Popular 10-K 2011
Documents found in this filing:
Annual Report 2010 Informe Anual
Annual Report 2010 Informe Anual
Popular, Inc. (NASDAQ:BPOP) is a full service financial provider based in Puerto Rico with operations in Puerto Rico and the United States. Popular is the leading banking institution by both assets and deposits in Puerto Rico, and ranks 35th in assets among U.S. banks. With 193 branches in Puerto Rico, Popular offers retail and commercial banking services, as well as auto and equipment leasing and financing, mortgage loans, investment banking and broker-dealer services. In the United States, Popular has established a community-banking franchise providing a broad range of financial services and products with branches in New York, New Jersey, Illinois, Florida and California.
Popular, Inc. (NASDAQ: BPOP) es un proveedor financiero de servicio completo con base en Puerto Rico y operaciones en Puerto Rico y los Estados Unidos continentales. En Puerto Rico es la institución bancaria líder tanto en activos como en depósitos, y está clasificada como la 35ta en activos entre los bancos estadounidenses. Con 193 sucursales en Puerto Rico, ofrece servicios bancarios a individuos y comerciales, así como arrendamiento y financiamiento de autos y equipo, préstamos hipotecarios, banca de inversión y transacciones de corredores de valores. En los Estados Unidos, Popular ha establecido una franquicia bancaria de base comunitaria mediante la cual provee una amplia gama de servicios y productos financieros, con sucursales en Nueva York, Nueva Jersey, Illinois, Florida y California.
POPULAR, INC. 2010 ANNUAL REPORT 1
letter to SHAREHOLDERS
I am pleased to report that Popular rose above significant challenges and ended 2010 in a considerably stronger position than the year before. We built up our capital base, further solidified our leadership position in Puerto Rico, and continued making progress in the restructuring of our operations in the United States.
2010 KEY EVENTS
In the context of a potential FDIC-driven consolidation process in Puerto Rico, we successfully completed a public offering in April, raising a total of $1.15 billion at a price equivalent to $3 per common share. This capital raise, along with the gain generated by the sale of a majority stake in EVERTEC, substantially strengthened all of our capital ratios. These transactions placed us in a position to participate in the consolidation of the Puerto Rico banking market and allowed us to pursue strategies to improve the overall credit quality of our loan portfolio, such as the reclassification and sale of high-risk portfolios.
ACQUISITION OF WESTERNBANK
The closing by the Office of the Commissioner of Financial Institutions, together with the FDIC, of three banks in Puerto Rico, which at the time accounted for 20% of assets in the market, significantly altered the local banking landscape. In what turned out to be the largest FDIC-assisted transaction in 2010, Popular acquired approximately $9 billion in assets and assumed approximately $2.4 billion in deposits. This transaction provided Banco Popular Puerto Rico with a substantial amount of incremental assets with a low level of credit risk since the FDIC reimburses Popular for 80% of the losses incurred on acquired loans. In addition, it further enhanced our leadership position on the island, which as of September 2010, boasted a deposit market share, excluding brokered deposits, of 42% and a loan market share of 32%.
SALE OF EVERTEC
As part of our capital plan, early in the year we launched a process to sell all or a majority interest in EVERTEC. In June, we signed an agreement to sell a 51% interest to Apollo Management. The transaction, which closed in September and valued EVERTEC at approximately $870 million, generated a net gain of $531 million. This was a difficult decision, as this company, this group of colleagues, had grown from within our organization. But the sale was necessary to accomplish other important objectives.
WE ARE PROUD OF EVERTEC AND ITS EVOLUTION, AND WE ARE EXTREMELY SATISFIED WITH THE TRANSACTION, WHICH ALLOWED US TO RETAIN SIGNIFICANT OWNERSHIP.
As both Apollos partner and EVERTECs largest client, we look forward to participating in the new ventures growth and success.
RECLASSIFICATION OF LOAN PORTFOLIOS FOR FUTURE SALE
With the objective of reducing credit risk in our balance sheet, in December of 2010 we reclassified approximately $1 billion of loans as held-for-sale with the intent of selling them in the coming months. In Puerto Rico, the reclassification involved approximately $603 million of construction and commercial real estate loans. In January of 2011, we signed a non-binding letter of intent to sell the majority of the reclassified loans. In the United States, we reclassified approximately $396 million of U.S. non-conforming residential mortgages and are actively pursuing several potential sale alternatives. While the reclassification of these portfolios involved marking these loans to market, with a combined incremental provision expense of $176 million, the sale of these assets will substantially reduce non-performing assets in our books and will allow us to refocus the organization and redeploy resources to generate new business.
2 POPULAR, INC. 2010 ANNUAL REPORT
letter to SHAREHOLDERS
FINANCIAL RESULTS AND STOCK PERFORMANCE
POPULAR ACHIEVED A NET INCOME OF $137.4 MILLION IN 2010 COMPARED TO A NET LOSS OF $573.9 MILLION IN 2009.
The results for 2010 include $531 million from the gain on the sale of a majority interest in EVERTEC, as well as additional income from the Westernbank operations acquired in April 2010, partially offset by $176 million in charges related to the reclassification of several portfolios to loans held-for-sale, among other items.
While credit remained the critical issue in 2010, for the first time in five years, we saw signs of stabilization. The provision for loan losses in 2010 totaled $1.0 billion, compared to $1.4 billion in 2009. Excluding the impact of the expense related to the reclassification of various portfolios to held-for-sale, the provision was 41% lower than 2009.
Our stock price closed 2010 at $3.14. While it does not change the fact that our stock lost 85% of its value in the last five years, 2010 was the first year since 2004 that the stock had a year-to-year positive performance. With a 39% gain, BPOP outperformed the S&P 500 and Keefe Bank Indices, as well as our peer institutions in the U.S. and all banks in Puerto Rico.
BANCO POPULAR PUERTO RICO
DURING 2010, BANCO POPULAR PUERTO RICO (BPPR) FOCUSED MOST OF ITS EFFORTS ON INTEGRATING WESTERNBANKS OPERATIONS AND MANAGING CREDIT QUALITY.
During 2010, BPPR acquired approximately $9 billion in loans and assumed approximately $2.4 billion in deposits. An acquisition of this magnitude normally requires significant attention, but the limited time frame and the complexities related to an FDIC-assisted transaction, demanded even more resources in order to guarantee a smooth transition. I am pleased to report that we completed the system and branch conversion in just four months after the acquisition, leveraging our infrastructure to generate significant synergies.
WE ADDED TWELVE BRANCHES TO OUR NETWORK AND RETAINED APPROXIMATELY 57% OF WESTERNBANKS EMPLOYEES. OUR HEADCOUNT IN BPPR IS PRACTICALLY AT THE SAME LEVEL IT WAS IN 2007, WHILE ASSETS HAVE INCREASED BY 8% IN THE SAME PERIOD.
The Westernbank acquisition also offers many opportunities to grow our business moving forward. Westernbank had approximately 240,000 clients, 140,000 of which did not have a relationship with Popular at the time of the transaction. Furthermore, the majority only had one banking relationship with Westernbank, which translates into great cross-selling possibilities for us. As of year-end, we had retained more than 90% of the incoming clients, and we are offering the entire array of Populars products, services and channels to expand our relationship with them.
The protracted recession in the Puerto Rican economy continued to have a negative impact on BPPRs credit quality during 2010. Net charge-offs totaled $680 million, an increase of 33% when compared to the previous year, including $153 million related to the decision to promptly charge-off the previously reserved impaired amounts of collateral dependent loans. Higher net charge-offs in the construction, commercial and mortgage portfolios were partially offset by an improvement in the consumer portfolio. Non-performing loans held for investment reached $1.1 billion at the end of 2010, 25% lower than 2009. This decrease was mainly due to the previously discussed reclassification of approximately $603 million of loans as held for sale, most of them in non-accruing status, as well as the charge-off of impaired collateral dependent loans mentioned above.
The groups in charge of managing credit quality have worked diligently to minimize losses. The commercial credit unit aimed for the early detection of problem loans and the timely transfer to a specialized group that develops
We work hand-in-hand with our communities. We are committed to actively promote the social and economic well-being of our communities.
We develop life-long relationships. Our relationship with the customer takes precedence over any particular transaction. We add value to each interaction by offering high quality personalized service, and efficient and innovative solutions.
We live up to the trust placed in us. We adhere to the strictest ethical and moral standards through our daily decisions and actions.
BPPRS FUNDAMENTALS REMAIN AS STRONG AS EVER, IF NOT MORE SO. AS THE LEADING BANKING FRANCHISE IN PUERTO RICO, WE ARE WELL-POSITIONED TO BENEFIT FROM THE EVENTUAL STABILIZATION OF THE ECONOMY. WE INTEND TO CAPITALIZE ON THESE STRENGTHS TO INCREASE OUR SHARE OF THE MARKET THROUGH A RENEWED FOCUS ON CUSTOMER SERVICE AND EFFICIENCY.
individual action plans for each loan it receives. The construction loan team continued working on accelerating absorption rates through aggressive marketing and sales initiatives and joined forces with Popular Mortgage to take advantage of the housing incentives introduced by the P.R. government in the latter part of the year. The consumer loss mitigation group implemented a more customer-oriented strategy, improving its facilities and creating a dedicated call center.
BPPR registered a net income of $47 million in 2010, compared to net income of $158 million in 2009. This reduction is mostly due to a persistently high provision for loan losses, as well as a gain of $228 million in the sale of securities registered in 2009. However, we are confident that the future sale of the reclassified portfolio, as well as the efforts to manage the quality of the loans on our books, will result in a better credit performance in 2011, lessening its pressure on our results.
BPPRs fundamentals remain as strong as ever, if not more so. As the leading banking franchise in Puerto Rico, we are well-positioned to benefit from the eventual stabilization of the economy. We intend to capitalize on these strengths to increase our share of the market through a renewed focus on customer service and efficiency.
BANCO POPULAR NORTH AMERICA
BANCO POPULAR NORTH AMERICA (BPNA) CLOSED 2010 WITH A NET LOSS OF $340 MILLION. THOUGH STILL FAR FROM WHERE WE NEED BPNA TO BE, THIS WAS A SIGNIFICANT IMPROVEMENT OVER THE $726 MILLION NET LOSS REGISTERED IN 2009.
The reduction in the net loss was driven by a lower provision for loan losses due to a general improvement in credit quality, partially offset by the impact of several transactions completed at year-end. First, in order to pursue the sale of the riskier portion of our non-conforming residential mortgage portfolio, we reclassified approximately $396 million in loans to held-for-sale, which resulted in an additional provision expense of $120 million. In addition, we terminated approximately $417 million in high-cost borrowings, incurring approximately $22 million in prepayment penalties. Even though these transactions had a significant impact in 2010, BPNA should benefit in the future from lower funding costs and an improvement in credit quality.
BPNA CONTINUED THE IMPLEMENTATION OF THE PLAN ANNOUNCED IN LATE 2008 THAT SEEKS TO FOCUS EFFORTS AND RESOURCES ON THE CORE COMMUNITY BANKING BUSINESS.
As part of the branch network optimization effort, we completed five additional branch consolidations in 2010, bringing the total number of branches from 147 in 2007 to 96 by the end of 2010. To expand our customers free access to ATMs, we signed an agreement with Allpoint, a surcharge-free network, which has more than 40,000 ATMs nationwide. We also upgraded our Internet banking service, presenting a more user-friendly layout, improving navigation and adding capabilities such as the ability to open transactional accounts and CDs online. Just seven months after its launch, the number of active users of our Internet platform increased by 19%. We continued expanding our product offering with the introduction of two segment-oriented credit cards, leveraging Banco Popular Puerto Ricos extensive expertise in this area.
On the commercial and construction loan side, 2010 signaled the reversal of the severe deterioration in credit quality that started in 2006. Non-performing held-for-investment loans in these categories declined by 28% during the year and net charge-offs would have been in line with those in 2009 if not for the decision to accelerate the charge-off of previously reserved impaired amounts of collateral dependent loans. Similar to the rest of the industry, organic loan growth has been challenging due to reduced demand. As a result of last years reduction, BPNAs commercial and construction loan portfolio declined by 19%, although 60% of the reduction came from those business segments we discontinued as part of the restructuring plan.
We strive to excel each day. We believe there is only one way to do things: doing them right from the first time while exceeding expectations.
We are a driving force for progress. We foster a constant search for innovative ideas and solutions in everything we do, thus enhancing our competitive advantage.
We have the best talent. We are leaders and work together as a team in a caring and disciplined environment.
We are fully committed to our shareholders. We aim to attain a high level of efficiency, both individually and as a team, to achieve superior and consistent financial results based on a long-term vision.
4 POPULAR, INC. 2010 ANNUAL REPORT
letter to SHAREHOLDERS
One of the most significant events of the year was the rebranding of the Banco Popular North America franchise in the Illinois region. The strategy and the new name, Popular Community Bank, seeks to present non-Hispanic customers with a more inclusive and welcoming proposition while maintaining the strong legacy that Popular has within the Hispanic market. Launched in August, the rebranding pilot was supported by branch improvements, a new corporate attire for our employees and an advertising campaign. Initial results have been encouraging, reflecting an increase in business from non-Hispanic customers. We will continue monitoring results to decide on a potential rollout to other regions.
Convinced that our efforts in the U.S. would benefit greatly from a stronger and more unified management team, in September we named Carlos J. Vázquez President of Banco Popular North America. Carlos, who at the time was the head of the Puerto Rico Consumer Lending Group in Puerto Rico, had also been leading the Retail Banking Operations at BPNA. As expected, Carlos hit the ground running, leading the efforts mentioned above and providing the BPNA team with the energy and direction necessary to continue the successful implementation of our restructuring plan to return BPNA to profitable levels as soon as possible.
In 2010, Ignacio Álvarez joined Popular as General Counsel. Bringing with him extensive experience in banking, corporate finance and securities law, Ignacio has been a great addition to our senior management team. In May, David H. Chafey, Jr. concluded his career at Popular. We thank him his many years of service to our organization.
THE ACHIEVEMENTS I HAVE SHARED WITH YOU ARE THE DIRECT RESULT OF THE WORK OF 8,277 DEDICATED EMPLOYEES WHO THROUGHOUT THE YEAR WENT ABOVE AND BEYOND THE CALL OF DUTY FOR THE BENEFIT OF THE ORGANIZATION.
I also want to express my gratitude to our Board of Directors for its invaluable contribution. There is much talk about corporate governance, and standards and rules abound. But for me, the true test of sound corporate governance is when, in difficult times, a Board strikes the right balance between guidance and support. Popular is blessed to have a Board that has continuously struck this balance throughout these critical years. A very special member of our Board, Frederic V. Salerno, will not run for reelection in 2011 in order to devote more time to other professional responsibilities. Fred has been an integral part of our Board since he became a member in 2003 performing important roles such as Lead Director and Chairman of the Audit Committee with great skill, remarkable dedication and unquestionable integrity. Even though his experience, guidance and camaraderie will be missed by other Board members and management, Fred will always remain a close friend of Popular. The Corporate Governance and Nominating Committee of the Board commenced the process of identifying a new nominee, while William J. Teuber, who has been a Board member since 2004 will assume the role of Lead Director.
There are still challenges ahead, including limited economic growth in our principal markets, the impact of new banking regulations and increased competition as the Puerto Rico banking market recovers from 2010 difficulties. However, we are confident that, given the steps taken in 2010 and our strategies for 2011, Popular is well-positioned to reach operational profitability in 2011. With continued optimism and renewed strength, we will work relentlessly to achieve it.
RICHARD L. CARRIÓN
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
2010 highlights KEYFACTS & FIGURES
35th largest bank holding company in the U.S.1 with $38.7 billion in assets and 8,277 employees
6 POPULAR, INC. 2010 ANNUAL REPORT
a legacy OF CARING
SINCE ITS FOUNDATION 117 YEARS AGO, POPULAR HAS DEMONSTRATED A SOLID COMMITMENT TO THE COMMUNITIES IT SERVES. FIRMLY GUIDED BY OUR VALUES, WE CONTRIBUTE IN NUMEROUS WAYS TO ENHANCE THE QUALITY OF LIFE OF THOUSANDS OF PEOPLE. IN 2010, POPULAR EXPANDED ITS OUTREACH FOR SOCIAL DEVELOPMENT THROUGH COLLABORATIVE EFFORTS AND ALLIANCES WITH OTHER ORGANIZATIONS.
Fundación Banco Popular supports non-profit organizations focused on improving the quality of education that students receive and on the social and economic development of our communities. In 2010, the Fundación invested $1,444,883 in support of 73 organizations in Puerto Rico. In the U.S., Banco Popular Foundation invested $116,350 in support of 27 non-profit organizations.
In an effort to multiply our individual impact on education non-profits, the Fundación joined three other local foundations and Hispanics in Philanthropy to create the Puerto Rico Donors Education Collaborative. The PRDEC is the first collaborative fund created in Puerto Rico to maximize available resources and donations for non-profit organizations working in the education area. In 2010, the PRDEC awarded $320,000 to seven local organizations.
In 2010, the Fundación contributed $321,200 in scholarships to 122 students through the Rafael Carrión Jr. Scholarship Fund, a scholarship program for children of Popular employees. Other educational programs include endowed scholarships for Puerto Rican students in seven colleges and universities and the Rafael Carrión Jr. Academic Excellence Award that granted $56,250 to 75 high school seniors.
ARTS AND MUSIC
Fundación Banco Popular promotes arts and music as an integral part of student education. Since 2008, Fundación joins the local firm Méndez & Co. every year in the Berklee in Puerto Rico program conducted by faculty members of the renowned Berklee College of Music. In 2010, more than 150 students received music classes during the week-long workshop.
For the fifth consecutive year, the Fundación Banco Popular and the Luis A. Ferré Foundation sponsored the Revive the Music project, which promotes music education for children and youngsters. This program serves as a platform to develop music talent through the donation of instruments, community concerts, workshops and concerts with well-known Puerto Rican musicians for the benefit of the participants and the general public.
Employee involvement goes well beyond monetary contributions. In the U.S., over 650 BPNA employees volunteered 2,800 hours of community service during 2010s Make a Difference Day benefiting 32 non-profit organizations. In Puerto Rico, the My School in Your Hands project alone counted with the support of 1,600 Popular employees who helped paint and refurbish 70 public schools that serve over 18,000 students.
The generosity of Popular employees is also manifested each year through voluntary contributions to the Fundación. In 2010, 75% of the employees showed their generous commitment to the community by donating $545,198 to the Fundación through payroll deduction.
A HAND TO HAITI
In 2010 Popular responded assertively to support our neighbors in Haiti affected by the earthquake. Fundación Banco Popular established a collection center where food and clothing items donated at the Banks branches were classified and sorted in 1,260 boxes, and sent to that country. Close to 300 volunteer employees participated in this effort. The Fundación opened an account to receive donations from the Puerto Rican public to help a local health organizations efforts in Haiti. Over $320,000 were collected to aid medical volunteer efforts and the establishment of a health clinic outside of Port-Au-Prince. The Fundación also contributed to a conference-workshop for professionals about suggestions for the reconstruction of the countrys capital.
A second account was opened by the Bank to benefit the American Red Cross Puerto Rico for its efforts in Haiti. Collections for this account totaled $920,000. Banco Popular made a direct donation to this fund to make it reach $1 million.
REACHING FOR THE FUTURE
Banco Popular believes that people well-informed about financial matters can contribute greatly to their personal well-being and to the well-being of their community and country. Thus, a Financial Education Program was launched during 2010. A total of 107 workshops were held throughout Puerto Rico, with the participation of 4,107 adults.
In the U.S., Banco Popular de Puerto Rico was recognized for its efforts in carrying out the Teach Children to Save project. Banco Popular reached 109,554 elementary school students, more than any other bank in the nation. BPNA employees personally gave the savings education lessons, providing students with the tools to make smarter, more informed personal finance decisions.
Populars commitment to SERVICE translates into numerous forms of expression. Whether as a provider of financial services or as an instigator for progress in our communities, we continue to be guided by our unwavering dedication to serve.
8 POPULAR, INC. 2010 ANNUAL REPORT
Popular, Inc. 25 year HISTORICAL FINANCIAL SUMMARY
Banco Popular is a local institution dedicating its efforts exclusively to the enhancement of the social and economic conditions in Puerto Rico and inspired by the most sound principles and fundamental practices of good banking.
Popular pledges its efforts and resources to the development of a banking service for Puerto Rico within strict commercial practices and so efficient that it could meet the requirements of the most progressive community in the world.
The men and women who work for our institution, from the highest executive to the employees who handle the most routine tasks, feel a special pride in serving our customers with care and dedication.
All of them feel the personal satisfaction of belonging to the Banco Popular Family, which fosters affection and understanding among its members, and which at the same time firmly complies with the highest ethical and moral standards of behavior.
Independent Registered Public Accounting Firm:
The 2011 Annual Stockholders Meeting of Popular, Inc. will be held on Thursday, April 28, at 9:00 a.m. at Centro Europa Building in San Juan, Puerto Rico.
The Annual Report to the Securities and Exchange Commission on Form 10-K and any other financial information may also be viewed by visiting our website: www.popular.com
BOARD OF DIRECTORS
RICHARD L. CARRIÓN
Chief Executive Officer
ALEJANDRO M. BALLESTER
Ballester Hermanos, Inc.
MARÍA LUISA FERRÉ
Chief Executive Officer
Grupo Ferré Rangel
MANUEL MORALES JR.
Parkview Realty, Inc.
FREDERIC V. SALERNO
WILLIAM J. TEUBER JR.
CARLOS A. UNANUE
Goya de Puerto Rico, Inc.
JOSÉ R. VIZCARRONDO
Chief Executive Officer
Desarrollos Metropolitanos, S.E.
SAMUEL T. CÉSPEDES, ESQ.
Secretary of the Board of Directors
RICHARD L. CARRIÓN
President & Chief Executive Officer
Popular, Inc. & Banco Popular
de Puerto Rico
JORGE A. JUNQUERA
Senior Executive Vice President
Chief Financial Officer
Corporate Finance Group
CARLOS J. VÁZQUEZ
Executive Vice President
President of Banco Popular
Executive Vice President
Chief Legal Officer
General Counsel & Corporate
Executive Vice President
Financial & Insurance Services Group
Banco Popular de Puerto Rico
Executive Vice President
Corporate Risk Management Group
Executive Vice President
Individual Credit Group
Banco Popular de Puerto Rico
EDUARDO J. NEGRÓN
Executive Vice President
NÉSTOR O. RIVERA
Executive Vice President
Retail Banking and
Banco Popular de Puerto Rico
Executive Vice President
Commercial Credit Group
Executive Vice President
Commercial Banking Group
Banco Popular de Puerto Rico
Financial Review and Supplementary Information
Managements Discussion and Analysis of Financial Condition and Results of Operations
The following Managements Discussion and Analysis (MD&A) provides information which management believes necessary for understanding the financial performance of Popular, Inc. and its subsidiaries (the Corporation or Popular). All accompanying tables, consolidated financial statements and corresponding notes included in this Financial Review and Supplementary Information - 2010 Annual Report (the report) should be considered an integral part of this MD&A.
The information included in this report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may relate to the Corporations financial condition, results of operations, plans, objectives, future performance and business, including, but not limited to, statements with respect to the adequacy of the allowance for loan losses, delinquency trends, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings and new accounting standards on the Corporations financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words anticipate, believe, continues, expect, estimate, intend, project and similar expressions and future or conditional verbs such as will, would, should, could, might, can, may, or similar expressions are generally intended to identify forward-looking statements.
Forward-looking statements are not guarantees of future performance and, by their nature, involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which are beyond the Corporations control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to, the rate of growth in the economy and employment levels, as well as general business and economic conditions; changes in interest rates, as well as the magnitude of such changes; the fiscal and monetary policies of the federal government and its agencies; changes in federal bank regulatory and supervisory policies, including required levels of capital; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Financial Reform Act) on the Corporations businesses, business practices and costs of operations; the relative strength or weakness of the consumer and commercial credit sectors and of the real estate markets in Puerto Rico and the other markets in which borrowers are located; the performance of the stock and bond markets; competition in the financial services industry; additional Federal Deposit Insurance Corporation (FDIC) assessments; and possible legislative, tax or regulatory changes. Other possible events or factors that could cause results or performance to differ materially from those expressed in these forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of non-performing assets, charge-offs and provision expense; changes in interest rates and market liquidity which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets; adverse movements and volatility in debt and equity capital markets; changes in market rates and prices which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; changes in accounting standards, rules and interpretations; increased competition; the Corporations ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change the business mix of the Corporation; and managements ability to identify and manage these and other risks. Moreover, the outcome of legal proceedings is inherently uncertain and depends on judicial interpretations of law and the findings of regulators, judges and juries.
All forward-looking statements included in this report are based upon information available to the Corporation as of the date of this report, and other than as required by law, including the requirements of applicable securities laws, management assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
The description of the Corporations business and risk factors contained in Item 1 and 1A of its Form 10-K for the year ended December 31, 2010, while not all inclusive, discusses additional information about the business of the Corporation and the material risk factors that, in addition to the other information in this report, readers should consider.
The Corporation is a diversified, publicly owned financial holding company subject to the supervision and regulation of the Board of Governors of the Federal Reserve System. The Corporation has operations in Puerto Rico, the mainland United States, the Caribbean and Latin America. In Puerto Rico, the Corporation provides retail and commercial banking services through its principal banking subsidiary, Banco Popular de Puerto Rico (BPPR), as well as auto and equipment leasing and financing, mortgage loans, investment banking, broker-dealer and insurance services through specialized subsidiaries. In the mainland United States, the Corporation operates Banco Popular North America (BPNA), including its wholly-owned subsidiary E-LOAN. BPNA is a community bank providing a broad range of financial services and products to the communities it serves. BPNA operates branches in New York, California, Illinois, New Jersey and Florida. E-LOAN markets deposit accounts under its name for the benefit of BPNA. The Corporation has a 49% interest in EVERTEC, which provides transaction processing services throughout the Caribbean and Latin America.
The Corporations net income amounted to $137.4 million for the year ended December 31, 2010, compared with a net loss of $573.9 million for the year ended December 31, 2009 and a net loss of $1.2 billion for the year ended December 31, 2008. The results of 2009 and 2008 included net losses of discontinued operations amounting to $20.0 million and $563.4 million, respectively. The discussions that follow pertain to Popular, Inc.s continuing operations, unless otherwise indicated.
The year 2010 was one of significant accomplishments for the Corporation. In the context of positioning the Corporation to participate in a potential FDIC-assisted transaction in Puerto Rico, the Corporation enhanced its capital position with an offering of equity whereby it raised $1.15 billion of new common equity capital. This capital raise, along with the after-tax gain of $531.0 million, net of transaction costs, on the sale of a 51% interest in EVERTEC, substantially strengthened the Corporations capital ratios, placing it in a position to participate in the consolidation of the Puerto Rico banking market and to pursue strategies to improve the credit quality of its loan portfolio, such as the reclassification to held-for-sale of high-risk portfolios.
During the second quarter of 2010, the Corporation completed the issuance of $1.15 billion of capital through the sale and subsequent conversion of depositary shares representing interests in shares of contingent convertible perpetual non-cumulative preferred stock into common stock. This transaction resulted in the issuance of over 383 million additional shares of common stock in May 2010. The net proceeds from the public offering amounted to approximately $1.1 billion, after deducting the underwriting discount and estimated offering expenses.
Acquisition of Westernbank in an FDIC-assisted transaction
The closing by the Office of the Commissioner of Financial Institutions, together with the FDIC, of three banks in Puerto Rico significantly altered the local banking landscape. On April 30, 2010, BPPR acquired certain assets and assumed certain liabilities of Westernbank Puerto Rico from the Federal Deposit Insurance Corporation (FDIC) (herein the Westernbank FDIC-assisted transaction). As a result of the Westernbank FDIC-assisted transaction, the Corporations total assets as of April 30, 2010 increased by $8.3 billion, principally consisting of a loan portfolio with an estimated fair value of $5.2 billion ($8.6 billion unpaid principal balance prior to purchase accounting adjustments) and a $2.3 billion FDIC loss share indemnification asset. Liabilities with a fair value of approximately $8.3 billion were recognized at the acquisition date, including $2.4 billion of assumed deposits, a $5.8 billion five-year promissory note issued to the FDIC at a fixed annual interest rate of 2.50% and an equity appreciation instrument issued to the FDIC with an estimated fair value of $52.5 million as of April 30, 2010. The indemnification asset represents the portion of estimated losses covered by loss sharing agreements between BPPR and the FDIC. The loss sharing agreements afford the Corporation significant protection against future losses in the acquired loan and other real estate portfolio. The Corporation recorded goodwill of $87 million as part of the transaction. Refer to the Westernbank FDIC-assisted transaction section in this MD&A for additional information on the transaction.
Sale of EVERTEC
On September 30, 2010, the Corporation completed the sale of a majority interest in its processing and technology business EVERTEC, including the businesses transferred by BPPR to EVERTEC in an internal reorganization that is discussed in Note 4 to the consolidated financial statements. Under the terms of the sale, an unrelated third party acquired a 51% interest in EVERTEC for cash pursuant to a leveraged buy-out. The Corporation retained the remaining 49% interest and EVERTECs operations in Venezuela and certain related contracts. The Corporations investment in EVERTEC is currently accounted for under the equity method and the investment amounted to $197 million at December 31, 2010, which is included in other assets in the consolidated statement of condition. As a result of the sale, the Corporation recognized a pre-tax gain, net of transaction costs, of approximately $616.2 million ($531.0 million after-tax), of which $640.8 million was separately disclosed within non-interest income in the consolidated statement of operations and $24.6 million are included as operating expenses (transaction costs). In connection with the sale, Popular entered into various agreements including a master services agreement pursuant to which EVERTEC will continue providing various processing and information technology services to Popular, BPPR, and their respective subsidiaries. The net cash proceeds received by the Corporation after transaction costs and taxes were approximately $528.6 million, which further boosted the Corporations liquidity position. The sale had a positive impact of approximately 2.19% on Tier 1 Common, 2.31% on Tier 1 Capital and Total Capital ratios, and of approximately 1.20% on Populars Tier 1 Leverage ratio.
Reclassification of loan portfolios for future sale
Actions taken in 2010 to reduce credit risk included the reclassification in the fourth quarter of approximately $1.0 billion of loans held-in-portfolio to held-for-sale. A majority of these loans are expected to be sold in the first quarter of 2011, and consist of approximately $603 million (book value) of construction, commercial real estate and land loans in Puerto Rico and of $396 million (book value) U.S. non-conventional residential mortgage loans. This action resulted in $327 million of write-downs to the allowance for loan losses to mark the loans to estimated sales price, which also considered an additional charge to the provision for loan losses of $176 million. Disposing of these loans will substantially reduce non-performing assets, further reduce the Corporations exposure to future real estate losses and allows the Corporation to refocus the organization and redeploy resources to generate new business. The subsequent events section in this MD&A provides more details on the Corporations plans with respect to these potential sales.
Table A provides selected financial data for the past five years.
Selected Financial Data
As indicated earlier, the Corporation achieved net income of $137.4 million in 2010, compared with a net loss of $573.9 million in 2009. The net income for 2010 primarily reflects the after-tax gain of $531.0 million on the sale of the majority interest in EVERTEC.
Table B presents a five-year summary of the components of net income (loss) as a percentage of average total assets.
Components of Net Income (Loss) as a Percentage of Average Total Assets
The discussion that follows provides highlights of the Corporations results of operations for the year ended December 31, 2010 compared to the results of operations of 2009. It also provides some highlights with respect to the Corporations financial condition, credit quality, capital and liquidity.
In late 2008, the Corporation discontinued the operations of Popular Financial Holdings (PFH) by selling assets and closing service branches and other units. The loss from discontinued operations, net of taxes, for the years ended December 31, 2009 and 2008 was $20.0 million and $563.4 million, respectively. The results of PFH are presented as part of Loss from discontinued operations, net of income tax in Table A. The discussions in this MD&A pertain to Popular, Inc.s continuing operations, unless otherwise indicated. Refer to the Discontinued Operations section in this MD&A for additional financial information.
Total assets at December 31, 2010 amounted to $38.7 billion, an increase of $4.0 billion, or 11%, compared with December 31, 2009. Total earning assets at December 31, 2010 increased by $1.2 billion, or 4%, compared with December 31, 2009. Total assets and total earning assets amounted to $38.9 billion and $36.1 billion, respectively, at December 31, 2008. The increase in total assets, when compared to December 31, 2009, was principally in loans held-in-portfolio by $1.9 billion, due to the loan portfolio acquired in the Westernbank FDIC-assisted transaction, partially offset by reductions in the Corporations non-covered loan portfolio. Also, the increase in total assets was related to the $2.3 billion FDIC loss share indemnification asset, partially offset by a decline in investment securities available-for-sale by $1.5 billion. The decline in the Corporations loan portfolio, excluding the impact
of the covered loans acquired, was influenced by high levels of loan charge-offs and the impact of exiting origination channels at BPNA as part of the restructuring activities undertaken during 2009. Also, the decline in loan originations reflects low demand in a weak economic environment. The reduction in total assets from 2008 to 2009 was also influenced by running off portfolio, charge-offs and low demand.
Refer to Statement of Condition Analysis section of this MD&A for the percentage allocation of the composition of the Corporations financing to total assets. Deposits totaled $26.8 billion at December 31, 2010, compared with $25.9 billion at December 31, 2009 and $27.6 billion at December 31, 2008. The increase in deposits during 2010 was associated with the Westernbank FDIC-assisted transaction, partially offset by lower volume of brokered certificates of deposit and reductions due to the effect of closure, sale and consolidation of branches in the U.S. mainland operations, and the attrition impact due to the reduction in the pricing of deposits, including internet deposits. Borrowed funds amounted to $6.9 billion at December 31, 2010, compared with $5.3 billion at December 31, 2009 and $6.9 billion at December 31, 2008. The increase in borrowings from December 31, 2009 to the same date in 2010 was related to the note issued to the FDIC in the Westernbank FDIC-assisted transaction, which had a carrying amount of $2.5 billion at December 31, 2010, partially offset by the impact of deleveraging strategies. The reduction in borrowings from 2008 to 2009 was the result of a smaller asset base given the reduction in size of the BPNAs operations, reduced loan levels in the Puerto Rico operations and sale of securities.
For detailed information on lending and investing activities, refer to the Statement of Condition Analysis and the Credit Risk Management and Loan Quality sections of this MD&A. A glossary of selected financial terms has been included at the end of this MD&A.
Stockholders equity totaled $3.8 billion at December 31, 2010, compared with $2.5 billion at December 31, 2009. The increase in stockholders equity from the end of 2009 to December 31, 2010 was principally due to the capital raised from the common stock issuance. Stockholders equity amounted to $3.3 billion at December 31, 2008. The reduction in total stockholders equity from December 31, 2008 to 2009 was principally due to the net loss incurred in 2009.
At December 31, 2010, the Corporation was well-capitalized under the regulatory framework. Refer to Table J of this report for information on capital adequacy data, including regulatory capital ratios.
The shares of the Corporations common stock are traded on the National Association of Securities Dealers Automated Quotations (NASDAQ) system under the symbol BPOP. Table C shows the Corporations common stock performance on a quarterly basis during the last five years, including market prices and cash dividends declared.
Further discussions of operating results, financial condition and business risks are presented in the narrative and tables included herein.
Common Stock Performance
N.M. Not meaningful.
The following table provides a calculation of net income (loss) per common share (EPS) for the years ended December 31, 2010 and 2009.
Table Net Income per Common Share
The principal factor that has affected the Corporations capital resources and results of operations in recent periods is the deterioration of credit quality and its related impact on the allowance for loan losses and provision. The deterioration of credit quality has been the result of the recessionary environment both in Puerto Rico and the mainland United States and the associated reduction in real estate and housing values in both markets. In addition, during the last three years the Corporation has incurred substantial losses in exiting certain non-conventional mortgage related operations in the mainland United States.
During 2010, the Corporations operations in Puerto Rico, its principal market, continued to experience a high level of charge-offs in the commercial and construction loan portfolios principally due to reductions in real estate collateral values. Credit management has remained a primary area of focus in the BPPR reportable segment, principally in the commercial and construction lending areas. The continuing recession in Puerto Rico makes loan growth a challenge.
Given the challenging economic environment in Puerto Rico, the Corporations credit metrics for its Puerto Rico operations will remain under pressure for 2011, particularly with respect to mortgage related assets. The Islands economy remained sluggish during 2010 and job creation continues to be a challenge. The government administration has taken a pragmatic approach toward a turnaround, reducing the budget deficit by close to 60% through difficult yet necessary cost-cutting initiatives. In September 2010, the Puerto Rico government signed into law an aggressive housing incentive package, providing a much needed jolt to the residential housing market. The whole package is generous, targets primarily new homes but also benefits existing ones, and has a ten-month expiration period which encourages people to act promptly. The program reduces cash outlays at closing and grants significant tax exemptions, such as no capital gain tax in the future sale of an acquired new home, no tax on rental income for 10 years and no property taxes for 5 years on new homes. Following the enactment of this new law, the Corporation saw an increase in interest among potential buyers and in originations for the fourth quarter of 2010.
In the U.S. mainland, management remains focused on managing legacy assets and improving the performance of BPNAs core banking business. The credit performance of BPNA has improved, resulting in a reduction in the provision for loan losses for the year 2010. The U.S. operations have followed the general credit trends on the mainland demonstrating progressive improvement. BPNAs top line income has remained steady. Management is working on increasing BPNAs customer base as it moves from being mainly a Hispanic-focused bank to a more broad-based community bank.
WESTERNBANK FDIC-ASSISTED TRANSACTION
As indicated previously, on April 30, 2010, BPPR entered into a purchase and assumption agreement with the FDIC to acquire certain assets and assume certain deposits and liabilities of Westernbank Puerto Rico.
The following table presents the fair values of major classes of identifiable assets acquired and liabilities assumed by the Corporation as of the April 30, 2010 acquisition date.
During the fourth quarter of 2010, retrospective adjustments were made to the estimated fair values of assets acquired and liabilities assumed associated with the Westernbank FDIC-assisted transaction to reflect new information obtained during the measurement period (as defined by ASC Topic 805), about facts and circumstances that existed as of the acquisition date that, if known, would have affected the acquisition-date fair value measurements. The retrospective adjustments were mostly driven by refinements in credit loss assumptions because of new information that became available. The revisions principally resulted in a decrease in the estimated credit losses, thus increasing the fair value of acquired loans and reducing the FDIC loss share indemnification asset.
The fair values assigned to the assets acquired and liabilities assumed are subject to refinement for up to one year after the closing date of the acquisition, as new information relative to closing date fair values becomes available, and thus the recognized goodwill may increase or decrease.
The following table depicts the principal changes in fair value as previously reported in Form 10-Qs filed during 2010 and the revised amounts recorded during the measurement period with general explanations of the major changes.
The following table summarizes the principal changes in the statement of operations as a result of the recasting for retrospective adjustments for the quarters ended June 30, 2010 and September 30, 2010.
The assets acquired and liabilities assumed were recorded at their estimated fair values as of the April 30, 2010 transaction date. These fair value estimates are considered preliminary, and are subject to change for up to one year after the closing date of the acquisition as additional information relative to closing date fair values may become available.
The Corporation refers to the loans acquired in the Westernbank FDIC-assisted transaction, except credit cards, as covered loans as the Corporation will be reimbursed by the FDIC for a substantial portion of any future losses on such loans under the terms of the loss sharing agreements. Foreclosed other real estate properties are also covered under the loss sharing agreements. Pursuant to the terms of the loss sharing agreements, the FDICs obligation to reimburse BPPR for losses with respect to assets covered by such agreements (collectively, covered assets) begins with the first dollar of loss incurred. On a combined basis, the FDIC will reimburse BPPR for 80% of all qualifying losses with respect to the covered assets. BPPR will reimburse the FDIC for 80% of qualifying recoveries with respect to losses for which the FDIC reimbursed BPPR. The loss sharing agreement applicable to single-family residential mortgage loans provides for FDIC loss sharing and BPPR reimbursement to the FDIC to last for ten years, and the loss sharing agreement applicable to commercial and other assets provides for FDIC loss sharing and BPPR reimbursement to the FDIC to last for five years, with additional recovery sharing for three years thereafter.
In June 2020, approximately ten years following the acquisition date, BPPR may be required to make a payment to the FDIC in the event that losses on covered assets under the loss sharing agreements have been less than originally estimated as determined pursuant to a formula established under the agreements that is described in Note 3 to the accompanying consolidated financial statements.
The FDIC has certain rights to withhold loss sharing payments if BPPR does not perform its obligations under the loss sharing agreements in accordance with their terms and to withdraw the loss share protection if certain significant transactions are effected without FDIC consent.
Covered loans under loss sharing agreements with the FDIC are reported in loans exclusive of the estimated FDIC loss share indemnification asset. The covered loans acquired in the Westernbank transaction are, and will continue to be, reviewed for collectability. Refer to the Critical Accounting Policies / Estimates section of this MD&A for the Corporations accounting policy on acquired loans and related indemnification assets.
As part of the consideration for the transaction, the FDIC received an equity appreciation instrument in which BPPR agreed to make a cash payment to the holder thereof equal to the product of (a) 50 million and (b) the amount by which the average volume weighted price of the Corporations common stock over the two NASDAQ trading days immediately prior to the date on which the equity appreciation instrument is exercised exceeds $3.43 (Popular, Inc.s 20-day trailing average common stock price on April 27, 2010). The equity appreciation instrument is exercisable by the FDIC, in whole or in part, up to May 7, 2011. As of April 30, 2010, the fair value of the equity appreciation instrument was estimated at $52.5 million, compared with $9.9 million at December 31, 2010. The equity appreciation instrument is recorded as a liability and any subsequent changes in its estimated fair value are recognized in earnings, adding volatility to the Corporations results of operations.
Refer to the Critical Accounting Policies / Estimates section and the Statement of Condition Analysis section of this MD&A, as well as Notes 2 and 3 of the consolidated financial statements for additional information on the accounting and additional information on the FDIC-assisted transaction.
Management has evaluated the effects of subsequent events that have occurred subsequent to December 31, 2010. There are no material events that would require recognition in the consolidated financial statements for the year ended December 31, 2010. Events occurring subsequent to December 31, 2010 not disclosed elsewhere in the consolidated financial statements are included in the section below.
BPPR Sale of Construction and Commercial Loans
In January 2011, BPPR signed a non-binding letter of intent to sell approximately $500 million (book value) of construction and commercial real estate loans, approximately 75% of which are non-performing, to a newly created joint venture that will be majority owned by an unrelated third party for a purchase price equal to 47% of their unpaid principal balance at December 31, 2010. The loans are part of a portfolio of approximately $603 million (book value) of construction, commercial real estate and land loans that were reclassified as loans held-for-sale at December 31, 2010. The unpaid principal balance of the loans does not reflect any charge-offs previously taken by the Corporation, which are reflected in their book value.
As part of the transaction, BPPR will make a 24.9% equity investment in the venture. BPPR will also provide financing to the venture for the acquisition of the loans in an amount equal to 50% of the purchase price and certain closing costs. In addition, BPPR will provide financing to the venture to cover unfunded commitments related to certain construction projects (subject to customary conditions of construction draws) and to fund certain operating expenses of the venture. The transaction, which is subject to the completion of due diligence and the execution of definitive documentation, as well as customary closing conditions, is expected to close during the first quarter of 2011. The terms of the non-binding letter were used as a basis for pricing the loans on an aggregate basis upon reclassification to loans held-for-sale.
BPNA Sale of Non-Conventional Mortgage Loans
On February 28, 2011, BPNA sold to an unrelated third party approximately $288 million (book value) of its approximately $396 million (book value) non-conventional mortgage loan portfolio classified as held-for-sale at December 31, 2010, for a purchase price of approximately $156 million, or 44% of their legal unpaid principal balance. BPNA is engaged in negotiations to sell the remaining portion of this loan portfolio to the same unrelated third party.
New Tax Code in Puerto Rico
On January 31, 2011, the Governor of Puerto Rico signed into law a new Internal Revenue Code for Puerto Rico. The most significant impact on corporations of this new Code is the reduction in the marginal corporate income tax rate from 39% to 30%. As a result of this reduction in rate, the Corporation will recognize an additional tax expense of $103.3 million during the first quarter of 2011 and a corresponding reduction in its deferred tax assets, which had been recognized at the higher marginal corporate income tax rate. Under the new code, the Corporation has a one-time election to opt-out of the new reduced rate. This election must be made with the filing of the 2011 income tax return. Currently, the corporate income tax rate is 40.95% due to a temporary five percent surtax approved in March 2009 for years beginning on January 1, 2009 through December 31, 2011.
CRITICAL ACCOUNTING POLICIES / ESTIMATES
The accounting and reporting policies followed by the Corporation and its subsidiaries conform with generally accepted accounting principles (GAAP) in the United States of America and general practices within the financial services industry. The Corporations significant accounting policies are described in detail in Note 2 to the consolidated financial statements and should be read in conjunction with this section.
Critical accounting policies require management to make estimates and assumptions, which involve significant judgment about the effect of matters that are inherently uncertain and that involve a high degree of subjectivity. These estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that differ from those estimates. The following MD&A section is a summary of what management considers the Corporations critical accounting policies / estimates.
Fair Value Measurement of Financial Instruments
The Corporation measures fair value as required by ASC Subtopic 820-10 Fair Value Measurements and Disclosures; which defines fair value as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Corporation currently measures at fair value on a recurring basis its trading assets, available-for-sale securities, derivatives, mortgage servicing rights and the equity appreciation instrument. Occasionally, the Corporation may be required to record at fair value other assets on a nonrecurring basis, such as loans held-for-sale, impaired loans held-in-portfolio that are collateral dependent and certain other assets. These nonrecurring fair value adjustments typically result from the application of lower of cost or fair value accounting or write-downs of individual assets.
The Corporation categorizes its assets and liabilities measured at fair value under the three-level hierarchy. The level within the hierarchy is based on whether the inputs to the valuation methodology used for fair value measurement are observable. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
The Corporation requires the use of observable inputs when available, in order to minimize the use of unobservable inputs to determine fair value. The inputs or methodologies used for valuing securities are not necessarily an indication of the risk associated with investing on those securities. The amount of judgment involved in estimating the fair value of a financial instrument depends upon the availability of quoted market prices or observable market parameters. In addition, it may be affected on other factors such as the type of instrument, the liquidity of the market for the instrument, transparency around the inputs to the valuation, as well as the contractual characteristics of the instrument.
If listed prices or quotes are not available, the Corporation employs valuation models that primarily use market-based inputs including yield curves, interest rate curves, volatilities, credit curves, and discount, prepayment and delinquency rates, among other considerations. When market observable data is not available, the valuation of financial instruments becomes more subjective and involves substantial judgment. The need to use unobservable inputs generally results from diminished observability of both actual trades and assumptions resulting from the lack of market liquidity for those types of loans or securities. When fair values are estimated based on modeling techniques such as discounted cash flow models, the Corporation uses assumptions such as interest rates, prepayment speeds, default rates, loss severity rates and discount rates. Valuation adjustments are limited to those necessary to ensure that the financial instruments fair value is adequately representative of the price that would be received or paid in the marketplace.
The fair value measurements and disclosures guidance in ASC Subtopic 820-10 also addresses measuring fair value in situations where markets are inactive and transactions are not orderly. Transactions or quoted prices for assets and liabilities may not be determinative of fair value when transactions are not orderly and thus may require adjustments to estimate fair value. Price quotes based on transactions that are not orderly should be given little, if any, weight in measuring fair value. Price quotes based upon transactions that are orderly shall be considered in determining fair value and the weight given is based on facts and circumstances. If sufficient information is not available to determine if price quotes are based upon orderly transactions, less weight should be given to the price quote relative to other transactions that are known to be orderly.
The lack of liquidity is incorporated into the fair value measurement based on the type of asset measured and the valuation methodology used. An illiquid market is one in which little or no observable activity has occurred or one that lacks willing buyers or willing sellers. Discounted cash flow techniques incorporate forecasting of expected cash flows discounted at appropriate market discount rates which reflect the lack of liquidity in the market which a market participant would consider. Broker quotes used for fair value measurements inherently reflect any lack of liquidity in the market since they represent an exit price from the perspective of the market participants.
Management believes that fair values are reasonable and consistent with the fair value measurement guidance based on the Corporations internal validation procedure and consistency of the processes followed, which include obtaining market quotes when possible or using valuation techniques that incorporate market-based inputs.
Refer to Note 36 to the consolidated financial statements for information on the Corporations fair value measurement disclosures required by the applicable accounting standard.
At December 31, 2010, approximately $5.8 billion, or 97%, of the assets measured at fair value on a recurring basis used market-based or market-derived valuation inputs in their valuation methodology and, therefore, were classified as Level 1 or Level 2. The majority of instruments measured at fair value are classified as Level 2, including U.S. Treasury securities, obligations of U.S. Government sponsored entities, obligations of Puerto Rico, States and political subdivisions, most mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs), and derivative instruments. U.S. Treasury securities are valued based on yields that are interpolated from the constant maturity treasury curve. Obligations of U.S. Government sponsored entities are priced based on an active exchange market and on quoted prices for similar securities. Obligations of Puerto Rico, States and political subdivisions are valued based on trades, bid price or spread, two sided markets, quotes, benchmark curves, market data feeds, discount and capital rates and trustee reports. MBS and CMOs are priced based on a bonds theoretical value from similar bonds
defined by credit quality and market sector. Refer to the Derivatives section below for a description of the valuation techniques used to value these derivative instruments.
The remaining 3% of assets measured at fair value on a recurring basis at December 31, 2010 were classified as Level 3 since their valuation methodology considered significant unobservable inputs. The financial assets measured as Level 3 included mostly Puerto Rico tax-exempt GNMA mortgage-backed securities and mortgage servicing rights (MSRs). GNMA tax exempt mortgage-backed securities are priced using a local demand price matrix prepared from local dealer quotes, and other local investments such as corporate securities and local mutual funds which are priced by local dealers. MSRs, on the other hand, are priced internally using a discounted cash flow model which considers servicing fees, portfolio characteristics, prepayment assumptions, delinquency rates, late charges, other ancillary revenues, cost to service and other economic factors. Additionally, the Corporation reported $875 million of financial assets that were measured at fair value on a nonrecurring basis at December 31, 2010, all of which were classified as Level 3 in the hierarchy.
Broker quotes used for fair value measurements inherently reflect any lack of liquidity in the market since they represent an exit price from the perspective of the market participants. Financial assets that were fair valued using broker quotes amounted to $63 million at December 31, 2010, of which $34 million were Level 3 assets and $29 million were Level 2 assets. These assets consisted principally of tax-exempt GNMA mortgage-backed securities. Fair value for these securities is based on an internally-prepared matrix derived from an average of two indicative local broker quotes. The main input used in the matrix pricing is non-binding local broker quotes obtained from limited trade activity. Therefore, these securities are classified as Level 3.
During the year ended December 31, 2010, there were $197 million in transfers out of Level 3 for financial instruments measured at fair value on a recurring basis. These transfers resulted from exempt FNMA and GNMA mortgage-backed securities, which were transferred out of Level 3 and into Level 2, as a result of a change in valuation methodology from an internally-developed pricing matrix to pricing them based on a bonds theoretical value from similar bonds defined by credit quality and market sector. Their fair value incorporates an option adjusted spread. Pursuant to the Corporations policy, these transfers were recognized as of the end of the reporting period. There were no transfers in and / or out of Level 1 during the year ended December 31, 2010.
Trading Account Securities and Investment Securities Available-for-Sale
The majority of the values for trading account securities and investment securities available-for-sale are obtained from third-party pricing services and are validated with alternate pricing sources when available. Securities not priced by a secondary pricing source are documented and validated internally according to their significance to the Corporations financial statements. Management has established materiality thresholds according to the investment class to monitor and investigate material deviations in prices obtained from the primary pricing service provider and the secondary pricing source used as support for the valuation results. During the year ended December 31, 2010, the Corporation did not adjust any prices obtained from pricing service providers or broker dealers.
Inputs are evaluated to ascertain that they consider current market conditions, including the relative liquidity of the market. When a market quote for a specific security is not available, the pricing service provider generally uses observable data to derive an exit price for the instrument, such as benchmark yield curves and trade data for similar products. To the extent trading data is not available, the pricing service provider relies on specific information including dialogue with brokers, buy side clients, credit ratings, spreads to established benchmarks and transactions on similar securities, to draw correlations based on the characteristics of the evaluated instrument. If for any reason the pricing service provider cannot observe data required to feed its model, it discontinues pricing the instrument. During the year ended December 31, 2010, none of the Corporations investment securities were subject to pricing discontinuance by the pricing service providers. The pricing methodology and approach of our primary pricing service providers is concluded to be consistent with the fair value measurement guidance.
Furthermore, management assesses the fair value of its portfolio of investment securities at least on a quarterly basis, which includes analyzing changes in fair value that have resulted in losses that may be considered other-than-temporary. Factors considered include, for example, the nature of the investment, severity and duration of possible impairments, industry reports, sector credit ratings, economic environment, creditworthiness of the issuers and any guarantees.
Securities are classified in the fair value hierarchy according to product type, characteristics and market liquidity. At the end of each period, management assesses the valuation hierarchy for each asset or liability measured. The fair value measurement analysis performed by the Corporation includes validation procedures and review of market changes, pricing methodology, assumption and level hierarchy changes, and evaluation of distressed transactions.
At December 31, 2010, the Corporations portfolio of trading and investment securities available-for-sale amounted to $5.8 billion and represented 96% of the Corporations assets measured at fair value on a recurring basis. At December 31, 2010, net unrealized gains on the trading and available-for-sale investment securities portfolios approximated $36 million and $185 million, respectively. Fair values for most of the Corporations trading and investment securities available-for-sale are classified as Level 2. Trading and investment securities available-for-sale classified as Level 3, which are the securities that involved the highest degree of judgment, represent less than 1% of the Corporations total portfolio of trading and investment securities available-for-sale.
The fair value of loans held-for-sale is principally based on terms of a recent non-binding sale agreement, bids received from potential buyers, and according to secondary market prices. Fair value is determined on an aggregate basis according to loan type and terms.
Mortgage Servicing Rights
Mortgage servicing rights (MSRs), which amounted to $167 million at December 31, 2010, do not trade in an active, open market with readily observable prices. Fair value is estimated based upon discounted net cash flows calculated from a combination of loan level data and market assumptions. The valuation model combines loans with common characteristics that impact servicing cash flows (e.g. investor, remittance cycle, interest rate, product type, etc.) in order to project net cash flows. Market valuation assumptions include prepayment speeds, discount rate, cost to service, escrow account earnings, and contractual servicing fee income, among other considerations. Prepayment speeds are derived from market data that is more relevant to the U.S. mainland loan portfolios and, thus, are adjusted for the Corporations loan characteristics and portfolio behavior since prepayment rates in Puerto Rico have been historically lower. Other assumptions are, in the most part, directly obtained from third-party providers. Disclosure of two of the key economic assumptions used to measure MSRs, which are prepayment speed and discount rate, and a sensitivity analysis to adverse changes to these assumptions, is included in Note 11 to the consolidated financial statements.
Derivatives, such as interest rate swaps, interest rate caps and indexed options, are traded in over-the-counter active markets. These derivatives are indexed to an observable interest rate benchmark, such as LIBOR or equity indexes, and are priced using an income approach based on present value and option pricing models using observable inputs. Other derivatives are liquid and have quoted prices, such as forward contracts or to be announced securities (TBAs). All of these derivatives held by the Corporation are classified as Level 2. Valuations of derivative assets and liabilities reflect the values associated with counterparty risk and nonperformance risk, respectively. The non-performance risk, which measures the Corporations own credit risk, is determined using internally-developed models that consider the net realizable value of the collateral posted, remaining term, and the creditworthiness or credit standing of the Corporation. The counterparty risk is also determined using internally-developed models which incorporate the creditworthiness of the entity that bears the risk, net realizable value of the collateral received, and available public data or internally-developed data to determine their probability of default. To manage the level of credit risk, the Corporation employs procedures for credit approvals and credit limits, monitors the counterparties credit condition, enters into master netting agreements whenever possible and, when appropriate, requests additional collateral. During the year ended December 31, 2010, inclusion of credit risk in the fair value of the derivatives resulted in a net loss of $0.2 million recorded in the other operating income and interest expense captions of the consolidated statement of operations, which consisted of a loss of $0.5 million resulting from the Corporations own credit standing adjustment and a gain of $0.3 million from the assessment of the counterparties credit risk.
Equity appreciation instrument
The fair value of the equity appreciation instrument issued to the FDIC was estimated by determining a call option value using the Black-Scholes Option Pricing Model. The principal variables in determining the fair value of the equity appreciation instrument include the implied volatility determined based on the historical daily volatility of the Corporations common stock, the exercise price of the instrument, the price of the call option, and the risk-free rate. The equity appreciation instrument is classified as Level 2. The Corporation recognized non-interest income of $42.6 million during the year ended December 31, 2010 as a result of a decrease in the fair value of the equity appreciation instrument. The carrying amount of the equity appreciation instrument, which is recorded as other liability in the consolidated statement of condition, amounted to $10 million at December 31, 2010.
Loans held-in-portfolio considered impaired under ASC Section 310-10-35 that are collateral dependent
The impairment is measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, size and supply and demand. Continued deterioration of the housing markets and the economy in general have adversely impacted and continue to affect the market activity related to real estate properties. These collateral dependent impaired loans are classified as Level 3 and are reported as a nonrecurring fair value measurement.
Other real estate owned
For other real estate owned received in satisfaction of debt, the collateral dependent valuation method is used for the impairment determination since the expected realizable value is based upon the proceeds received from the liquidation of the property. The other real estate owned is classified as Level 3 and is reported as a nonrecurring fair value measurement.
Loans and Allowance for Loan Losses
Interest on loans is accrued and recorded as interest income based upon the principal amount outstanding.
Recognition of interest income on commercial and construction loans is discontinued when the loans are 90 days or more in arrears on payments of principal or interest or when other factors indicate that the collection of principal and interest is doubtful. The impaired portions of secured loans past due as to principal and interest is charged-off not later than 365 days past due. However, in the case of collateral dependent loans individually evaluated for impairment, the excess of the recorded investment over the fair value of the collateral (portion deemed as uncollectible) is generally promptly charged-off, but in any event not later than the
quarter following the quarter in which such excess was first recognized. Recognition of interest income on mortgage loans is discontinued when 90 days or more in arrears on payments of principal or interest. The impaired portions on mortgage loans are charged-off at 180 days past due. Recognition of interest income on closed-end consumer loans and home equity lines of credit is discontinued when the loans are 90 days or more in arrears on payments of principal or interest. Income is generally recognized on open-end consumer loans, except for home equity lines of credit, until the loans are charged-off. Recognition of interest income for lease financing is ceased when loans are 90 days or more in arrears. Closed-end consumer loans and leases are charged-off when they are 120 days in arrears. Open-end (revolving credit) consumer loans are charged-off when 180 days in arrears.
Certain loans which would be treated as non-accrual loans pursuant to the foregoing policy are treated as accruing loans if they are considered well-secured and in the process of collection.
Once a loan is placed on non-accrual status, the interest previously accrued and uncollected is charged against current earnings and thereafter income is recorded only to the extent of any interest collected. Loans designated as non-accruing are returned to an accrual status when the Corporation expects repayment of the remaining contractual principal and interest. Special guidelines exist for troubled-debt restructurings.
One of the most critical and complex accounting estimates is associated with the determination of the allowance for loan losses. The provision for loan losses charged to current operations is based on this determination. The Corporations assessment of the allowance for loan losses is determined in accordance with accounting guidance, specifically guidance of loss contingencies in ASC Subtopic 450-20 and loan impairment guidance in ASC Section 310-10-35.
The accounting guidance provides for the recognition of a loss allowance for groups of homogeneous loans.
During 2009, the Corporation enhanced the reserve assessment of homogeneous loans by establishing a more granular segmentation of loans with similar risk characteristics, reducing the historical base loss periods employed, and strengthening the analysis pertaining to the environmental factors considered. The change in the methodology was implemented as of June 30, 2009. The impact in the Corporations allowance and provision for loan losses as a result of each of the changes described above was a decrease of approximately $3.5 million. The determination for general reserves of the allowance for loan losses includes the following principal factors:
According to the accounting guidance criteria for specific impairment of a loan, up to December 31, 2008, the Corporation defined as impaired loans those commercial and construction borrowers with outstanding debt of $250,000 or more and with interest and /or principal 90 days or more past due. Also, specific commercial and construction borrowers with outstanding debt of $500,000 and over were deemed impaired when, based on current information and events, management considered that it was probable that the debtor would be unable to pay all amounts due according to the contractual terms of the loan agreement. Effective January 1, 2009, the Corporation continues to apply the same definition except that it prospectively increased the threshold of outstanding debt to $1,000,000 for the identification of newly impaired loans. At December 31, 2008, 88% of the ASC Section 310-10-35 specific reserves were coming from cases of $1 million or higher. Cases $1 million or higher represented 81% of the loan balances under ASC Section 310-10-35 (SFAS 114).This decision allowed management to focus on those cases with a higher level of risk for the Corporation. Loans that were below the new threshold at the time the change was implemented but were classified as impaired at the time of the change remained individually analyzed for impairment until the case was resolved. Management is of the opinion that the enhancements in the general reserve methodology previously discussed adequately covers the credit risk on the impaired loans excluded from the specific reserve analysis as a result of changing the threshold for the identification of impaired loans.
An allowance for loan impairment is recognized to the extent that the carrying value of an impaired loan exceeds the present value of the expected future cash flows discounted at the loans effective rate, the observable market price of the loan, if available, or the fair value of the collateral if the loan is collateral dependent. The fair value of the collateral is generally obtained from appraisals.
The Corporations management evaluates the adequacy of the allowance for loan losses on a quarterly basis following a systematic methodology in order to provide for known and inherent risks in the loan portfolio. In developing its assessment of the adequacy of the allowance for loan losses, the Corporation must rely on estimates and exercise judgment regarding matters where the ultimate outcome is unknown such as economic developments affecting specific customers, industries or markets. Other factors that can affect managements estimates are the years of historical data to include when estimating losses, the level of volatility of losses in a specific portfolio, changes in underwriting standards, financial accounting standards and loan impairment measurement, among others. Changes in the financial condition of individual borrowers, in economic conditions, in historical loss experience and in the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses. Consequently, the business, financial condition, liquidity, capital and results of operations could also be affected.
The Corporation requests updated appraisal reports for loans that are considered impaired following a corporate reappraisal policy. This policy requires updated appraisals for loans secured by real estate (including construction loans) either annually, every two years or every three years depending on the total exposure of the borrower. As a general procedure, the Corporation internally reviews appraisals as part of the underwriting and approval process and also for credits considered impaired.
The collateral dependent method is used for the impairment determination on commercial and construction loans since the expected realizable value of the loan is based upon the proceeds received from the liquidation of the collateral property. For commercial properties, the as is value or the income approach value is used depending on the financial condition of the subject borrower and/or the nature of the subject collateral. In most cases, impaired commercial loans do not have reliable or sustainable cash flow to use the discounted cash flow valuation method. On construction loans, as developed collateral values are used when the loan is originated since the assumption is that the cash flow of the property once leased or sold will provide sufficient funds to repay the loan. In the case of many impaired construction loans, the as developed collateral value is also used since completing the project reflects the best exit strategy in terms of potential loss reduction. In these cases, the costs to complete are considered as part of the impairment determination. As a general rule, the appraisal valuation used by the Corporation impaired construction loans is based on discounted value to a single purchaser, discounted sell out or as is depending on the condition and status of the project and the performance of the same.
For mortgage loans that are modified with regard to payment terms, the discounted cash flow value method is used, as the impairment valuation is more appropriately calculated based on the ongoing cash flow from the individuals rather than the liquidation of the asset.
With regard to performing loans, the Corporation will require an appraisal when there is a refinancing or modification of the loan (if the existing appraisal is older than 12 months). If there is no new money being disbursed as part of the restructuring or the loan is less than $250,000, the appraisal cannot be more than 3 years old. Also, appraisals can be requested at any time when events become known that might materially alter the value of the property.
It is the Corporations policy to require updated appraisals for all commercial and construction impaired loans and OREO properties over $3 million at least annually. Cases between $1 million to $3 million are reappraised at least every 24 months.
For loans secured by residential real estate properties (mortgage loans) and following the requirements of the Uniform Retail Credit Classification and Account Management Policy of the Board of Governors of the Federal Reserve System, a current assessment of value is made not later than 180 days past the contractual due date. Any outstanding loan balance in excess of the estimated value of the property, less estimated cost to sell, is charged-off. For this purpose and for residential real estate properties, the Corporation requests independent broker price opinions of value of the collateral property periodically depending on the delinquency status of the loans.
Although the accounting codification guidance for specific impairment of a loan excludes large groups of smaller balance homogeneous loans that are collectively evaluated for impairment (e.g., mortgage loans), it specifically requires that loan modifications considered troubled debt restructurings (TDRs) be analyzed under its provisions.
TDRs represent loans where concessions have been granted to borrowers experiencing financial difficulties that the creditor would not otherwise consider. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. These concessions stem from an agreement between the creditor and the debtor or are imposed by law or a court. Classification of loan modifications as TDRs involves a degree of judgment. Indicators that the debtor is experiencing financial difficulties include, for example: (i) the debtor is currently in default on any of its debt; (ii) the debtor has declared or is in the process of declaring bankruptcy; (iii) there is significant doubt as to whether the debtor will continue to be a going concern; (iv) currently, the debtor has securities that have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange; and (v) based on estimates and projections that
only encompass the current business capabilities, the debtor forecasts that its entity-specific cash flows will be insufficient to service the debt (both interest and principal) in accordance with the contractual terms of the existing agreement through maturity; and absent the current modification, the debtor cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a non-troubled debtor. The identification of TDRs is critical in the determination of the adequacy of the allowance for loan losses. Loans classified as TDRs are reported in non-accrual status if the loan was in non-accruing status at the time of the modification. The TDR loan should continue in non-accrual status until the borrower has demonstrated a willingness and ability to make the restructured loan payments (at least six months of sustained performance after classified as TDR). Loans classified as TDRs are excluded from TDR status if performance under the restructured terms exists for a reasonable period (at least twelve months of sustained performance after classified) and the loan yields a market rate.
At December 31, 2010, the Corporation had not closed any restructuring involving the type of loan splitting discussed in the Policy Statement on Prudent Commercial Real Estate Workouts, although it may do so in the future.
Acquisition Accounting for Loans and Related Indemnification Asset
Beginning in 2009, the Corporation accounts for its acquisitions under ASC Topic No. 805, Business Combinations, which requires the use of the purchase method of accounting. All identifiable assets acquired, including loans, are recorded at fair value. No allowance for loan losses related to the acquired loans is recorded on the acquisition date as the fair value of the loans acquired incorporates assumptions regarding credit risk. Loans acquired are recorded at fair value in accordance with the fair value methodology prescribed in ASC Topic 820, exclusive of the shared-loss agreements with the FDIC. These fair value estimates associated with the loans include estimates related to expected prepayments and the amount and timing of expected principal, interest and other cash flows.
Because the FDIC has agreed to reimburse the Corporation for losses related to the acquired loans in the Westernbank FDIC-assisted transaction, an indemnification asset was recorded at fair value at the acquisition date. The indemnification asset is recognized at the same time as the indemnified loans, and measured on the same basis, subject to collectability or contractual limitations. The loss share indemnification asset on the acquisition date reflects the reimbursements expected to be received from the FDIC, using an appropriate discount rate, which reflects counterparty credit risk and other uncertainties.
The initial valuation of these loans and related indemnification asset requires management to make subjective judgments concerning estimates about how the acquired loans will perform in the future using valuation methods, including discounted cash flow analysis and independent third-party appraisals. Factors that may significantly affect the initial valuation include, among others, market-based and industry data related to expected changes in interest rates, assumptions related to probability and severity of credit losses, estimated timing of credit losses including the timing of foreclosure and liquidation of collateral, expected prepayment rates, required or anticipated loan modifications, unfunded loan commitments, the specific terms and provisions of any loss share agreements, and specific industry and market conditions that may impact discount rates and independent third-party appraisals.
ASC 310-30 provides two specific criteria that need to be met in order for a loan to be within its scope: (1) credit deterioration on the loan from its inception until the acquisition date and (2) that it is probable that not all of the contractual cash flows will be collected on the loan. Once in the scope of ASC 310-30, it is explicit that the credit portion of the fair value discount on an acquired loan would not be accreted into income until the acquirer had assessed that it expected to receive more cash flows on the loan than initially anticipated.
Acquired loans that meet the definition of nonaccrual status fall within the Corporations definition of impaired loans under ASC 310-30. It is possible that performing loans would not meet criteria number 1 above related to evidence of credit deterioration since the date of loan origination, and therefore not fall within the scope of ASC 310-30. Based on the fair value determined for the acquired portfolio, acquired loans that did not meet the entitys definition of non-accrual status also resulted in the recognition of a significant discount attributable to credit quality.
Given the significant discount related to credit in the valuation of the Westernbank acquired portfolio, the Corporation considered two possible options for the performing loans (1) Accrete the entire fair value discount (including the credit portion) using the interest method over the life of the loan in accordance with ASC 310-20; or (2) analogize to ASC 310-30 and only accrete the portion of the fair value discount unrelated to credit.
Pursuant to an AICPA letter dated December 18, 2009, the AICPA summarized the SEC Staffs view regarding the accounting in subsequent periods for discount accretion associated with loan receivables acquired in a business combination or asset purchase. Regarding the accounting for such loan receivables that, in the absence of further standard setting, the AICPA understands that the SEC Staff would not object to an accounting policy based on contractual cash flows (Option 1 ASC 310-20 approach) or an accounting policy based on expected cash flows (Option 2 ASC 310-30 approach). As such, the Corporation considered the two allowable options as follows:
Based on the above, the Corporation elected Option 2 the ASC 310-30 approach to the outstanding balance for all the acquired loans in the Westernbank FDIC-assisted transaction with the exception of revolving lines of credit with active privileges as of the acquisition date, which are explicitly scoped out by the ASC 310-30 accounting guidance. New advances / draws after the acquisition date under existing credit lines that did not have revolving privileges as of the acquisition date, particularly for construction loans, will effectively be treated as a new loan for accounting purposes and accounted for under the provisions of ASC 310-20, resulting in a hybrid accounting for the overall construction loan balance.
Management used judgment in evaluating factors impacting expected cash flows and probable loss assumptions, including the quality of the loan portfolio, portfolio concentrations, distressed economic conditions in Puerto Rico, quality of underwriting standards of the acquired institution, reductions in collateral real estate values, and material weaknesses disclosed by the acquired institution in its most recent Form 10-K, including matters related to credit quality review and appraisal report review.
At April 30, 2010, the acquired loans accounted for pursuant to ASC 310-30 by the Corporation totaled $4.9 billion which represented undiscounted unpaid contractually-required principal and interest balances of $9.9 billion reduced by a discount of $5.0 billion resulting from acquisition date fair value adjustments. The non-accretable discount on loans accounted for under ASC 310-30 amounted to $3.4 billion or approximately 68% of the total discount, thus indicating a significant amount of expected credit losses on the acquired portfolios.
Pursuant to ASC 310-20-15-5, the Corporation aggregated loans acquired in the FDIC-assisted transaction into pools with common risk characteristics for purposes of applying the recognition, measurement and disclosure provisions for this subtopic. Each loan pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. Characteristics considered in pooling loans in the Westernbank FDIC-assisted transaction included loan type, interest rate type, accruing status, amortization type, rate index and source type. Once the pools are defined, the Corporation maintains the integrity of the pool of multiple loans accounted for as a single asset.
Under ASC Subtopic 310-30, the difference between the undiscounted cash flows expected at acquisition and the fair value in the loans, or the accretable yield, is recognized as interest income using the effective yield method over the estimated life of the loan if the timing and amount of the future cash flows of the pool is reasonably estimable. The non-accretable difference represents the difference between contractually required principal and interest and the cash flows expected to be collected. Subsequent to the acquisition date, increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively as an adjustment to accretable yield. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses.
The fair value discount of lines of credit with revolving privileges that are accounted for pursuant to the guidance of ASC Subtopic 310-20, represents the difference between the contractually required loan payment receivable in excess of the initial investment in the loan. This discount is accreted into interest income over the life of the loan if the loan is in accruing status. Any cash flows collected in excess of the carrying amount of the loan are recognized in earnings at the time of collection. The carrying amount of lines of credit with revolving privileges, which are accounted pursuant to the guidance of ASC Subtopic 310-20, are subject to periodic review to determine the need for recognizing an allowance for loan losses.
The FDIC loss share indemnification asset for loss share agreements is measured separately from the related covered assets as it is not contractually embedded in the assets and is not transferable with the assets should the assets be sold. The indemnification asset is recognized on the same basis as the assets subject to loss share protection. As such, for covered loans accounted pursuant to ASC Subtopic 310-30, decreases in expected reimbursements will be recognized in income prospectively consistent with the approach taken to recognize increases in cash flows on covered loans. For covered loans accounted for under ASC Subtopic 310-20, as the loan discount recorded as of the acquisition date is accreted into income, a reversal of the corresponding indemnification asset is recorded as a reduction to non-interest income in order to reflect reciprocal accounting.
Increases in expected reimbursements will be recognized in income in the same period that the allowance for credit losses for the related loans is recognized. Likewise, decreases in expected reimbursements will be recognized in income in the same periods that the adjustment to accretable yield on the related acquired loans is recognized.
Over the life of the acquired loans that are accounted under ASC Subtopic 310-30, the Corporation continues to estimate cash flows expected to be collected on individual loans or on pools of loans sharing common risk characteristics. The Corporation evaluates at each balance sheet date whether the present value of its loans determined using the effective interest rates has decreased and if so, recognizes a provision for loan loss in its consolidated statement of operations and an allowance for loan losses in its consolidated statement of condition. For any increases in cash flows expected to be collected, the Corporation adjusts the amount of accretable yield recognized on a prospective basis over the loans or pools remaining life.
Loss assumptions used in the basis of the indemnified loans are consistent with the loss assumptions used to measure the indemnification asset. Fair value accounting incorporates into the fair value of the indemnification asset an element of the time value of money, which is accreted back into income over the life of the shared loss agreements. The loss share indemnification asset will be reduced by the amount owed by the FDIC for incurred losses. A corresponding claim receivable is recorded until cash is received from the FDIC.
The evaluation of estimated cash flows expected to be collected subsequent to acquisition on loans accounted pursuant to ASC Subtopic 310-30 and inherent losses on loans accounted pursuant to ASC Subtopic 310-20 require the continued usage of key assumptions and estimates. Given the current economic environment, the Corporation must apply judgment to develop its estimates of cash flows considering the impact of home price and property value changes, changing loss severities and prepayment speeds. Decreases in the expected cash flows for ASC Subtopic 310-30 loans and decreases in the net realizable value of ASC Subtopic 310-20 loans will generally result in a charge to the provision for credit losses resulting in an increase to the allowance for loan losses. These estimates are particularly sensitive to changes in loan credit quality.
The amount that the Corporation realizes on the covered loans and related indemnification assets could differ materially from the carrying value reflected in these financial statements, based upon the timing and amount of collections on the acquired loans in future periods. The Corporations losses on these assets may be mitigated to the extent covered under the specific terms and provisions of the loss share agreements.
Refer to Notes 3 and 10 to the consolidated financial statements for further discussions on the Westernbank FDIC-assisted transaction and loans acquired.
Income taxes are accounted for using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and attributable to operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which the temporary differences are expected to be recovered or paid. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period when the changes are enacted.
The calculation of periodic income taxes is complex and requires the use of estimates and judgments. The Corporation has recorded two accruals for income taxes: (1) the net estimated amount currently due or to be received from taxing jurisdictions, including any reserve for potential examination issues, and (2) a deferred income tax that represents the estimated impact of temporary differences between how the Corporation recognizes assets and liabilities under GAAP, and how such assets and liabilities are recognized under the tax code. Differences in the actual outcome of these future tax consequences could impact the Corporations financial position or its results of operations. In estimating taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into consideration statutory, judicial and regulatory guidance.
A deferred tax asset should be reduced by a valuation allowance if based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. The realization of deferred tax assets, including carryforwards and deductible temporary differences, depends upon the existence of sufficient taxable income of the same character during the carryback or carryforward period. The realization of deferred tax assets requires the consideration of all sources of taxable income available to realize the deferred tax asset, including the future reversal of existing temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in carryback years and tax-planning strategies.
The Corporations U.S. mainland operations are in a cumulative loss position for the three-year period ended December 31, 2010. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position is considered significant negative evidence and has caused the Corporation to conclude that it will not be able to realize the deferred tax assets in the future. At December 31, 2010, the Corporation recorded a full valuation allowance of approximately $1.3 billion on the deferred tax assets of the Corporations U.S. operations. At December 31, 2010, the Corporation had deferred tax assets related to its Puerto
Rico operations amounting to $398 million. The Corporation has assessed the realization of the Puerto Rico portion of the net deferred tax assets based on the weighting of all available evidence.
The Corporations Puerto Rico Banking operation is in a cumulative loss position for the three-year period ended December 31, 2010. This situation is mainly due to the performance of the construction loan portfolio, including the charges related to the future sale of the portfolio. Currently, a significant portion of this portfolio has been written-down to fair value based on a bid received. The Banking operations in Puerto Rico have a very strong earnings history, and the event causing this loss is not a continuing condition of the operations. Accordingly there is enough positive evidence to outweigh the negative evidence of the cumulative loss. Based on this evidence, the Corporation has concluded that it is more likely than not that such net deferred tax asset will be realized. Management will reassess the realization of the deferred tax assets based on the criteria of the applicable accounting pronouncement each reporting period.
Changes in the Corporations estimates can occur due to changes in tax rates, new business strategies, newly enacted guidance, and resolution of issues with taxing authorities regarding previously taken tax positions. Such changes could affect the amount of accrued taxes. The current income tax payable for 2010 has been paid during the year in accordance with estimated tax payments rules. Any remaining payment will not have any significant impact on liquidity and capital resources.
The valuation of deferred tax assets requires judgment in assessing the likely future tax consequences of events that have been recognized in the financial statements or tax returns and future profitability. The accounting for deferred tax consequences represents managements best estimate of those future events. Changes in managements current estimates, due to unanticipated events, could have a material impact on the Corporations financial condition and results of operations.
The Corporation establishes tax liabilities or reduces tax assets for uncertain tax positions when, despite its assessment that its tax return positions are appropriate and supportable under local tax law, the Corporation believes it may not succeed in realizing the tax benefit of certain positions if challenged. In evaluating a tax position, the Corporation determines whether it is more likely than not that the position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The Corporations estimate of the ultimate tax liability contains assumptions based on past experiences, and judgments about potential actions by taxing jurisdictions as well as judgments about the likely outcome of issues that have been raised by taxing jurisdictions. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Corporation evaluates these uncertain tax positions each quarter and adjusts the related tax liabilities or assets in light of changing facts and circumstances, such as the progress of a tax audit or the expiration of a statute of limitations. The Corporation believes the estimates and assumptions used to support its evaluation of uncertain tax positions are reasonable.
The amount of unrecognized tax benefits, including accrued interest, at December 31, 2010 amounted to $32 million. Refer to Note 31 to the consolidated financial statements for further information on this subject matter. During 2010, the U.S. Internal Revenue Service (IRS) completed an examination of the Corporations U.S. operations tax return for 2007. As a result of the examination, the Corporation reduced the total amount of unrecognized tax benefits by $14.3 million. The Corporation anticipates a reduction in the total amount of unrecognized tax benefits within the next 12 months, which could amount to approximately $12 million.
The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to the statutes of limitation, changes in managements judgment about the level of uncertainty, status of examinations, litigation and legislative activity and the addition or elimination of uncertain tax positions. Although the outcome of tax audits is uncertain, the Corporation believes that adequate amounts of tax, interest and penalties have been provided for any adjustments that are expected to result from open years. From time to time, the Corporation is audited by various federal, state and local authorities regarding income tax matters. Although management believes its approach in determining the appropriate tax treatment is supportable and in accordance with the accounting standards, it is possible that the final tax authority will take a tax position that is different than the tax position reflected in the Corporations income tax provision and other tax reserves. As each audit is conducted, adjustments, if any, are appropriately recorded in the consolidated financial statement in the period determined. Such differences could have an adverse effect on the Corporations income tax provision or benefit, or other tax reserves, in the reporting period in which such determination is made and, consequently, on the Corporations results of operations, financial position and / or cash flows for such period.
The Corporations goodwill and other identifiable intangible assets having an indefinite useful life are tested for impairment. Intangibles with indefinite lives are evaluated for impairment at least annually and on a more frequent basis if events or circumstances indicate impairment could have taken place. Such events could include, among others, a significant adverse change in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment and a decision to change the operations or dispose of a reporting unit.
Under applicable accounting standards, goodwill impairment analysis is a two-step test. The first step of the goodwill impairment test involves comparing the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value, the second step must be performed. The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated possible impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangibles (including any unrecognized intangible assets, such as unrecognized core deposits and trademark) as if the reporting unit was being acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The Corporation estimates the fair values of the assets and liabilities of a reporting unit, consistent with the requirements of the fair value measurements accounting standard, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of the assets and liabilities reflects market conditions, thus volatility in prices could have a material impact on the determination of the implied fair value of the reporting unit goodwill at the impairment test date. The adjustments to measure the assets, liabilities and intangibles at fair value are for the purpose of measuring the implied fair value of goodwill and such adjustments are not reflected in the consolidated statement of condition. If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted under applicable accounting standards.
At December 31, 2010, goodwill totaled $647 million. Note 14 to the consolidated financial statements provides an aggregation of goodwill by reportable segment and Corporate group.
The Corporation performed the annual goodwill impairment evaluation for the entire organization during the third quarter of 2010 using July 31, 2010 as the annual evaluation date. The reporting units utilized for this evaluation were those that are one level below the business segments, which are the legal entities within the reportable segment. The Corporation follows push-down accounting, as such all goodwill is assigned to the reporting units when carrying out a business combination.
In determining the fair value of a reporting unit, the Corporation generally uses a combination of methods, including market price multiples of comparable companies and transactions, as well as discounted cash flow analysis. Management evaluates the particular circumstances of each reporting unit in order to determine the most appropriate valuation methodology. The Corporation evaluates the results obtained under each valuation methodology to identify and understand the key value drivers in order to ascertain that the results obtained are reasonable and appropriate under the circumstances. Elements considered include current market and economic conditions, developments in specific lines of business, and any particular features in the individual reporting units.
The computations require management to make estimates and assumptions. Critical assumptions that are used as part of these evaluations include:
For purposes of the market comparable approach, valuations were determined by calculating average price multiples of relevant value drivers from a group of companies that are comparable to the reporting unit being analyzed and applying those price multiples to the value drivers of the reporting unit. Multiples used are minority based multiples and thus, no control premium adjustment is made to the comparable companies market multiples. While the market price multiple is not an assumption, a presumption that it provides an indicator of the value of the reporting unit is inherent in the valuation. The determination of the market comparables also involves a degree of judgment.
For purposes of the discounted cash flows (DCF) approach, the valuation is based on estimated future cash flows. The financial projections used in the DCF valuation analysis for each reporting unit are based on the most recent (as of the valuation date) financial projections presented to the Corporations Asset / Liability Management Committee (ALCO). The growth assumptions included in these projections are based on managements expectations for each reporting units financial prospects considering economic and industry conditions as well as particular plans of each entity (i.e. restructuring plans, de-leveraging, etc.). The cost of equity used to discount the cash flows was calculated using the Ibbotson Build-Up Method and ranged from 8.42% to 23.24% for the 2010 analysis. The Ibbottson Build-Up Method builds up a cost of equity starting with the rate of return of a risk-free asset (10-year
U.S. Treasury note) and adds to it additional risk elements such as equity risk premium, size premium and industry risk premium. The resulting discount rates were analyzed in terms of reasonability given the current market conditions and adjustments were made when necessary.
For BPNA, the only reporting unit that failed Step 1, the Corporation determined the fair value of Step 1 utilizing a market value approach based on a combination of price multiples from comparable companies and multiples from capital raising transactions of comparable companies. The market multiples used included price to book and price to tangible book. Additionally, the Corporation determined the reporting unit fair value using a DCF analysis based on BPNAs financial projections, but assigned no weight to it given that the current market approaches provide a more meaningful measure of fair value considering the reporting units financial performance and current market conditions. The Step 1 fair value for BPNA under both valuation approaches (market and DCF) was below the carrying amount of its equity book value as of the valuation date (July 31), requiring the completion of Step 2. In accordance with accounting standards, the Corporation performed a valuation of all assets and liabilities of BPNA, including any recognized and unrecognized intangible assets, to determine the fair value of BPNAs net assets. To complete Step 2, the Corporation subtracted from BPNAs Step 1 fair value the determined fair value of the net assets to arrive at the implied fair value of goodwill. The results of the Step 2 indicated that the implied fair value of goodwill exceeded the goodwill carrying value of $402 million at July 31, 2010, resulting in no goodwill impairment. The reduction in BPNAs Step 1 fair value was offset by a reduction in the fair value of its net assets, resulting in an implied fair value of goodwill that exceeds the recorded book value of goodwill.
The analysis of the results for Step 2 indicates that the reduction in the fair value of the reporting unit was mainly attributed to the deteriorated fair value of the loan portfolios and not to the fair value of the reporting unit as a going concern. The current negative performance of the reporting unit is principally related to deteriorated credit quality in its loan portfolio, which is consistent with the results of the Step 2 analysis. The fair value determined for BPNAs loan portfolio in the July 31, 2010 annual test represented a discount of 23.6%, compared with 20.2% at December 31, 2009. The discount is mainly attributed to market participants expected rate of returns, which affected the market discount on the commercial and construction loan portfolios and deteriorated credit quality of the consumer and mortgage loan portfolios of BPNA. Refer to the Reportable Segments Results section of this MD&A, which provides highlights of BPNAs reportable segment financial performance for the year ended December 31, 2010. BPNAs provision for loan losses, as a stand-alone legal entity, which is the reporting unit level used for the goodwill impairment analysis, amounted to $397 million for year ended December 31, 2010, which represented 122% of BPNA legal entitys net loss of $326 million for that period. The provision for loan losses included charges of $120 million to the provision for loan losses related to a reclassification to loans held-for-sale of approximately $396 million (book value) of non-conventional mortgage loans in December 2010.
If the Step 1 fair value of BPNA declines further in the future without a corresponding decrease in the fair value of its net assets or if loan discounts improve without a corresponding increase in the Step 1 fair value, the Corporation may be required to record a goodwill impairment charge. The Corporation engaged a third-party valuator to assist management in the annual evaluation of BPNAs goodwill (including Step 1 and Step 2) as well as BPNAs loan portfolios as of the July 31, 2010 valuation date. Management discussed the methodologies, assumptions and results supporting the relevant values for conclusions and determined they were reasonable.
For the BPPR reporting unit, had the average reporting unit estimated fair value calculated in Step 1 using all valuation methodologies been approximately 16% lower, there would still be no requirement to perform a Step 2 analysis, thus there would be no indication of impairment on the goodwill recorded in BPPR at July 31, 2010. For the BPNA reporting unit, had the estimated implied fair value of goodwill calculated in Step 2 been approximately 63% lower, there would still be no impairment of the goodwill recorded in BPNA at July 31, 2010. The goodwill balance of BPPR and BPNA, as legal entities, represented approximately 91% of the Corporations total goodwill balance as of the July 31, 2010 valuation date.
Furthermore, as part of the analyses, management performed a reconciliation of the aggregate fair values determined for the reporting units to the market capitalization of Popular, Inc. concluding that the fair value results determined for the reporting units in the July 31, 2010 annual assessment were reasonable.
The goodwill impairment evaluation process requires the Corporation to make estimates and assumptions with regard to the fair value of the reporting units. Actual values may differ significantly from these estimates. Such differences could result in future impairment of goodwill that would, in turn, negatively impact the Corporations results of operations and the reporting units where the goodwill is recorded. Declines in the Corporations market capitalization increase the risk of goodwill impairment in the future.
Management monitors events or changes in circumstances between annual tests to determine if these events or changes in circumstances would more likely than not reduce the fair value of a reporting unit below its carrying amount. As indicated in this MD&A, the economic situation in the United States and Puerto Rico, including deterioration in the housing market and credit market, continued to negatively impact the financial results of the Corporation during 2010. As part of the monitoring process, management performed an assessment for BPNA at December 31, 2010 since this unit had failed the Step 1 test in the annual goodwill evaluation. The Corporation determined BPNAs fair value utilizing the same valuation approaches (market and DCF) used in the annual goodwill impairment test. The determined fair value for BPNA at December 31, 2010 continued to be below its carrying amount under all valuation approaches. The fair value determination of BPNAs assets and liabilities was updated at December 31,
2010 utilizing valuation methodologies consistent with the July 31, 2010 test. The results of the assessment at December 31, 2010 indicated that the implied fair value of goodwill exceeded the goodwill carrying amount, resulting in no goodwill impairment. The results obtained in the December 31, 2010 assessment were consistent with the results of the annual impairment test in that the reduction in the fair value of BPNA was mainly attributable to the reduced fair value of BPNAs loan portfolio. The discount on BPNAs loan portfolio was approximately 20% at December 31, 2010.
Pension and Postretirement Benefit Obligations
The Corporation provides pension and restoration benefit plans for certain employees of various subsidiaries. The Corporation also provides certain health care benefits for retired employees of BPPR. The non-contributory defined pension and benefit restoration plans (the Plans) are frozen with regards to all future benefit accruals.
The estimated benefit costs and obligations of the pension and postretirement benefit plans are impacted by the use of subjective assumptions, which can materially affect recorded amounts, including expected returns on plan assets, discount rates, rates of compensation increase and health care trend rates. Management applies judgment in the determination of these factors, which normally undergo evaluation against current industry practice and the actual experience of the Corporation. The Corporation uses an independent actuarial firm for assistance in the determination of the pension and postretirement benefit costs and obligations. Detailed information on the plans and related valuation assumptions are included in Note 28 to the consolidated financial statements.
The Corporation periodically reviews its assumption for the long-term expected return on pension plan assets. The Plans assets fair value at December 31, 2010 was $464.6 million. The expected return on plan assets is determined by considering various factors, including a total fund return estimate based on a weighted average of estimated returns for each asset class in the plan. Asset class returns are estimated using current and projected economic and market factors such as real rates of return, inflation, credit spreads, equity risk premiums and excess return expectations.
As part of the review, the Corporations independent consulting actuaries performed an analysis of expected returns based on the plans asset allocation at January 1, 2011. This analysis is reviewed by the Corporation and used as a tool to develop expected rates of return, together with other data. This forecast reflects the actuarial firms view of expected long-term rates of return for each significant asset class or economic indicator; for example, 8.3% for large / mid-cap stocks, 5.1% for long-term government/credit, 9.0% for small cap stocks and 2.1% inflation at January 1, 2011. A range of expected investment returns is developed, and this range relies both on forecasts and on broad-market historical benchmarks for expected returns, correlations, and volatilities for each asset class.
As a consequence of recent reviews, the Corporation left unchanged its expected return on plan assets for year 2011 at 8.0%, similar to the expected rate assumed in 2010 and 2009. Since the expected return assumption is on a long-term basis, it is not materially impacted by the yearly fluctuations (either positive or negative) in the actual return on assets. However, if the actual return on assets performs below managements expectations for a continued period of time, this could eventually result in the reduction of the expected return on assets percentage assumption.
Pension expense for the Plans amounted to $13.9 million in 2010, which includes a settlement loss of $4.2 million in the Corporations U.S. retirement plan. The total pension expense included a credit of $32.5 million for the expected return on assets.
Pension expense is sensitive to changes in the expected return on assets. For example, decreasing the expected rate of return for 2011 from 8.00% to 7.50% would increase the projected 2011 expense for the Banco Popular de Puerto Rico Retirement Plan, the Corporations largest plan, by approximately $2.8 million.
The Corporation accounts for the underfunded status of its pension and postretirement benefit plans as a liability, with an offset, net of tax, in accumulated other comprehensive income or loss. The determination of the fair value of pension plan obligations involves judgment, and any changes in those estimates could impact the Corporations consolidated statement of financial condition. The valuation of pension plan obligations is discussed above. Management believes that the fair value estimates of the pension plan assets are reasonable given that the plan assets are managed, in the most part, by the fiduciary division of BPPR, which is subject to periodic audit verifications. Also, the composition of the plan assets, as disclosed in Note 28 of the consolidated financial statements, is primarily in equity and debt securities, which have readily determinable quoted market prices.
The Corporation uses the Tower Watson RATE: Link (10/90) Model to discount the expected program cash flows of the plans as a guide in the selection of the discount rate. The Corporation decided to use a discount rate of 5.30% to determine the benefit obligation at December 31, 2010, compared with 5.90% at December 31, 2009.
A 50 basis point decrease in the assumed discount rate of 5.30% as of the beginning of 2011 would increase the projected 2011 expense for the Banco Popular de Puerto Rico Retirement Plan by approximately $2.5 million. The change would not affect the minimum required contribution to the Plan.
The Corporation also provides a postretirement health care benefit plan for certain employees of BPPR. This plan was unfunded (no assets were held by the plan) at December 31, 2010. The Corporation had an accrual for postretirement benefit costs of $164 million at December 31, 2010. Assumed health care trend rates may have significant effects on the amounts reported for the health care plan. Note 28 to the consolidated financial statements provides information on the assumed rates considered by the Corporation and on the sensitivity that a one-percentage point change in the assumed rate may have on specified cost components and postretirement benefit obligation of the Corporation.
STATEMENT OF OPERATIONS ANALYSIS
Net Interest Income
Net interest income on a taxable equivalent basis for the year ended December 31, 2010 resulted in an increase of $123.0 million when compared with the same period in 2009. This source of earnings is subject to volatility derived from several risk factors which include market driven events as well as strategic decisions made by the Corporations management.
Tax-exempt interest earning assets include the investment securities and loans that are exempt from income tax, principally in Puerto Rico. The main sources of tax-exempt interest income are certain investments in obligations of U.S. Government sponsored entities, and certain obligations of the Commonwealth of Puerto Rico and its agencies and instrumentalities. Assets held by the Corporations international banking entities, which previously were tax exempt under Puerto Rico law, are subject to a temporary 5% income tax rate. To facilitate the comparison of all interest related to these assets, the interest income has been converted to a taxable equivalent basis, using the applicable statutory income tax rates at each quarter, in the subsidiaries that have the benefit. The taxable equivalent computation considers the interest expense disallowance required by the Puerto Rico tax law. Under this law, the exempt interest can be deducted up to the amount of taxable income. BPPRs tax position changed during 2010 and the benefit previously obtained from exempt investments is, for now, not applicable; therefore, no adjustments were made to BPPRs net interest income since its current tax is the marginal tax rate.
Average outstanding securities balances are based upon amortized cost excluding any unrealized gains or losses on securities available-for-sale. Non-accrual loans have been included in the respective average loans and leases categories. Loan fees collected and costs incurred in the origination of loans are deferred and amortized over the term of the loan as an adjustment to interest yield. Prepayment penalties, late fees collected and the amortization of premiums / discounts on purchased loans are also included as part of the loan yield. Interest income for the period ended December 31, 2010 included a favorable impact, excluding the discount accretion on covered loans accounted for under ASC Subtopic 310-20 and ASC Subtopic 310-30, of $19.1 million, related to those items, compared to a favorable impact of $21.7 million for the same period in 2009 and $17.4 million in 2008. The discount accretion on covered loans accounted for under ASC Subtopic 310-20 and 310-30, as described below, was $79.8 million and $207.0 million, respectively for the year ended December 31, 2010.
Table D presents the different components of the Corporations net interest income, on a taxable equivalent basis, for the year ended December 31, 2010, as compared with the same period in 2009, segregated by major categories of interest earning assets and interest bearing liabilities.
Net Interest Income Taxable Equivalent Basis
Notes: The changes that are not due solely to volume or rate are allocated to volume and rate based on the proportion of the change in each category
The increase in net interest margin, on a taxable equivalent basis, for the year ended December 31, 2010, compared with the same period in 2009, was driven mostly by:
The above variances were partially offset by the following factors which affected negatively the Corporations net interest margin:
Excluding the loans acquired in the FDIC-assisted transaction, most loan categories decreased in volume, especially commercial and construction loan portfolios, due to lower origination activity and loan charge-offs. The consumer loan portfolio shows a decrease due to the slowdown in the auto and consumer loan origination activity in Puerto Rico, and the run-off of E-LOANs home equity lines of credit (HELOCs) and closed-end second mortgages. On the positive side, the covered loans acquired in the Westernbank FDIC-assisted transaction, that contributed $3.4 billion in average loan volume for the year 2010, net of fair value adjustments, mitigated the decrease in the volume of earning assets. The covered loans, which are segregated in Table D, contributed $303.1 million to the Corporations interest income during 2010. Investment securities decreased in average volume as a result of maturities and prepayments of mortgage-related investment securities, which funds were not reinvested due in part to deleveraging strategies, and to the sale of certain investment securities during the quarter ended September 30, 2010.
Also affecting net interest income was the increase in the volume of medium and long-term debt, particularly the note payable issued to the FDIC in April 2010. Despite the deposits acquired on the FDIC-assisted transaction, the Corporations deposit volume has declined, mainly in time deposits, including brokered certificates of deposit, due to deleveraging in the U.S. mainland operations, which was driven by a reduction in the earning assets funded by such deposits. Management is actively monitoring the impact the rate reductions could have on the Corporations liquidity.
The average key index rates for the years 2008 through 2010 were as follows:
Table Key Index Rates
The decrease in the taxable equivalent adjustment for the year 2010, compared with the previous year, relates to the fact that there were no benefits associated to BPPRs tax-exempt assets during 2010 as explained above.
Table E presents the different components of the Corporations net interest income for the year ended December 31, 2009, as compared with the same period in 2008.
Net Interest Income Taxable Equivalent Basis
Notes: The changes that are not due solely to volume or rate are allocated to volume and rate based on the proportion of the change in each category
Net interest margin in 2009 showed a decrease as compared to 2008 due to:
A lower cost of short term borrowing and interest bearing deposits during 2009 as compared to 2008 positively affected the Corporations net interest margin.
Provision for Loan Losses
The provision for loan losses totaled $1.0 billion, or 88% of net charge-offs, for the year ended December 31, 2010, compared with $1.4 billion, or 137%, respectively, for 2009, and $991.4 million, or 165%, respectively, for 2008. The provision for loan losses for the year ended December 31, 2010 considers the effect of a $176.0 million charge to provide for the difference between the book value and the estimated fair value of the portfolios transferred to loans held-for-sale. Excluding the $176.0 million increase in provision related to these reclassifications, the provision for loan losses declined by $570 million during the year ended December 31, 2010, compared with the year ended December 31, 2009.
The provision for loan losses for the year ended December 31, 2010, when compared with the previous year, reflects higher net charge-offs by $125.2 million, mainly in commercial loans by $175.0 million and construction loans by $85.1 million. Partially offsetting this negative variance were lower net charge-offs in consumer loans by $102.0 million, mortgage loans by $25.8 million, and lease financing by $7.1 million. During the year ended December 31, 2010, the Corporation recorded $605.4 million in provision for loan losses for loans individually evaluated for impairment, compared with $566.0 million for 2009. The increases in the commercial and construction loans net charge-offs were primarily attributed to the Corporations decision to promptly charge-off previously reserved impaired amounts of collateral dependent loans both in Puerto Rico and the U.S. mainland. The decreases in the consumer and mortgage loan net charge-offs were mostly related to the favorable credit trends experienced by the Corporations U.S. mainland operations, particularly in the home equity lines of credit and closed-end second mortgages, and the non-conventional mortgage business.
As indicated previously, the covered loans were recognized at fair value upon acquisition. Based on managements analysis, there was no need to establish an allowance for the covered loans from the acquisition date to December 31, 2010, thus this loan portfolio did not influence the variance in provision for loan losses.
The increase in the provision for loan losses for 2009, compared with 2008, was principally the result of higher general reserve requirements for commercial loans, construction loans, U.S. mainland non-conventional residential mortgages and home equity lines of credit, combined with specific reserves recorded for loans considered impaired. The continued recessionary conditions of the Puerto Rico and the United States economies, housing value declines, a slowdown in consumer spending and the turmoil in the global financial markets impacted the Corporations commercial and construction loan portfolios; increasing charge-offs, non-performing assets and loans judgmentally classified as impaired. The stress consumers experienced from depreciating home prices, rising unemployment and tighter credit conditions resulted in higher levels of delinquencies and losses in the Corporations mortgage and consumer loan portfolios.
Refer to the Credit Risk Management and Loan Quality section for a detailed analysis of net charge-offs, non-performing assets, the allowance for loan losses and selected loan losses statistics.
Refer to Table F for a breakdown on non-interest income by major categories for the past five years. Non-interest income accounted for 50% of total revenues in 2010, while it represented 45% of total revenues in the year 2009 and 39% in 2008.
Non-interest income for the year ended December 31, 2010, compared with the previous year, increased by $391.7 million, or 44%, principally due to the gain of $640.8 million, before tax and transaction costs, recognized on the sale of the 51% ownership interest in the Corporations processing and technology business, EVERTEC.
In addition, there were $42.6 million in favorable changes in the fair value of the equity appreciation instrument issued to the FDIC during the year ended December 31, 2010 due to a reduction in the assumption of volatility related to the Corporations stock price and a shorter period remaining for the expiration of the instrument.
Also, other operating income increased by $28.4 million due mainly to the $39.4 million accretion of the fair value of unfunded loan commitments that had been recorded as part of the FDIC-assisted transaction (which is offset by approximately 80% of this balance recorded in the category of FDIC loss share expense within non-interest income) and lower net derivative losses, including lower unfavorable credit adjustments by $8.2 million; partially offset by losses of $14.8 million from the retained ownership interest in EVERTEC, which represented $574 thousand of the share of EVERTECs net income for the period from October 1, 2010 through December 31, 2010, offset by the 49% of intercompany income eliminations of $15.4 million. This elimination mostly represents 49% of the costs that the Corporation records in the professional fees category within operating expenses and that EVERTEC has recognized as part of its net income, and must be eliminated as it represents a transaction with an affiliate.
The above favorable variances in non-interest income were partially offset by the unfavorable variances discussed in the paragraphs below.
There were lower net gains on sales of investment securities, net of valuation adjustments of investment securities, in 2010 by $215.6 million, compared with 2009, as shown in the table below:
Table Non-Interest Income Investment Securities
During the year ended December 31, 2010, there were $3.8 million in gains on the sale of available-for-sale securities, compared to $236.6 million in gains on the sale of investment securities during 2009, mostly related to the sale of $3.4 billion in U.S. Treasury notes and U.S. agency obligations by BPPR and the sale of equity securities by the BPPR and EVERTEC reportable segments. The valuation adjustments recorded during 2010 were related to write-downs on equity securities available-for-sale, while the valuation adjustments recorded during 2009 were also related to write-downs on equity securities available-for-sale and to tax credit investments classified as other investment securities in the consolidated statement of condition.
Also, there were $25.8 million in losses in the caption of FDIC loss share expense for the year ended December 31, 2010. These losses resulted from a reduction in the indemnification asset by $95.4 million resulting principally from the Corporations application of reciprocal accounting for covered loans accounted for under ASC Subtopic 310-20 and the accounting for the unfunded commitments recorded at fair value on acquisition date. The Corporation was required to reduce the indemnification asset by approximately 80% of the loan discount accreted, and thus record a reduction in non-interest income. The above decrease in the FDIC loss share indemnification asset was partially offset by accretion of the indemnification asset, which amounted to $69.6 million for the period from April 30, 2010 through December 31, 2010.
The decrease in trading account profit by $23.3 million for the year ended December 31, 2010, when compared with the same period of the previous year, was mostly in the Puerto Rico mortgage banking subsidiary and was mainly related to $51.1 million in lower realized gains as a result of a lower volume of mortgage-backed securities sold, partially offset by $23.2 million in higher unrealized gains of outstanding mortgage-backed securities.
There were higher losses on sales of loans, net of lower of cost or fair value adjustments on loans held-for-sale, by $21.1 million, as detailed in the table below:
Table Non-Interest Income Loans
For the year ended December 31, 2010, there were higher adjustments to the indemnity reserve of $31.8 million compared to 2009, mainly in the BPPR reportable segment by $54.0 million resulting from loans sold with recourse and to settlements on certain representation and warranty arrangements by E-LOAN. Partially offsetting the higher adjustment to the indemnity reserves, were lower unfavorable fair value adjustments on loans-held-for-sale by $3.3 million, higher gains of $6.1 million recorded by the Corporations mortgage banking business related to residential mortgage loans securitized and whole loan sales, and higher gains by $3.6 million on sales of commercial loans and leases in the BPNA reportable segment.
In addition, service charges on deposit accounts for the year ended December 31, 2010 decreased by $17.7 million, when compared with the same period in 2009, mostly in the BPNA reportable segment related to lower non-sufficient funds fees and reduced fees from money services clients, the impact of Regulation E, and due to fewer customer accounts resulting from the reduction in BPNAs branches.
For the year ended December 31, 2009, non-interest income increased by $66.5 million, or 8%, when compared to 2008, mostly as a result of higher gains on sales of investment securities, net of valuation adjustments of investment securities. Net gains on sales of investment securities realized during 2009 included $182.7 million derived from the sale of $3.4 billion in U.S. Treasury notes and
U.S. agency obligations during the first quarter of 2009 by BPPR and $52.3 million in gains from the sale of equity securities during 2009 by the BPPR and EVERTEC reportable segments, compared to approximately $49.3 million in gains related to the redemption of equity securities held by the Corporation during the first quarter of 2008 and $28.3 million in gains realized from the sale of $2.4 billion in U.S. agency securities during the second quarter of 2008 by BPPR. The fair value adjustments on loans held-for-sale were lower by $15.2 million for the year ended December 31, 2009, compared with the same period in 2008, mostly as a result of a $16.1 million adjustment recorded by Popular Equipment Finance in December 2008 on certain loans reclassified to held-for-sale, which were sold in early 2009. These favorable variances were partially offset by losses on sales of loans, including adjustments to indemnity reserves, of $31.4 million during the year ended December 31, 2009 mainly in the BPNA reportable segment and PFH which was adjusted by $40.2 million. Additionally, there were lower other service fees by $22.0 million resulting from a decrease in credit card fees by $13.1 million associated with reduced late payment fees as a result of lower volume of credit cards subject to the fee and a lower average rate charged per transaction, and to reduced merchant fees because of lower volume of purchases; and lower mortgage servicing fees, net of fair value adjustments, by $10.9 million due to higher unfavorable fair value adjustments due to the impact of a higher discount rate, an increase in delinquencies, and foreclosure costs, and other economic assumptions, partially offset by higher servicing fees. Moreover, there was a decline in other operating income by $22.9 million due to lower gains on the sale of real estate properties by $20.5 million, principally because of a $21.1 million gain realized by BPNA in the third quarter of 2008 on the sale of a commercial building located in New York City and the sale of six retail bank branches of BPNA in Texas during the first quarter of 2008 with a realized gain of $12.8 million; and higher derivative losses, including unfavorable credit adjustments, by $11.3 million; partially offset by lower write-downs on certain investments accounted under the equity method that are held by the Corporate group by $35.8 million.
Refer to Table G for the detail of operating expenses by major categories along with various related ratios for the last five years.
Operating expenses for the year ended December 31, 2010 increased by $171.4 million, or 15%, compared with the year ended December 31, 2009. The increase in operating expenses was principally due to $38.8 million in prepayment penalties recognized in 2010 mostly as a result of the cancellation of FHLB advances and certain public fund certificates of deposit as part of BPNAs deployment of excess liquidity and as part of a strategy to increase margin in future periods, and to the repurchase of certain term notes. This compares to $78.3 million in gains on the early extinguishment of debt in 2009, which resulted principally from the junior subordinated debentures that were extinguished as a result of the exchange of trust preferred securities for common stock in August 2009. Also contributing to the increase in operating expenses for the year ended December 31, 2010, compared with the previous year, were higher professional fees, principally in the categories of consulting fees related to the EVERTEC sale and the Westernbank FDIC-assisted transactions and legal fees related in part to credit collection services and litigation support. Furthermore, there were higher maintenance and selling costs on repossessed properties as well as higher write-downs on the value of these properties. These
unfavorable variances were partially offset by lower personnel costs, principally a reduction of $12.4 million in pension and restoration plan expenses, and lower equipment expenses. Full time equivalent employees totaled 8,277 as December 31, 2010 compared with 9,407 at December 31. 2009. A decrease in salaries from a reduction in headcount at the BPNA reportable segment, due to restructuring and staff reductions during 2009 and to the sale of EVERTEC in the fourth quarter of 2010, was partially offset by the salaries related to the employees hired from the Westernbank former operations. The decrease in equipment expenses was mainly due to lower depreciation expense of software licenses and electronic equipment as a result of the EVERTEC sale, and to lower depreciation and maintenance and repair expenses in the BPNA reportable segment due to fewer licensing needs and fewer branches as a result of the restructuring of its operations.
The primary contributor to the reduction in operating expenses for 2009, compared with 2008, was due to the gain on early extinguishment of debt. A second contributor was the decrease in personnel costs, which was primarily the result of a reduction in headcount from 10,387 (excluding discontinued operations) at December 31, 2008 to 9,407 at December 31, 2009, a freeze in the pension plan, the suspension of matching contributions to all savings plans and continuation of a salary and hiring freeze. Furthermore, there was a decrease in business promotion for the year ended December 31, 2009, compared with 2008, principally related to the BPNA reportable segment mostly associated with downsizing of the operations. The BPPR reportable segment also contributed with a reduction in business promotion as a result of cost control measures on expenditures in general, including mailing campaigns, among others. Equipment expenses decreased due to lower amortization of software packages and depreciation of technology equipment, in part because such software and equipment was fully amortized in 2008 or early 2009. Also, the decrease is partially due to lower equipment requirements and software licensing because of the downsizing of the Corporations U.S. mainland operations and the transfer of E-LOANs technology operations to EVERTEC in Puerto Rico, eliminating two data processing centers. The reduction in professional fees was mostly due to the fact that, in 2008, the Corporation incurred consulting and advisory services associated to the U.S. sale transactions and valuation services, which were not recurrent in 2009. Also, the reduction was influenced by lower credit bureau fees and other loan origination related services given the exiting by E-LOAN of the direct lending business during 2008, lower programming fees and temporary services. The favorable variances in operating expenses comparing 2009 with 2008 results were partially offset by higher FDIC deposit insurance premiums resulting in part from an FDIC revised risk-weighted methodology and an FDIC special assessment designed to replenish the deposit insurance fund.
Income tax expense amounted to $108.2 million for the year December 31, 2010, compared with an income tax benefit of $8.3 million for the previous year. The increase in income tax expense for 2010 was due to higher pre-tax earnings in 2010 related to the Puerto Rico operations, mostly related to income subject to capital gain tax rate and by lower benefit on net exempt interest income.
In addition, in 2009, there was an increase in the Puerto Rico statutory tax rate from 39% to 40.95% that resulted in an income tax benefit during the year 2009 as compared to 2010.
The change in the effective tax rate for the year ended December 31, 2010 as compared with 2009 was mainly due to a reduction in the net tax exempt interest income. Also, in 2009 there was an increase in the Puerto Rico statutory tax rate from 39% to 40.95% which resulted in an income tax benefit due to the increase in the deferred tax asset. The change in the effective tax rate for the year ended 2009 as compared with 2008 was mainly due to the establishment during 2008 of a valuation allowance on all of the deferred tax assets related to the U.S. operations.
Income tax benefit for the year ended December 31, 2009 was $8.3 million, compared with an income tax expense of $461.5 million for 2008. The decrease in income tax expense for 2009 was primarily due to the impact on the initial recording of the valuation allowance on the U.S. deferred tax assets during 2008 as compared to the year 2009, and by lower pre-tax earnings in 2009 related to the Puerto Rico operations.
The Corporations net deferred tax assets at December 31, 2010 amounted to $377 million (net of the valuation allowance of $1.3 billion) compared to $364 million at December 31, 2009. Note 31 to the consolidated financial statements provides the composition of the net deferred tax assets as of such dates. All of the net deferred tax assets at December 31, 2010 pertain to the Puerto Rico operations. Of the amount related to the U.S. operations, without considering the valuation allowance, $1.1 billion is attributable to net operating losses of such operations.
The components of the income tax expense (benefit) for the years ended December 31, 2010, 2009 and 2008 are included in the following table.
Table Components of Income Tax
The full valuation allowance in the Corporations U.S. operations was recorded in the year 2008 in consideration of the requirements of ASC Topic 740. Refer to the Critical Accounting Policies / Estimates section of this MD&A for information on the requirements of ASC Topic 740. The Corporations U.S. mainland operations are in a cumulative loss position for the three-year period ended December 31, 2010. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position, along with the evaluation of all sources of taxable income available to realize the deferred tax asset, has caused management to conclude that it is more likely than not that the Corporation will not be able to fully realize the deferred tax assets in the future, considering solely the criteria of ASC 740.
The Corporations Puerto Rico Banking operation is in a cumulative loss position for the three-year period ended December 31, 2010. This situation is mainly due to the increased charge-offs in the construction loan portfolio in particular, including the charges related to the proposed sale of the portfolio. The Corporation weights all available evidence, positive and negative, to assess the realization of the deferred tax asset. Positive evidence assessed included the Corporations Puerto Rico banking operations very strong earnings history and managements view, based on that history, that the event causing this loss is not a continuing condition of the operations; new legislation extending the period of carryover of net operating losses to 10 years; and unrealized gain on appreciated assets that could be realized to increase taxable income. Such positive evidence is enough to outweigh the negative evidence of the cumulative loss. Based on this evidence, the Corporation has concluded that it is more likely than not that such net deferred tax asset of the Puerto Rico operations will be realized.
Management will reassess the realization of the deferred tax assets based on the criteria of ASC Topic 740 each reporting period. To the extent that the financial results of the U.S. operations improve and the deferred tax asset becomes realizable, the Corporation will be able to reduce the valuation allowance through earnings.
Refer to Note 31 to the consolidated financial statements for additional information on income taxes.
Fourth Quarter Results
The Corporation recognized a net loss of $227.1 million for the quarter ended December 31, 2010, compared with a net loss of $213.2 million for the same quarter of 2009.
Net interest income for the fourth quarter of 2010 was $354.6 million, compared with $269.3 million for the fourth quarter of 2009. The increase in net interest income was primarily due to discount accretions on covered loans acquired from the Westernbank FDIC-assisted transaction. The Corporations borrowing costs also decreased as a result of a low interest rate scenario and managements actions to reduce borrowing costs, principally prepaying high cost FHLB advances. Additionally, there were higher yields on consumer loans principally reflected in the credit cards portfolio, due in part to revisions made to the spread charged over the prime rate for different risk categories.
The provision for loan losses totaled $354.4 million or 74% of net charge-offs for the quarter ended December 31, 2010, compared to $352.8 million or 118% of net charge-offs for the fourth quarter of 2009. The provision for loan losses for the quarter ended December 31, 2010 includes the effect of the $176 million charge to provide for the difference between the book value and the estimated fair value of the portfolios transferred to loans held-for-sale. Excluding the $176 million increase in provision related to these reclassifications, the provision for loan losses declined by $175 million in the fourth quarter of 2010, compared with the same quarter in the previous year.
The provision for loan losses for the fourth quarter of 2010, when compared with the same quarter in 2009, reflects higher net charge-offs by $179.0 million, mainly in construction loans and commercial loans by $126.9 million and $94.8 million, respectively. These increases were offset by decreases in net charge-offs in consumer loans by $27.9 million, mortgage loans by $11.7 million,
and leases by $3.0 million. The increases in the commercial and construction loans net charge-offs were primarily attributed to the Corporations decision to promptly charge-off previously reserved impaired amounts of collateral dependent loans both in Puerto Rico and the U.S. mainland. The decreases in the consumer and mortgage loan net charge-offs were mostly driven by more stable credit trends experienced by the Corporations U.S. mainland operations, particularly in the home equity lines of credit and closed-end second mortgages portfolios. Also, these decreases were influenced in part by portfolio reductions in U.S. mortgage loans, and in the consumer loan portfolios at both reportable segments.
Non-interest income totaled $105.6 million for the quarter ended December 31, 2010, compared with $175.9 million for the same quarter in 2009. The decrease in non-interest income was mainly impacted by higher adjustments to indemnity reserve of $35.0 million compared to the fourth quarter of 2009, related to loans sold with credit recourse and final settlements on some representation and warranty liabilities. The decrease in non-interest income is also due to lower credit card and debit cards fees as a result of lower merchant banking fees due to sale of this operations as part of the EVERTEC transaction. These unfavorable variances were partially offset by lower unfavorable valuation adjustment in the value of mortgage servicing rights and a favorable impact due to the fair value change of the equity appreciation instrument issued as part of the Westernbank FDIC-assisted transaction.
Operating expenses totaled $344.7 million for the quarter ended December 31, 2010, compared with $298.8 million for the same quarter in the previous year. The increase in operating expenses was impacted by the prepayment penalties of $12.1 million on the cancellation of $183 million in FHLB advances, the $7.5 million payment to cover the uninsured portion of the settlement of certain securities class action lawsuits and higher processing fees. The higher processing fees reflect the fact that following the sale of the majority interest in EVERTEC, the costs related to continuing services provided by EVERTEC are no longer fully eliminated in the consolidation of financial results. There were also higher other real estate expenses and unfavorable fair value adjustments on repossessed property and higher charges to increase the reserve for unfunded lending commitments. These unfavorable variances were partially offset by lower equipment expenses mainly because most software packages were transferred to EVERTEC as part of the sale.
Income tax benefit amounted to $11.8 million for the quarter ended December 31, 2010, compared with an income tax expense of $6.9 million for the same quarter of 2009. The variance of $18.7 million was primarily due to a higher loss before tax in the Puerto Rico operations for the fourth quarter of 2010 as compared to the fourth quarter of 2009.
REPORTABLE SEGMENT RESULTS
The Corporations reportable segments for managerial reporting purposes consist of Banco Popular de Puerto Rico and Banco Popular North America. A Corporate group has been defined to support the reportable segments. For managerial reporting purposes, the costs incurred by the corporate group are not allocated to the reportable segments. For a description of the Corporations reportable segments, including additional financial information and the underlying management accounting process, refer to Note 39 to the consolidated financial statements.
As a result of the sale of a 51% interest in EVERTEC described in the Overview section, the Corporation no longer presents EVERTEC as a reportable segment and therefore, historical financial information for EVERTEC, including the merchant acquiring business that was part of the BPPR reportable segment but transferred to EVERTEC in connection with the sale, has been reclassified under Corporate for all periods discussed. The financial results for Tarjetas y Transacciones en Red Tranred, a former subsidiary of EVERTEC, and the equity investments in CONTADO and Serfinsa, formerly included as part of the EVERTEC reportable segment, are included as part of the Corporate group. Revenues from the Corporations equity interest in EVERTEC are being reported as non-interest income in the Corporate group.
Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. The segments were determined based on the organizational structure, which focuses primarily on the markets the segments serve, as well as on the products and services offered by the segments.
The Corporate group had a net income of $432.9 million for the year ended December 31, 2010, compared with a net income of $17.7 million for the year ended December 31, 2009. The variance in the year-to-date results for the Corporate group was principally due to:
Highlights on the earnings results for the reportable segments are discussed below.
Banco Popular de Puerto Rico
The Banco Popular de Puerto Rico reportable segments net income amounted to $46.6 million for the year ended December 31, 2010, compared with $158.3 million for 2009 and $227.5 million for 2008. During 2010, this reportable segment focused most of its efforts on integrating Westernbanks operations and managing credit quality. As indicated previously, the Westernbank FDIC-assisted transaction added approximately $8.6 billion in unpaid principal balance of loans and $2.4 billion in deposits. A majority of the loans are covered under the FDIC loss sharing agreements, thus reducing the Corporations exposure to credit risk on those loans. As part of the transaction, the Corporation added twelve branches to its branch network and retained approximately 57% of Westernbanks employees. The Westernbank acquisition also offers many opportunities to grow the Corporations business moving forward. Westernbank had approximately 240,000 clients, 140,000 of which did not have a relationship with Popular at the time of the transaction. Furthermore, the majority had only one banking relationship with Westernbank, which translates into cross-selling opportunities for the Corporation.
The prolonged recession in the Puerto Rican economy continued to have a negative impact on BPPRs credit quality during 2010. As shown in the credit quality data included in the Credit Risk Management and Loan Quality section of this MD&A, during 2010, the Corporations operations in Puerto Rico continued to experience high level of charge-offs in the commercial and construction loan portfolios, and to a lesser extent, in mortgage loans, principally due to reductions in real estate collateral values. Deterioration in the construction, commercial and mortgage loan portfolios was partially offset by an improvement in the consumer loan portfolios.
The main factors that contributed to the variance in the financial results for 2010, compared with the previous year, included the following:
The main factors that contributed to the variance in results for the year ended December 31, 2009, when compared with 2008, included:
Banco Popular North America
For the year ended December 31, 2010, the reportable segment of Banco Popular North America had a net loss of $340.3 million, compared to a net loss of $725.9 million for 2009 and a net loss $524.8 million for 2008. The reduction in the loss was driven by a lower provision for loan losses due to a general improvement in credit quality, partially offset by the impact of several transactions, which included an additional provision for loan losses of $120 million in December 2010 in connection with the reclassification of a portfolio of non-conventional residential mortgage loans to held-for-sale and the termination of approximately $417 million in high-cost borrowings, incurring approximately $21.9 million in prepayment penalties. Even though these transactions had a significant impact in 2010, BPNA should benefit in the future from lower funding costs and an improvement in credit quality.
In the U.S. mainland, management remains focused on managing legacy assets and improving the performance of BPNAs core banking business. The U.S. operations have followed the general credit trends on the mainland demonstrating progressive improvement; nonetheless, credit quality continues to be closely monitored. BPNAs provision for loan losses in 2010 was almost half of what it was in year 2009.
Management is working on increasing BPNAs customer base as it moves from being a mainly Hispanic-focused bank to a more broad-based community bank. To that end, in July 2010, the Corporation launched a rebranding pilot program in Illinois changing the name of the bank from Banco Popular North America to Popular Community Bank in order to appeal to a broader demographic group. Initial results have been encouraging, reflecting an increase in business from non-Hispanic customers. Management will continue monitoring results to decide on a potential rollout to other regions.
The main factors that contributed to the variance in results for the year ended December 31, 2010, when compared with 2009, included:
The main factors that contributed to the variance in results for the year ended December 31, 2009, when compared with 2008, included:
In 2008, the Corporation discontinued the operations of Popular Financial Holdings (PFH) by selling assets and closing service branches and other units. The following table provides financial information for the discontinued operations for the years ended December 31, 2009 and 2008. For financial reporting purposes, the results of the discontinued operations of PFH are presented as Assets / Liabilities from discontinued operations in the consolidated statements of condition and as Loss from discontinued operations, net of tax in the consolidated statements of operations.
STATEMENT OF CONDITION ANALYSIS
Refer to the consolidated financial statements included in this 2010 Annual Report for the Corporations consolidated statements of condition at December 31, 2010 and December 31, 2009. Also, refer to the Statistical Summary 2006-2010 in this MD&A for condensed statements of condition for the past five years. At December 31, 2010, the Corporations total assets were $38.7 billion, compared with $34.7 billion at December 31, 2009. The increase in total assets from December 31, 2009 to December 31, 2010 was mostly due to the Westernbank FDIC-assisted transaction, which as of the April 30, 2010 transaction date added $8.3 billion in total assets, net of fair value adjustments. This increase was offset in part by a reduction in the portfolio of investment securities and lower volume of loan originations, a run-off of legacy loans in the BPNA reportable segment associated to business lines exited in previous years, and the high volume of loan charge-offs. New originations have been adversely impacted by a negative economic environment that has resulted in weak loan demand.
The following table provides a breakdown of the Corporations portfolio of investment securities available-for-sale (AFS) and held-to-maturity (HTM) on a combined basis at December 31, 2010, 2009 and 2008. Also, Notes 8 and 9 to the consolidated financial statements provide additional information by contractual maturity categories and gross unrealized gains / losses with respect to the Corporations available-for-sale (AFS) and held-to-maturity (HTM) investment securities.
Table AFS and HTM Investment Securities
The portfolio of investment securities consists primarily of liquid, high quality securities. The reduction in investment securities from December 31, 2009 to December 31, 2010 was mostly impacted by maturities, prepayments and sales. The cash proceeds from these activities were not fully reinvested as part of a strategy to deleverage the balance sheet, including making prepayments on the note issued to the FDIC, as part of the Westernbank-assisted transaction. Proceeds from the sale of investment securities available-
for-sale for the year ended December 31, 2010 amounted to $397.1 million, with gains of approximately $3.8 million. The decline in the Corporations available-for-sale and held-to-maturity investment portfolios from December 31, 2008 to the end of 2009 was mainly associated with sales of securities in early 2009 and the repayment of maturing securities. As previously indicated in this MD&A, during the first quarter of 2009, the Corporation sold $3.4 billion of investment securities available-for-sale, principally U.S. agency securities (FHLB notes) and U.S. Treasury securities. From the proceeds received from this sale, approximately $2.9 billion were later reinvested, primarily in GNMA mortgage-backed securities. The sale and reinvestment was performed primarily to strengthen common equity by realizing a gain and improving the Corporations regulatory capital ratios.
At December 31, 2010, there were investment securities AFS and HTM with a fair value of $290 million in an unrealized loss position amounting to $9 million. These figures compare with securities of $1.8 billion with unrealized losses of $31 million at December 31, 2009. Management performed its quarterly analysis of all debt securities in an unrealized loss position at December 31, 2010 and concluded that no individual debt security was other-than-temporarily impaired as of such date. At December 31, 2010, the Corporation does not have the intent to sell debt securities in an unrealized loss position and it is not more likely than not that the Corporation will have to sell those investment securities prior to recovery of their amortized cost basis.
Refer to Table H, for a breakdown of the Corporations loan portfolio, the principal category of earning assets. Included in Table H are $894 million of loans held-for-sale at December 31, 2010, compared with $91 million at December 31, 2009. During the quarter ended December 31, 2010, the Corporation reclassified approximately $1.0 billion (carrying amount prior to lower of cost or fair value adjustments) of loans held-in-portfolio to loans-held-for-sale, which are expected to be sold during the first quarter of 2011. The loans reclassified consisted principally of non-performing construction, commercial real estate and land loans in Puerto Rico and U.S. non-conventional residential mortgage loans and did not include any loans covered under the FDIC loss sharing agreements.
Loans covered under the FDIC loss sharing agreements are presented in a separate line item in Table H. Because of the loss protection provided by the FDIC, the risks of the covered loans are significantly different, thus the Corporation has determined to segregate them in the information included in Table H.
Excluding the acquired covered loans, the volume of all loan portfolios at December 31, 2010, except for mortgage loans, declined when compared to December 31, 2009. This generally reflects weak loan demand, the high level of loan charge-offs as a result of the downturn in the real estate market, a continued weak economy, and the exiting or downsizing of certain loan origination channels at certain business lines at BPNA, which portfolios are currently in a run-off mode. A similar trend was experienced in the loan portfolio from 2008 to 2009, impacted by similar factors. Furthermore, the reduction since 2008 was influenced by the restructuring of the Corporations U.S. operations, including the discontinuance of PFH operations and E-LOAN ceasing to originate loans since the end of 2008 and the exiting of certain business lines at BPNA, primarily during 2009.
Loans Ending Balances (including Loans Held-for-Sale)
The explanations for loan portfolio variances discussed below exclude the impact of the acquired covered loans.
At December 31, 2010, the commercial and construction loan portfolios decreased $2.0 billion when compared to December 31, 2009. The decrease in these portfolios was both reflected in the BPPR and BPNA reportable segments and was impacted by lower new loan origination activity, portfolio run-off associated with exited origination channels in the U.S. operations, and loan net charge-offs during the year ended December 31, 2010 that totaled $833 million. During the quarter ended December 31, 2010, the
Corporation decided to promptly charge-off previously reserved impaired amounts of collateral dependent loans, both in Puerto Rico and U.S. operations, which totaled $210 million.
The decrease in the consumer loan portfolio from December 31, 2009 to December 31, 2010 of approximately $340 million, or 8%, was mostly reflected in personal and auto loans in Puerto Rico and home equity lines of credit and closed-end second mortgages in E-LOAN. Net charge-offs in the consumer loan portfolio amounted to $214 million for the twelve months ended December 31, 2010. Also, portfolio run-off exceeded the volume of new personal and auto loan originations in the BPPR reportable segment due to current weak economic conditions. Furthermore, the run-off of Popular Finances loan portfolio contributed to such decrease. Popular Finances operations were closed in late 2008. Also, there were reductions in the consumer loan portfolio of the BPNA reportable segment, primarily due to loan charge-offs and the run-off of its auto, closed-end second mortgages and home equity lines of credit portfolios, which are part of the business lines exited in prior years.
The decline in the lease financing portfolio from December 31, 2009 to December 31, 2010 was mostly at the BPPR reportable segment by $46 million, which similar to other loan portfolios continues to reflect the general slowdown in loan originations. The Corporations U.S. operations are no longer originating lease financing and as such, the outstanding portfolio in those operations is running off. At December 31, 2010, this portfolio had decreased $27 million when compared with December 31, 2009.
The mortgage loan portfolio at December 31, 2010 increased $254 million from December 31, 2009. The BPPR reportable segment showed an increase of $646 million, while the BPNA reportable segment experienced a reduction of $392 million. The Corporations mortgage loan origination subsidiary in Puerto Rico, Popular Mortgage, continued its efforts to originate loans despite the weak economic conditions in the Island. During the third quarter of 2010, the Puerto Rico government signed into law an aggressive housing incentive package which is helping boost residential housing sales activity. The reduction at BPNA resulted principally from the discontinuance of the non-conventional mortgage loan origination business and a higher volume of net charge-offs in the non-conventional mortgage loan portfolio.
As previously reported, the loan portfolio acquired amounted to over $8.6 billion in unpaid principal balance with a fair value of $5.2 billion. Note 10 to the consolidated financial statements presents the carrying amount of the covered loans broken down by major loan type categories. A substantial amount of the covered loans, or approximately $4.5 billion of their carrying value at December 31, 2010, is accounted for under ASC Subtopic 310-30. Refer to the Critical Accounting Policies / Estimates section of this MD&A for information on the accounting for the acquired loans.
The following table presents acquired loans accounted for pursuant to ASC Subtopic 310-30 as of the April 30, 2010 acquisition date:
The cash flows expected to be collected consider the estimated remaining life of the underlying loans and include the effects of estimated prepayments.
Changes in the carrying amount and the accretable yield for the acquired loans in the Westernbank FDIC-assisted transaction from date of acquisition through December 31, 2010, and which are accounted pursuant to the ASC Subtopic 310-30, were as follows:
At December 31, 2010, none of the acquired loans accounted under ASC Subtopic 310-30 were considered non-performing loans. Therefore, interest income, through accretion of the difference between the carrying amount of the loans and the expected cash flows, was recognized on all acquired loans.
As indicated in Note 2 to the consolidated financial statements and the Critical Accounting Policies / Estimates section of this MD&A, the Corporation accounts for acquired lines of credit with revolving privileges under the accounting guidance of ASC
Subtopic 310-20, which requires that any differences between the contractually required loan payment receivable in excess of the initial investment in the loans be accreted into interest income over the life of the loan, if the loan is accruing interest. The following table presents acquired loans accounted for under ASC Subtopic 310-20 as of the April 30, 2010 acquisition date:
The cash flows expected to be collected consider the estimated remaining life of the underlying loans and include the effects of estimated prepayments.
FDIC loss share indemnification asset
As part of the loan portfolio fair value estimation in the Westernbank FDIC-assisted transaction, the Corporation established the FDIC loss share indemnification asset, which represented the present value of the estimated losses on loans to be reimbursed by the FDIC. The FDIC loss share indemnification asset amounted to $2.3 billion at December 31, 2010 and is presented in a separate line item in the consolidated statement of condition. Refer to Note 3 to the consolidated financial statements for additional information on the FDIC loss sharing agreements and the resulting indemnification asset.
The following table provides a breakdown of the principal categories that comprise the caption of Other assets in the consolidated statements of condition at December 31, 2010 and 2009.
Table Other Assets
The increase in other assets from December 31, 2009 to the same date in 2010 was primarily due to the 49% ownership interest in EVERTEC, which is being accounted as an investment under the equity method. Refer to the Overview section of this MD&A and Note 4 to the consolidated financial statements for a description of the EVERTEC transaction. This increase was partially offset by reductions in the FDIC insurance premiums prepayment due to amortization and in other prepaid expenses, principally software packages due to the sale of EVERTEC.
Deposits and Borrowings
The composition of the Corporations financing to total assets at December 31, 2010 and 2009 was as follows:
Table Financing to Total Assets
N.M. means not meaningful.
A breakdown of the Corporations deposits at period-end is included in Table I.
Deposits Ending Balances
Brokered certificates of deposit, which are included in time deposits, amounted to $2.3 billion at December 31, 2010, compared with $2.7 billion at December 31, 2009. The decline was principally in the BPNA reportable segment.
The increase in demand and saving deposits from December 31, 2009 to December 31, 2010 was principally related to the deposits assumed in the Westernbank FDIC-assisted transaction. Time deposits, excluding brokered deposits, showed an increase of $81 million, which consisted of an increase of $885 million in BPPR primarily from the assumed deposits of Westernbank, partially offset by a reduction in the BPNA reportable segment of $804 million mainly due to reduced levels of individual certificates of deposits and lower deposits gathered through E-LOANs internet platform, the effect of a reduction in the pricing of these deposits and strategic actions taken that reduced BPNAs asset base considerably.
The decrease in deposits from December 31, 2008 to December 31, 2009 was the result of a combination of factors, which included lower brokered deposits, which declined from $3.1 billion at December 31, 2008 to $2.7 billion at the same date in 2009, and the impact of the closure and sale of branches in the U.S. mainland operations. In October 2009, the Corporation sold six New Jersey bank branches with approximately $225 million in deposits. In addition, there were reduced levels of deposits gathered through E-LOANs internet platform, in part influenced by the effect of a gradual reduction in the pricing of these deposits.
The Corporations borrowings amounted to $6.9 billion at December 31, 2010, compared with $5.3 billion at December 31, 2009. The increase of $1.6 billion in borrowings from the end of 2009 to December 31, 2010 was related to the note issued to the FDIC in relation to the FDIC-assisted transaction, which amounted to $2.5 billion at December 31, 2010, partially offset by a decrease of $439 million in advances with the Federal Home Loan Bank (FHLB), a reduction of $220 million in repurchase agreements, and the cancellation of $175 million in term notes, which had contractual maturities in September 2011 and were repurchased by the Corporation from holders of record in July 2010. During 2010, the Corporation prepaid $363 million in FHLB advances. The prepayment of the FHLB advances as well as the repurchase of the term notes was associated with the Corporations strategy to extinguish certain high-cost debt, which will benefit the Corporations cost of funds going forward.
The note issued to the FDIC is collateralized by the covered loans (other than certain consumer loans) and other real estate acquired in the agreement with the FDIC and all proceeds derived from such assets, including cash inflows from claims to the FDIC under the loss sharing agreements. Borrowings under the note bear interest at the per annum rate of 2.50% and is paid monthly. The Corporation may prepay the note in whole or in part without any penalty subject to certain notification requirements indicated in the agreement. During the year 2010, the Corporation prepaid $2.6 billion of the note issued to the FDIC from funds unrelated to the assets securing the note.
The decline in borrowings from December 31, 2008 to December 31, 2009 was directly related to the maturity of unsecured senior term notes of Popular North America during 2009, which had been used to fund the Corporations U.S. mainland operations. Term notes classified as notes payable declined by $803 million from the end of 2008 to the same date in 2009. Assets sold under agreements to repurchase at December 31, 2009 presented a reduction of $774 million when compared with December 31, 2008. This decline was associated in part to lower financing needs as a result of a lower volume of investment securities due to deleveraging.
In August 2009, the Corporation issued junior subordinated debentures with an aggregate liquidation amount of $936 million as part of the exchange agreement with the U.S. Treasury. At December 31, 2009, the outstanding balance of these debentures was $424 million since it is reported net of a discount amounting to $512 million. The discount resulted from the recording of the debentures at fair value because of the accounting treatment of the exchange. The increase in junior subordinated debentures was partially offset by the reduction in previously outstanding junior subordinated debentures of $410 million, associated with the exchange of trust preferred securities for common stock. Refer to a subsequent section titled Exchange Offers in this MD&A for detailed information on these exchange transactions.
In March 2010, the SECs Division of Corporation Finance sent a letter to certain public companies requesting information about repurchase agreements, securities lending transactions or other transactions involving the obligation to repurchase the transferred assets. The letter requests several disclosures with respect to such transfers that are recorded as sales. In this regard, the Corporation records all its repurchase transactions as collateralized borrowings rather than as sales transactions.
Refer to Notes 18, 19 and 20 to the consolidated financial statements for detailed information on the Corporations borrowings at December 31, 2010 and December 31, 2009. Also, refer to the Liquidity Risk section in this MD&A for additional information on the Corporations funding sources at December 31, 2010.
The increase in other liabilities of $229 million from December 31, 2009 to December 31, 2010 included the equity appreciation instrument issued as part of the Westernbank FDIC-assisted transaction with a fair value of $10 million at December 31, 2010, an increase of $44 million in the GNMA buy-back option and an increase of $31 million in the reserve for loans serviced with credit recourse and on loans sold with representation and warranty arrangements. Refer to the Liquidity Risk section in this MD&A for additional information on the Corporations contractual obligations at December 31, 2010.
Stockholders equity totaled $3.8 billion at December 31, 2010, compared with $2.5 billion at December 31, 2009 and $3.3 billion at December 31, 2008. Refer to the consolidated statements of condition and of stockholders equity for information on the composition of stockholders equity. Also, the disclosures of accumulated other comprehensive income (loss), an integral component of stockholders equity, are included in the consolidated statements of comprehensive loss. The increase in stockholders equity from December 31, 2009 to December 31, 2010 was principally due to a common stock issuance during the second quarter of 2010, which contributed $1.15 billion in additional capital. Refer to the Overview section of this MD&A for the main driver of this capital raise.
The decrease in stockholders equity from the end of 2008 to the end of 2009 was principally the result of the net loss of $573.9 million recorded during the year ended December 31, 2009. Certain significant transactions that occurred during 2009 had an impact on various categories of stockholders equity, including a reduction in preferred stock and an increase in common stockholders equity.
During the third quarter of 2009, the Corporation issued 357,510,076 new shares of common stock in exchange for its Series A and Series B preferred stock and trust preferred securities, which resulted in a total increase in common stockholders equity of $923 million. This increase included newly issued shares of common stock and surplus of $612 million and a favorable impact to accumulated deficit of $311 million, including $80.3 million in gains on the extinguishment of junior subordinated debentures that relate to the trust preferred securities. Preferred stock reflected a reduction as a result of the exchange of Series A and B preferred stock for shares of common stock of $537 million.
In December 2008, the Corporation received $935 million from the United States Department of the Treasury (U.S. Treasury) as part of the Troubled Asset Relief Program (TARP) Capital Purchase Program in exchange for the Corporations Class C preferred stock and warrants on common stock. In August 2009, the Corporation exchanged newly issued trust preferred securities for the shares of Series C Preferred Stock that were issued to the U.S. Treasury. The reduction in total stockholders equity related to the U.S. Treasury exchange transaction at the exchange date was approximately $416 million, which was principally impacted by the reduction of $935 million of aggregate liquidation preference value of the Series C preferred stock, partially offset by the $519 million discount on the junior subordinated debentures.
Refer to Note 22 to the consolidated financial statements for detailed information on the exchange offers, ratios, relevant price per share and fair value per share used for the exchange computations and accounting impact. The objective of the exchange offer was to boost common equity.
Included within surplus in stockholders equity at December 31, 2010 and December 31, 2009 was $402 million corresponding to a statutory reserve fund applicable exclusively to Puerto Rico banking institutions. The Banking Act of the Commonwealth of Puerto Rico requires that a minimum of 10% of BPPRs net income for the year be transferred to a statutory reserve account until such statutory reserve equals the total of paid-in capital on common and preferred stock. Any losses incurred by a bank must first be charged to retained earnings and then to the reserve fund. Amounts credited to the reserve fund may not be used to pay dividends without the prior consent of the Puerto Rico Commissioner of Financial Institutions. The failure to maintain sufficient statutory reserves would preclude BPPR from paying dividends. At December 31, 2010 and December 31, 2009, BPPR was in compliance with the statutory reserve requirement.
In June 2009, management announced the suspension of dividends on the Corporations common stock and Series A and B preferred stock. The Corporation did not pay dividends on its common stock during 2010. At the end of 2010, the Corporation began
paying dividends once again on the Series A and B preferred stock. Dividends paid on the Series A and B preferred stock totaled $310 thousand in 2010, compared with $22.5 million in 2009 and $31.4 million in 2008.
Table J presents the Corporations capital adequacy information for the years 2006 through 2010. Note 25 to the consolidated financial statements presents further information on the Corporations regulatory capital requirements, including the regulatory capital ratios of its depository institutions, BPPR and BPNA.
Capital Adequacy Data