof: (1) legal tender of the United States;
(2)
checks on banks or trust companies located in any part of Puerto Rico, to
be
presented for collection during the day following that on which they are
received; (3) money deposited in other banks or depository institutions,
subject
to immediate collection; (4) federal funds sold to any Federal Reserve Bank
and
securities purchased under agreement to resell executed by the bank with
such
funds that are subject to be repaid to the bank on or before the close of
the
next business day and (5) any other asset that the Commissioner of Financial
Institutions of Puerto Rico determines from time to time.
Section
17 of the Puerto Rico Banking Law permits Puerto Rico commercial banks to
make
unsecured loans to any one person, firm, partnership or corporation, up to
an
aggregate amount of 15.0% the sum of (i) paid-in capital; (ii) reserve fund
of
the commercial bank; (iii) 50.0% of the commercial bank’s retained earnings and
(iv) any other components that the Commissioner of Financial Institutions
of
Puerto Rico may determine from time to time. As of December 31, 2006, the
legal
lending limit for Eurobank under this provision was approximately $14.6 million.
If such loans are secured by collateral worth at least 25.0% more than the
amount of the loan, the aggregate maximum amount may reach one-third of the
sum
of Eurobank’s paid-in capital, reserve fund, 50% of retained earnings and any
other components that the Commissioner of Financial Institutions of Puerto
Rico
may determine from time to time. As of December 31, 2006, the legal lending
limit for Eurobank under this provision was approximately $32.3 million.
There
are no restrictions under Section 17 of the Puerto Rico Banking Law on the
amount of loans which are fully secured by bonds, securities and other evidences
of indebtedness of the Government of the United States, of the Commonwealth
of
Puerto Rico, or by bonds, not in default, of authorities, instrumentalities
or
dependencies of the Commonwealth of Puerto Rico or its
municipalities.
Section
17 of the Puerto Rico Banking Law also prohibits Puerto Rico commercial banks
from making loans secured by their own stock and from purchasing their own
stock, unless such purchase is necessary to prevent losses because of a debt
previously contracted in good faith. The stock so purchased by the Puerto
Rico
commercial bank must be sold by the bank in a public or private sale within
one
year from the date of purchase.
Section
27 of the Puerto Rico Banking Law also requires that at least 10.0% of the
yearly net income of a Puerto Rico commercial bank be credited to a reserve
fund
until the amount deposited to the credit of the reserve fund is equal to
100.0%
of total paid-in capital (common and preferred) of the commercial bank. As
of
December 31, 2006, Eurobank had $7.6 million in its reserve fund.
Section
27 of the Puerto Rico Banking Law also provides that when the expenditures
of a
Puerto Rico commercial bank are greater than receipts, the excess of the
expenditures over receipts shall be charged against the undistributed profits
of
the bank, and the balance, if any, shall be charged against the reserve fund,
as
a reduction thereof. If there is no reserve fund sufficient to cover such
balance in whole or in part, the outstanding amount shall be charged against
the
capital account and no dividends shall be declared until said capital has
been
restored to its original amount and the reserve fund to 20% of the original
capital of the bank.
25
Section
14 of the Puerto Rico Banking Law authorizes Eurobank to conduct certain
financial and related activities directly or through subsidiaries, including
lease financing of personal property, operating small loans companies and
mortgage loans activities. In 2004, Eurobank organized an IBE subsidiary,
EBS
Overseas.
Puerto
Rico Usury Law
The
rate
of interest that Eurobank may charge on real estate and other types of loans
to
individuals in Puerto Rico is subject to Puerto Rico’s usury law. That law is
administered by the Finance Board, which consists of the Secretaries of the
Treasury, Commerce and Consumer Affairs Departments, the Commissioner of
Financial Institutions of Puerto Rico, the President of the Planning Board,
the
President of the Government Development Bank for Puerto Rico, the Secretary
of
Economic Development and Commerce Department and a representative of the
private
financial industry. The Finance Board promulgates regulations which specify
maximum rates on various types of loans to individuals and revises those
regulations periodically as general interest rates change.
Among
the
most important regulations enforced on interest rates are Regulations 5722,
5782
and 6070. Pursuant to Regulation 5782, there is no limitation on interest
rates
that may be charged on small personal loans. The same rule applies to retail
installment sale contracts and credit card loans as provided by Regulation
6070.
The rates on these loans are established as a result of the market and
competition.
Interest
rates that may be charged on personal loans, personal lines of credit, cash
advances on credit cards, commercial loans or commercial lines of credit
and
residential and commercial mortgage loans are not restricted by Regulation
5722.
The rates on these loans are established as a result of the market and
competition. Regulation 5722 does establish restrictions on prepayment penalties
and late charges for all loans, except commercial loans.
International
Banking Center Regulatory Act
In
2004,
we transferred all of the assets and liabilities of Eurobank International,
an
IBE that operated as a division of Eurobank, to an IBE subsidiary of Eurobank,
EBS Overseas, Inc. We also have an IBE that operates as a division of Eurobank
under the name EBS International Bank. This IBE was acquired under the name
of
BT International in connection with the acquisition of BankTrust and changed
to
EBS International Bank on September 27, 2005. We have continued to operate
EBS
International as a division of Eurobank and do not have immediate plans to
transfer its assets to our subsidiary, EBS Overseas, Inc.
The
business and operations of our IBEs are subject to supervision and regulation
by
the Commissioner of Financial Institutions of Puerto Rico. Under the IBE
Act, no
sale, encumbrance, assignment, merger, exchange or transfer of shares, interest
or participation in the capital of an IBE may be initiated without the prior
approval of the Commissioner of Financial Institutions of Puerto Rico, if
by
such transaction a person would acquire, directly or indirectly, control
of 10%
or more of any class of stock, interest or participation in the capital of
the
IBE. The IBE Act and the regulations issued thereunder by the Commissioner
of
Financial Institutions of Puerto Rico limit the business activities that
may be
carried out by an IBE. Such activities are limited in part to persons and
assets
located outside of Puerto Rico. The IBE Act provides further that every IBE
must
have not less than $300,000 of unencumbered assets or acceptable financial
guarantees.
Pursuant
to the IBE Act and the IBE regulations, our IBEs must maintain books and
records
of all their transactions in the ordinary course of business. The IBEs are
also
required to submit to the Commissioner of Financial Institutions of Puerto
Rico
quarterly and annual reports of their financial condition and results of
operations, including annual audited financial statements.
The
IBE
Act empowers the Commissioner of Financial Institutions of Puerto Rico to
revoke
or suspend, after notice and hearing, a license issued thereunder if, among
other things, the IBE fails to comply with the IBE Act, the IBE regulations
or
the terms of its license, or if the Commissioner of Financial Institutions
of
Puerto Rico finds that the business or affairs of the IBE are conducted in
a
manner that is not consistent with the public interest.
IBEs
generally are exempt from taxation under United States federal law and Puerto
Rico law. Recently, the Legislature of Puerto Rico and the Governor of Puerto
Rico approved a law amending the IBE Act. This law imposes income taxes at
normal statutory rates on each IBE that operates as a unit of a bank, if
the
IBE’s net income generated after December 31, 2003 exceeds 40% of the bank’s net
income in the taxable year commenced on July 1, 2003, 30% of the bank’s net
income in the taxable year commencing on July 1, 2004, and 20% of the bank’s net
income in the taxable year commencing on July 1, 2005, and thereafter. It
does
not impose income taxation on an IBE that operates as a subsidiary of a bank.
Thus, only EBS International Bank, which operates as a division of Eurobank
rather than a subsidiary, is impacted by the new law. However, we cannot
give
any assurance that the IBE Act will not be modified in the future in a manner
to
reduce the tax benefits available to EBS Overseas. A reduction of such tax
benefits may reduce our earnings.
26
EuroSeguros,
Inc.
EuroSeguros
is a wholly-owned subsidiary of EuroBancshares and is registered as a corporate
agent and general agency with the Office of the Commissioner of Insurance
of the
Commonwealth of Puerto Rico. EuroSeguros is subject to regulation by the
Commissioner of Insurance relating to, among other things, licensing of
employees, sales practices, charging of commissions and obligations to
customers.
Future
Legislation and Economic Policy
Management
of EuroBancshares and Eurobank cannot predict what other legislation or economic
and monetary policies of the various regulatory authorities might be enacted
or
adopted or what other regulations might be adopted or the effects thereof.
Future legislation and policies and the effects thereof might have a significant
influence on overall growth and distribution of loans, investments and deposits
and affect interest rates charged on loans or paid from time and savings
deposits. Such legislation and policies have had a significant effect on
the
operating results of commercial banks in the past and are expected to continue
to do so in the future.
Recent
Developments
On
March
13, 2007, Eurobank, the wholly-owned banking subsidiary of EuroBancshares,
Inc.,
and the Board of Directors of Eurobank executed and entered into, without
admitting or denying the allegations, a Stipulation and Consent Order (the
“Stipulation”) with the Federal Deposit Insurance Corp. (the “FDIC”) agreeing to
the issuance of a Cease and Desist Order (the “Order”). The Order, which was
issued by the FDIC on March 15, 2007, was based upon the findings of the
most
recent joint examination of the Bank by the FDIC and the Commonwealth of
Puerto
Rico Office of the Commissioner of Financial Institutions (the “Commonwealth”).
There were no fines or civil money penalties imposed on the Bank in connection
with the examination findings. The joint examination was concluded in October
2006 and the Bank signed the Stipulation on March 13, 2007.
The
findings set out in the joint Report of Examination concluded that the Bank
Secrecy Act/Anti-Money Laundering Program (“BSA Program”) at the Bank was
deficient based upon allegations of inadequate training for bank personnel,
an
inadequate system of independent testing for BSA compliance, failure to comply
with certain recordkeeping requirements, and failure to comply completely
with
the rules of the Office of Foreign Assets Control (“OFAC”). The Order contains
several Articles, each addressing a separate issue concerning the BSA Program
and its operation. The Order lays out the specific steps the Bank needs to
take
in order to bring the BSA Program back into compliance with the laws and
regulations, including, among others, requirements that the Bank: (i) perform
a
new risk assessment of the Bank’s operations; (ii) adopt and implement new
procedures for customer due diligence; (iii) amend its policies and procedures
for identifying and monitoring high-risk accounts; (iv) amend its procedures
for
monitoring currency transactions and wire transfers; (v) amend its policies
and
procedures for detecting and reporting suspicious activity; (vi) strengthen
its
Customer Identification Program procedures; and (vii) ensure that it has
the
necessary staffing, properly trained, to manage the BSA program. Each of
these
requirements and the various deadlines for remediation are described in more
detail in the Order.
In
response to the requirements of the Order, management and the Board of Directors
of the Bank are in the process of developing a corrective action plan that
is
designed to remediate the deficiencies alleged in the Order. As part of this
process, the Bank has engaged an independent, third party consultant to assist
with the development and implementation of its corrective action
plan.
27
ITEM
1A. Risk Factors.
Risks
Relating to Our Business
Our
decisions regarding credit risk could be inaccurate and our allowance for
loan
and lease losses may be inadequate, which could materially and adversely
affect
our business, financial condition, results of operations, cash flows and/or
future prospects.
Our
loan
and lease portfolio and investments in marketable securities subject us to
credit risk. Inherent risks in lending also include fluctuations in collateral
values and economic downturns. Making loans and leases is an essential element
of our business, and there is a risk that our loans and leases will not be
repaid.
We
attempt to maintain an appropriate allowance for loan and lease losses to
provide for losses inherent in our loan and lease portfolio. As of December
31,
2006, our allowance for loan and lease losses totaled $18.9 million, which
represents approximately 1.08% of our total loans and leases. There is no
precise method of predicting loan and lease losses, and therefore, we always
face the risk that charge-offs in future periods will exceed our allowance
for
loan and lease losses and that we would need to make additional provisions
to
our allowance for loan and lease losses.
Our
methodology for the determination of the adequacy of the allowance for loan
and
lease losses for impaired loans is based on classifications of loans and
leases
into various categories and the application of SFAS No. 114, as amended.
For
non-classified loans, the estimated allowance is based on historical loss
experiences as adjusted for changes in trends and conditions on an annual
basis.
In addition, on a quarterly basis, the estimated allowance for non-classified
loans is adjusted for the
probable effect that current environmental factors could have on the historical
loss factors currently in use.
While
our allowance for loan and lease losses is established in different portfolio
components, we maintain an allowance that we believe is sufficient to absorb
all
credit losses inherent in our portfolio.
In
addition, the FDIC as well as the Commissioner of Financial Institutions
of
Puerto Rico review our allowance for loan and lease losses and may require
us to
establish additional reserves. Additions to the allowance for loan and lease
losses will result in a decrease in our net earnings and capital and could
hinder our ability to grow our assets.
We
have a concentration of exposure to a number of individual borrowers and
a
significant loss on any one of these credits could materially affect our
financial condition and results of operations.
Under
applicable law, there are quantitative limitations on the amount of loans
we can
make to one borrower or a group of related borrowers. As of December 31,
2006,
our legal lending limit was approximately $14.6 million in the unsecured
category, and approximately $32.3 million in the secured category. As of
December 31, 2006, we had 14 individual borrowers with a loan principal balance
of more than $10.0 million per borrower and another 25 individual borrowers
with a loan principal balance of more than $5.0 million per borrower. Given
the size of these current outstanding loans relative to our capital levels
and
earnings, a significant loss on any one of these credits could materially
and
adversely affect our business, financial condition, results of operations,
cash
flows and/or future prospects.
A
significant portion of our leases are secured by automobiles, and the loss
of
purchasers for our leases or a downturn in automobile purchases could have
a
material adverse effect on our business, financial condition, results of
operations, cash flows and/or future prospects.
A
significant portion of our leases are secured by automobiles. As of December
31,
2006, the total amount of automobile leases was $432.6 million or 17.3% of
our total assets. We sometimes sell our leases to other financial institutions
in order to manage our lease financing concentration. The loss of purchasers
of
our leases could cause us to reduce our lease originations, reducing our
net
income. Alternatively, we may increase the portion of the leases that we
retain
for our portfolio with the result that our exposure to automobile leases
will
increase. In addition, a downturn in automobile purchases could have a material
adverse effect on our business, financial condition, results of operations,
cash
flows and/or future prospects.
28
We
rely heavily on short-term funding sources to meet our liquidity needs, such
as
brokered deposits and repurchase obligations, which are generally more sensitive
to changes in interest rates and can be adversely affected by local and general
economic conditions.
We
have
frequently utilized as a source of funds certificates of deposit obtained
through deposit brokers that solicit funds from their customers for deposit
with
us, or brokered deposits. Brokered deposits, when compared to retail deposits
attracted through a branch network, are generally more sensitive to changes
in
interest rates and volatility in the capital markets and could reduce our
net
interest spread and net interest margin. In addition, brokered deposit funding
sources may be more sensitive to significant changes in our financial condition.
As of December 31, 2006, brokered deposits amounted to $1.2 billion, or
approximately 64.35% of our total deposits, compared to brokered deposits
in the
amount of $967.2 million, or approximately 55.77% of our total deposits for
the
same period in 2005. Approximately $841.7 million of these brokered
deposits, or approximately 68.6% of our total brokered deposits, mature within
one year. Our ability to continue to acquire brokered deposits is subject
to our
ability to price these deposits at competitive levels, which may substantially
increase our funding costs, and the confidence of the market. In addition,
if
our capital ratios fall below the levels necessary to be considered
“well-capitalized” under current regulatory guidelines, we could be restricted
in using brokered deposits as a short-term funding source.
We
also
have borrowings in the form of repurchase obligations with the Federal Home
Loan
Bank, or the FHLB, and other broker-dealers. These agreements are collateralized
by some of our investment securities. As of December 31, 2006, our repurchase
obligations totaled $365.7 million, of which $206.4 million, or
approximately 56.4% of the total repurchase obligations, mature within one
year.
If we are unable to borrow in the form of repurchase obligations, we may
be
required to seek higher cost funding sources, which could materially and
adversely affect our net interest income.
We
have experienced rapid growth in recent years, and we may be unable to
successfully continue to implement our growth strategy, which may adversely
affect our business, financial condition, results of operations, cash flows
and/or future prospects.
Our
assets have grown rapidly in recent years. With the ultimate goal of increasing
net income, we have grown our assets from $1.0 billion as of December 31,
2002 to $2.5 billion as of December 31, 2006. The types of assets on our
balance sheet that have experienced the largest categorical increases are
commercial loans and lease financings. We have funded this growth, in part,
with
brokered deposits, FHLB advances, and other borrowings. These types of funds
are
generally more costly and volatile than traditional retail deposits.
We
may
not be able to sustain our current growth rate. Throughout our expansion,
we
have been successful in attracting new customers, expanding new services
to
existing customers, adding new business lines, engaging in acquisitions and
increasing our deposit base. We cannot assure you that we will be able to
continue this trend, and it will become more difficult to maintain sustained
growth as we increase in size. Our ability to implement our strategy for
continued growth depends on our ability to attract and retain customers in
a
highly competitive market, on the growth of those customers’ businesses, on
entering and expanding in lines of business in which we do not have significant
past experience or for which we have only recently added personnel with the
requisite experience, on our ability to continue to identify new acquisition
targets and on our ability to increase our deposit base. Many of these growth
prerequisites may be affected by circumstances that are beyond our control.
Our
inability to meet any of these growth prerequisites could have a material
adverse effect on our business, financial condition, results of operations,
cash
flows and/or future prospects.
We
rely heavily on our management team and the unexpected loss of key officers
could adversely affect our business, financial condition, results of operations,
cash flows and/or future prospects.
Our
success has been and will continue to be greatly influenced by our ability
to
retain the services of existing senior management and, as we expand, to attract
and retain qualified additional senior and middle management. Rafael
Arrillaga-Torréns, Jr., our President and Chief Executive Officer, has been
instrumental in managing our business affairs. Our other senior executive
officers have had, and will continue to have, a significant role in the
development and management of our business. The loss of the services of Mr.
Arrillaga-Torrens, Jr. or any of our other senior executive officers could
have
an adverse effect on our business, financial condition, results of operations,
cash flows and/or future prospects. We have not established a formal management
succession plan. Accordingly, should we lose the services of
Mr. Arrillaga-Torr’ens, Jr., our Board of Directors may have to search
outside of EuroBancshares for a qualified permanent replacement. This search
may
be prolonged and we cannot assure you that we will be able to locate and
hire a
qualified replacement. We do not maintain key man life insurance policies
on any
of our senior executive officers. We currently do not have any employment
agreements with our senior executive officers, with the exception of a Severance
Payment Agreement with Yadira R. Mercado, our Executive Vice President and
Chief
Financial Officer. If any of our senior executive officers leaves his or
her
respective position, our business, financial condition, results of operations,
cash flows and/or future prospects may suffer.
29
The
regulatory capital treatment of our junior subordinated debentures and related
trust preferred securities is uncertain.
Financial
holding companies with more than $500 million in assets, like us, must
maintain minimum capital ratios. In particular, we must maintain a leverage
ratio of Tier 1 capital to average assets of 5.0%; a Tier 1 risk-based
capital ratio of 6.0% of risk-weighted assets; and a total risk-based capital
ratio (Tier 1 and Tier 2 capital) of 10.0% of risk-weighted assets to
be considered “well-capitalized” for regulatory purposes. The Federal Reserve
Board’s current rules regarding the capital treatment of trust preferred
securities allow us to count trust preferred securities as Tier 1 capital
up to 25.0% of our total Tier 1 capital for regulatory purposes. The
remaining portion counts as Tier 2 capital.
On
March
1, 2005 the Federal Reserve Board adopted the final rule that allows the
continued limited inclusion of trust preferred securities in the Tier 1 capital
of bank holding companies (BHCs). Under the final rule, trust preferred
securities and other restricted core capital elements would be subject to
stricter quantitative limits. The Federal Reserve Board’s final rule limits
restricted core capital elements to 25% of all core capital elements, net
of
goodwill less any associated deferred tax liability. Amounts of restricted
core
capital elements in excess of these limits generally may be included in Tier
2
capital. The final rule provides a five-year transition period, ending March
31,
2009, for application of the quantitative limits. As of December 31, 2006,
we
had $20.0 million in trust preferred securities of which all counted as
Tier 1 capital.
A
determination by the Federal Reserve Board not to continue to allow the
inclusion of our junior subordinated debentures or the trust preferred
securities in Tier 1 capital, or otherwise limiting the inclusion of such
debentures or securities in Tier 1 capital, could have a material and
adverse impact on our regulatory capital levels and cause our capital ratios
to
fall below the levels necessary to be considered “well-capitalized” under
current regulatory guidelines. This could impact our ability to grow our
assets.
In addition, inadequate regulatory capital levels may result in the imposition
of certain operating restrictions on us and Eurobank, including restrictions
in
using brokered deposits as a short-term funding source.
Eurobank
has entered into a Cease and Desist Order with the FDIC regarding its compliance
with anti-money laundering laws and the Bank Secrecy Act.
On
March
13, 2007, the Board of Directors of Eurobank (the “Bank”), the wholly-owned
banking subsidiary of EuroBancshares, consented to the issuance of a Cease
and
Desist Order by the Federal Deposit Insurance Corporation based upon the
findings of the FDIC and the Commonwealth of Puerto Rico Office of the
Commissioner of Financial Institutions relating to deficiencies in the Bank’s
Bank Secrecy Act/Anti-Money Laundering Compliance Program. Under the terms
of
the FDIC order, the Bank is required to make specific improvements to its
anti-money laundering and BSA compliance activities. While Eurobank believes
that it will be able to implement effective compliance procedures necessary
to
remediate the deficiencies identified in the FDIC order, in the event that
Eurobank is unable to satisfy the requirements imposed by the FDIC order,
Eurobank may become subject to monetary fines and penalties as well as
additional restrictions on its banking operations, which could affect its
ability to execute certain aspects of its business plan. Such measures could
materially and adversely affect its business, financial condition, results
of
operations, cash flows and/or future prospects.
Risks
Relating to an Investment in Our Common Stock
Our
common stock has a short trading history and you may not be able to trade
our
common stock if an active trading market does not prevail. Additionally,
the
price of our common stock may fluctuate
significantly.
The
market price of our common stock may be subject to significant fluctuation
in
response to numerous factors, including variations in our annual or quarterly
financial results or those of our competitors, changes by financial research
analysts in their evaluation of our financial results or those of our
competitors, or our failure or that of our competitors to meet such estimates,
conditions in the economy in general or the banking industry in particular,
or
unfavorable publicity affecting us or the banking industry. In addition,
the
equity markets have, on occasion, experienced significant price and volume
fluctuations that have affected the market prices for many companies’ securities
and have been unrelated to the operating performance of those companies.
In
addition, the sale by any of our large stockholders of a significant portion
of
that stockholder’s holdings could have a material adverse effect on the market
price of our common stock. Further, the registration of any significant amount
of additional shares of our common stock will have the immediate effect of
increasing the public float of our common stock and any such increase may
cause
the market price of our common stock to decline or fluctuate significantly.
Any
such fluctuations may adversely affect the prevailing market price of the
common
stock.
30
Our
executive officers and directors own a significant number of shares of our
common stock, allowing management significant control over our corporate
affairs.
As
of
December 31, 2006, our executive officers and directors beneficially own
49.30%
of the outstanding shares of our common stock. Accordingly, these executive
officers and directors will be able to control, to a significant extent,
the
outcome of all matters required to be submitted to our stockholders for
approval, including decisions relating to the election of directors, the
determination of our day-to-day corporate and management policies and other
significant corporate transactions.
Your
share ownership may be diluted by the issuance of additional shares of our
common stock in the future.
Your
share ownership may be diluted by the issuance of additional shares of our
common stock in the future. First, we have adopted a stock option plan that
provides for the granting of stock options to our directors, executive officers
and other employees. As of December 31, 2006, 996,362 shares of our common
stock were issuable under options granted in connection with our stock option
plan. In addition, 621,200 shares of our common stock are reserved for
future issuance to directors, officers and employees under our stock option
plan. It is probable that the stock options will be exercised during their
respective terms if the fair market value of our common stock exceeds the
exercise price of the particular option. If the stock options are exercised,
your share ownership will be diluted.
In
addition, our amended and restated certificate of incorporation authorizes
the
issuance of up to 150,000,000 shares of common stock, but does not provide
for
preemptive rights to the holders of our common stock. Any authorized but
unissued shares are available for issuance by our Board of Directors. As
a
result, if we issue additional shares of common stock to raise additional
capital or for other corporate purposes, you may be unable to maintain your
pro
rata ownership in EuroBancshares.
Future
sales of common stock by existing stockholders may have an adverse impact
on the
market price of our common stock.
Sales
of
a substantial number of shares of our common stock in the public market,
or the
perception that large sales could occur, could cause the market price of
our
common stock to decline or limit our future ability to raise capital through
an
offering of equity securities. As of December 31, 2006, there were
19,123,821 shares of our common stock outstanding, which are freely
tradable without restriction or further registration under the federal
securities laws unless purchased by our “affiliates” within the meaning of
Rule 144 under the Securities Act.
Holders
of our junior subordinated debentures have rights that are senior to those
of
our stockholders.
On
December 19, 2002, we issued $20.6 million of floating rate junior
subordinated interest debentures in connection with a $20.0 million trust
preferred securities issuance by our subsidiary, Eurobank Statutory
Trust II. The 2002 junior subordinated debentures mature in 2032. The
purpose of this transaction was to raise additional capital to fund our
continued growth.
Payments
of the principal and interest on the trust preferred securities of Eurobank
Statutory Trust II are conditionally guaranteed by us. The 2002 junior
subordinated debentures are senior to our shares of common stock. As a result,
we must make payments on the junior subordinated debentures before any dividends
can be paid on our common stock and, in the event of our bankruptcy, dissolution
or liquidation, the holders of the junior subordinated debentures must be
satisfied before any distributions can be made on our common stock. We have
the
right to defer distributions on the 2002 junior subordinated debentures (and
the
related trust preferred securities) for up to five years, during which time
no
dividends may be paid on our common stock.
31
Holders
of our Series A Preferred Stock have rights senior to those of our common
stockholders.
In
connection with our acquisition of BankTrust, we issued 430,537 shares in
the
amount of $10.8 million of our Series A Preferred Stock to certain
stockholders of BankTrust in exchange for their shares of the Series A and
Series B preferred stock of BankTrust. Our Series A Preferred Stock
has rights and preferences that could adversely affect holders of our common
stock. For example, we generally are unable to declare and pay dividends
on our
common stock if there are any accrued and unpaid dividends on our Series A
Preferred Stock for the preceding twelve months. Additionally, upon any
voluntary or involuntary liquidation, dissolution, or winding up of our
business, the holders of our Series A Preferred Stock are entitled to
receive distributions out of our available assets before any distributions
can
be made to holders of our common stock.
Provisions
of our amended and restated certificate of incorporation and amended and
restated bylaws could delay or prevent a takeover of us by a third
party.
Our
amended and restated certificate of incorporation and amended and restated
bylaws could delay, defer or prevent a third party from acquiring us, despite
the possible benefit to our stockholders, or could otherwise adversely affect
the price of our common stock. For example, our bylaws contain advance notice
requirements for nominations for election to our Board of Directors and for
proposing matters that stockholders may act on at stockholder meetings. We
also
have a staggered board of directors, which means that only one-third of our
Board of Directors can be replaced by stockholders at any annual meeting.
We
currently do not intend to pay dividends on our common stock. In addition,
our
future ability to pay dividends is subject to restrictions. As a result,
capital
appreciation, if any, of our common stock will be your sole source of gains
for
the foreseeable future.
We
have
not historically and we currently do not intend to pay any dividends on our
common stock. In addition, since we are a financial holding company with
no
significant assets other than Eurobank, we have no material source of income
other than dividends that we receive from Eurobank. Therefore, our ability
to
pay dividends to our stockholders will depend on Eurobank’s ability to pay
dividends to us. Moreover, banks and bank holding companies are both subject
to
federal and Puerto Rico regulatory restrictions on the payment of cash
dividends. We intend to retain the earnings of Eurobank to support growth
and
build equity capital. Accordingly, you should not expect to receive dividends
from us in the foreseeable future.
We
are
also restricted from paying dividends on our common stock if we have deferred
payments of the interest on, or an event of default has occurred with respect
to, our junior subordinated debentures. In addition, we generally are unable
to
declare and pay dividends on our common stock if there are any accrued and
unpaid dividends on our Series A Preferred Stock for the preceding
12 months.
Your
shares are not an insured deposit.
Your
investment in our common stock will not be a bank deposit and will not be
insured or guaranteed by the FDIC or any other government agency. Your
investment will be subject to investment risk, and you must be capable of
affording the loss of your entire investment.
Risks
Relating to the Economic Environment
The
recent economic and government budget crisis in Puerto Rico could adversely
affect our business, financial condition, results of operations, cash flows
and/or future prospects.
Between
May 1 and May 17, 2006, Puerto Rico experienced a partial government shutdown
caused by the inability of the Legislature and Governor to agree on a budget,
which resulted in an estimated $740 million budget shortfall. This government
shutdown forced the closure of approximately 43 public agencies, including
Puerto Rico’s public schools, leaving an estimated 90,000 government employees
out of work. In response to this economic crisis, several bills were approved
by
the Puerto Rico legislature
to
impose additional taxes, some of which were applicable to the banking industry,
resulting in an increase in our effective tax rate. For more information
relating to additional taxes imposed to the banking industry, see the section
captioned “Provision
for Income Taxes”
in Item
7 - Management’s Discussion and Analysis of Financial Condition and Results of
Operations of this Annual Report on Form 10-K.
32
On
May
17, 2006, the Puerto Rico Legislature reached an agreement on the retail
sales
tax rate that was approved in July 2006 and the Government Development Bank
for
Puerto Rico granted a loan of up to $741 million to
the
Puerto Rico Department of the Treasury to cover payroll and operational expenses
of the Central Government. In addition, the
Government Development Bank for Puerto Rico
authorized the issuance of $675 million in General Obligation Bonds,
of
which
$173 million benefits the municipalities for public works and infrastructure,
and $316 million covers anticipations authorized for these public works.
As per
the Government
Development Bank for Puerto Rico,
this
millionaire investment will have an immediate effect on the local
economy.
In
July
4, 2006, the Commonwealth of Puerto Rico enacted legislation authorizing
a new
sales and use tax of up to 7%. The new sales and use tax is comprised of a
1.5% municipal tax, which some municipalities started collecting after the
approval of this law, and a 5.5% central government sales and use tax that
became effective as of November 15, 2006. This legislation also abrogated
the general excise tax on most imported and manufactured goods.
In
addition, the legislation mandates the establishment of measures to limit
spending and a controlled budget plan for fiscal 2007. These measures include
a
significant reduction in debt service due to the 1% of sales tax designated
for
debt service and restructuring of debt transactions, as well as a millionaire
reduction in non-debt service expenses by planned savings in the health and
education areas.
On
June
30, 2006, the Puerto Rico Planning Board (the “Planning Board”) revised its
growth forecasts for fiscal years 2006 and 2007. According to the revision,
the
Planning Board estimated the Puerto Rico’s Gross National Product (GNP) growth
rates for fiscal years 2006 and 2007 in 1.2% and 0.6% in real terms for the
base
case scenario, respectively, compared to 2.2% and 2.5% the Planning Board
forecasted in January 2006 for those same periods.
In
July
2006, Standard and Poor’s and Moody’s Investor Services (“Moody’s”) removed the
Commonwealth of Puerto Rico general obligations and public debt from their
“Watchlists.” As per the Government Development Bank for Puerto Rico, their
determination reflects the recent passage of legislation authorizing a retail
sales tax and mandating spending controls, as well as a balanced budget for
the
current fiscal year.
Although
these actions could represent an affirmative attempt to address the government’s
prolonged trend of budget and borrowings deficits, certain sectors believe
the
revenue yield of the sales tax could be lower than previously expected because
of tax exemptions included in the law. Also, these sectors believe the
government's plan to reduce expenditures heavily depends on debt restructuring
and health and education cuts, which could be in an early phase of
development.
An
economic downturn, such as this, could contribute to the deterioration of
the
quality of our loan and corporate bond portfolios. During an economic downturn,
affected borrowers may be less likely to repay interest and principal on
their
loans or bonds as scheduled. Moreover, the value of real estate or other
collateral that secures the loans and bonds could be adversely affected by
an
economic downturn. This would cause the number of foreclosures to increase
and,
therefore, decrease our ability to recover losses on such properties and
assets.
Risks
Related to United States Taxation
If
we or any of our subsidiaries are determined to be a passive foreign investment
company, U.S. holders of our stock could be subject to adverse tax
consequences.
If
we or
any of our subsidiaries are determined to be a passive foreign investment
company, known as a “PFIC”, U.S. holders could be subject to adverse United
States federal income tax consequences. Specifically, if either we or any
of our
subsidiaries are determined to be a PFIC for any taxable year, each
U.S. holder would generally be subject to taxation under special rules,
regardless of whether we or any of our subsidiaries remains a PFIC, with
respect
to (1) any “excess distribution” made by us to the U.S. holders during
that taxable year, and (2) any gain realized on the sale, pledge or other
disposition during that taxable year of our common stock or the stock of
the
subsidiary that was determined to be a PFIC. These rules could, in addition
to
other consequences, cause certain income otherwise classified as capital
gain to
be taxed at ordinary income rates or the highest rate of tax for ordinary
income
in the year to which it is allocated regardless of the U.S. holder’s particular
tax situation and cause the U.S. holder to be subject to an interest charge
on
the deemed deferred amount at the underpayment rate. “Excess distributions”
generally are any distributions received by the U.S. holder on the common
stock in a taxable year that exceed 125% of the average annual distributions
received by the U.S. holder in the three preceding taxable years, or the
U.S. holder’s holding period for the common stock, if shorter. We believe
that neither we nor any of our subsidiaries will be determined to be a PFIC
in
our current taxable year, and we expect to continue to conduct our affairs
in a
manner so that neither we nor any of our subsidiaries qualifies as a PFIC
in the
foreseeable future. However, we have not requested or received an opinion
from
our United States tax counsel as to whether we will be determined to be a
PFIC
in our current taxable year and we can give no assurance in this regard.
33
Repeal
of foreign personal holding company rules.
Prior
to
December 31, 2004, if we or any of our subsidiaries were classified as a
foreign
personal holding company, known as a “FPHC”, certain U.S. holders of our stock
could have been subject to adverse United States federal income tax
consequences. The 2004 American Jobs Creation Act repealed the foreign personal
holding company rules, effective for taxable years beginning after December
31,
2004, and for taxable years of U.S. shareholders with or within which the
taxable year of applicable foreign corporation ends. As a result, we are
not
subject to these rules for taxable years from 2005 going forward.
ITEM
1B. Unresolved Staff Comments.
None.
ITEM
2. Properties.
Our
principal offices, including the principal offices of the Bank, are located
in
our main office building at 270 Muñoz Rivera Avenue in San Juan, Puerto Rico.
On
February 6, 2007, Eurobank, our wholly-owned banking subsidiary, closed on
the
purchase of land and an office building to serve as our new headquarters.
The
property, which is located in San Juan, includes a 57,187 square foot office
building that will be used to consolidate our headquarter and administrative
operations. We anticipate that there may be a benefit from certain efficiencies
associated with centralizing these operations in one location.
The
purchase price for the property was $12,360,000. We are in the process of
renovating the space to conform to our needs, and expect to move in between
the
summer and December 2007.
Currently,
in addition to the main office, we operate at 27 locations. The following
is a
list of our operating locations:
Location
Lease
Expiration Date(1)
Owned
or Leased
Main
Office:
270
Muñoz Rivera Avenue
N/A
Owned(2)
San
Juan, Puerto Rico 00918
Departments
EuroLease
Credit, Accounting, Marketing and Human Resources:
Fourth
Floor
12/31/2007
Leased
270
Muñoz Rivera Avenue
San
Juan, Puerto Rico 00918
EuroLease:
State
Road #2, Km. 2.5
8/31/2007
Leased
Kennedy
Avenue
San
Juan, Puerto Rico 00920
EuroMortgage:
State
Road #190
5/31/2007
Leased
Lot
#1, Km. 0.7
La
Cerámica Industrial Park
Carolina,
Puerto Rico 00983
34
Location
Lease
Expiration Date(1)
Owned
or Leased
Compliance:
1302
Jesús T. Piñero Avenue
12/31/2011
Leased
San
Juan, Puerto Rico 00918
Credit
Administration, Security and MIS:
Old
Corona Building
4/30/2007
Leased
Building
#5, Second and Fifth Floor
Santurce,
Puerto Rico 00907
Operations:
Old
Corona Building
8/31/2007
Leased
Building
#5, Second Floor, Local #3
Santurce,
Puerto Rico 00907
Branches
Aguadilla
Branch
10/31/2006(3)
Leased
State
Road No. PR2, Km. 129.3
Aguadilla,
Puerto Rico 00603
Bayamón
Branch
9/30/2017
Leased
Comerío
Avenue, corner of Sierra Bayamón
Bayamón,
Puerto Rico 00961
Caguas
I Branch
5/31/2007
Leased
A-1
Muñoz Rivera Avenue
Caguas,
Puerto Rico 00725
Caguas
II Branch
6/30/2010
Leased
32
Acosta Street, corner of Ruiz Belvis
Caguas,
Puerto Rico 00725
Canóvanas
Branch
6/30/2025
Leased
Marginal
PR-3, Km. 20.3
Canóvanas,
Puerto Rico 00729
Carolina
Branch
9/30/2007
Leased
State
Road #190
Lot
#1, Km. 0.7
La
Cerámica Industrial Park
Carolina,
Puerto Rico 00983
Cidra
Branch
4/30/2006
Leased
Luis
Muñoz Rivera Street
corner
of José de Diego
Cidra,
Puerto Rico 00739
Condado
Branch
3/31/2009
Leased
1408
Magdalena Avenue
Santurce,
Puerto Rico 00907
Hatillo
Branch
11/30/2007
Leased
State
Road No. PR2, Km. 87.0
Hatillo,
Puerto Rico 00659
Hato
Rey Branch
N/A
Owned(2)
270
Muñoz Rivera Avenue
San
Juan, Puerto Rico 00918
35
Location
Lease
Expiration Date(1)
Owned
or Leased
Humacao
Branch
5/31/2026
Leased
Plaza
Mall Lot #3, State Road No. PR52
Corner
State Road No. PR3
Humacao,
Puerto Rico 00791
Luquillo
Branch
4/29/2006
Leased
State
Road No. PR3, Km. 36.2
Luquillo,
Puerto Rico 00773
Manatí
Branch
8/30/2011
Leased
State
Road No. PR2, Km. 49.5
Manatí,
Puerto Rico 00674
Ponce
Plaza Branch
12/31/2006
Leased
Mayor
Street, corner of Isabel Street
Ponce,
Puerto Rico 00731
Ponce
Hostos Branch
10/31/2008
Leased
26
Hostos Avenue
Ponce,
Puerto Rico 00731
Ponce
Morell Campos Branch
4/01/2011
Leased
State
Road #10, Km. 1.5
Ponce,
Puerto Rico 00731
Ponce
Marvesa Branch
Expired(4)
Leased
Marvesa
Building #100
La
Rambla
Ponce,
Puerto Rico 00731
Puerto
Nuevo Branch
12/31/2011
Leased
1302
Jesús T. Piñero
corner
de Diego Avenue
San
Juan, Puerto Rico 00921
San
Francisco Branch
4/30/2011
Leased
Villas
de San Francisco Shopping Center
85
de Diego Avenue
Río
Piedras, Puerto Rico 00927
San
Lorenzo Branch
8/01/2008
Leased
155
South Luis Muñoz Rivera Street
San
Lorenzo, Puerto Rico 00754
San
Patricio Branch
2/15/2010
Leased
San
Patricio Office Center
8
Tabonuco Street
Guaynabo,
Puerto Rico 00969
Villa
Palmera Branch
12/31/2008
Leased
Eduardo
Conde Avenue
corner
of Tapia Street
Santurce,
Puerto Rico 00915
Mayagüez
Branch
11/30/2025
Leased
State
Road No. PR2, Km. 153.2
Mayagüez,
Puerto Rico 00681
(1)
Most
of these leases have options for extensions. In addition, several
have
early termination clauses.
36
(2)
The
properties owned by EuroBancshares located at 270 Muñoz Rivera Avenue are
part of a 180,000 square foot commercial office building. EuroBancshares
owns a portion of the lobby area on the ground floor where it operates
a
branch, the mezzanine where it operates its trust business, and
also owns
the first floor of this office building where its headquarters
are
located. In addition, EuroBancshares also owns certain parking
spaces and
a portion of the common areas of this office
building.
(3)
The
Aguadilla Branch is currently under construction. Once the construction
is
finished, the lease term will be twenty years with an option to
extend the
contract for two additional terms of five years each. We started
operating
the branch in a trailer until construction is
finished.
(4)
The
lease at this location expired on January 1, 1997, but Eurobank
continues
to pay rent to the lessor on a month-to-month basis. Eurobank believes
that the lessor will not require Eurobank to vacate the premises
in the
immediate future.
ITEM
3. Legal
Proceedings.
From
time
to time, we and our subsidiaries are engaged in legal proceedings in the
ordinary course of business, none of which are currently
considered to have a material impact on our financial position or results
of
operation.
ITEM
4. Submission
of Matters to a Vote of Security Holders.
No
matters were submitted to a vote of security holders during the fourth quarter
of 2006.
PART
II
ITEM
5. Market
for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities.
Market
Information
Our
common stock began trading on August 11, 2004 and is listed on the NASDAQ
Global
Select Market under the symbol “EUBK”. Prior to that date, our common stock was
privately held and not listed on any public exchange or actively traded.
As of
February 28, 2007, there were 20,028,398 shares issued and 19,374,683
shares outstanding held by 353 stockholders of record, including all directors
and officers of EuroBancshares, Inc., excluding beneficial owners whose shares
are held in “street” name by securities broker-dealers or other nominees. The
number of beneficial owners is unknown to us at this time.
The
following table presents the high and low sales prices for our common stock
reported on the NASDAQ Global Select Market for the last two fiscal
years:
Quarter
Ended
High
Low
March
31, 2005
$
22.19
$
16.80
June
30, 2005
$
17.60
$
13.58
September
30, 2005
$
17.55
$
14.78
December
31, 2005
$
15.06
$
10.20
March
31, 2006
$
15.13
$
11.64
June
30, 2006
$
12.00
$
8.35
September
30, 2006
$
9.90
$
8.47
December
31, 2006
$
9.47
$
8.50
Dividends
We
have
not paid cash dividends historically, nor do we anticipate paying any cash
dividends on our common stock in the foreseeable future. Instead, we anticipate
that all of our earnings in the foreseeable future will be used for working
capital, to support our operations and to finance the growth and development
of
our business. Any future determination relating to dividend policy will be
made
at the discretion of our Board of Directors and will depend on a number of
factors, including our future earnings, capital requirements, financial
condition, future prospects and other factors that our Board of Directors
may
deem relevant.
37
As
a
holding company, we ultimately depend on Eurobank to provide funding for
our
noninterest expenses and dividends. Various banking laws applicable to Eurobank
limit the payment of dividends, management fees and other distributions by
Eurobank to us, and may therefore limit our ability to pay dividends on our
common stock. We are also restricted from paying dividends on our common
stock
if we have deferred payments of the interest, or if an event of default has
occurred, on our junior subordinated debentures. In addition, we generally
are
unable to declare and pay dividends on our common stock if there are any
accrued
and unpaid dividends on our Series A Preferred Stock for the preceding 12
months. For additional information, see the sections of this report captioned
“Supervision
and Regulation — EuroBancshares — Regulatory Restrictions on Dividends; Source
of Strength” and “Supervision and Regulation — Eurobank —
Dividends.”
Securities
Authorized for Issuance Under Equity Compensation Plans
Under
the
2005 Stock Option Plan, approved at the 2005 annual meeting held at the main
office of EuroBancshares on May 12, 2005, 700,000 shares of our common stock
have been reserved for issuance pursuant to the exercise of stock options
granted under the plan. As of December 31, 2006, 98,700 options to acquire
shares of our common stock have been granted under the 2005 Stock Option
Plan.
Since the 2005 Stock Options Plan was approved, no further options were
permitted to be issued under the 2002 Stock Option Plan.
The
following table presents information regarding our equity compensation plans
at
December 31, 2006:
Equity
Compensation Plan Information
Plan
Category
Number
of securities to be issued upon exercise of outstanding options,
warrants
and rights
(a)
Weighted-average
exercise price of outstanding options, warrants and
rights
(b)
Number
of securities remaining available for future issuance under equity
compensation plans (excluding securities reflected in column
(a))
(c)
Equity
compensation plans approved by security holders
2002
Stock Option Plan
984,362
$
7.21
—
2005
Stock Option Plan
78,800
14.17
621,200
ITEM
6. Selected
Financial Data.
We
derived our selected consolidated financial data as of and for each of the
years
in the five year period ended December 31, 2006 from our audited consolidated
financial statements and the notes thereto.
You
should read this information in conjunction with “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations”
and the
financial statements and the related notes included elsewhere in this Annual
Report. Results from past periods are not necessarily indicative of results
that
may be expected for any future period. Average balances have been computed
using
daily averages.
As
of or for the Year Ended December 31,
2006
2005
2004
2003
2002
(Dollars
in thousands, except per share data)
Income
Statement Data:
Total
interest income
$
162,146
$
133,233
$
95,394
$
64,949
$
49,756
Total
interest expense
95,363
64,936
41,481
31,922
25,124
Net
interest income
66,783
68,297
53,913
33,027
24,632
Provision
for loan and lease losses
16,903
12,775
7,100
6,451
3,354
Net
interest income after provision for loan
and lease losses
49,880
55,522
46,813
26,576
21,278
38
As
of or for the Year Ended December 31,
2006
2005
2004
2003
2002
(Dollars
in thousands, except per share data)
Noninterest
income:
Service
charges and other fees
8,476
9,069
8,057
5,456
4,331
Net
loss on non-hedging derivatives
-
(944
)
—
—
—
Gain
on sale of loans and leases, net
401
945
1,395
3,547
—
(Loss)
gain on sale of securities, net
(1,092
)
(301
)
—
707
—
Gain
(loss) on sale of other real estate owned and repossessed assets,
net
16
(1,040
)
(359
)
(663
)
(310
)
Total
noninterest income
7,801
7,729
9,093
9,047
4,021
Noninterest
expense:
Salaries
and benefits
17,507
14,727
11,111
8,867
6,731
Professional
fees
4,104
3,912
2,196
1,402
1,055
Other
noninterest expense
21,775
19,005
15,635
12,039
8,936
Total
noninterest expense
43,386
37,644
28,942
22,308
16,722
Income
before income taxes and extraordinary gain
14,295
25,607
26,964
13,315
8,577
Income
taxes
6,283
9,077
8,663
3,432
2,724
Extraordinary
gain(1)
—
—
4,419
—
1,081
Net
income
$
8,012
$
16,530
$
22,720
$
9,883
$
6,934
Common
Share Data:
Earnings
per common share — basic:
Income
before extraordinary gain
$
0.38
$
0.81
$
1.08
$
0.71
$
0.43
Extraordinary
gain
—
—
0.27
—
0.08
Net
income
0.38
0.81
1.35
0.71
0.51
Earnings
per common share — diluted:
Income
before extraordinary gain
0.37
0.78
1.04
0.69
0.42
Extraordinary
gain
—
—
0.26
—
0.08
Net
income
0.37
0.78
1.30
0.69
0.50
Cash
dividends declared
—
—
—
—
—
Book
value per common share
8.32
7.95
7.54
4.67
4.13
Common
shares outstanding at end of period
19,123,821
19,398,848
19,564,086
13,947,396
13,879,370
Average
diluted shares outstanding
19,657,559
20,277,799
17,152,261
14,234,168
13,724,248
Balance
Sheet Data (at end of period):
Total
assets
$
2,500,920
$
2,391,283
$
2,102,789
$
1,320,934
$
1,035,305
Investment
securities available-for-sale
535,159
627,080
555,482
324,938
145,795
Investment
securities held-to-maturity
38,433
42,471
49,504
—
—
Total
loans and leases, net of unearned
1,750,838
1,577,196
1,387,613
899,392
767,792
Allowance
for loan and lease losses
18,937
18,188
19,039
9,394
6,918
Deposits
1,905,356
1,734,128
1,409,036
984,549
843,045
Other
borrowings
394,991
475,712
520,206
264,616
127,963
Total
stockholders’ equity
169,878
164,967
158,302
65,075
57,335
Performance
Ratios:
Return
on average common stockholders’ equity(2)
5.19
%
10.70
%
18.67
%
16.50
%
11.45
%
Return
on average assets(3)
0.33
0.74
1.03
0.87
0.77
Net
interest margin(4)
2.86
3.29
3.29
3.15
3.57
Efficiency
ratio(5)
57.89
47.84
44.44
51.48
56.33
Loans
and leases to deposits
91.89
90.95
98.48
91.35
91.07
Asset
Quality Data:
Nonperforming
loans and leases
$
49,978
$
36,263
$
40,533
$
26,758
$
22,060
Other
real estate owned and repossessed assets
13,048
9,517
6,441
6,417
7,644
Total
nonperforming assets
63,026
45,780
46,974
33,175
29,704
Nonperforming
assets to total assets
2.52
%
1.91
%
2.23
%
2.51
%
2.87
%
Nonperforming
loans to total loans and leases
2.85
2.30
2.92
2.98
2.87
Allowance
for loan and lease losses to nonperforming loans
37.89
50.16
46.97
35.11
31.36
Allowance
for loan and lease losses to total loans
1.08
1.15
1.37
1.04
0.90
Net
charge-offs to average loans
0.97
0.92
0.69
0.47
0.51
39
As
of or for the Year Ended December 31,
2006
2005
2004
2003
2002
(Dollars
in thousands, except per share
data)
Capital
Ratios:
Leverage
ratio
7.92
%
9.35
%
9.91
%
6.76
%
7.93
%
Tier
1 risk-based capital
10.25
12.45
12.73
8.30
8.63
Total
risk-based capital
11.25
13.49
13.94
11.60
12.79
Tangible
common equity to tangible assets
6.44
6.91
7.54
4.93
5.54
(1)
Extraordinary
gains resulting from the negative goodwill on the acquisition of
BankTrust
and Banco Financiero in 2004 and 2002, respectively. The excess
of the
fair value of the assets acquired over the purchase price resulted
in a
negative goodwill of $5.7 million and 1.5 million, respectively.
The
negative goodwill of BankTrust was allocated between a $4.4 million
extraordinary gain, $670,000 of the fair value of intangible assets,
net
of their tax effect, and the $627,000 of the fair value of the
acquired
furniture, fixtures and equipment. The negative goodwill of Banco
Financiero was allocated between a $1.1 million extraordinary gain
and the
$456,000 of the fair value of the acquired furniture, fixtures
and
equipment.
(2)
Return
on average common equity is determined by dividing net income before
extraordinary gain by average common
equity.
(3)
Return
on average assets is determined by dividing net income before
extraordinary gain by average
assets.
(4)
Net
interest margin is determined by dividing net interest income (fully
taxable equivalent) by average interest-earning
assets.
(5)
The
efficiency ratio is determined by dividing total noninterest expense
by an
amount equal to net interest income (fully taxable equivalent)
plus
noninterest income.
ITEM
7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operation.
The
following discussion and analysis presents our consolidated financial condition
and results of operations for the years ended December 31, 2006, 2005 and
2004.
This discussion should be read together with the “Selected
Consolidated Financial Data,”
our
consolidated financial statements and the notes related thereto which appear
elsewhere in this Annual Report on Form 10-K.
Executive
Overview
Introduction
We
are a
diversified financial holding company headquartered in San Juan, Puerto Rico,
offering a broad array of financial services through our wholly owned banking
subsidiary, Eurobank, and our wholly owned insurance agency subsidiary,
EuroSeguros. As of December 31, 2006, we had, on a consolidated basis, total
assets of $2.5 billion, net loans and leases of $1.7 billion, total deposits
of
$1.9 billion, and stockholders’ equity of $169.9 million. We currently operate
through a network of 23 branch offices located throughout Puerto Rico. On
May 3, 2004, we acquired all of the capital stock of The Bank & Trust
of Puerto Rico, a commercial bank headquartered in San Juan, Puerto Rico.
On the
closing date, the estimated fair value of assets acquired was $522.0 million
and
the estimated fair value of the deposits and other liabilities assumed was
$492.9 million.
Over
the
past three years, we have experienced significant balance sheet growth. Our
management team has implemented a strategy of building our core banking
franchise by focusing on commercial loans, business transaction accounts,
our
lease financing business and acquisitions. We believe that this strategy
will
increase recurring revenue streams, enhance profitability, broaden our product
and service offerings and continue to build stockholder value.
In
2001
and 2002, we raised an aggregate of $46.4 million through the issuance of
junior
subordinated debentures in connection with trust preferred securities issuances.
In an effort to improve our net interest margin, on December 18, 2006, we
redeemed $25.8 million of floating rate junior subordinated deferrable interest
debentures bearing an interest rate of 8.99% at the time of redemption.
This
redemption resulted in the write-off of approximately $626,000 in unamortized
placement costs related to the redeemed trust preferred securities. For more
detail on notes payable to statutory trusts please refer to “Note
17 - Notes Payable to Statutory Trusts”
to our
consolidated financial statements. We
believe that remaining supplemental capital raised in connection with the
issuance of these securities will allow us to maintain our status as a
well-capitalized institution and to sustain our continued loan
growth.
40
We
completed our initial public offering in August 2004 in which we sold 3,450,000
shares of our common stock at the initial offering price of $14.00 per share.
In
September 2004, we sold an additional 517,500 shares in connection with the
exercise of the underwriters’ over-allotment option, also at the initial
offering price of $14.00 per share. The net proceeds that we received from
the
offering plus the exercise of the underwriters’ over-allotment option, after
deducting offering expenses, including underwriting discounts and commissions,
were approximately $50.1 million.
On
October 27, 2005, EuroBancshares’ Board of Directors announced the authorization
of a program to acquire shares of its common stock for an aggregate purchase
price of up to $10.0 million in open market purchases, block trades and
privately negotiated transactions over a period of one year, which expired
in
October 2006. Between November 2005 and May 2006, we purchased 652,027 shares
of
our common stock under the program.
On
November 18, 2005, we recorded 1,688 shares at a price of $12.95 per share
held
in treasury as a result of a payment in lieu of foreclosure from a former
customer.
2006
Key Performance Indicators
We
believe the following
were key
indicators of our performance and results of operations in 2006:
●
the
write-off of approximately $626,000 in unamortized placement costs
in 2006
related to the redemption of $25.8 million of floating rate junior
subordinated deferrable interest debentures on December 18,
2006;
●
our
net loss on sale of securities increased to $1.1 million in 2006,
representing a $791,000 increase, from $301,000 in
2005;
●
our
total revenue grew to $169.9 million in 2006, representing an increase
of
20.56%, from $141.0 million in 2005;
●
our
net interest margin and spread on a fully taxable equivalent basis
decreased to 2.86% and 2.33% in 2006, respectively, compared to
3.29% and
2.88% in 2005;
●
our
provision for loan and lease losses grew to $16.9 million in 2006,
representing an increase of 32.31%, from $12.8 million in 2005;
●
our
total noninterest expense grew to $43.4 million in 2006, representing
an
increase of 15.25%, from $37.6 million in
2005;
●
our
effective tax rate increased to 43.95% in 2006, from 35.45% in
2005;
●
our
total assets grew to $2.501 billion at the end of 2006, representing
an
increase of 4.58%, from $2.391 billion at the end of
2005;
●
our
net loans and leases grew to $1.732 billion at the end of 2006,
representing an increase of 11.09%, from $1.559 billion at the
end of
2005; and
●
our
total deposits grew to $1.905 billion at the end of 2006, representing
an
increase of 9.87%, from $1.734 billion at the end of
2005.
These
items, as well as other factors, resulted in a net income for 2006 of $8.0
million, compared to $16.5 million in 2005, or $0.37 per common share for
2006,
compared to $0.78 per common share for 2005, assuming dilution, and are
discussed in further detail throughout this “Management’s
Discussion and Analysis of Financial Condition and Results of Operations”
section
of this Annual Report on Form 10-K.
41
Critical
Accounting Policies
This
discussion and analysis of our financial condition and results of operations
is
based upon our financial statements, which have been prepared in accordance
with
generally accepted accounting principles in the United States. The preparation
of these consolidated financial statements requires management to make estimates
and judgments that affect the reported amounts of assets and liabilities,
revenues and expenses, and related disclosures of contingent assets and
liabilities at the date of our financial statements. Actual results may differ
from these estimates under different assumptions or conditions. The following
is
a description of our significant accounting policies used in the preparation
of
the accompanying consolidated financial statements.
Loans
and Allowance for Loan and Lease Losses
Loans
that management has the intent and ability to hold for the foreseeable future,
or until maturity or payoff, are reported at their outstanding unpaid principal
balances adjusted by any charge-offs, unearned finance charges, allowance
for
loan and lease losses, and net deferred nonrefundable fees or costs on
origination. The allowance for loan and lease losses is an estimate to provide
for probable collection losses in our loan and lease portfolio. Losses are
charged and recoveries are credited to the allowance account at the time
a loss
is incurred or a recovery is received. The allowance for loan and lease losses
amounted to $18.9 million, $18.2 million and $19.0 million as of December
31,
2006, 2005 and 2004, respectively. Losses charged to the allowance amounted
to
$18.8 million, $16.6 million and $10.5 million as of December 31, 2006, 2005
and
2004, respectively. Recoveries were credited to the allowance in the amounts
of
$2.6 million, $3.0 million and $2.1 million for those same periods,
respectively.
We
follow
a consistent procedural discipline and account for loan and lease loss
contingencies in accordance with Statement of Financial Accounting Standards
(SFAS) No. 5, Accounting for Contingencies, and SFAS No. 114, Accounting
by
Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting
by
Creditors for Impairment of a Loan — Income Recognition and
Disclosures.
To
mitigate any difference between estimates and actual results relative to
the
determination of the allowance for loan and lease losses, our loan review
department is specifically charged with reviewing monthly delinquency reports
to
determine if additional allowances are necessary. Delinquency reports and
analysis of the allowance for loan and lease losses are also provided to
senior
management and the Board of Directors on a monthly basis.
The
loan
review department evaluates significant changes in delinquency with regard
to a
particular loan portfolio to determine the potential for continuing trends,
and
loss projections are estimated and adjustments are made to the historical
loss
factor applied to that portfolio in connection with the calculation of loss
allowances. Portfolio performance is also monitored through the monthly
calculation of the percentage of non-performing loans to the total portfolio
outstanding. A significant change in this percentage may trigger a review
of the
portfolio and eventually lead to additional allowances. We also track the
ratio
of net charge-offs to total portfolio outstanding.
Our
methodology for the determination of the adequacy of the allowance for loan
and
lease losses for impaired loans is based on classifications of loans and
leases
into various categories and the application of SFAS No. 114. For non-classified
loans, the estimated allowance is based on historical loss experiences, which,
at least on an annual basis, are adjusted for changes in trends and conditions.
While our allowance for loan and lease losses is established in different
portfolio components, we maintain an allowance that we believe is sufficient
to
absorb all credit losses inherent in our portfolio.
As
a
result of increasing loss ratios experienced in the later part of 2005,
particularly with the Company’s auto lease portfolio, during the quarter ended
March 31, 2006, we made some revisions to our methodology for the determination
of the allowance for loan and lease losses to provide for more structured
and
timely monitoring of changes in loss trends and conditions. Additionally,
new
reports and analyses have been incorporated into our control process over
such
determination.
With
the
exception of the commercial loans pool and loans secured by real estate with
a
60% or lower loan-to-value, loans that are more than 90 days delinquent result
in an additional allowance. When commercial loans become 90 days delinquent,
each is subjected to full review by the loan review officer including, but
not
limited to, a review of financial statements, repayment ability and collateral
held. Depending on the review results, our allowance may be increased. In
connection with this review, the loan review officer will determine what
economic factors may have led to the change in the client’s ability to service
the obligation, and this in turn may result in an additional review of a
particular sector of the economy. For additional information relating to
how
each portion of the allowance for loan and lease losses is determined, see
the
section of this discussion and analysis captioned “Allowance
for Loan and Lease Losses.”
42
We
believe that our allowance for loan and lease losses is adequate; however,
regulatory agencies, including the Commissioner of Financial Institutions
of
Puerto Rico and the FDIC, as an integral part of their examination processes,
periodically review our allowance for loan and lease losses and may from
time to
time require us to reclassify our loans and leases or make additional provisions
to our allowance for loan and lease losses.
Other
Real Estate Owned and Repossessed Assets
Other
real estate owned, or OREO, and repossessed assets, normally obtained through
foreclosure or other workout situations, are initially recorded at the lower
of
net realizable value or book value at the date of foreclosure, establishing
a
new cost basis. Any resulting loss is charged to the allowance for loan and
lease losses. An appraisal of other real estate properties and valuation
of
repossessed assets is made periodically after its acquisition, and comparison
between the appraised value and the carrying value is performed. Additional
declines in value after acquisition, if any, are charged to current operations.
Other real estate owned amounted to $3.6 million, $1.5 million, and $2.9
million
as of December 31, 2006, 2005 and 2004, respectively.
Other
repossessed assets amounted to $9.4 million, $8.0 million, and $3.6 million
for
those same periods, respectively.
Other
repossessed assets are mainly comprised of vehicles from our leasing
operation.
For
additional information relating to the composition of other repossessed assets,
see the section of this discussion and analysis captioned “Nonperforming
Loans, Leases and Assets.”
During
the first quarter of 2006, we made certain refinements to our methodology
for
estimating net realizable value of vehicles upon repossession. We feel these
improvements in our estimation procedures, together with revisions in the
determination of the allowance for automobile lease losses, will result in
more
timely recognition of losses in our automobile lease portfolio and better
valuation of our repossessed vehicles.
During
the third quarter of 2006, we increased the valuation allowance of repossessed
vehicles in an effort to expedite the disposition of slow moving inventory.
This
new strategy resulted from management’s decision of being more aggressive on the
disposition of these units in the future in an effort to reduce the build-up
of
the inventory.
We
monitor the total loss ratio on sale of repossessed assets, which is determined
by dividing the sum of net charge offs, declines in value, repairs and the
gain
or loss on sale by the book value of repossessed assets sold. The total loss
ratio on sale of repossessed vehicles was 25.4%, 19.6% and 15.2% for the
years
ended December 31, 2006, 2005 and 2004, respectively. The increase in our
total
loss on the sale of repossessed vehicles as a percentage of the lease balance
at
the date of repossession for year 2006 was in part due to the sale of damaged
units previously charged-off as part of our strategy to aggressively dispose
of
deteriorated repossessed vehicles, but primarily to the deterioration of
our
leasing portfolio. The increase in this ratio for year 2005 was due in part
to
an increase in the size of our lease portfolio, which increased our volume
of
repossessed vehicles, and to portfolio deterioration primarily in the last
quarter of 2005.
For
the
year ended December 31, 2006, the total loss ratio on sale of repossessed
equipment was 51.2%, compared to 34.1% and 31.3% for the years ended December
31, 2005 and 2004, respectively. The increase in the total loss on sale of
repossessed equipment as a percentage of the lease balance at the date of
repossession for year 2006 was mainly due to the sale of damaged equipment
previously charged-off as part our strategy to aggressively dispose of
deteriorated repossessed equipment. The total loss ratio on sale of repossessed
equipment for 2005 remained relatively stable when compared to year
2004.
We
also
monitor the ratio of total loss on the leasing business to the average balance
of our leasing portfolio. This ratio is determined by dividing the sum of
net
charge offs, declines in value, repairs and the gain or loss on sale during
the
period by the average balance of the leasing portfolio. The total loss ratio
on
the leasing business was 2.40%, 1.81% and 1.31% for the years ended December
31,
2006, 2005 and 2004, respectively. The increase in our total loss on the
leases
business during 2006 was mainly due to the combined effect of portfolio
deterioration and a decrease in our lease portfolio to $443.3 million as
of
December 31,2006, from $487.9 million at the end of fiscal year 2005. The
increase in this ratio for 2005 was mainly due to portfolio deterioration
primarily in the last quarter of 2005. We have been closely monitoring the
lease
portfolio and have tightened underwriting standards in order to manage
delinquencies and possible future losses.
43
For
the
year ended December 31, 2006, the total loss ratio on sale of repossessed
boats
was 39.0%, compared to 49.6% and 48.7% for the years ended December 31, 2005,
and 2004, respectively. The boat financing portfolio amounted to $37.4 million,
$39.7 million and $45.8 million as of December 31, 2006, 2005 and 2004,
respectively. The decrease in the total loss ratio on sale of repossessed
boats
during 2006 was mainly due to the sale of five high profile boats, which
resulted in lower losses. The total loss ratio on sale of repossessed boats
for
2005 remained stable when compared to year 2004.
In
2006,
the total gain on sale of OREO totaled $454,000 over eleven properties sold
with
a book value of approximately $4.0 million, compared to a total loss of $581,000
over nine properties sold with a book value of approximately $3.9 million
in
2005, and a total loss of $37,000 in 2004 over three properties sold with
a book
value of approximately $724,000. The total gain on sale of OREO in 2006 included
a $362,000 gain from the sale of a real estate property during the second
quarter of 2006. The total loss on sale of OREO in 2005 included a total
loss of
$406,000 related to one real estate property sold in September
2005.
Results
of Operations as of and for the Years Ended December 31, 2006, 2005 and
2004
Net
Interest Income and Net Interest Margin
Net
interest income is the difference between interest income, principally from
loan, lease and investment securities portfolios, and interest expense,
principally on customer deposits and borrowings. Net interest income is our
principal source of earnings. Changes in net interest income result from
changes
in volume, spread and margin. Volume refers to the average dollar level of
interest-earning assets and interest-bearing liabilities. Spread refers to
the
difference between the average yield on interest-earning assets and the average
cost of interest-bearing liabilities. Margin refers to net interest income
divided by average interest-earning assets, and is influenced by the level
and
relative mix of interest-earning assets and interest-bearing
liabilities.
Net
interest income was $66.8 million during the year ended December 31, 2006,
compared to $68.3 million during the year ended December 31, 2005 and $53.9
million during the year ended December 31, 2004, representing a decrease
of $1.5
million, or 2.22%, in 2006 and an increase of $14.4 million, or 26.68%, in
2005.
The decrease in the net interest income during 2006 was due to increased
cost of
funds during 2006. The increase
in 2005 was mainly due to the combined result of increases in average
interest-earning assets and increased yields resulting from higher interest
rates.
Our net
interest margin decreased to 2.86% for the year ended December 31, 2006 and
remained at 3.29% for the year ended December 31, 2005, compared to year
ended
December 31, 2004. Our net interest spread decreased to 2.33% in 2006, from
2.88% in 2005 and 3.00% in 2004. These declines in the net interest margin
and
spread were primarily caused by the increase in the average cost of interest
bearing liabilities as a result of: (i) the rising short-term interest rates
and
the inverted yield curve, which caused short term borrowing costs to increase
at
a faster rate than the yield on earning-assets; and (ii) the increase in
average
deposits has been comprised substantially of brokered deposits and higher
rate
time deposits driven by the extremely competitive local environment. In
addition, during 2006, our net interest margin and spread were also affected
by
the write-off of $626,000 in unamortized placement costs related to the
redemption of $25.8 million of floating rate junior subordinated deferrable
interest debentures, as previously mentioned. Without the effect of the
write-off of $626,000 in unamortized placement costs, net interest margin
and
spread on a fully taxable equivalent basis would have been 2.89% and 2.36%
for
the year ended December 31, 2006, respectively.
Our
average interest-earning assets were $2.3 billion in 2006, compared to
$2.2 billion in 2005 and $1.7 billion in 2004, representing increases of
8.84% in 2006 and 26.8% in 2005. Average net loans were $1.6 billion in 2006,
compared to $1.5 billion in 2005 and $1.2 billion in 2004,
representing increases of 11.79% and 22.5% in 2006 and 2005, respectively.
Total
interest income increased by 21.70% to $162.1 million in 2006, compared to
$133.2 million in 2005, after increasing by 39.67% from $95.4 million in
2004.
These increases in our interest income were mainly due to the organic growth
of
our loan portfolio. The average interest yield we received for interest-earning
assets increased to 7.53% in 2006, from 6.69% in 2005, and from 5.90% in
2004.
Between 2006 and 2004, the Federal Reserve Board’s interest rate raises
positively impacted average yields on our commercial and construction loans
since a significant portion of these portfolios were variable rate loans.
As of
December 31, 2006, approximately 74.68% and 86.62% of our commercial and
construction loans, respectively, were variable rate loans.
Average
interest-bearing liabilities also increased by 9.69% to $2.1 billion in 2006,
compared to $1.9 billion in 2005, after increasing by 26.1% from $1.5
billion in 2004. Total interest expense increased by 46.86% to $95.4 million
in
2006, compared to $64.9 million in 2005, after increasing by 56.5% from $41.5
million in 2004. During
2006 and 2005, the increase in average liabilities had been substantially
in
brokered deposits, higher rate time deposits driven by the extremely competitive
local environment, and other borrowings, all of which are higher cost categories
resulting in increased interest expense.
The
average interest rate we paid for interest-bearing liabilities increased
to
5.20% in 2006, from 3.81% in 2005, and from 2.90% in 2004.
44
The
following tables set forth, for the periods indicated, our average balances
of
assets, liabilities and stockholders’ equity, in addition to the major
components of net interest income and our net interest margin. Net loans
and
leases shown on these tables include nonaccrual loans although interest accrued
but not collected on these loans is placed in nonaccrual status and reversed
against interest income.
Year
Ended December 31,
2006
2005
2004
Average
Balance
Interest
Average
Rate/
Yield(1)
Average
Balance
Interest
Average
Rate/
Yield(1)
Average
Balance
Interest
Average
Rate/
Yield(1)
(Dollars
in thousands)
ASSETS:
Interest-earning
assets:
Net
loans and leases(2)
$
1,643,587
$
130,003
8.00
%
$
1,470,256
$
107,971
7.41
%
$
1,200,445
$
82,790
6.94
%
Securities
of U.S. government agencies(3)
604,606
27,137
6.45
600,461
21,795
5.14
433,456
11,180
3.53
Other
investment securities(3)
46,083
2,296
7.03
38,811
1,726
6.12
18,116
602
4.34
Puerto
Rico government obligations(3)
9,397
412
6.29
8,783
352
5.67
7,515
306
5.66
Securities
purchased under agreements to resell and federal funds
sold
