Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE YEAR ENDED DECEMBER 31, 2003

 

  Commission File Number: 1-11515  

 

 COMMERCIAL FEDERAL CORPORATION 

(Exact Name of Registrant as Specified in its Charter)

 

                            Nebraska                             


 

        47-0658852        


(State or Other Jurisdiction of Incorporation

or Organization)

 

(I.R.S. Employer

Identification No.)

13220 California Street, Omaha, Nebraska


 

            68154            


(Address of Principal Executive Offices)   (Zip Code)

 

Registrant’s telephone number, including area code:    (402) 554-9200

 

Securities registered pursuant to Section 12(b) of the Act:

 

Common Stock, Par Value $.01 Per Share    New York Stock Exchange
Shareholder Rights Plan    New York Stock Exchange

7.95% Subordinated Notes due December 2006


  

New York Stock Exchange


Title of Each Class    Name of Each Exchange on Which Registered

 

Securities registered pursuant to Section 12(g) of the Act:    None

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934. Yes x  No ¨

 

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the average high and low sales price of the registrant’s common stock as quoted on the New York Stock Exchange on June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, was $782,920,450. As of March 1, 2004, there were issued and outstanding 40,916,744 shares of the registrant’s common stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement for the 2004 Annual Meeting of Stockholders—See Part III.



Table of Contents

COMMERCIAL FEDERAL CORPORATION

 

FORM 10-K INDEX

 


               Page No.

PART I

   Item 1.    Business    1
     Item 2.    Properties    37
     Item 3.    Legal Proceedings    37
     Item 4.    Submission of Matters to a Vote of Security Holders    38

PART II

   Item 5.    Market for Commercial Federal Corporation’s Common Equity and Related Stockholder Matters    38
     Item 6.    Selected Financial Data    39
     Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    41
     Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    69
     Item 8.    Financial Statements and Supplementary Data    70
     Item 9.    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    125
     Item 9A.    Controls and Procedures    125

PART III

   Item 10.    Directors and Executive Officers of Commercial Federal Corporation    126
     Item 11.    Executive Compensation    127
     Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    127
     Item 13.    Certain Relationships and Related Transactions    127

PART IV

   Item 14.    Principal Accountant Fees and Services    128
     Item 15.    Exhibits, Financial Statement Schedules, and Reports on Form 8-K    128

SIGNATURES

   130

 

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PART I

 

ITEM 1.    BUSINESS

 

Forward Looking Statements

 

This document contains certain statements that are not historical fact but are forward-looking statements that involve inherent risks and uncertainties. Management cautions readers that a number of important factors could cause actual results to differ materially from those in the forward looking statements. Factors that might cause a difference include, but are not limited to: fluctuations in interest rates, inflation, the effect of regulatory or government legislative changes, expected cost savings and revenue growth not fully realized, the progress of strategic initiatives and whether realized within expected time frames, general economic conditions, adequacy of allowance for loan losses, costs or difficulties associated with restructuring initiatives, technology changes and competitive pressures in the geographic and business areas where Commercial Federal Corporation conducts its operations. These forward-looking statements are based on management’s current expectations. Actual results in future periods may differ materially from those currently expected because of various risks and uncertainties.

 

General

 

Commercial Federal Corporation (the “parent company”) was incorporated in the state of Nebraska on August 18, 1983, as a unitary non-diversified savings and loan holding company. References in this document to the “Corporation” are to Commercial Federal Corporation and its consolidated subsidiaries and references to the “Bank” are to Commercial Federal Bank, a Federal Savings Bank, and its consolidated subsidiaries. The primary purpose of the parent company was to acquire all of the capital stock of Commercial Federal Bank, a Federal Savings Bank, in connection with the Bank’s 1984 conversion from mutual to stock ownership. A secondary purpose of the organizational structure was to provide the structure to expand and diversify the Corporation’s financial services to activities allowed by regulation for a unitary savings and loan holding company. The general offices of the Corporation are located at 13220 California Street, Omaha, Nebraska 68154.

 

The primary subsidiary of the parent company is the Bank. The Bank was originally chartered in 1887 and converted to a federally chartered mutual savings and loan association in 1972. On December 31, 1984, the Bank completed its conversion from mutual to stock ownership and became a wholly-owned subsidiary of the parent company. On August 27, 1990, the Bank’s federal charter was amended from a savings and loan to a federal savings bank.

 

The assets of the parent company, on an unconsolidated basis, substantially consist of 100% of the Bank’s common stock. The parent company has no significant independent source of income, and therefore depends almost exclusively on cash distributions from the Bank to meet its funding requirements. During the calendar year ended December 31, 2003, the parent company incurred interest expense on its subordinated extendible notes, junior subordinated debentures and unsecured term notes. Interest was payable monthly on the subordinated extendible notes, and quarterly on the junior subordinated debentures and the unsecured term note. For additional information on the debt of the Corporation see Note 12 “Other Borrowings” to the Consolidated Financial Statements that are filed under Item 8 of this Form 10-K Annual Report for the year ended December 31, 2003 (the “Report”).

 

The parent company began repurchasing its common stock in April 1999. For the year ended December 31, 2003, the parent company purchased and cancelled 3,992,100 shares of its common stock at a cost of $95.5 million. As of December 31, 2003, since the inception of the repurchase program in April 1999, the parent company has purchased and canceled 20,751,300 shares of its common stock, or 34.0% of the outstanding common stock at inception, at a cost of $451.1 million. The parent company also pays operating expenses

 

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primarily for shareholder and stock related expenditures such as the annual report, proxy, corporate filing fees and assessments and certain costs directly attributable to the parent company. In addition, common stock cash dividends totaling $17.9 million, or $.415 per common share, were declared during the year ended December 31, 2003.

 

The Bank pays cash distributions to the parent company on a periodic basis primarily to cover the amount of the principal and interest payments on the parent company’s debt, to fund the parent company’s common stock repurchases and to repay the parent company for the common stock cash dividends paid to the parent company’s stockholders. During the year ended December 31, 2003, the Corporation received cash distributions totaling $125.0 million from the Bank. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)—Liquidity and Capital Resources” under Item 7 of this Report for additional information.

 

The Bank operates as a federally chartered savings institution with deposits insured by the Savings Association Insurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”) both administered by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is a community banking institution offering commercial and consumer banking services including mortgage loan origination and servicing, commercial and industrial lending, small business banking, construction lending, cash management, deposit services, brokerage and insurance services, and Internet banking.

 

At December 31, 2003, the Corporation had assets of $12.2 billion and stockholders’ equity of $755.4 million, and operated 192 branches located in Colorado (45), Nebraska (42), Iowa (40), Kansas (27), Oklahoma (19), Missouri (13) and Arizona (6). The Bank is one of the largest retail financial institutions in the Midwest and, based upon total assets at December 31, 2003, the Corporation was the 11th largest publicly-held thrift institution in the United States. In addition, the Corporation serviced a loan portfolio totaling $15.0 billion at December 31, 2003, with approximately $11.4 billion in loans serviced for third parties and $3.6 billion in loans serviced for the Bank. See “MD&A—Overview” of this Report for additional information.

 

The Corporation’s business and earnings are sensitive to general business and economic conditions in the United States and, in particular, the Midwestern states where it has significant operations. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, the strength of the national and local economies and consumer spending, borrowing and savings habits. An economic downturn, an increase in unemployment or higher interest rates could decrease the demand for loans and other products and services and result in a deterioration in credit quality, loan performance and collectibility. Higher interest rates also could increase the Corporation’s cost to borrow funds and increase the rate the Corporation pays on deposits.

 

The long-term economic and political effects of terrorism and international hostilities remain uncertain which could hinder further economic recovery and could negatively affect the Corporation’s financial condition. Events that could adversely affect the Corporation’s business and operating results in other ways presently cannot be predicted. In addition, continued uncertainty in the economy could negatively impact the purchasing and decision making activities of the Corporation’s customers. If terrorist activity, international hostilities or other factors cause a further economic decline, the financial condition and operating results of the Corporation could be materially adversely affected.

 

The Corporation’s operations also are significantly affected by the fiscal and monetary policies of the federal government and by the policies of financial institution regulatory authorities, including the Office of Thrift Supervision (“OTS”), the Board of Governors of the Federal Reserve System and the FDIC. The policies of the Federal Reserve Board impact the Corporation significantly. The Federal Reserve Board regulates the supply of money and credit in the United States. Those policies directly and indirectly influence the rate of

 

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interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments the Corporation holds. Those policies determine to a significant extent the Corporation’s cost of funds for lending and investing. Changes in those policies are beyond the Corporation’s control and are difficult to predict. Deposit flows and costs of funds are also influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for mortgage and commercial financing, consumer loans and other types of loans, which, in turn, are affected by the interest rates at which such financings may be offered, the availability of funds, and other factors, such as the supply of housing for mortgage loans and regional economic situations.

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Topeka, which is one of the 12 regional banks comprising the FHLB System. The Bank is further subject to regulations of the Federal Reserve Board, which governs reserves required to be maintained against deposits and certain other matters. As a federally chartered savings bank, the Bank is subject to numerous restrictions on operations and investments imposed by applicable statutes and regulations. See the “Regulation” section of this Report.

 

Segment Reporting

 

The Corporation’s operations are aligned into four lines of business for management reporting purposes: Commercial Banking, Retail Banking, Mortgage Banking and Treasury. This business operation alignment allows management to make well-informed operating decisions, to focus resources to benefit both the Corporation and its customers, and to assess performance and products on a continuous basis. See “MD&A—Operating Results by Segment” and Note 21 “Segment Information” for additional information.

 

Regulatory Capital Compliance

 

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s financial position and results of operations. The regulations require the Bank to meet specific capital adequacy guidelines. Prompt corrective action provisions contained in the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) require specific capital ratios to be considered well-capitalized. At December 31, 2003, the Bank exceeded the minimum requirements for the well-capitalized category. As of December 31, 2003, the most recent notification from the OTS categorized the Bank as “well-capitalized” under the regulatory framework for prompt corrective action provisions under FDICIA. There are no conditions or events since such notification that management believes have changed the Bank’s classification. See “Regulation—Regulatory Capital Requirements” and Note 16 “Regulatory Capital” of this Report.

 

Supervisory Goodwill Lawsuits

 

On September 12, 1994, the Bank and the Corporation commenced litigation relating to supervisory goodwill against the United States government (“the Government”) in the United States Court of Federal Claims seeking to recover monetary relief for the Government’s refusal to honor certain contracts that it had entered into with the Bank. The suit alleged that such governmental action constituted a breach of contract and an unlawful taking of property by the Government without just compensation or due process in violation of the Constitution of the United States. On March 25, 1998, the Corporation filed a motion for summary judgment and the Government filed a cross motion for summary judgment on the question of liability for breach of contract. On March 24, 2003, the Corporation received an order from the United States Court of Federal Claims denying its motion for summary judgment seeking to establish liability for breach of contract and granting the Government’s cross motion concluding that there was no “contract” with respect to the Corporation’s 1987 acquisition of Empire Savings Building and Loan (“Empire”). In the litigation, the Corporation alleged that with respect to its acquisition of Empire, the Federal Home Loan Bank Board promised that $190.0 million of goodwill (the amount by which Empire’s liabilities exceeded its assets) would be included in the Bank’s regulatory capital as well as

 

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the $60.0 million of preferred stock issued by the Bank to fund the acquisition of Empire. The March 2003 order from the United States Court of Federal Claims also granted the Corporation’s motion for summary judgment and denied the Government’s cross-motion for summary judgment on the question of liability for breach of contract with respect to the Corporation’s acquisition of the savings deposits of Territory Savings and Loan Association (“Territory”) whereby the Bank accepted a five year $20.0 million promissory note from the Federal Savings and Loan Insurance Corporation (“FSLIC”) as part of the FSLIC’s payment for the Bank’s assumption of the savings deposits. The United States Court of Federal Claims agreed with the Corporation that the FSLIC had promised that the Bank could include the promissory note in its regulatory capital. On July 22, 2003, the United States Court of Federal Claims issued its ruling dismissing the Corporation’s complaint and the Corporation and the Bank determined not to appeal this ruling. As a result, the litigation with respect to the Empire and Territory claims has been terminated with no damages awarded to the Corporation or the Bank.

 

The Bank also assumed a lawsuit in the merger with Mid Continent Bancshares, Inc. (“Mid Continent”), a fiscal year 1998 acquisition, against the Government also relating to a supervisory goodwill claim filed by the former Mid Continent. The Mid Continent claim was tried in June and July 2003 with a final summation completed in October 2003. A final ruling was entered on January 29, 2004, awarding the Bank $5.6 million in damages. On February 12, 2004, the Department of Justice, on behalf of the Government, filed a Defendant’s Motion for Reconsideration of the ruling entered on January 29, 2004. The Government’s motion argued the amount of lost profit damages awarded by the Court was inappropriate. On or about February 26, 2004 the Court denied the Government’s motion. The Government has sixty days to file a formal appeal of the ruling entered on January 29, 2004. The ultimate collectibility of this award is contingent on a number of factors and future events which are beyond the control of the Bank, as to substance, timing and amount of damages that may be paid to the Bank. The Corporation has not recorded a receivable pursuant to this award.

 

Other Information

 

Additional information concerning the general business of the Corporation during the year ended December 31, 2003, is included in the following sections of this Report and under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and under Item 8 “Notes to the Consolidated Financial Statements” of this Report. Information concerning the Bank’s regulatory capital requirements and other regulations, which affect the Corporation, is included in the “Regulation” section of this Report.

 

The Corporation makes its annual, current and quarterly reports available, free of charge, on its corporate web site, www.comfedbank.com, as reasonably practicable after such reports are electronically filed with the Securities and Exchange Commission. Other information on the Corporation and the Bank are also available on this web site. All information and reports on the Corporation’s web site are not incorporated by reference to this Annual Report on Form 10-K.

 

Lending Activities

 

General

 

The Corporation’s lending activities focus on the origination of first mortgage loans for the purpose of financing or refinancing single-family residential properties, single-family residential construction loans, commercial real estate loans, commercial operating loans, and consumer and home equity loans. The Corporation conducts loan origination activities primarily through its branch offices to leverage its extensive network. Growth in commercial real estate, commercial operating and consumer loans has been a primary focus during the year ended December 31, 2003. The origination of these loans has increased significantly over 2002. Management plans to continue to expand the Corporation’s commercial lending activity in 2004 and beyond. Residential loan origination activity, including origination volume through a network of correspondents and brokers, increased

 

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significantly in calendar year 2003 as a direct result of the historically low interest rate environment that generated increased residential loan production volumes as well as a significant volume of loan refinancings compared to prior years. The Corporation will continue to originate real estate loans through its branches, loan offices and through its nationwide correspondent and broker network. See the “Loan Activity” section of this Report for further information.

 

The Corporation originates mortgage loans primarily secured by existing single-family residences. Single-family residential loans are originated using underwriting guidelines, appraisals and documentation which are acceptable to the Federal Home Loan Mortgage Corporation (“FHLMC”), the Government National Mortgage Association (“GNMA”) and the Federal National Mortgage Association (“FNMA”) to facilitate the sale of such loans to such agencies in the secondary market. The Corporation also originates single-family residential loans using internal lending policies in accordance with what management believes are prudent underwriting standards but which may not strictly adhere to FHLMC, GNMA and FNMA guidelines.

 

Commercial real estate loans are secured by various types of commercial properties including office buildings, shopping centers, warehouses and other income producing properties primarily located within the Corporation’s primary market areas of Denver, Colorado, Omaha, Nebraska, and Des Moines, Iowa. The Corporation’s single-family residential construction lending activity is primarily attributable to operations in its primary market areas and in Las Vegas, Nevada. Multi-family residential loans consist of loans secured by various types of properties, including townhomes, condominiums and apartment projects with more than four dwelling units. These properties are also primarily located in the Corporation’s primary market areas.

 

As part of the Corporation’s goal to build its commercial banking relationships, the Corporation offers an internet-based full-service cash management program. This service allows businesses access to electronic banking features such as funds transfers, vendor payments, direct payroll deposit, wire transfers and other services. Commercial operating loans are subject to prudent credit review and other underwriting standards and collection procedures. As the momentum from the strategic growth emphasis in commercial operating loans continues to build, these loans are expected to constitute a greater portion of the Corporation’s lending business in the future.

 

In addition to real estate and commercial loans, the Corporation originates consumer, automobile, home equity, agricultural, commercial business and savings account loans, as well as consumer credit card loans, through the Corporation’s branch and loan office network and direct mail solicitation. Management intends to continue to increase its consumer loan origination activity with strict adherence to prudent underwriting and credit review procedures.

 

Regulatory guidelines generally limit loans and extensions of credit to one borrower. At December 31, 2003, all loans were within the regulatory limitation of $202.5 million to one borrower. The aggregate amount of outstanding loans to the five highest borrowers totaled $141.6 million at December 31, 2003.

 

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Composition of Loans Receivable Portfolio

 

The following table sets forth the composition of the Corporation’s loans receivable portfolio as of the dates indicated below. Other than as disclosed below, there were no concentrations of loans which exceeded 10% of loans receivable at December 31, 2003.

 

     December 31,

   

June 30,

2000


 
     2003

    2002

    2001

    2000

   
     Amount

    Percent

    Amount

    Percent

    Amount

    Percent

    Amount

    Percent

    Amount

    Percent

 
     (Dollars in Thousands)  

Loan Portfolio

                                                                      

Residential real estate

   $ 3,420,692     42.5 %   $ 3,670,388     47.1 %   $ 4,329,595     53.1 %   $ 5,286,232     60.7 %   $ 7,106,409     69.1 %

Commercial real estate

     1,969,802     24.5       1,834,512     23.5       1,711,171     21.0       1,252,744     14.4       1,107,966     10.8  

Construction, net of loans-in-process

     519,599     6.5       492,409     6.3       534,719     6.5       517,788     5.9       413,107     4.0  

Commercial operating and other

     525,431     6.5       302,906     3.9       247,823     3.0       297,904     3.4       270,699     2.6  

Consumer home equity

     859,383     10.7       817,912     10.5       738,784     9.1       795,821     9.1       770,832     7.5  

Consumer other

     750,745     9.3       675,477     8.7       592,481     7.3       564,084     6.5       617,126     6.0  
    


 

 


 

 


 

 


 

 


 

Total loans receivable

     8,045,652     100 %     7,793,604     100 %     8,154,573     100 %     8,714,573     100 %     10,286,139     100 %
            

         

         

         

         

Unearned income, net

     19,245             15,560             14,161             18,864             8,694        

Allowance for loan losses

     (108,154 )           (106,148 )           (102,359 )           (82,263 )           (70,497 )      
    


       


       


       


       


     

Total loans receivable portfolio

   $ 7,956,743           $ 7,703,016           $ 8,066,375           $ 8,651,174           $ 10,224,336        
    


       


       


       


       


     

 

For additional information regarding the Corporation’s loans receivable portfolio, see Note 4 “Loans Receivable.”

 

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The following table presents the composition of the Corporation’s real estate loans receivable portfolio (before any reduction for unearned income and allowance for loan losses) by state and property type at December 31, 2003:

 

State


  

Residential

Real Estate


   

Commercial

Real Estate


   

Construction,

Net of Loans

in Process


    Total

   

% of

Total


 
     (Dollars in Thousands)  

Colorado

   $ 462,573     $ 458,557     $ 120,039     $ 1,041,169     17.6 %

Iowa

     213,576       407,467       100,383       721,426     12.2  

Nebraska

     307,587       140,625       31,294       479,506     8.1  

Kansas

     265,353       148,565       32,572       446,490     7.6  

Arizona

     130,440       215,342       83,598       429,380     7.3  

Missouri

     151,414       208,443       20,469       380,326     6.4  

Oklahoma

     115,667       194,143       26,750       336,560     5.7  

Massachusetts

     322,779       —         —         322,779     5.5  

Nevada

     15,487       54,360       93,433       163,280     2.8  

Georgia

     145,910       15,346       —         161,256     2.7  

Minnesota

     152,770       1,293       —         154,063     2.6  

Virginia

     135,556       —         —         135,556     2.3  

California

     82,384       18,882       —         101,266     1.7  

Texas

     56,362       44,465       —         100,827     1.7  

Washington

     96,322       —         —         96,322     1.6  

Maryland

     94,141       —         —         94,141     1.6  

Florida

     57,935       15,001       11,061       83,997     1.4  

Michigan

     80,741       —         —         80,741     1.4  

Illinois

     78,546       1,968       —         80,514     1.4  

North Carolina

     53,688       4,568       —         58,256     1.0  

Ohio

     57,432       —         —         57,432     1.0  

Alabama

     56,442       —         —         56,442     1.0  

Connecticut

     45,940       —         —         45,940     0.8  

South Carolina

     27,816       4,593       —         32,409     0.5  

Maine

     25,571       —         —         25,571     0.4  

Oregon

     10,650       14,314       —         24,964     0.4  

New Hampshire

     24,120       —         —         24,120     0.4  

New Jersey

     19,312       —         —         19,312     0.3  

Other states (22 states)

     134,178       21,870       —         156,048     2.6  
    


 


 


 


 

Total

   $ 3,420,692     $ 1,969,802     $ 519,599     $ 5,910,093     100.0 %
    


 


 


 


 

Percent of total

     57.9 %     33.3 %     8.8 %     100.0 %      
    


 


 


 


     

 

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Contractual Principal Repayments

 

The following table shows the maturities of loans receivable of the Corporation’s portfolio based on contractual terms. The table does not reflect the effects of loan prepayments or scheduled principal amortization. Demand loans (loans having no stated schedule of repayments and no stated maturity) and overdrafts are reported as due in one year or less. Since prepayments significantly shorten the average life of loans, management believes that the following table will bear little resemblance to what will be the actual repayments. Loan balances have not been reduced for (i) unearned income (ii) allowance for loan losses or (iii) nonperforming loans.

 

     Due During the Year Ended December 31,

     2004

   2005-2008

   After 2008

   Total

     (In Thousands)

Principal Repayments

                           

Residential real estate:

                           

Fixed-rate

   $ 5,412    $ 99,640    $ 1,083,402    $ 1,188,454

Adjustable-rate

     4,753      26,632      2,200,853      2,232,238
    

  

  

  

       10,165      126,272      3,284,255      3,420,692
    

  

  

  

Commercial real estate:

                           

Fixed-rate

     61,453      543,198      239,850      844,501

Adjustable-rate

     89,732      166,620      868,949      1,125,301
    

  

  

  

       151,185      709,818      1,108,799      1,969,802
    

  

  

  

Construction loans, net of loans in process:

                           

Fixed-rate

     75,504      2,305      —        77,809

Adjustable-rate

     441,563      227      —        441,790
    

  

  

  

       517,067      2,532      —        519,599
    

  

  

  

Commercial operating and other:

                           

Fixed-rate

     99,277      165,213      22,509      286,999

Adjustable-rate

     129,710      68,132      40,590      238,432
    

  

  

  

       228,987      233,345      63,099      525,431
    

  

  

  

Consumer home equity:

                           

Fixed-rate

     5,270      144,556      404,788      554,614

Adjustable-rate

     794      3,750      300,225      304,769
    

  

  

  

       6,064      148,306      705,013      859,383
    

  

  

  

Consumer other:

                           

Fixed-rate

     66,788      542,539      140,459      749,786

Adjustable-rate

     191      181      587      959
    

  

  

  

       66,979      542,720      141,046      750,745
    

  

  

  

Total principal repayments

   $ 980,447    $ 1,762,993    $ 5,302,212    $ 8,045,652
    

  

  

  

 

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The following table sets forth the amount of all loans receivable due after December 31, 2004 (January 1, 2005, and thereafter), which have fixed interest rates and those which have adjustable interest rates.

 

     Fixed-Rate

   Adjustable
Rate


   Total

     (In Thousands)

Residential real estate

   $ 1,183,042    $ 2,227,485    $ 3,410,527

Commercial real estate

     783,048      1,035,569      1,818,617

Construction loans, net of loans in process

     2,305      227      2,532

Commercial operating and other

     187,722      108,722      296,444

Consumer home equity

     549,344      303,975      853,319

Consumer other

     682,998      768      683,766
    

  

  

Total principal repayments due after December 31, 2004

   $ 3,388,459    $ 3,676,746    $ 7,065,205
    

  

  

 

Residential Real Estate Loans

 

The Corporation originates and purchases both fixed-rate and adjustable-rate mortgage loans secured by single-family units through its branch network, its loan offices and a nationwide correspondent network. Such residential mortgage loans are either:

 

    conventional mortgage loans which comply with the requirements for sale to, or conversion into, securities issued by FNMA or FHLMC (“conforming loans”),

 

    mortgage loans which exceed the maximum loan amount allowed by FNMA or FHLMC but which otherwise generally comply with FNMA and FHLMC loan requirements, or mortgage loans not exceeding the maximum loan amount allowed by FNMA or FHLMC but do not meet all of the conformity requirements of FNMA and FHLMC (“nonconforming loans”) or

 

    Federal Housing Administration (“FHA”) and Department of Veteran’s Administration (“VA”) guaranteed loans which qualify for sale in the form of securities guaranteed by GNMA.

 

The Corporation originates substantially all conforming or nonconforming loans with loan-to-value ratios at or below 80.0% unless the borrower obtains private mortgage insurance (which premium the borrower pays with their mortgage payment) for the Corporation’s benefit covering that portion of the loan in excess of 80.0% of the appraised value or purchase price, whichever is less. Occasional exceptions to the 80.0% loan-to-value ratio for mortgage loans are made to facilitate the resolution of nonperforming assets.

 

Fixed-rate residential mortgage loans generally are originated with terms of 15 and 30 years and are amortized on a monthly basis with principal and interest due each month. Adjustable-rate residential mortgage loans are also originated with terms of 15 and 30 years. However, certain adjustable-rate loans contain provisions which permit the borrower, at the borrower’s option, to convert to a long-term fixed-rate loan at certain periodic intervals over the life of the loan. The adjustable-rate loans generally have interest rates which are scheduled to adjust at six and 12 month intervals based upon various indices, including the Treasury Constant Maturity Index or the Eleventh District Federal Home Loan Bank Cost of Funds Index. The amount of any such interest rate increase is limited to one or two percentage points annually and four to six percentage points over the life of the loan. Certain adjustable-rate loans are also offered which have interest rates fixed over annual periods ranging from two through seven years, or ten years, with such loans repricing annually after the fixed interest-rate term. The Corporation applies its underwriting criteria to such loans based on the amount of the loan for which the borrower could qualify at the indexed rate. At December 31, 2003, approximately 1.05%, or $35.9 million, of the Corporation’s residential real estate loan portfolio was 90 days or more delinquent compared to 1.20%, or $43.9 million, at December 31, 2002.

 

Commercial Real Estate Loans

 

Commercial real estate lending entails significant additional risks compared with residential real estate lending. These additional risks are due to larger loan balances, which are more sensitive to economic conditions,

 

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business cycle downturns and construction related risks. The payment of principal and interest due on the Corporation’s commercial real estate loans is substantially dependent upon the performance of the projects securing the loans. As an example, to the extent that the occupancy and rental rates on the secured commercial real estate are not high enough to generate the income necessary to make payments, the Corporation could experience an increased rate of delinquency and could be required either to declare the loans in default and foreclose upon the properties or to make concessions on the terms of the repayment of the loans. At December 31, 2003, approximately .32%, or $6.3 million, of the Corporation’s commercial real estate loans were 90 days or more delinquent compared to .83%, or $15.3 million, at December 31, 2002.

 

The aggregate amount of loans which a federal savings institution may make on the security of liens on nonresidential real property may not exceed 400.0% of the institution’s total risk-based capital as determined under current regulatory capital standards. This limitation totaled approximately $3.4 billion at December 31, 2003, compared to $2.0 billion of actual commercial real estate loans outstanding at December 31, 2003. This restriction has not and is not expected to materially affect the Corporation’s business.

 

Construction Loans

 

The Corporation conducts its construction lending operations in its primary market areas and in Las Vegas, Nevada. The residential construction lending operations are expected to continue to increase over prior periods. These loans are subject to prudent credit review and other underwriting standards and procedures. At December 31, 2003, approximately 1.01%, or $5.2 million, of the Corporation’s construction loan portfolio was 90 days or more delinquent compared to 1.02%, or $5.0 million, at December 31, 2002.

 

Construction financing is considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction and the total estimated cost, including interest. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Corporation may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value proves to be inaccurate, the Corporation may be confronted, at or prior to the maturity of the loan, with a project having a value which is insufficient to assure full repayment.

 

Commercial Operating and Other Loans

 

Commercial operating and other loans represent commercial loans for the primary purpose of providing operating capital for commercial entities and also for agricultural and small business purposes. The performance of these loans is highly dependent on the stability of the operations of the commercial enterprise and the state of the economy as it relates to the industry of the borrower. The credit risk related to these loans is also high since the value of collateral underlying these loans may be highly specialized and more sensitive to economic downturns. At December 31, 2003, approximately .69%, or $3.7 million, of the Corporation’s commercial operating loans were 90 days or more delinquent compared to 1.09%, or $3.3 million, at December 31, 2002.

 

Consumer Loans

 

Federal regulations permit federal savings institutions to make secured and unsecured consumer loans up to 35.0% of an institution’s total regulatory assets. Any loans in excess of 30.0% of assets may only be made directly to the borrower and cannot involve the payment of any finders or referral fees. In addition, a federal savings institution has lending authority above the 35.0% category for certain consumer loans, such as home equity loans, property improvement loans, mobile home loans and savings account secured loans. Consumer loans originated by the Corporation are primarily second mortgage loans, loans secured by automobiles and loans to depositors on the security of their savings accounts. The Corporation has increased its secured consumer lending activities in order to meet its customers’ financial needs and will continue to increase such lending activities in the future in its primary market areas. The consumer loan federal regulation limitations have not and are not expected to materially affect the Corporation’s business.

 

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Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans, which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. Such loans may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loans such as the Corporation, and a borrower may be able to assert against such assignee claims and defenses which it has against the seller of the underlying collateral. At December 31, 2003, approximately .30%, or $4.8 million, of the Corporation’s consumer loans are 90 days or more delinquent compared to .32%, or $4.8 million, at December 31, 2002.

 

Loan Sales

 

In addition to originating loans for its portfolio, the Corporation participates in secondary mortgage market activities by selling whole and securitized loans to institutional investors or other financial institutions with the Corporation generally retaining the right to service such loans. Substantially all of the Corporation’s secondary mortgage market activity is with GNMA, FNMA and FHLMC. Conventional conforming loans are either sold for cash as individual whole loans to FNMA or FHLMC, or pooled in exchange for securities issued by FNMA or FHLMC, which are then sold to investment banking firms. FHA and VA loans are originated or purchased by the Corporation and either are retained for the Corporation’s real estate loan portfolio or are pooled to form GNMA securities which are subsequently sold to investment banking firms or retained by the Bank.

 

During the years ended December 31, 2003, 2002 and 2001, the Corporation sold an aggregate of $5.1 billion, $3.4 billion and $2.7 billion, respectively, in mortgage loans. These sales resulted in net realized gains during calendar years 2003, 2002 and 2001 totaling $23.9 million, $36.2 million and $8.7 million, respectively. The mortgage loans were primarily sold in the secondary market. At December 31, 2003, the carrying value of loans held for sale totaled $351.5 million compared to $914.5 million at December 31, 2002.

 

Loan Activity

 

The following table sets forth the Corporation’s loan activity for the years ended December 31 as indicated:

 

     2003

   2002

   2001

     (In Thousands)

Originations:

      

Residential real estate loans

   $ 2,081,142    $ 1,601,121    $ 1,201,279

Commercial real estate loans

     625,277      805,639      768,578

Construction loans

     734,459      792,290      728,432

Consumer and other loans

     1,760,569      1,058,210      1,343,577
    

  

  

Loans originated

   $ 5,201,447    $ 4,257,260    $ 4,041,866
    

  

  

Purchases:

                    

Residential real estate loans

   $ 4,493,310    $ 3,613,275    $ 2,613,945

Commercial real estate loans

     —        —        19,075
    

  

  

Loans purchased

   $ 4,493,310    $ 3,613,275    $ 2,633,020
    

  

  

Securitizations:

                    

Mortgage loans securitized into mortgage-backed
securities held by the Bank

   $ 216,049    $ 76,947    $ 41,910
    

  

  

Sales:

                    

Mortgage loans sold

   $ 5,107,012    $ 3,361,384    $ 2,736,379
    

  

  

 

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Loan Servicing for Other Institutions

 

The Corporation services substantially all of the mortgage loans that it originates and purchases (whether retained for the Bank’s portfolio or sold in the secondary market), thereby generating ongoing loan servicing fee income. The Corporation also periodically purchases and sells mortgage servicing rights. During the second quarter of 2003, the Corporation sold the servicing rights relating to $501.9 million of loans serviced for other institutions. At December 31, 2003, the Corporation was servicing approximately 118,700 loans and participations for others with principal balances aggregating $11.4 billion, compared to approximately 136,200 loans and participations for others with principal balances totaling $11.5 billion at December 31, 2002.

 

Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, holding escrow (impound funds) for payment of taxes and insurance, making inspections as required of the mortgage premises, collecting amounts due from delinquent mortgagors, supervising foreclosures in the event of unremedied defaults and generally administering the loans for the investors to whom they have been sold.

 

The Corporation receives fees for servicing mortgage loans for others, ranging generally from .18% to .57% per annum on the declining principal balances of the loans. The average service fee collected by the Corporation was .33%, .33% and .35%, respectively, for the years ended December 31, 2003, 2002 and 2001. The Corporation’s servicing portfolio is subject to reduction primarily by reason of normal amortization and prepayment of outstanding mortgage loans. In general, the value of the Corporation’s loan servicing portfolio may also be adversely affected as mortgage interest rates decline and loan prepayments increase. It is expected that income generated from the Corporation’s loan servicing portfolio also will decline in such an environment. This negative effect on the Corporation’s income may be offset somewhat by a rise in origination and servicing fee income attributable to new loan originations, which historically have increased in periods of low mortgage interest rates. The weighted average mortgage loan note rate of the Corporation’s servicing portfolio at December 31, 2003, was 6.09% compared to 6.82% at December 31, 2002.

 

At December 31, 2003 and 2002, approximately 95.7% and 95.3%, respectively, of the Corporation’s mortgage servicing portfolio for other institutions was covered by servicing agreements pursuant to the mortgage-backed securities programs of GNMA, FNMA and FHLMC. Under these agreements, the Corporation may be required to advance funds temporarily to make scheduled payments of principal, interest, taxes or insurance if the borrower fails to make such payments. Although the Corporation cannot charge any interest on these advanced funds, the Corporation typically recovers the advances within a reasonable number of days upon receipt of the borrower’s payment, or in the absence of such payment, advances are recovered through FHA insurance, VA guarantees or FNMA or FHLMC reimbursement provisions in connection with loan foreclosures. During each of the years ended December 31, 2003 and 2002, the average amount of funds advanced by the Corporation pursuant to servicing agreements totaled approximately $4.3 million.

 

Interest Rates and Loan Fees

 

Interest rates charged by the Corporation on its loans are primarily determined by secondary market yield requirements and competitive loan rates offered in its lending areas. In addition to interest earned on loans, the Corporation receives loan origination fees for originating certain loans. These fees are a percentage of the principal amount of the mortgage loan and are charged to the borrower.

 

Loan Commitments

 

At December 31, 2003, the Corporation had issued commitments totaling $931.9 million, excluding the undisbursed portion of loans in process, to fund and purchase loans and to extend credit on consumer and commercial unused lines of credit. These commitments are generally expected to settle within three months following December 31, 2003. These outstanding loan commitments to extend credit do not necessarily represent future cash requirements since many of the commitments may expire without being drawn. Additionally,

 

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mortgage loan commitments included in total commitments include loans in the process of approval for which the Corporation has rate lock commitments. The Corporation expects to have sufficient liquidity to fund these loan commitments. See “MD&A—Liquidity and Capital Resources and Contractual Obligations and Other Commitments” of this Report.

 

Collection Procedures

 

If a borrower fails to make required payments on a loan, the Corporation generally will take immediate action to satisfy its claim against the security on the loan. If a delinquency cannot otherwise be cured, the Corporation records a notice of default and commences foreclosure proceedings. When a trustee sale is held, the Corporation generally acquires title to the property. The property may then be sold for cash or with financing conforming to normal loan requirements, or it may be sold or financed with a “loan to facilitate” involving terms more favorable to the borrower than those permitted by applicable regulations for new loans.

 

Asset Quality

 

Nonperforming Assets

 

Loans are reviewed on a regular basis and, except for first mortgage loans and credit card loans, are placed on a nonaccruing status when either principal or interest is 90 days or more past due. Interest accrued and unpaid at the time a loan is placed on nonaccruing status is charged against interest income. First mortgage loans are placed on a nonaccruing status if four or more monthly payments are missed. Credit card loans continue to accrue interest up to 120 days past due at which time the credit card loan balance plus accrued interest are charged off.

 

Real estate acquired by the Corporation as a result of foreclosure or by deed in lieu of foreclosure is classified as foreclosed real estate. At foreclosure, such property is stated at the lower of cost or fair value, minus estimated costs to sell. Subsequent impairment losses are recorded when the carrying value exceeds the fair value minus estimated costs to sell the property.

 

In certain circumstances the Corporation does not immediately foreclose when a delinquency is not cured promptly, particularly when the borrower does not intend to abandon the collateral, since by not foreclosing the risk of ownership would still be retained by the borrower. The evaluation of borrowers and collateral may involve determining that the most economic way to reduce the Corporation’s risk of loss may be to allow the borrower to remain in possession of the property and to restructure the debt as a troubled debt restructuring. In these circumstances, the Corporation would strive to ensure that the borrower’s continued participation in and management of the collateral does not put the Corporation at further risk of loss. In situations in which the borrower is not performing under the restructured terms, foreclosure proceedings are commenced when legally allowable.

 

A troubled debt restructuring is a loan in which the Corporation, for reasons related to the debtor’s financial difficulties, grants a concession to the debtor, such as a reduction in the loan’s interest rate, a reduction in the face amount of the debt, or an extension of the maturity date of the loan, that the Corporation would not otherwise consider. A loan classified as a troubled debt restructuring may be reclassified as current if such loan has returned to a performing status at a market rate of interest for at least eight to twelve months, the loan-to-value ratio is 80.0% or less, the cash flows generated from the collateralized property support the loan amount subject to minimum debt service coverage, as defined, and overall applicable economic conditions are favorable.

 

For a discussion of the major components of the changes in nonperforming assets at December 31, 2003, compared to December 31, 2002, see “MD&A—Provision for Loan Losses and Asset Quality” of this Report.

 

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The following table sets forth information with respect to the Corporation’s nonperforming assets as follows:

 

     December 31,

   

June 30,

2000


 
     2003

    2002

    2001

    2000

   
     (Dollars in Thousands)  

Loans accounted for on a nonaccrual basis: (1)

                                        

Real estate—

                                        

Residential

   $ 40,065     $ 46,394     $ 52,792     $ 46,075     $ 37,535  

Commercial

     7,363       17,890       23,423       27,349       2,550  

Consumer, commercial operating and

    other loans

     8,491       8,130       6,929       10,019       13,466  
    


 


 


 


 


Total nonperforming loans

     55,919       72,414       83,144       83,443       53,551  
    


 


 


 


 


Foreclosed real estate:

                                        

Commercial

     32,839       24,707       30,368       10,198       12,862  

Residential

     16,905       15,301       14,840       15,824       16,803  
    


 


 


 


 


Total foreclosed real estate

     49,744       40,008       45,208       26,022       29,665  
    


 


 


 


 


Troubled debt restructurings: (2)

                                        

Commercial

     4,712       1,547       3,057       4,195       5,259  

Residential

     —         —         84       90       172  
    


 


 


 


 


Total troubled debt restructurings

     4,712       1,547       3,141       4,285       5,431  
    


 


 


 


 


Total nonperforming assets

   $ 110,375     $ 113,969     $ 131,493     $ 113,750     $ 88,647  
    


 


 


 


 


Nonperforming loans to loans receivable (3)

     .69 %     .93 %     1.02 %     .96 %     .52 %

Nonperforming assets to total assets

     .91 %     .87 %     1.02 %     .91 %     .64 %

Allowance for loan losses

   $ 108,154     $ 106,291     $ 102,451     $ 83,439     $ 70,556  

Allowance for loan losses to:

                                        

Loans receivable (3)

     1.34 %     1.36 %     1.25 %     .96 %     .69 %

Total nonperforming loans

     193.41 %     146.78 %     123.22 %     100.00 %     131.75 %

(1)   Excluding credit card loans, no interest income was recorded on loans contractually past due 90 days or more during the years ended December 31, 2003, 2002 and 2001, the six months ended December 31, 2000, or during the fiscal year ended June 30, 2000. Had these nonaccruing loans, excluding credit card loans, been current in accordance with their original terms and outstanding throughout this year or since origination, the Corporation would have recorded gross interest income on these loans totaling $3.4 million, $6.5 million, $6.4 million, $5.3 million and $3.8 million, respectively, during the aforementioned periods. Residential real estate loans are considered nonperforming if four or more monthly payments are missed. Credit card loans continue to accrue interest up to 120 days past due at which point the credit card loan balances plus accrued interest are charged off.
(2)   During the years ended December 31, 2003, 2002 and 2001, the six months ended December 31, 2000, and the fiscal year ended June 30, 2000, the Corporation recognized interest income on loans classified as troubled debt restructurings aggregating $238,000, $224,000, $236,000, $176,000 and $430,000, respectively, whereas under their original terms the Corporation would have recognized interest income of $254,000, $255,000, $268,000, $194,000 and $494,000, respectively. At December 31, 2003, the Corporation had no commitments to lend additional funds to borrowers whose loans were subject to troubled debt restructuring.
(3)   Based on the net book value of loans receivable before deducting allowance for loan losses at the respective dates.

 

The preceding table excludes nonperforming loans held for sale totaling $25.0 million, $32.0 million and $37.9 million, respectively, at December 31, 2003, 2002 and 2001, related to the GNMA optional repurchase program. These guaranteed mortgage loans serviced for GNMA include loans that have been repurchased or are

 

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eligible for repurchase by the Corporation at the Corporation’s option and without prior authorization from GNMA when specific delinquency criteria are met. Therefore, the Corporation is deemed to have regained effective control over these loans. These nonperforming loans are guaranteed by the FHA or VA with the Corporation either reselling these loans or undertaking collection efforts through the FHA/VA foreclosure process for reimbursement of these repurchased loans. The Corporation is reimbursed for substantially all costs incurred after the foreclosure process is complete. There were no nonperforming loans held for sale at December 31, 2000, and June 30, 2000.

 

The geographic concentration of nonperforming loans in the Corporation’s primary market areas and those states with 10% or more of total nonperforming loans at December 31, 2003, follows:

 

State


   Amount

   Percent

 
     (Dollars in Thousands)  

Iowa

   $ 8,282    14.8 %

Oklahoma

     7,413    13.3  

Colorado

     6,971    12.5  

Kansas

     6,846    12.2  

Nebraska

     3,426    6.1  

Missouri

     1,998    3.6  

Arizona

     1,293    2.3  

Other states (32 states)

     19,690    35.2  
    

  

Nonperforming loans

   $ 55,919    100.0 %
    

  

 

Nonperforming loans at December 31 consisted of the following types and number of loans:

 

     2003

   2002

     Amount

   Number
of Loans


   Amount

   Number
of Loans


     (Dollars in Thousands)

Residential real estate loans

   $ 35,907    550    $ 43,939    750

Commercial real estate loans

     6,286    24      15,306    40

Residential construction loans

     4,158    11      2,243    10

Commercial construction loans

     1,077    3      2,796    3

Consumer loans

     4,840    365      4,820    467

Agricultural loans

     1,301    8      1,865    23

Commercial operating loans

     1,968    24      1,334    28

Small business loans

     382    5      111    3
    

  
  

  

Totals

   $ 55,919    990    $ 72,414    1,324
    

  
  

  

 

The geographic concentration of foreclosed real estate in the Corporation’s primary market areas and those states with 10% or more of total foreclosed real estate at December 31, 2003, follows:

 

State


   Amount

   Percent

 
     (Dollars in Thousands)  

Nevada

   $ 28,361    57.0 %

Colorado

     4,833    9.7  

Iowa

     4,149    8.3  

Oklahoma

     2,936    5.9  

Kansas

     1,860    3.7  

Nebraska

     1,471    3.0  

Missouri

     908    1.8  

Arizona

     798    1.6  

Other states (22 states)

     4,428    9.0  
    

  

Foreclosed real estate

   $ 49,744    100.0 %
    

  

 

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At December 31, 2003, foreclosed real estate totaling $49.7 million (341 properties) consisted of commercial real estate totaling $32.8 million (15 properties) or 66.0% of the total and residential real estate totaling $16.9 million (326 properties). The real estate located in Nevada primarily consists of a residential master planned community property totaling $28.4 million at December 31, 2003. The Corporation continues to develop and manage this property while listing such property for sale.

 

Under the Corporation’s credit policies and practices, certain real estate loans meet the definition of impaired loans under Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan” and Statement of Financial Accounting Standards No. 118, “Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures.” A loan is considered impaired when it is probable that the Corporation, based upon current information, will not collect amounts due, both principal and interest, according to the contractual terms of the loan agreement. Loan impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent. Certain loans are exempt from the provisions of the aforementioned accounting statements, including large groups of smaller-balance homogenous loans that are collectively evaluated for impairment which, for the Corporation, include one-to-four family first mortgage loans and consumer loans.

 

Loans reviewed for impairment by the Corporation are primarily commercial loans and loans modified in a troubled debt restructuring. The Corporation’s impaired loan identification and measurement processes are conducted in conjunction with the Corporation’s review of classified assets and the adequacy of its allowance for possible loan losses. Specific factors utilized in the impaired loan identification process include, but are not limited to, delinquency status, loan-to-value ratio, debt coverage and certain other conditions pursuant to the Corporation’s classification policy. At December 31, 2003, the Corporation had impaired loans totaling $28.5 million, net of specific allowances. Troubled debt restructurings totaling $4.2 million, net of specific allowances, are classified as impaired loans and included in the table for nonperforming assets. At December 31, 2002, impaired loans totaled approximately $13.3 million.

 

Classification of Assets

 

Savings institutions are required to review their assets on a regular basis and, as warranted, classify them as “substandard,” “doubtful,” or “loss” as defined by OTS regulations. Adequate valuation allowances are required to be established for assets classified as substandard or doubtful. If an asset is classified as a loss, the institution must either establish a specific valuation allowance equal to the amount classified as loss or charge off such amount. An asset which does not currently warrant classification as substandard but which possesses credit deficiencies or potential weaknesses deserving close attention is required to be designated as “special mention.” In addition, a savings institution is required to set aside adequate valuation allowances to the extent that any affiliate possesses assets which pose a risk to the savings institution. The OTS has the authority to approve, disapprove or modify any asset classification or any amount established as an allowance pursuant to such classification. The Corporation generally charges off the amount of loans classified as loss. At December 31, 2003, the Corporation had $37.8 million in assets classified as special mention, $198.7 million in assets classified as substandard, $4.2 million in assets classified as doubtful and no assets classified as loss. Substantially all nonperforming assets at December 31, 2003, are classified as substandard pursuant to applicable asset classification standards. Of the Corporation’s loans which were not classified at December 31, 2003, there were no loans where known information about possible credit problems of borrowers caused management to have serious doubts as to the ability of the borrowers to comply with present loan repayment terms.

 

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Loan and Real Estate Review Policy

 

Management of the Corporation has the responsibility for establishing policies and procedures for the timely evaluation of the credit risk in the Corporation’s loan and real estate portfolios. Management is also responsible for the determination of all specific and estimated provisions for loan losses and impairments for real estate losses, taking into consideration a number of factors, including changes in the composition of the Corporation’s loan portfolio and real estate balances, current economic conditions, including real estate market conditions in the Corporation’s lending areas that may affect the borrower’s ability to make payments on loans, regular examinations by the Corporation’s credit review team of the quality of the overall loan and real estate portfolios, and regular review of specific problem loans and real estate.

 

Management also has the responsibility of ensuring timely charge-offs of loan and real estate balances, as appropriate, when general and economic conditions warrant a change in the value of these loans and real estate. To ensure that credit risk is properly and timely monitored, this responsibility has been delegated to a credit review team which consists of key personnel of the Corporation knowledgeable in the specific areas of loan and real estate valuation.

 

The objectives of the credit review team are:

 

    to examine the risk of collectibility of the Corporation’s loans,

 

    to assess the likelihood of partial or full liquidation of real estate and other assets,

 

    to confirm problem assets at the earliest possible time,

 

    to assure an adequate level of allowances for loan losses to cover identified and anticipated credit risks,

 

    to monitor the Corporation’s compliance with established policies and procedures, and

 

    to provide the Corporation’s management with information obtained through the asset review process.

 

The Corporation’s policy for calculating the allowance for loan losses on the commercial loan portfolio (commercial real estate, construction, commercial operating and agricultural) incorporates classifying the credit risk of the portfolio into eight categories. Classes one through four (excellent, good, satisfactory and acceptable, respectively) represent varying degrees of pass rated credits, or minimal credit risk. Classes five (special mention), six (substandard), seven (doubtful) and eight (loss), mirror regulatory definitions and are consistent between all commercial loan types. These credit risk categories are designed to more accurately reflect the inherent risk in the Corporation’s loan portfolio relative to the current economic environment. The credit review team analyzes all significant loans and real estate of the Corporation for appropriate levels of allowance for loan losses and real estate impairment losses based on varying degrees of loan or real estate value weakness.

 

Loans with minimal credit risk (not adversely classified or with a credit risk rating of one to five) generally have allowances established on the basis of the Corporation’s historical loss experience and various other factors. Loans adversely classified (substandard, doubtful, loss or with a credit risk rating of six to eight) have greater levels of allowances established, including specific allowances, if applicable, to recognize impairment in the value of loans. Impairment losses are recorded on real estate when the fair value less estimated selling costs of the property is less than the carrying value of the property.

 

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Table of Contents

It is management’s responsibility to maintain a reasonable allowance for loan losses applicable to all categories of loans through periodic charges to operations. Management employs a systematic methodology to determine the amount of specific allowances allocated to specific loans. Specific loans that are impaired, or any portion impaired, may be allocated a specific allowance equal to the amount of impairment or, instead of establishing a specific allowance, the impaired portion also may be 100% charged off when management determines such amount to be uncollectible. The estimated allowances established on each of the Corporation’s specific pools of outstanding loan portfolios is based on a minimum and maximum percentage range of the specific portfolios as follows:

 

Type of Loan and Status


  

Minimum

Loan Loss

Percentage


   

Maximum

Loan Loss

Percentage


 

Residential real estate loans:

            

Current

   .10 %   .20 %

90 days delinquent (or classified substandard)

   7.50     10.00  

Commercial real estate loans: (1)

            

Class 1—excellent

   .25     .50  

Class 2—good

   .60     1.20  

Class 3—satisfactory

   .85     1.70  

Class 4—acceptable

   1.35     2.70  

Construction loans: (1)

            

Class 1—excellent

   .45     .90  

Class 2—good

   .80     1.60  

Class 3—satisfactory

   1.05     2.10  

Class 4—acceptable

   1.55     3.10  

Commercial operating loans: (1)

            

Class 1—excellent

   .55     1.10  

Class 2—good

   .90     1.80  

Class 3—satisfactory

   1.15     2.30  

Class 4—acceptable

   1.65     3.30  

Agricultural loans: (1)

            

Class 1—excellent

   .30     .60  

Class 2—good

   .65     1.30  

Class 3—satisfactory

   .90     1.80  

Class 4—acceptable

   1.40     2.80  

Consumer loans:

            

Current—auto

   1.75     2.50  

Current—indirect

   2.75     3.50  

Current—home equity

   .75     1.50  

Current—all other

   2.75     3.50  

Substandard and 90 days delinquent

   20.00     30.00  

120 days delinquent (unsecured balances of consumer loans 120 days delinquent are generally written off)

   100.00     100.00  

Small business loans:

            

Pass

   2.00     4.00  

Special mention

   2.00     10.00  

Substandard

   30.00     50.00  

Doubtful/loss

   100.00     100.00  

Credit card/taxsaver:

            

Current standard

   4.50     5.50  

Current taxsaver

   2.00     3.00  

Substandard and 90 days delinquent

   20.00     30.00  

120 days delinquent (credit cards 120 days delinquent are generally written off)

   100.00     100.00  

Commercial leases:

            

Pass

   2.00     4.00  

Special mention

   2.00     10.00  

Substandard

   30.00     50.00  

Doubtful/loss

   100.00     100.00  

(1)   Loans rated class five through class eight have the following minimum and maximum allowance requirement ranges: class five (special mention)—5.00% to 10.00%, class six (substandard)—10.00% to 20.00%, class seven (substandard)—50.00% to 75.00% and class eight (doubtful)—100.00% and 100.00%.

 

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Table of Contents

The allowance for loan losses is based upon management’s continuous evaluation of the collectibility of outstanding loans which takes into consideration such factors as changes in the composition of the loan portfolio and economic and business conditions that may affect the borrower’s ability to pay, credit quality and delinquency trends, regular examinations by the Corporation’s credit review team of specific problem loans and of the overall portfolio quality and real estate market conditions in the Corporation’s lending areas.

 

Management determines the elements of the allowance through two methods. The first valuation process is the analysis of specific loans for individual impairment. This impairment is measured according to the provisions of Statements of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan” and No. 118, “Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures.” Management applies specific monitoring policies and procedures that vary according to the relative risk profile and other characteristics of the loans within the various loan portfolios. Management completes periodic specific credit evaluations on commercial real estate, construction, commercial operating, and agricultural loans and loan relationships with committed balances in excess of $1.0 million. Management reviews these loans to assess the ability of the borrower to service all principal and interest obligations and, as a result, may adjust the risk grade accordingly. Loans and loan relationships in these portfolios which possess, in management’s estimation, potential or well defined weaknesses which could affect the full collection of the Corporation’s contractual principal and interest are evaluated under more stringent reporting and oversight procedures. These specific loans are classified as either special mention, substandard, doubtful or loss. The loans, or a portion of a loan, classified as loss are allocated a specific allowance equal to 100% of the amount of the loan, or such loan is charged off.

 

The second valuation process in determining the estimated allowance is based on minimum and maximum range percentages applied to each of the Corporation’s pools of outstanding loan portfolios. The Corporation’s residential, small business, consumer and credit card portfolios are relatively homogenous. Generally, no single loan is individually significant in terms of its size or potential loss. Therefore, management reviews these portfolios by analyzing their performance as a specific pool against which management estimates an allowance for impairment. Management’s determination of the level of the allowance within the minimum and maximum percentages for these homogenous pools rests upon various judgments and assumptions used to determine the impairment related to the risk characteristics of the specific portfolio pools. The minimum and maximum range percentages are evaluated at least on a quarterly basis for appropriateness based on historical write-offs, delinquency trends, economic conditions and other factors.

 

The Corporation’s policy is to charge-off loans or portions thereof against the allowance for loan losses in the period in which loans or portions thereof are determined to be uncollectible. Management of the Corporation anticipates that 2004 loan charge-offs will approximate 2003 historical experience. When the Corporation records charge-offs on these loans, it typically also begins the foreclosure process of taking possession of the real estate which served as collateral for such loans. A majority of the Corporation’s loans are collateralized by residential or commercial real estate. Therefore, the collectibility of such loans is susceptible to changes in prevailing real estate market conditions and other factors which can cause the fair value of the collateral to decline below the loan balance. Recoveries of loan charge-offs occur when the loan payments are received on the deficient loan in excess of the remaining recorded book balance of the loan. Upon foreclosure and conversion of the loan into real estate owned, the Corporation may realize income through the disposition of such real estate when the sale proceeds exceed the carrying value of the real estate.

 

Although management believes that the Corporation’s allowance for loan losses is adequate to reflect the risk inherent in its portfolios, there can be no assurance that the Corporation will not experience increases in its nonperforming assets, that it will not increase the level of its allowances in the future or that significant provisions for losses will not be required based on factors such as deterioration in market conditions, changes in borrowers’ financial conditions, delinquencies and defaults. In addition, regulatory agencies review the adequacy of the allowance for loan losses on a regular basis as an integral part of their examination process. Such agencies may require additions to the allowance based on their judgments of information available to them at the time of their examinations.

 

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Table of Contents

The following table sets forth the activity in the Corporation’s allowance for loan losses for the periods indicated:

 

          

Six Months

Ended
December 31,

2000


   

Year Ended

June 30,

2000


 
     Year Ended December 31,

     
     2003

    2002

    2001

     
     (Dollars in Thousands)  

Allowance for loan losses at beginning of year

   $ 106,291     $ 102,451     $ 83,439     $ 70,556     $ 80,419  

Loans charged-off:

                                        

Single-family residential

     (2,834 )     (4,743 )     (2,405 )     (909 )     (1,874 )

Multi-family residential and commercial real estate

     (2,400 )     (8,247 )     (1,054 )     (2,564 )     (1,938 )

Consumer and other

     (21,094 )     (19,703 )     (21,615 )     (13,435 )     (20,350 )
    


 


 


 


 


Loans charged-off

     (26,328 )     (32,693 )     (25,074 )     (16,908 )     (24,162 )
    


 


 


 


 


Recoveries:

                                        

Single-family residential

     1       —         6       9       81  

Multi-family residential and commercial real estate

     429       60       —         —         5  

Consumer and other

     6,376       5,615       5,312       2,539       5,747  
    


 


 


 


 


Recoveries

     6,806       5,675       5,318       2,548       5,833  
    


 


 


 


 


Net loans charged-off

     (19,522 )     (27,018 )     (19,756 )     (14,360 )     (18,329 )

Provision charged to operations

     22,003       31,002       38,945       27,854       13,760  

Change in estimate of allowance for bulk purchased loans

     (779 )     (144 )     (172 )     (87 )     (5,294 )

Charge-off to allowance on sale of securitized loans

     —         —         (5 )     (496 )     —    

Charge-off to allowance for bulk purchased loans

     —         —         —         (28 )     —    

Other

     161       —         —         —         —    
    


 


 


 


 


Allowance for loan losses at end of year

   $ 108,154     $ 106,291     $ 102,451     $ 83,439     $ 70,556  
    


 


 


 


 


Ratio of net loans charged-off to average loans receivable outstanding during the period

     .25 %     .34 %     .23 %     .14 %     .19 %
    


 


 


 


 


Average balance of outstanding loans receivable

   $ 7,851,848     $ 7,951,229     $ 8,440,881     $ 10,049,346     $ 9,710,022  
    


 


 


 


 


 

20


Table of Contents

Investment Activities

 

Management believes that the Bank’s procedures for managing liquidity are sufficient to ensure its safe and sound operation. The Corporation’s management objective is to maintain liquidity at a level sufficient to assure adequate and readily available funds by investing primarily in short-term liquid assets, taking into account anticipated cash flows and available sources of credit. The Bank’s procedures for managing its liquidity also allow for future flexibility to meet withdrawal requests, to fund loan commitments, to maximize income while protecting against credit risks and to balance the repricing characteristics of the Corporation’s assets and liabilities. Such liquid funds are managed in an effort to produce the highest yield consistent with maintaining safety of principal. The relative size and mix of investment securities in the Corporation’s portfolio are based on management’s judgment compared to the yields and maturities available on other investment securities. The Corporation emphasizes low credit risk in selecting investment options. Federal regulations outline the permissible investments for federal savings associations. Subject to certain restrictions and limitations, these permissible investments are generally of relatively low credit risk. The Bank invests only in permissible investments consistent with all applicable regulations.

 

The following table sets forth the carrying value of the Corporation’s available-for-sale investment securities and short-term cash investments as of December 31 as follows:

 

     2003

   2002

     (In Thousands)

U.S. Treasury and other Government agency obligations

   $ 669,490    $ 882,017

Obligations of states and political subdivisions

     235,276      228,648

Other debt securities

     150,289      185,385
    

  

Total investment securities

     1,055,055      1,296,050

Short-term cash investments

     1,334      505
    

  

Total investments

   $ 1,056,389    $ 1,296,555
    

  

 

21


Table of Contents

The following table sets forth the scheduled maturities, amortized cost, market values and weighted average yields for the Corporation’s investment securities at December 31, 2003:

 

     One Year
or Less


   

Over One Within

Five Years


   

Over Five Within

Ten Years


    More Than Ten
Years


    Total

    

Amortized

Cost


  

Average

Yield


   

Amortized

Cost


  

Average

Yield


   

Amortized

Cost


  

Average

Yield


   

Amortized

Cost


  

Average

Yield


   

Amortized

Cost


  

Average

Yield


   

Market

Value


     (Dollars in Thousands)

U.S. Treasury and other Government agency obligations

   $ —      —   %   $ 176    5.58 %   $ 675,136    4.59 %   $ —      —   %   $ 675,312    4.59 %   $ 669,490

States and political subdivisions

     568    5.34       22,093    5.76       7,357    4.65       188,663    4.73       218,681    4.84       235,276

Other debt securities

     150    2.29       3,989    4.81       7,699    7.40       138,198    2.87       150,036    3.24       150,289
    

  

 

  

 

  

 

  

 

  

 

Total

   $ 718    4.70 %   $ 26,258    5.62 %   $ 690,192    4.62 %   $ 326,861    3.98 %   $ 1,044,029    4.43 %   $ 1,055,055
    

  

 

  

 

  

 

  

 

  

 

 

For further information regarding the Corporation’s investment securities available for sale, see Note 2 “Investment Securities.”

 

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Table of Contents

Sources of Funds

 

General

 

Deposits are the primary source of the Corporation’s funding for lending and other investment purposes. In addition to deposits, the Corporation derives funds from principal and interest repayments on loans and mortgage-backed securities, sales of loans, FHLB advance borrowings, prepayment and maturity of investment securities, and other borrowings. At December 31, 2003, deposits made up 57.9% of total deposits and interest-bearing liabilities compared to 54.1% at December 31, 2002. Deposit levels are significantly influenced by general interest rates, economic conditions and competition. Other borrowings, primarily FHLB advances, are utilized to compensate for any decreases in the normal or expected inflow of deposits.

 

Deposits

 

The Corporation’s deposit strategy is to emphasize acquisition and retention of consumer and commercial deposits obtained primarily through the retail branch network from retail, commercial and small business customers. Deposits are obtained through extensive marketing and advertising efforts and product promotion, such as offering a variety of checking accounts and other deposit programs to satisfy customer needs. The Corporation has increased its non-interest-bearing checking accounts and plans a continued focus on the growth of non-interest-bearing checking accounts in the future. In addition, the Corporation intends to continue pricing its deposit products at rates that minimize the Corporation’s total costs of funds while still allowing the Corporation to retain the customer deposit and the overall customer relationship. Rates on deposits are set based on the competitive environment, what is considered necessary in order to retain the customer deposit and relationship, and also considering other investment opportunities available to the customers. In addition, rates on deposits are based upon the Corporation’s desire to control the flow of funds in its deposit accounts according to its business objectives and the cost of alternative sources of funds.

 

 

23


Table of Contents

The following table sets forth the balances and percentages of the various types of deposits offered by the Corporation at the date indicated and the change in the dollar amount of deposits between such dates:

 

    December 31, 2003

    December 31, 2002

    December 31, 2001

 
    Amount

  % of
Deposits


    Increase
(Decrease)


    Amount

  % of
Deposits


    Increase
(Decrease)


    Amount

  % of
Deposits


 
    (Dollars in Thousands)  

Checking accounts— Interest-bearing

  $ 546,110   8.5 %   $ 51,263     $ 494,847   7.7 %   $ (3,875 )   $ 498,722   7.8 %

Non-interest-bearing

    638,658   9.9       118,094       520,564   8.1       116,715       403,849   6.3  

Custodial escrow

    299,249   4.6       (154,670 )     453,919   7.0       157,844       296,075   4.6  
   

 

 


 

 

 


 

 

Total checking accounts

    1,484,017   23.0       14,687       1,469,330   22.8       270,684       1,198,646   18.7  

Savings accounts

    1,267,916   19.6       (350,677 )     1,618,593   25.1       (321,003 )     1,939,596   30.3  

Money market accounts

    1,099,478   17.1       593,799       505,679   7.9       201,059       304,620   4.8  

Certificates of deposit

    2,603,199   40.3       (242,240 )     2,845,439   44.2       (108,221 )     2,953,660   46.2  
   

 

 


 

 

 


 

 

Total deposits

  $ 6,454,610   100.0 %   $ 15,569     $ 6,439,041   100.0 %   $ 42,519     $ 6,396,522   100.0 %
   

 

 


 

 

 


 

 

 

The following table shows the composition of average deposit balances and average rates for the years ended December 31:

 

     2003

    2002

    2001

 
    

Average

Balance


  

Avg.

Rate


   

Average

Balance


  

Avg.

Rate


   

Average

Balance


  

Avg.

Rate


 
     (Dollars in Thousands)  

Non-interest-bearing checking accounts

   $ 1,059,562    —   %   $ 728,774    —   %   $ 599,205    —   %

Interest-bearing checking accounts

     540,489    .47       549,767    .25       520,014    .80  

Savings accounts (1)

     1,416,203    4.25       1,802,558    4.32       1,958,022    4.73  

Money market acounts

     893,820    1.58       314,243    1.32       335,798    2.77  

Certificates of deposit

     2,719,225    2.58       2,862,960    3.36       3,709,030    5.51  
    

  

 

  

 

  

Average deposit accounts

   $ 6,629,299    2.22 %   $ 6,258,302    2.87 %   $ 7,122,069    4.36 %
    

  

 

  

 

  


(1)   The average rate is affected by interest expense on interest rate swap agreements totaling $48.6 million, $50.4 million and $28.1 million for the respective periods.

 

The following table sets forth the Corporation’s certificates of deposit (fixed maturities) classified by rates at December 31:

 

Rate


   2003

   2002

   2001

     (In Thousands)

Less than 2.00%

   $ 1,264,333    $ 672,486    $ 45,207

2.00% – 2.99%

     765,263      986,701      562,840

3.00% – 3.99%

     291,322      705,000      537,808

4.00% – 4.99%

     260,992      418,350      825,086

5.00% – 5.99%

     17,361      55,487      611,563

6.00% – 6.99%

     2,279      5,681      257,613

7.00% and over

     1,649      1,734      113,543
    

  

  

Certificates of deposit

   $ 2,603,199    $ 2,845,439    $ 2,953,660
    

  

  

 

24


Table of Contents

The following table presents the outstanding amount of certificates of deposit in amounts of $100,000 or more by time remaining until maturity at December 31:

 

Maturity Period


   2003

   2002

   2001

     (In Thousands)

Three months or less

   $ 221,992    $ 180,134    $ 256,828

Over three through six months

     133,289      196,738      69,244

Over six through twelve months

     129,689      183,690      87,912

Over twelve months

     161,096      99,868      70,136
    

  

  

Total

   $ 646,066    $ 660,430    $ 484,120
    

  

  

 

Borrowings

 

The Corporation has also relied upon other borrowings, primarily advances from the FHLB, as additional sources of funds. The maximum amount of FHLB advances fluctuates from time to time in accordance with federal regulatory policies. The Corporation is required to maintain an investment in FHLB stock in an amount equal to the greater of 1.0% of the aggregate unpaid loan principal of the Corporation’s loans secured by home mortgage loans, home purchase contracts and similar obligations, or 5.0% of advances from the FHLB to the Corporation. The Corporation is also required to pledge such stock as collateral for FHLB advances. In addition to this collateral requirement, the Corporation is required to pledge additional collateral which may be unencumbered whole residential first mortgage loans with an aggregate unpaid principal amount equal to 158.0% of the Corporation’s total outstanding FHLB advances. Alternatively, the Corporation can pledge 90.0% of the market value of U.S. government or U.S. government agency guaranteed securities, including mortgage-backed securities, as collateral for the outstanding FHLB advances. Pursuant to these requirements, as of December 31, 2003, the Corporation had pledged $4.1 billion of its real estate loans, $400.2 million of its mortgage backed securities, $243.3 million of its FHLB stock and $199.3 million of its investment securities.

 

Set forth below is certain information relating to the Corporation’s FHLB advances and securities sold under agreements to repurchase at and as of December 31 as indicated:

 

     2003

    2002

    2001

 
     (Dollars in Thousands)  

FHLB Advances:

                        

Balance at end of year

   $ 4,484,708     $ 4,848,997     $ 4,939,056  

Maximum month-end balance

   $ 4,844,642     $ 5,508,180     $ 4,928,075  

Average balance

   $ 4,542,015     $ 5,204,501     $ 4,265,468  

Weighted average effective interest rate during the year (1)

     4.56 %     4.68 %     5.49 %

Weighted average effective interest rate at end of year (1)

     4.26 %     4.66 %     4.76 %

Repurchase Agreements:

                        

Balance at end of year

   $ 265     $ 400,446     $ 201,912  

Maximum month-end balance

   $ 400,734     $ 402,228     $ 201,912  

Average balance

   $ 352,492     $ 353,977     $ 82,215  

Weighted average interest rate during the year

     2.97 %     3.93 %     5.32 %

Weighted average interest rate at end of year

     0.51 %     3.30 %     4.30 %

(1)   Inclusive of the effects of derivative-related adjustments.

 

For additional information on the Corporation’s FHLB advances, repurchase agreements and other borrowings, see Note 11 “Advances from the Federal Home Bank” and Note 12 “Other Borrowings.” See Note 13 “Derivative Financial Instruments” for additional information relating to the Corporation’s hedging strategies for the management of interest rate risk involving FHLB advances.

 

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Table of Contents

Customer Services

 

Retail banking management aggressively markets the Bank’s various checking and loan products since these are the principal entry points for consumers seeking a banking relationship. The Corporation’s goal is to become the new customer’s primary bank for an immediate and long-term opportunity to cross-sell the Corporation’s numerous services to develop profitable household relationships. Accordingly, management continues to update technology within the branch to provide a cost-effective and efficient delivery of services to the Corporation’s customers. Management has also been proactive in the implementation of new consumer-oriented technologies, including online banking and bill-paying through the Corporation’s web site at www.comfedbank.com. Management continues to strive to provide customers with the convenience of alternative delivery channels to obtain services. The Corporation utilizes a full-service cash management program to further develop the Corporation’s commercial banking relationships. The cash management program includes an internet-based cash management tool providing business owners access to full-service electronic banking. Services of this program, among others, include funds transfer, electronic payment of vendors, payroll direct deposits and wire transfers. In addition to online banking, the Bank offers customers the ability to bank in person at free-standing branch offices and supermarket locations, many of which offer extended weekday and weekend hours; by telephone, utilizing 24-hour AccessNow automated customer service system tied to extended-hour operator availability; and by ATMs through the Corporation’s proprietary network and links to other national and international ATM services.

 

Subsidiaries

 

The Bank is permitted to invest an amount up to 2.0% of its consolidated regulatory assets in capital stock and secured and unsecured loans in its service corporations, and an amount up to an additional 1.0% of its consolidated regulatory assets when such additional investment is used for community development purposes. In addition, federal savings institutions meeting regulatory capital requirements and certain other tests may invest up to 50.0% of their regulatory core capital in conforming first mortgage loans to service corporations. Under such limitations, at December 31, 2003, the Bank was allowed to invest up to $359.2 million in the stock of, and loans to, service corporations (based upon the 3.0% limitation). As of December 31, 2003, the Bank’s investment in its service corporations and their wholly-owned subsidiaries was $10.0 million.

 

Regulatory capital standards also contain a provision requiring that in determining capital compliance all savings associations must deduct from capital the amount of all post - April 12, 1989 investments in and extensions of credit to subsidiaries engaged in activities not permissible for national banks. Currently, the Bank has two subsidiaries (Commercial Federal Service Corporation and First Savings Investment Corporation) engaged in activities not permissible for national banks. Investments in such subsidiaries must be 100% deducted from capital. See “Regulation—Regulatory Capital Requirements.” At December 31, 2003, the total investment in such subsidiaries was $9.1 million, which was deducted from capital. Capital deductions are not required for investment in subsidiaries engaged in non-national bank activities as agent for customers rather than as principal, subsidiaries engaged solely in mortgage banking activities, and certain other exempted subsidiaries.

 

The Bank is also required to give the FDIC and the Director of the OTS 30 days prior notice before establishing or acquiring a new subsidiary, or commencing any new activity through an existing subsidiary. Both the FDIC and the Director of the OTS have authority to order termination of subsidiary activities determined to pose a risk to the safety or soundness of the institution.

 

At December 31, 2003, the Bank had ten wholly-owned subsidiaries, four of which own and operate certain real estate properties of the Bank. With the exception of the two real estate subsidiaries discussed above, these subsidiaries are classified as service corporations and are considered engaged in permissible activities therefore not requiring deductions from capital. Descriptions of the principal active subsidiaries of the Bank follow.

 

26


Table of Contents

Commercial Federal Investment Services, Inc. (“CFIS”)

 

CFIS provides customers discount brokerage services at all of the Bank’s branch offices. CFIS provides investment advice and access to all major stock, bond, mutual fund, and option markets through a third party registered broker-dealer, who provides all support functions either independently or through affiliates.

 

Commercial Federal Insurance Corporation (“CFIC”)

 

CFIC serves as a full-service independent insurance agency, offering a full line of homeowners, commercial (including property and casualty), health, auto and life insurance products. Additionally, a wholly-owned subsidiary of CFIC provides reinsurance on credit life and disability policies written by an unaffiliated carrier for consumer loan borrowers of the Corporation.

 

Commercial Federal Service Corporation (“CFSC”)

 

CFSC was formed primarily to develop and manage real estate, principally apartment complexes located in eastern Nebraska, directly and through a number of limited partnerships. Subsidiaries of CFSC act as general partner and syndicator in many of the limited partnerships. Under the capital regulations previously discussed, the Bank’s investments in and loans to CFSC are fully excluded from regulatory capital. See “Regulation—Regulatory Capital Requirements.”

 

REIT Holding Company (“REIT”)

 

The real estate investment trust was formed to hold mortgage loan participation interests. All earnings from the REIT are derived from loan participation interests acquired from the Bank.

 

See Exhibit 21 “Subsidiaries of the Corporation” of this Report for a complete listing of all subsidiaries of the Corporation.

 

Employees

 

At December 31, 2003, the Corporation and its wholly-owned subsidiaries had 2,861 employees. The Corporation provides its employees with a comprehensive benefit program, including major medical insurance, dental insurance, life and accidental death and dismemberment insurance, short and long-term disability coverage and a 401(k) plan. The Corporation also offers a tuition reimbursement program, an employee assistance program and discounts on loan rates and fees to its employees who qualify based on term of employment (except that no preferential rates or terms are offered to executive officers, senior management or directors). The Corporation considers its employee relations to be good.

 

Competition

 

The Corporation faces strong competition in the attraction of deposits and in the origination of real estate, consumer and commercial loans. Its most direct competition for deposits has come historically from commercial banks and from thrift institutions located in its primary market areas. The Corporation’s primary market area for deposits includes Colorado, Nebraska, Iowa, Kansas, Oklahoma, Missouri and Arizona and, for retail loan originations, includes Colorado, Nebraska, Iowa, Kansas, Oklahoma, Missouri, Arizona and Las Vegas, Nevada (primarily residential construction lending). Management believes that the Corporation’s extensive branch network enables the Corporation to compete effectively for deposits and loans against other financial institutions. The Corporation has been able to attract deposits primarily by offering depositors a wide variety of deposit accounts, convenient branch locations, a full range of financial services and competitive rates of interest.

 

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The Corporation’s competition for real estate, consumer and commercial loans comes principally from other thrift institutions, mortgage banking companies, commercial banks, insurance companies and other institutional lenders. The Corporation competes for loans principally through the efficiency and quality of the service provided to borrowers and the interest rates and loan fees charged.

 

Regulation

 

General

 

The Bank must comply with various regulations of both the OTS and the FDIC. The Bank’s lending and investing activities must comply with federal statutory and regulatory requirements. The Bank must also comply with the reserve requirements of the Federal Reserve Board. This supervision and regulation is intended primarily for the protection of the FDIC insurance funds and depositors. Both the OTS and the FDIC have extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies regarding the classification of assets and the establishment of adequate allowance for loan losses. The OTS regularly examines the Bank and prepares reports to the Board of Directors of the Bank regarding any deficiencies. The Bank must also file reports with the OTS and the FDIC concerning its activities and financial condition and must obtain regulatory approval before engaging in certain transactions.

 

As a savings and loan holding company, the parent company is also subject to the OTS’s regulation, examination, supervision and reporting requirements. In addition, since the Corporation’s common stock is registered under the Securities Exchange Act of 1934 Act, as amended (the “Exchange Act”), the Corporation is subject to regulation by the Securities and Exchange Commission (the “SEC”) under the federal securities laws and must comply with the Exchange Act information, proxy solicitation, insider trading restrictions and other requirements. Finally, as the Corporation’s common stock is listed on the New York Stock Exchange (the “NYSE”), the Corporation must comply with the NYSE’s listing standards in order for the common stock to continue to be listed. Certain of these regulatory requirements are referred to within this “Regulation” section or appear elsewhere in this Report.

 

The Gramm-Leach-Bliley Act

 

On November 12, 1999, the Gramm-Leach-Bliley Act (the “GLB Act”) was signed into law. Effective March 11, 2000, the GLB Act authorized affiliations between banking, securities and insurance firms and authorized bank holding companies and national banks to engage in a variety of new financial activities. Among the new activities that are permitted for bank holding companies are securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Federal Reserve Board, in consultation with the Secretary of the Treasury, may approve additional financial activities. The GLB Act, however, prohibits future acquisitions of existing unitary savings and loan holding companies, like the parent company, by firms which are engaged in commercial activities, unless the parent company ceases to engage in activities that are not permissible for a savings and loan holding company which is not an exempt unitary holding company, and it limits the permissible activities of unitary holding companies formed after May 4, 1999.

 

The GLB Act imposes certain burdens on the parent company’s operations. From a competitive environment perspective, the GLB Act reduces the range of companies with which the parent company may affiliate, although the GLB Act may facilitate affiliations with companies in the financial services industry.

 

The GLB Act imposed new privacy requirements on financial institutions. Financial institutions are generally prohibited from disclosing customer information to non-affiliated third parties unless the customer has been given the opportunity to object and the customer has not objected to such disclosure. Financial institutions are also required to disclose their privacy policies to customers annually. Financial institutions, however, must comply with state law if it is more protective of customer privacy than the GLB Act.

 

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Regulatory Capital Requirements

 

At December 31, 2003, the Bank exceeded all minimum regulatory capital requirements mandated by the OTS. The following table sets forth information relating to the Bank’s regulatory capital compliance at December 31, 2003:

 

     Actual

    Requirement

    Excess

 
     (Dollars in Thousands)  

Bank’s stockholder’s equity

   $ 820,623              

Add accumulated losses on certain available for sale securities and cash flow hedges, net

     78,700              

Less intangible assets

     (179,549 )            

Less investments in non-includable subsidiaries

     (9,104 )            
    


           

Tangible capital

   $ 710,670              
    


           

Tangible capital to adjusted assets (1)

     5.93 %   1.50 %   4.43 %
    


 

 

Tangible capital

   $ 710,670              

Plus certain restricted amounts of other intangible assets

     250              

Less disallowed portion of mortgage servicing rights

     (6,570 )            
    


           

Core capital (Tier 1 capital)

   $ 704,350              
    


           

Core capital to adjusted assets (2)

     5.88 %   4.00 %(3)   1.88 %
    


 

 

Core capital

   $ 704,350              

Less equity investments and other assets required to be deducted

     (12,445 )            

Plus qualifying subordinated debt

     50,000              

Plus qualifying loan loss allowances

     96,532              
    


           

Risk-based capital (Total capital)

   $ 838,437              
    


           

Risk-based capital to risk-weighted assets (4)

     10.87 %   8.00 %   2.87 %
    


 

 


(1)   Based on adjusted total assets totaling $11,980,467.
(2)   Based on adjusted total assets totaling $11,974,147.
(3)   For institutions that have well-diversified risks, including minimal interest rate risk exposure, excellent asset quality, high liquidity, stable and sufficient earnings and are not anticipating or experiencing significant growth, the minimum percentage of required core capital is 3.00%.
(4)   Based on risk-weighted assets totaling $7,716,021.

 

The Federal Deposit Insurance Corporation Improvement Act of 1991 established five regulatory capital categories: well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized; and authorized banking regulatory agencies to take prompt corrective action with respect to institutions in the three undercapitalized categories. These corrective actions become increasingly more stringent as an institution’s regulatory capital declines. At December 31, 2003, the Bank exceeded the minimum requirements for the well-capitalized category as shown in the following table:

 

    

Tier 1
Capital

to Adjusted

Total
Assets


   

Tier 1
Capital

to Risk-

Weighted
Assets


   

Total
Capital

to Risk-

Weighted
Assets


 

Percentage of adjusted assets

   5.88 %   9.13 %   10.87 %

Minimum requirements to be classified well-capitalized

   5.00 %   6.00 %   10.00 %

 

Under OTS capital regulations, the Bank must maintain “tangible” capital equal to at least 1.5% of adjusted total assets, “core” or “Tier 1” capital equal to at least 4.0% of adjusted total assets and “total” or “risk-based”

 

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capital (a combination of core and “supplementary” capital) equal to at least 8.0% of risk-weighted assets. In addition, the OTS can impose certain restrictions on savings associations that have a total risk-based capital ratio that is less than 8.0%, a ratio of Tier 1 capital to risk-weighted assets of less than 4.0% or a ratio of Tier 1 capital to adjusted total assets of less than 4.0% (or 3.0% if the institution is rated a Composite 1 under the regulatory CAMELS examination rating system).

 

Tangible capital is defined as common shareholders’ equity (including retained earnings), noncumulative perpetual preferred stock and related earnings, minority interests in the equity accounts of fully consolidated subsidiaries and certain nonwithdrawable accounts and pledged deposits that would qualify as core capital, less intangible assets, non-mortgage servicing assets, and credit-enhancing interest-only strips above the amount that may be included in core capital. Tangible capital is increased by any accumulated net losses on certain available-for-sale securities and cash flow hedges, net of income taxes. These losses classified in the Bank’s total stockholder’s equity under the caption “accumulated other comprehensive loss, net” totaled $78.7 million at December 31, 2003. Tangible capital is also reduced by an amount equal to the savings association’s debt and equity investments in subsidiaries engaged in activities not permissible for national banks. At December 31, 2003, the Bank had approximately $9.1 million of debt and equity invested in two subsidiaries which are engaged in activities not permissible for national banks that was deducted from capital. See “Business — Subsidiaries.”

 

Core capital consists of tangible capital plus restricted amounts of certain grandfathered intangible assets, purchased credit card relationships, mortgage and non-mortgage servicing rights and credit-enhancing interest only strips. The Bank’s core capital totaling $704.4 million at December 31, 2003, includes $250,000 of restricted amounts of certain intangible assets (core value of deposits) reduced by $6.6 million for the disallowed portion of mortgage servicing rights.

 

Total capital is comprised of core capital and supplementary capital. Supplementary capital consists of certain preferred stock issues, nonwithdrawable accounts and pledged deposits that do not qualify as core capital, certain approved subordinated debt, certain other capital instruments, a portion of the Bank’s loan loss allowances and up to 45.0% of unrealized gains on available for sale equity securities. The portion of the allowances for loan losses includable in supplementary capital is limited to 1.25% of risk-weighted assets and totaled $96.5 million at December 31, 2003. Qualifying subordinated debt is included in supplementary capital and totaled $50.0 million at December 31, 2003. Supplementary capital at December 31, 2003, was required to be reduced by the amount of real property the Bank acquired for investment purposes. Therefore, a total of $12.4 million in real estate held for investment was deducted at December 31, 2003, in determining risk-based capital.

 

The risk-based capital requirement is measured against risk-weighted assets, which equal the sum of every on-balance-sheet asset and the credit-equivalent amount of every off-balance-sheet item after being multiplied by an assigned risk weight. The risk weights are determined by the OTS and range from 0% for cash to 100% for consumer loans, non-qualifying single-family, multi-family and residential construction loans and commercial real estate loans, repossessed assets and loans more than 90 days past due. OTS capital regulations require savings institutions to maintain minimum total capital, consisting of core capital plus supplementary capital (limited to 100% of core capital), equal to 8.0% of risk-weighted assets.

 

The OTS requires savings institutions with more than a “normal” level of interest rate risk to maintain additional total capital. A savings institution with a greater than normal interest rate risk is required to deduct from total capital, for purposes of calculating its risk-based capital requirement, an amount (the “interest rate risk component”) equal to one-half the difference between the institution’s measured interest rate risk and the normal level of interest rate risk, multiplied by the economic value of its total assets. The Bank has determined that, on the basis of its current financial data, it will not be deemed to have more than a normal level of interest rate risk, as defined, and therefore will not be required to increase its total capital as a result of the rule.

 

In addition to these standards, the Director of the OTS is authorized to establish higher minimum levels of capital for a savings institution if the Director determines that such institution is in need of more capital in light of the particular circumstances of the institution. The Director of the OTS may treat the failure of any savings

 

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institution to maintain capital at or above such level as an unsafe or unsound practice and may issue a directive requiring any savings institution which fails to maintain capital at or above the minimum level required by the Director to submit and adhere to a plan for increasing capital. Such an order may be enforced in the same manner as an order issued by the FDIC.

 

Federal Home Loan Bank System

 

The Bank is a member of the FHLB of Topeka, which is one of 12 regional FHLBs. Each FHLB serves as a reserve or central bank for its member institutions within its assigned region. It is funded primarily from funds deposited by financial institutions and proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members in accordance with policies and procedures established by the Board of Directors of the FHLB of Topeka.

 

As a member of the FHLB of Topeka, the Bank must purchase and maintain shares of capital stock in the FHLB of Topeka in an amount at least equal to the greater of:

 

    1.0% of the Bank’s aggregate unpaid principal of its residential mortgage loans, home purchase contracts, and similar obligations at the beginning of each year; or

 

    5.0% of its then outstanding advances (borrowings) from the FHLB.

 

The Bank was in compliance with this requirement at December 31, 2003, with an investment in FHLB stock totaling $243.3 million.

 

Liquidity Requirements

 

Under OTS regulations, savings associations are required to maintain sufficient liquidity to ensure their safe and sound operation. Management believes that the Bank’s procedures for managing liquidity are sufficient to ensure the Bank’s safe and sound operations.

 

Qualified Thrift Lender Test

 

Savings institutions like the Bank are required to satisfy a qualified thrift lender (“QTL”) test. To meet the QTL test, the Bank must maintain at least 65.0% of its portfolio assets (total assets less goodwill and other intangible assets, property the Bank uses in conducting its business and liquid assets in an amount not exceeding 20.0% of total assets) in “Qualified Thrift Investments.” Qualified Thrift Investments consist primarily of residential mortgage loans and mortgage-backed securities and other securities related to domestic, residential real estate or manufactured housing. The shares of stock the Bank owns in the FHLB of Topeka also qualify as Qualified Thrift Investments as do loans for educational purposes, loans to small businesses and loans made through credit cards or credit card accounts. Certain other types of assets also qualify as Qualified Thrift Investments subject to an aggregate limit of 20.0% of portfolio assets.

 

If the Bank satisfies the test, it will continue to enjoy full borrowing privileges from the FHLB of Topeka. If it does not satisfy the test it may lose its borrowing privileges and be subject to activities and branching restrictions applicable to national banks. Compliance with the QTL test is measured on a monthly basis and the Bank must meet the test in nine out of every 12 months. Throughout 2003, the Bank was in compliance with the QTL test with approximately 69.10% of the Bank’s portfolio assets invested in Qualified Thrift Investments as of December 31, 2003.

 

Restrictions on Capital Distributions

 

The OTS limits the payment of dividends and other capital distributions (including stock repurchases and cash mergers) by the Bank. Under these regulations, a savings institution must submit notice to the OTS prior to making a capital distribution if:

 

    the association does not qualify for expedited treatment under OTS application processing regulations,

 

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    it would not be well capitalized after the distribution,

 

    the distribution would result in the retirement of any of the association’s common or preferred stock or debt counted as its regulatory capital, or

 

    the association is a subsidiary of a holding company.

 

A savings association must file an application to the OTS and obtain its approval prior to paying a capital distribution if:

 

    the association does not qualify for expedited treatment under OTS application processing regulations,

 

    the association would not be adequately capitalized following the distribution,

 

    the association’s total distributions for the calendar year exceeds the association’s net income for the calendar year to date plus its net income (less distributions) for the preceding two years, or

 

    the distribution would otherwise violate applicable law or regulation or an agreement with or condition imposed by the OTS.

 

The Bank pays cash distributions to the parent company on a periodic basis primarily to cover the amount of the principal and interest payments on the parent company’s debt, to fund the parent company’s common stock repurchases and to repay the parent company for the common stock cash dividends paid to the parent company’s stockholders. The Bank is currently required to file an application to the OTS prior to paying a capital distribution. During calendar year 2003 the Bank recorded net income of approximately $92.3 million and made capital distributions totaling $125.0 million. Total distributions exceeded the Bank’s retained net income for calendar year 2003 plus the preceding two years (the “retained net income standard”) by $115.6 million. In addition to the above authority, the OTS may prohibit any savings institution from making a capital distribution if the OTS determined that the distribution constituted an unsafe or unsound practice. Furthermore, under the OTS’s prompt corrective action regulations the Bank would be prohibited from making any capital distributions if, after making the distribution, the Bank would not satisfy its minimum capital requirements.

 

Deposit Insurance

 

The Bank’s deposit accounts are insured up to applicable regulatory limits by the SAIF and the BIF, both of which are administered by the FDIC. The FDIC establishes an assessment rate for deposit insurance premiums which protects the insurance fund and considers the fund’s operating expenses, case resolution expenditures, income and effect of the assessment rate on the earnings and capital of SAIF members. The SAIF assessment is based on the capital adequacy and supervisory rating of the institution and is assigned by the FDIC.

 

The FDIC’s assessment schedule for SAIF deposit insurance mandates the assessment rate for well-capitalized institutions. Institutions with the highest supervisory ratings are assessed at a zero rate and institutions in the lower risk classification are assessed at the rate of .27% of insured deposits. In addition, all institutions are required to pay assessments to help fund interest payments on certain bonds issued by the Financing Corporation. The Financing Corporation assessment rate is reset quarterly. The annualized rates assessed on insured deposits for each of the calendar quarters during 2003 were 1.68 basis points, 1.62 basis points, 1.60 basis points and 1.52 basis points, respectively.

 

Transactions with Related Parties

 

Generally, transactions between the Bank and any of its affiliates must comply with Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder as interpreted by the OTS. Section 23A limits the extent to which the savings institution or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10.0% of such institution’s capital stock and surplus, and contains an aggregate limit on all such transactions with all affiliates to an amount equal to 20.0% of such capital stock and

 

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surplus. Savings institutions are also prohibited from making loans to any affiliate that is not engaged in activities permissible to bank holding companies. Section 23B requires that such transactions be on terms as substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. An affiliate of a savings institution is any company or entity that controls, is controlled by or is under common control with the savings institution. In a holding company context, the parent holding company of a savings institution and any companies that are controlled by such parent holding company are affiliates of the savings institution.

 

Loans to Executive Officers, Directors and Principal Stockholders

 

Savings institutions are also subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the Federal Reserve Board’s Regulation O thereunder on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, executive officer and to a greater than 10.0% stockholder of a savings institution and certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution’s loans-to-one-borrower limit (generally equal to 15.0% of the institution’s unimpaired capital and surplus). Section 22(h) also prohibits the making of loans above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and greater than 10.0% stockholders of a savings institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the institution with any “interested” director not participating in the voting. Regulation O prescribes the loan amount (which includes all other outstanding loans to such person) as to which such prior board of director approval is required as being the greater of $25,000 or 5.0% of capital and surplus (up to $500,000). Further, Section 22(h) requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons. Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or directors.

 

Savings institutions must also comply with Section 22(g) of the Federal Reserve Act and Regulation O on loans to executive officers and the restrictions of 12 U.S.C. Section 1972 on certain tying arrangements and extensions of credit by correspondent banks. Pursuant to Section 22(g) of the Federal Reserve Act, the institution’s board of directors must approve loans to executive officers, directors and principal shareholders of the institution. Section 1972 also prohibits a depository institution from extending credit to or offering any other services, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution, subject to certain exceptions. Section 1972 also prohibits extensions of credit to executive officers, directors, and greater than 10.0% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.

 

Federal Reserve System

 

Pursuant to current regulations of the Federal Reserve Board, a thrift institution must maintain average daily reserves equal to 3.0% on transaction account balances over $6.6 million and up to $45.4 million, plus 10.0% on the remainder. This percentage is subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets. As of December 31, 2003, the Bank exceeded its reserve requirements.

 

The USA PATRIOT Act

 

In response to the events of September 11, 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), was signed into law on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to

 

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address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.

 

Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:

 

    Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at a minimum: (i) internal policies, procedures, and controls; (ii) specific designation of an anti-money laundering compliance officer; (iii) ongoing employee training programs; and (iv) an independent audit function to test the anti-money laundering program.

 

    Section 326 authorizes the Secretary of the Department of the Treasury, in conjunction with other bank regulators, to issue regulations that provide for minimum standards with respect to customer identification at the time new accounts are opened.

 

    Section 312 requires financial institutions that establish, maintain, administer or manage private banking accounts or correspondence accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.

 

    A prohibition against establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and certain record keeping obligations with respect to correspondent accounts of foreign banks.

 

    Bank regulators are directed to consider a holding company’s effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.

 

The federal banking agencies have begun to propose and implement regulations pursuant to the USA PATRIOT Act. These proposed and interim regulations require financial institutions to adopt the policies and procedures contemplated by the USA PATRIOT Act.

 

Savings and Loan Holding Company Regulation

 

The parent company is a registered savings and loan holding company. As such, it is subject to OTS regulations, examinations, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the parent company and any affiliates.

 

Activities Restrictions

 

Since the parent company only owns one thrift institution, it is classified as a unitary savings and loan holding company. There are generally no restrictions on the activities of a unitary savings and loan holding company. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity that constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings institution, the Director of the OTS may impose restrictions to address such risk. If the parent company were to acquire control of another savings institution, other than through merger or other business combination with the Bank, the parent company would become a multiple savings and loan holding company. In addition, if the Bank fails to meet the QTL test, then the parent company would also become subject to the activity restrictions applicable to multiple holding companies. A multiple savings and loan holding company may only engage in the following activities:

 

    furnishing or performing management services for a subsidiary savings institution;

 

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    conducting an insurance agency or escrow business;

 

    holding, managing, or liquidating assets owned by or acquired from a subsidiary savings institution;

 

    holding or managing properties used or occupied by a subsidiary savings institution;

 

    acting as trustee under deeds of trust;

 

    those activities authorized by regulation as of March 5, 1987, to be engaged in by multiple holding companies; or

 

    those activities authorized by the Federal Reserve Board as permissible for bank holding companies, unless the Director of the OTS by regulation prohibits or limits such activities.

 

The parent company would also have to register as a bank holding company and become subject to applicable restrictions unless the Bank requalified as a QTL within one year thereafter. See “Regulation — Qualified Thrift Lender Test.”

 

Restrictions on Acquisitions

 

The parent company must obtain the prior approval of the OTS before acquiring control of any other savings institution. Except with the prior approval of the Director of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25.0% of such company’s stock, may also acquire control of any savings institution, other than a subsidiary savings institution, or of any other savings and loan holding company.

 

The Director of the OTS may only approve acquisitions resulting in the formation of a multiple savings and loan holding company which controls savings institutions in more than one state if:

 

    the multiple savings and loan holding company involved controls a savings institution which operated a home or branch office in the state of the institution to be acquired as of March 5, 1987;

 

    the acquired is authorized to acquire control of the savings institution pursuant to the emergency acquisition provisions of the Federal Deposit Insurance Act; or

 

    the statutes of the state in which the institution to be acquired is located specifically permit institutions to be acquired by state-chartered institutions or savings and loan holding companies located in the state where the acquiring entity is located (or by a holding company that controls such state-chartered savings institutions).

 

Corporate Governance

 

On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the “Act”) which mandated a variety of reforms intended to address corporate and accounting fraud. The Act provides for the establishment of a new Public Company Accounting Oversight Board (“PCAOB”) which will enforce auditing, quality control and independence standards for firms that audit SEC-reporting companies and will be funded by fees from all SEC-reporting companies. The Act imposes higher standards for auditor independence and restricts provision of consulting services by auditing firms to companies they audit. Any non-audit services being provided to an audit client will require preapproval by the Corporation’s audit committee members. In addition, certain audit partners must be rotated periodically. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

 

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Longer prison terms will also be applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company’s financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from trading during retirement plan “blackout” periods, and loans to company executives are restricted. In addition, a provision directs that civil penalties levied by the SEC as a result of any judicial or administrative action under the Act be deposited in a fund for the benefit of harmed investors. Directors and executive officers must also report most changes in their ownership of a company’s securities within two business days of the change.

 

The Act also increases the oversight and authority of audit committees of publicly traded companies. Audit committee members must be independent, pursuant to Rule 10A-3 of the Exchange Act and the listing standards of the NYSE, and are barred from accepting consulting, advisory or other compensatory fees from the issuer. In addition, all SEC reporting companies must disclose whether at least one member of the committee is a “financial expert” (as such term is defined by the SEC rules) and if not, why not. Audit committees of publicly traded companies will have authority to retain their own counsel and other advisors funded by the company. Audit committees must establish procedures for the receipt, retention and treatment of complaints regarding accounting and auditing matters and procedures for confidential, anonymous submission of employee concerns regarding questionable accounting or auditing matters.

 

It is unlawful for any person that is not a registered public accounting firm (“RPAF”) with the PCAOB to audit an SEC-reporting company. Under the Act, a RPAF is prohibited from performing statutorily mandated audit services for a company if such company’s chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions has been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the Corporation’s financial statements for the purpose of rendering the financial statement’s materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to shareholders. The Act requires the RPAF that issues the audit report to attest to and report on management’s assessment of the Corporation’s internal controls. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) generally accepted accounting principles and filed with the SEC reflect all material correcting adjustments that are identified by a RPAF in accordance with generally accepted accounting principles and the rules and regulations of the SEC.

 

The Corporation has complied with all provisions of the Act effective through 2003 and will comply with all other provisions as they become effective in 2004.

 

Under newly adopted NYSE rules, by the date of the Corporation’s annual meeting of stockholders, the Corporation must comply with the following corporate governance standards:

 

    a majority of the Corporation’s directors must be “independent” as defined in the NYSE Listed Company Manual;

 

    the Board of Directors must have scheduled executive sessions;

 

    the Board of Directors must have a nominating/corporate governance committee (such committee must have a written charter) composed entirely of independent directors;

 

    the Board of Directors must have a compensation committee (such committee must have a written charter) composed entirely of independent directors;

 

    the Board of Directors must have an audit committee composed of a minimum of three members, each of whom is financially literate, independent and at least one of whom has accounting or financial management expertise;

 

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    the audit committee must have a written charter, containing certain specific provisions;

 

    the Corporation must adopt and disclose corporate governance guidelines; and

 

    the Corporation must adopt and disclose a code of business conduct and ethics for directors, officers and employees.

 

Failure to comply with these requirements could result in the delisting of the common stock of the Corporation or subject the Corporation to other penalties as determined by the NYSE. The Corporation has implemented most of the NYSE requirements and expects to be in full compliance by the date of its 2004 annual stockholders’ meeting. The Corporation has incurred additional expense in complying with the provisions of the Act and the related rules, however, management does not believe that such compliance had a material negative impact on the Corporation’s financial condition or results of operations.

 

Taxation

 

The Corporation is subject to the provisions of the Internal Revenue Code of 1986, as amended. The Corporation and all includible subsidiaries file a consolidated federal income tax return based on a June 30 fiscal year end. Taxable income is determined on an accrual basis. The Internal Revenue Service has completed examination of the income tax returns of the Corporation through June 30, 1999.

 

The State of Nebraska imposes a franchise tax on all financial institutions, including the Bank. The franchise tax is assessed at a rate of $.47 per $1,000 of average deposits, limited to 3.81% of the financial institution’s income before tax (including subsidiaries) as reported on the financial institution’s regulatory filings. Many of the other states in which the Corporation conducts business impose franchise or income taxes on companies doing business in those states. For further information regarding income taxes see Note 14 “Income Taxes.”

 

ITEM 2.    PROPERTIES

 

At December 31, 2003, the Corporation conducted business through 192 branch offices in seven states: Colorado (45), Nebraska (42), Iowa (40), Kansas (27), Oklahoma (19), Missouri (13) and Arizona (6). During 2003, five new branches were opened in Denver, Colorado, Omaha, Nebraska and Des Moines, Iowa and two branches were consolidated. In 2004, the Corporation plans to open seven new branches in the Denver, Omaha and Des Moines markets and to construct a new operations center building.

 

At December 31, 2003, the Corporation owned the buildings for 109 of its branch offices and leased the remaining 83 branches under leases expiring (not assuming exercise of renewal options) between April 2004 and April 2048. The Corporation has 232 “Cashbox” ATMs located throughout its seven-state region. At December 31, 2003, the total net book value of land, office properties and equipment owned by the Corporation was $147.4 million. Management believes that the Corporation’s premises are suitable for its present and anticipated needs. The Corporation’s segments utilize all of the Corporation’s properties except for the Treasury segment which utilizes primarily the corporate headquarters.

 

ITEM 3.    LEGAL PROCEEDINGS

 

There are no pending legal proceedings to which the Corporation, the Bank or any subsidiary is a party or to which any of their property is subject which are expected to have a material adverse effect on the Corporation’s financial position.

 

On September 12, 1994, the Bank and the Corporation commenced litigation relating to supervisory goodwill against the Government in the United States Court of Federal Claims seeking to recover monetary relief for the Government’s refusal to honor certain contracts that it had entered into with the Bank. The suit

 

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alleged that such governmental action constituted a breach of contract and an unlawful taking of property by the Government without just compensation or due process in violation of the Constitution of the United States. On July 22, 2003, the United States Court of Federal Claims issued its ruling dismissing the Corporation’s complaint and the Corporation and the Bank determined not to appeal this ruling. As a result, the litigation with respect to the Empire and Territory claims has been terminated with no damages awarded to the Corporation or the Bank.

 

The Bank also assumed a lawsuit in the merger with Mid Continent against the Government also relating to a supervisory goodwill claim filed by the former Mid Continent. The Mid Continent claim was tried in June and July 2003 with a final summation completed in October 2003. A final ruling was entered on January 29, 2004, awarding the Bank $5.6 million in damages. On February 12, 2004, the Department of Justice, on behalf of the Government, filed a Defendant’s Motion for Reconsideration of the ruling entered on January 29, 2004. The Government’s motion argued the amount of lost profit damages awarded by the Court was inappropriate. On or about February 26, 2004 the Court denied the Government’s motion. The Government has sixty days to file a formal appeal of the ruling entered on January 29, 2004. The ultimate collectibility of this award is contingent on a number of factors and future events which are beyond the control of the Bank, as to substance, timing and amount of damages that may be paid to the Bank. The Corporation has not recorded a receivable pursuant to this award.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

There were no matters submitted to a vote of stockholders during the quarter ended December 31, 2003.

 

PART II

 

ITEM 5.   MARKET FOR COMMERCIAL FEDERAL CORPORATION’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

The Corporation’s common stock is traded on the New York Stock Exchange under the symbol “CFB.” The following table sets forth the high, low and closing sales prices and dividends declared for the periods indicated for the common stock:

 

     Common Stock Price

  

Dividends

Declared


Quarter Ended


   High

   Low

   Close

  

December 31, 2003

   $ 27.68    $ 24.13    $ 26.71    $ .125

September 30, 2003

     25.18      21.38      24.35      .100

June 30, 2003

     23.75      20.25      21.20      .100

March 31, 2003

     24.10      20.70      21.72      .090

December 31, 2002

     24.20      19.31      23.35      .090

September 30, 2002

     28.31      20.75      21.77      .090

June 30, 2002

     30.00      26.37      29.00      .090

March 31, 2002

     26.90      23.20      26.90      .080

 

As of December 31, 2003, there were 41,452,691 shares of common stock issued and outstanding that were held by over 5,219 shareholders of record and 4,008,017 shares subject to outstanding options. The number of shareholders of record does not reflect the persons or entities who hold their stock in nominee or “street” name.

 

Cash dividends declared for calendar year 2003 totaled $17.9 million, or $.415 per common share, compared to $15.8 million, or $.35 per common share, for calendar year 2002. For information regarding the payment of future dividends and any possible restrictions see “MD&A—Liquidity and Capital Resources” under Item 7 of this Report and Note 15 “Stockholders’ Equity and Regulatory Restrictions.”

 

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ITEM 6.    SELECTED FINANCIAL DATA

 

          

Six Months

Ended

December 31,

2000 (1)


   

Year Ended

June 30,

2000


 
     Year Ended December 31,

     
     2003

    2002

    2001

     
     (Dollars in Thousands Except Per Share Data)  

Interest income

   $ 650,744     $ 777,053     $ 871,374     $ 498,732     $ 927,690  

Interest expense

     375,174       449,325       563,945       344,297       585,549  
    


 


 


 


 


Net interest income

     275,570       327,728       307,429       154,435       342,141  

Provision for loan losses

     (22,003 )     (31,002 )     (38,945 )     (27,854 )     (13,760 )

Retail fees and charges

     57,798       55,279       53,519       25,650       43,230  

Loan servicing fees, net of mortgage servicing rights amortization

     (29,995 )     8,099       22,680       12,104       25,194  

Mortgage servicing rights valuation adjustment

     28,678       (60,417 )     (19,058 )     (583 )     —    

Gain (loss) on sales of securities and changes in fair values of derviatives, net

     26,767       40,583       15,422       (69,462 )     —    

Gain (loss) on sales of loans

     23,916       36,173       8,739       (18,023 )     (110 )

Bank owned life insurance

     11,574       12,654       12,986       (3,370 )     —    

Other operating income

     27,943       28,067       27,235       12,123       33,613  

General and administrative expenses

     271,409       260,070       234,483       151,017       252,019  

Amortization of core value of deposits

     5,533       6,368       7,211       3,903       8,563  

Amortization of goodwill

     —         —         8,134       4,250       8,673  
    


 


 


 


 


Income (loss) before income taxes and cumulative effect of change in accounting principle

     123,306       150,726       140,179       (74,150 )     161,053  

Income tax provision (benefit)

     34,286       43,723       43,374       (19,691 )     55,269  
    


 


 


 


 


Income (loss) before cumulative effect of change in accounting principle

     89,020       107,003       96,805       (54,459 )     105,784  

Cumulative effect of change in accounting principle, net (2)

     —         —         —         (19,125 )     (1,776 )
    


 


 


 


 


Net income (loss)

   $ 89,020     $ 107,003     $ 96,805     $ (73,584 )   $ 104,008  
    


 


 


 


 


Earnings (loss) per common share: (3)

                                        

Income (loss) before cumulative effect of change in accounting principle

   $ 2.02     $ 2.33     $ 1.92     $ (1.00 )   $ 1.82  

Cumulative effect of change in accounting principle, net (2)

     —         —         —         (.35 )     (.03 )
    


 


 


 


 


Net income (loss)

   $ 2.02     $ 2.33     $ 1.92     $ (1.35 )   $ 1.79  
    


 


 


 


 


Dividends declared per common share

   $ .415     $ .350     $ .310     $ .140     $ .280  
    


 


 


 


 


Other data:

                                        

Net interest rate spread

     2.43 %     2.76 %     2.59 %     2.46 %     2.67 %

Net yield on interest-earning assets

     2.38 %     2.74 %     2.62 %     2.44 %     2.78 %

Return on average total assets

     .70 %     .81 %     .75 %     (1.07 )%     .77 %

Return on average total stockholders’ equity

     12.01 %     14.10 %     12.12 %     (16.19 )%     10.85 %

Average total stockholders’ equity to average total assets

     5.79 %     5.76 %     6.21 %     6.62 %     7.10 %

Dividend payout ratio

     20.54 %     15.02 %     16.15 %     n/a       15.36 %

Total number of branches at end of period

     192       189       196       241       255  

 

(Continued on next page)

 

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Six Months

Ended

December 31,

2000


   

Year Ended

June 30,

2000


 
     Year Ended December 31,

     
     2003

    2002

    2001

     
     (Dollars in Thousands Except Per Share Data)  

Total assets

   $ 12,188,859     $ 13,092,932     $ 12,902,994     $ 12,536,221     $ 13,793,038  

Investment securities

     1,055,055       1,296,050       1,150,345       771,137       993,167  

Mortgage-backed securities

     1,337,805       1,632,622       1,829,728       1,514,510       1,220,138  

Loans held for sale, net

     351,539       914,474       381,365       242,200       183,356  

Loans receivable, net

     7,956,743       7,703,016       8,066,375       8,651,174       10,224,336  

Core value of deposits

     16,832       22,365       28,733       36,209       42,488  

Goodwill

     162,717       162,717       162,717       171,218       188,362  

Deposits

     6,454,610       6,439,041       6,396,522       7,694,486       7,330,500  

Advances from Federal Home Loan Bank

     4,484,708       4,848,997       4,939,056       3,565,465       5,049,582  

Other borrowings

     215,243       621,192       526,582       175,343       206,026  

Stockholders’ equity

     755,353       750,100       729,694       859,656       987,978  

Book value per common share

     18.20       16.57       15.87       16.16       17.67  

Regulatory capital ratios of the Bank:

                                        

Tangible capital

     5.93 %     5.75 %     5.54 %     6.48 %     6.55 %

Core capital (Tier 1 capital)

     5.88 %     5.69 %     5.56 %     6.51 %     6.59 %

Risk-based capital—

                                        

Tier 1 capital

     9.13 %     9.15 %     9.47 %     10.80 %     11.74 %

Total capital

     10.87 %     10.87 %     11.37 %     11.79 %     12.59 %

(1)   In 2000, the Corporation changed its year end to December 31 from June 30.
(2)   Represents the cumulative effect of the change in method of accounting for derivative instruments and hedging activities, net of income tax benefit, for the six months ended December 31, 2000, and for start-up and organizational costs, net of income tax benefit, for the fiscal year ended June 30, 2000.
(3)   All periods presented are based on diluted earnings (loss) per share. The conversion of stock options for the six months ended December 31, 2000, is not assumed since the Corporation incurred a loss from operations. As a result, for the six months ended December 31, 2000, the diluted loss per share is computed the same as the basic loss per share.

 

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Commercial Federal Corporation (the “Corporation”) is a unitary non-diversified savings and loan holding company whose primary asset is Commercial Federal Bank, a Federal Savings Bank (the “Bank”). The Corporation is one of the largest financial institutions in the Midwest and the 11th largest publicly held thrift holding company in the United States. The Bank, with a thrift charter, operates as a community banking institution, offering commercial and consumer banking, mortgage banking, insurance and investment services.

 

Executive Management Overview

 

At December 31, 2003, the Corporation, headquartered in Omaha, Nebraska, operated 192 branches with 45 located in Colorado, 42 in Nebraska, 40 in Iowa, 27 in Kansas, 19 in Oklahoma, 13 in Missouri and 6 in Arizona. To serve its customers, the Corporation conducts commercial and consumer banking operations and loan origination activities through its branch network, loan offices and a nationwide correspondent network of mortgage loan originators. The Corporation also provides insurance products and securities brokerage services in addition to other retail financial services.

 

The Corporation’s core revenues are from three principal sources: net interest income, retail fee income and loan servicing income. These revenues are derived from loan products (primarily single-family residential, consumer, commercial real estate, commercial operating and small business lending), deposit products, ancillary financial services and mortgage loan servicing. During 2003 and continuing into 2004, the Corporation’s focus is the growth of loan and deposit products that diversify the product mix and contribute to enhanced core profitability. This focus aligns with the Corporation’s objective to transition its balance sheet from a traditional thrift institution to more of a commercial banking franchise. During 2003, the Corporation recorded net growth in the following targeted core business drivers:

 

    13% increase in core deposit balances (excluding custodial escrows),

 

    5% growth in the number of retail checking accounts,

 

    16% growth in the number of commercial and small business checking accounts,

 

    64% increase in commercial operating and small business loan balances, and

 

    5% increase in home equity outstanding loan balances.

 

The Corporation’s strategy is further centered on building multiple product relationships with the Bank’s existing customer base and expanding the Bank’s market share in its high-growth markets (Denver, Colorado; Omaha, Nebraska and Des Moines, Iowa). Five new branches were opened in 2003 utilizing a state of the art design that leverages the latest technology to most conveniently and effectively serve the customer. The expansion plan for 2004 calls for seven more branch openings in our core Denver, Omaha, and Des Moines markets. The investment in branch expansion is one of the keys for future earnings growth and a stronger overall franchise. By incorporating new technology and creating a customer experience focused on client convenience and service, the new offices offer alternatives to broaden and strengthen customer relationships. With the expansion and strengthening of the Bank’s customer relationships, the potential for growth in net interest and fee income will be enhanced. The Corporation’s operations are also continually reviewed in order to gain efficiencies, enhance productivity and minimize costs.

 

Net income for the year ended December 31, 2003, was $89.0 million, or $2.02 per diluted share compared to net income for the year ended December 31, 2002 of $107.0 million, or $2.33 per diluted share. Results for 2003 were significantly affected by an unprecedented interest rate environment primarily driven by the Federal Reserve’s reductions of the targeted federal funds interest rate down to one percent, the lowest level in over 40 years. This low interest rate environment negatively impacted the entire industry. The resulting compression in the Corporation’s net interest margin was accentuated by record levels of prepayments on higher-yielding loans

 

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and mortgage-backed securities. Furthermore, increased amortization of net deferred loan costs and premiums on loans and mortgage-backed securities, which are fully amortized against interest income when a loan pays off, magnified the compression to net interest margin. The higher loan prepayments also caused a considerable increase in the amortization of mortgage servicing rights, although the stabilization and slight increase in interest rates toward the end of 2003 allowed the Corporation to record net recoveries in its mortgage servicing rights valuation allowance for 2003. The low interest rate environment also resulted in record levels of residential mortgage loan production and refinancing activity as consumers took advantage of lower interest rates to refinance existing loans or originate new mortgage loans. The significantly higher levels of loan prepayments contributed to an increase in corresponding expenses for 2003.

 

During 2003, the Corporation sold available-for-sale securities which resulted in the recognition of net gains to strategically offset continued high levels of amortization of mortgage servicing rights, accelerated amortization of net deferred costs and premiums on mortgage loans and mortgage-backed securities, and losses recognized on the termination of certain swap agreements. The Corporation also sold available-for-sale securities during the year that resulted in net losses to strategically offset net recoveries in the valuation allowance of mortgage servicing rights. Gains on sales of loans decreased in 2003 compared to 2002 as production volumes for residential mortgages held for sale slowed during the latter part of 2003 and pricing spreads began to shrink in response to changing competitive market factors. Gains on sales of loans are expected to decline further during 2004 due to lower expected mortgage production volumes and competitive market conditions.

 

The Corporation’s credit quality saw additional improvement in 2003 which is indicative of the Corporation’s diligence in credit underwriting and monitoring procedures, as well as the Corporation’s focus on identifying and limiting credit concentrations. The positive trends in credit quality also reflect the general stability of the economy in the Midwestern markets where the Corporation operates. The Corporation does not foresee any significant asset quality issues in 2004.

 

During the second half of 2003, the Corporation strategically reduced the size of its balance sheet as part of a plan to decrease certain residential mortgage loan and available-for-sale securities portfolios that were lower margin contributors to net interest income. In addition to decreasing lower-yielding assets, a portion of the advances from the FHLB was paid down. As a related part of this strategy, the Corporation sold certain available-for-sale securities resulting in net gains realized to partially offset the recognition of a $29.4 million loss on the termination of certain interest rate swap agreements that were previously hedging the FHLB debt that was paid down. The Corporation also executed FHLB debt restructuring strategies in the fourth quarter of 2003 that have begun to favorably impact net interest margin. The reduction in the size of the balance sheet also resulted in a decrease to required levels of regulatory capital allowing management to continue repurchasing approximately 3.8 million shares of the Corporation’s common stock in 2003. Although the future interest rate environment is uncertain, management anticipates that market interest rates in 2004 will remain near the same level of interest rates in effect toward the end of 2003. This projected stability in interest rates coupled with the restructuring of the Corporation’s balance sheet and FHLB debt that occurred in 2003, is expected to improve net interest margin performance for 2004.

 

On March 1, 2004, the Corporation filed with the SEC amended Forms 10-Q for the three calendar quarters ended September 30, 2003, and an amended Form 10-K for the year ended December 31, 2002. These amendments restated the Corporation’s consolidated financial statements correcting an error in accounting for certain components of a bank owned life insurance (“BOLI”) policy. As a result of management’s review of this BOLI policy’s terms in conjunction with the restatement of the Corporation’s consolidated financial statements, management signed an amendment to this BOLI policy effective February 25, 2004 that will result in the recognition of an asset and an increase in net income of approximately $5.3 million (or approximately $.13 per diluted share) for the first quarter ending March 31, 2004. The amendment will allow the Corporation to receive a guaranteed payment of a certain component of the BOLI policy if there is a full and complete surrender of all outstanding certificates of the BOLI.

 

Net income for the year ended December 31, 2002, was $107.0 million, or $2.33 per diluted share. Net income for 2002 includes pre-tax gains on the sales of available-for-sale securities totaling $35.9 million and

 

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mortgage loans totaling $36.2 million. These net gains were substantially offset by the valuation adjustment losses totaling $60.4 million in the mortgage servicing rights portfolio incurred during 2002. The gains on the sales of mortgage loans were the result of the Corporation taking advantage of pricing opportunities on its loans resulting from historically low interest rates and unprecedented loan demand during 2002. These low interest rates in 2002 significantly affected mortgage loan pay-downs which in turn increased the amortization expense of mortgage servicing rights and impacted the valuation allowances for impairment losses of mortgage servicing rights.

 

Critical Accounting Policies

 

The “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and disclosures included within this Form 10-K Annual Report, are based on the Corporation’s audited consolidated financial statements. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, management evaluates the estimates used, including the adequacy of allowances for loan losses, valuation of mortgage-servicing rights and contingencies. Estimates are based upon historical experience, current economic conditions and other factors that management considers reasonable under the circumstances. These estimates result in judgments regarding the carrying values of assets and liabilities where these values are not readily available from other sources as well as assessing and identifying the accounting treatments of commitments and contingencies. Actual results may differ from these estimates under different assumptions or conditions. The following critical accounting policies involve the more significant judgments and assumptions used in the preparation of the consolidated financial statements.

 

Allowance for Loan Losses

 

The allowance for loan losses is a valuation allowance for estimated credit losses inherent in the loan portfolio as of the balance sheet date. The allowance for loan losses consists of two elements. The first element is an allocated allowance established for specifically identified loans that are evaluated individually for impairment. A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal and interest, when due, according to the contractual terms of the loan agreement. Impairment is measured by (i) the present value of expected future cash flows, (ii) the loan’s obtainable market price, or (iii) the fair value of the collateral if the loan is collateral dependent (the primary method used by the Corporation). The second element is an estimated allowance established for impairment on each of the Corporation’s pools of outstanding loans. See “Provision for Loan Losses” in the MD&A and “Asset Quality” under Item 1 of this Report for additional information. These estimated allowances are based on several analysis factors including the Corporation’s past loss experience, economic and business conditions that may affect the borrower’s ability to pay, geographic and industry concentrations, composition of the loan portfolio, credit quality and delinquency trends, regular examinations of specific problem loans by the Corporation’s credit review team, the overall portfolio quality and real estate market conditions in the Corporation’s lending areas, and known and inherent risks in each of the portfolios. These evaluations are inherently subjective because, while they are based on objective data (delinquency trends, portfolio composition, loan grading and other data), it is the interpretation of that data by management that ultimately determines the estimate of the appropriate allowance. Due to the interplay of the variety of factors that impact the estimated allowance for loan losses, a significant change in a single factor generally does not result in a significant change in the overall required level of the allowance for loan losses. Additionally, while the allowance attempts to measure the impairment inherent in the loan portfolio at the balance sheet date, its adequacy will ultimately be dependent upon how conditions existing at the balance sheet date impact the loans in the future. Consequently, these estimates require revisions as new or changed information becomes available.

 

A majority of the Corporation’s loans are collateralized by residential or commercial real estate. Therefore, the collectibility of such loans is susceptible to changes in prevailing real estate market conditions and other

 

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factors, which can cause the fair value of the collateral to decline below the loan balance. If it becomes necessary to initiate foreclosure on real estate collateralizing a loan, a new appraisal is obtained to determine if the market value of the underlying collateral has declined to justify a charge-off of the loan. Recoveries of loan charge-offs occur when loan payments are received on the deficient loan in excess of the remaining recorded book balance of the loan. Upon foreclosure and conversion of the loan into real estate owned, the Corporation may realize income through the disposition of such real estate when the sale proceeds exceed the carrying value of the real estate.

 

Although management believes that the Corporation’s allowance for loan losses is adequate to reflect the risk inherent in its loan portfolios, there can be no assurance that the Corporation will not experience increases in its nonperforming assets, that it will not increase the level of its allowances in the future or that significant provisions for loan losses will not be required based on factors such as deterioration in market conditions, changes in borrowers’ financial conditions, delinquencies and defaults. In addition, regulatory agencies review the adequacy of the allowance for loan losses on a regular basis as an integral part of their examination process. Such agencies may require additions to the allowance based on their judgments of information available to them at the time of their examinations.

 

Mortgage Servicing Rights

 

Mortgage servicing rights are established based on the cost of acquiring the right to service mortgage loans or the allocated fair value of servicing rights retained on loans originated by the Bank and subsequently sold in the secondary market. These costs are initially capitalized and then amortized in proportion to, and over the period of, estimated net servicing revenues. Projected net servicing revenues are determined on the basis of the estimated future balance of the underlying mortgage loan portfolio which decreases over time from scheduled loan amortization and prepayments. Future prepayment rates are estimated based on third party sources and relevant characteristics of the servicing portfolio, such as loan types, interest rate stratification and recent prepayment experience, as well as current interest rate levels, market forecasts and other economic conditions.

 

The Corporation reports mortgage servicing rights at the lower of amortized cost or fair value. The fair value of mortgage servicing rights is determined using the present value of estimated future cash flow techniques, incorporating assumptions that market participants would use in their estimates of values. Mortgage servicing rights are assessed for impairment periodically, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment, if any, recognized through a write-off of the mortgage servicing rights asset and the related valuation allowance. For purposes of measuring impairment, the rights are stratified based on loan type and note rate. Loan types include government, conventional and adjustable-rate mortgage loans. Impairment losses are recognized to the extent the unamortized carrying value of the mortgage servicing rights for each stratum exceeds the current fair value of that stratum. A valuation adjustment recovery for previously recognized temporary impairment losses totaling $28.7 million was recorded during the year ended December 31, 2003, compared to valuation adjustment losses totaling $60.4 million and $19.1 million, respectively, recorded during the years ended December 31, 2002 and 2001. Valuation allowances totaling $49.3 million, $80.1 million and $19.6 million, respectively, were outstanding at December 31, 2003, 2002 and 2001. The carrying value of mortgage servicing rights, net of the valuation allowance, totaled $135.9 million at December 31, 2003, compared to $88.4 million and $114.1 million, respectively, at December 31, 2002 and 2001. As part of its overall strategy to manage the level of exposure to the risk of interest rates adversely affecting the value of mortgage servicing rights, the Corporation uses interest rate floor agreements to protect the value of the mortgage servicing rights. Additionally, the Corporation partially offsets recorded changes in the fair value of mortgage servicing rights through the recognition of gains on the sales of available-for-sale securities.

 

The determination of the fair value of mortgage servicing rights is an important estimate. Since mortgage servicing rights are not quoted in an active market, the fair value of mortgage servicing rights is estimated using a software model which is calibrated against variables affecting the value of this asset, including prepayment speeds, discount rates, servicing costs and market liquidity. Management uses third party estimates of

 

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prepayment speeds and maintains relationships with servicing brokers to keep abreast of any market developments which may impact the value of this asset. On a periodic basis, management of the Corporation obtains an independent valuation report for comparison to the valuation results of the software model. See Note 7 “Mortgage Banking Activities” for a sensitivity analysis of how changes in prepayment speeds and discount rates affect the fair value of mortgage servicing rights.

 

Derivative Financial Instruments

 

Derivatives are recognized as either assets or liabilities in the consolidated statement of financial condition and measured at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. For a derivative designated as hedging the exposure to changes in fair value of an asset or liability (referred to as a fair value hedge), any gain or loss associated with the derivative is reported in earnings along with the change in fair value of the asset or liability being hedged. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. On the date the Corporation enters into a derivative contract, management must designate the derivative as a hedge of the identified cash flow exposure, fair value exposure or as a “no hedging” derivative.

 

Proper documentation is a critical aspect pursuant to hedge accounting treatment. The Corporation formally documents all relationships between derivative instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. In this documentation, the Corporation specifically identifies the asset, liability, firm commitment, or forecasted transaction that has been designated as a hedged item and states how the hedging instrument is expected to hedge the risks related to the hedged item. The Corporation formally measures effectiveness of its hedging relationships both at the hedge inception and on an ongoing basis in accordance with its risk management policy. The methods used to measure effectiveness vary depending on the hedging relationship, however, the method chosen at the inception of each hedge is not subsequently changed. The fair value of the Corporation’s derivatives is determined using various methods depending on the nature of the derivatives such as quotes obtained from independent pricing services, valuation models of independent pricing services with known factors put into the model, or software models utilizing assumptions or data obtained from independent sources.

 

Segment Reporting

 

Operating Results by Segment

 

The Corporation’s operations are aligned into four lines of business for management reporting purposes. These lines of business units are Commercial Banking, Retail Banking, Mortgage Banking and Treasury. See Note 21 “Segment Information” for additional information on the Corporation’s lines of business including tabular results of operations for the years ended December 31, 2003, 2002 and 2001. The financial information presented does not necessarily represent the business unit’s results of operations or financial condition as if they were independent companies. Results of operations for each business unit are derived from management’s internal reporting system used to measure the performance of the segments and the Corporation in total. This management reporting system and the results of operations and financial condition by reported business unit may not be in accordance with accounting principles generally accepted in the United States.

 

Commercial Banking

 

The Commercial Banking segment involves the origination of commercial operating loans, commercial real estate loans, commercial and residential construction loans, indirect lending loans, agricultural loans and small

 

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business loans. Also included in this segment are commercial demand deposits, time deposits and cash management products and services. The Commercial Banking segment reported net income of $35.7 million for the year ended December 31, 2003, compared to $33.4 million and $29.3 million, respectively, for the years ended December 31, 2002 and 2001.

 

For the year ended December 31, 2003, net interest income for the segment increased $23.4 million compared to the year ended December 31, 2002. This increase in net interest income is due primarily to a $315 million increase in the average balance of the commercial loan portfolio during 2003 over 2002. The portfolio increase is due to the successful sales efforts of commercial lenders and the development of cash management products to meet client needs. Additionally, the segment was fully staffed for 2003 as a result of the growth emphasis and strategic direction of the segment, with specific focus on upgrading the regional management positions. The provision for loan losses decreased $2.5 million for 2003 compared to 2002. The primary reason for the decrease was a reduction in the expected loss rate applied to the segment’s loans. Total other income decreased $12.2 million in 2003. This decrease is primarily due to the Treasury segment charging the Commercial Banking segment a break funding fee totaling $17.8 million relating to commercial real estate loans paying off in full prior to maturity. This intersegment charge was implemented in 2003. Offsetting this charge is an increase in other income from cash management services, which increased $1.7 million in 2003. Total other expense increased $11.2 million for 2003 compared to 2002 primarily due to an $8.4 million reclassification of commercial deposits cost entirely to the Commercial segment for 2003, while the segment was only allocated 50% of the cost in 2002, increased production incentive bonuses and more full-time equivalent employees during 2003 compared to 2002.

 

For the year ended December 31, 2002, net interest income increased $12.6 million compared to 2001. This increase in net interest income was due primarily to the $344 million increase in the average balance of the commercial loan portfolio during 2002 over 2001. The provision for loan losses increased $7.3 million due to the larger commercial loan portfolio and a higher anticipated loss percentage compared to 2001. Total other income decreased $2.7 million for 2002 compared to 2001. Total other expense decreased $2.3 million for 2002 compared to 2001. The primary reason was the allocation of 50% of the cost for commercial deposits to the Retail Banking segment totaling $8.4 million in 2002. This reduction was offset by the allocated portion of the net gain from exit costs and termination benefits totaling $2.4 million during 2001. In addition, the Corporation recorded an impairment loss totaling $1.9 million on a residential master planned community development located in Nevada during 2002.

 

Retail Banking

 

The Retail Banking segment involves a variety of traditional banking and financial services including the origination of residential mortgage loans through the Bank’s branch network and the sale of these mortgage loans to the Treasury segment or the Mortgage Banking segment. In addition, servicing rights to mortgage loans are sold to the Mortgage Banking segment. Other core Retail Banking services include consumer checking, savings and certificates of deposit accounts (regular and retirement); consumer loans for home equity, autos, secured and unsecured purposes, as well as credit cards; and other ancillary retail banking services including overdraft protection, electronic and telephone bill-paying and cash advances. Also included in this segment are insurance and securities brokerage services. The Retail Banking segment reported net income of $14.3 million for the year ended December 31, 2003, compared to $15.5 million and $23.7 million for the years ended December 31, 2002 and 2001.

 

Net interest income decreased $14.6 million for 2003 compared to 2002. This decrease in net interest income is primarily due to a lower transfer pricing spread on consumer deposits. The spread for calendar year 2003 was 4.33% compared to 5.65% for 2002. The provision for loan losses decreased $2.5 million for 2003 compared to 2002 due to a reduction in the expected loss rate applied to the segment’s home equity loans. Total other income increased $5.4 million from intersegment fees received for the origination of mortgage servicing for 2003 compared to 2002 primarily due to the $626 million increase in mortgage loan volume. This increase was

 

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offset by a $1.7 million decrease in credit life insurance income due to a change in federal regulations limiting premiums on loans. The potential growth for debit card interchange fees during 2003 was limited by a third-party settlement with VISA, Inc., which occurred during the year. In addition, reimbursed loan fees collected were reclassified from other income in 2002 to other expense in 2003. These fees totaled $1.8 million in 2002. Total other expense decreased $4.0 million for 2003 compared to 2002. The primary reasons for this decrease were the $8.4 million reclassification of costs associated with commercial deposits being allocated entirely to the Commercial Banking segment for 2003, while the segment was charged 50% of this cost in 2002, reimbursed loan fees reclassified from other income in 2002 to other expense in 2003 totaling $1.4 million and a $700,000 decrease in title search fees due to the segment switching to the use of third party title insurance in 2003 for home equity loans. In addition, there was a $500,000 decrease in fraud losses compared to 2002, as well as a $500,000 decrease in item processing costs in 2003 due to less paper items processed for checking accounts. These decreases were offset by an increase of $6.0 million in compensation primarily due to increased staffing in the branches over the summer and incentives paid on higher production volumes, a $2.2 million increase in advertising cost for the Bank’s promotion to provide cash back on debit card activity and a $1.3 million increase in facilities expense due to additional maintenance costs incurred to improve the appearance of certain branches.

 

For the year ended December 31, 2002 compared to 2001, net interest income decreased $1.3 million. This decrease in net interest income was primarily due to lower interest rates on consumer loans comparing 2002 to 2001. The provision for loan losses increased $1.6 million due to the increase in the Retail Banking segment’s home equity portfolio. Total other income increased $2.1 million for 2002 compared to 2001 due to the increased retail fee pricing structure, which was effective September 1, 2001. This increase was offset by decreases in commission revenues from brokerage operations due to lower transaction volumes. Total other expense increased $12.5 million for 2002 compared to 2001 due to the allocation of 50% of the cost for commercial deposits to the Retail Banking segment totaling $8.4 million in 2002. In addition, the segment received an allocated portion of the net gain from exit costs and termination benefits totaling $7.8 million during 2001.

 

Mortgage Banking

 

The Mortgage Banking segment involves the acquisition of a portion of correspondent, brokered and originated residential mortgage loans, the sale of these mortgage loans in the secondary mortgage market and to the Treasury segment, the purchase, sale and origination of rights to service mortgage loans, and the servicing of mortgage loans for the Treasury segment and outside investors. The Mortgage Banking segment reported a net loss of $26.8 million for the year ended December 31, 2003, compared to net income of $35.7 million and $16.8 million, respectively, for the years ended December 31, 2002 and 2001.

 

For 2003, net interest income increased $9.9 million compared to 2002. This increase in net interest income comparing the respective years is primarily due to increases in custodial cash earnings that were credited using an internal cost of funds rate and higher warehouse loan balances. The custodial cash earnings increased due to increases in escrow balances primarily from the higher volume of mortgage refinancing activity and the increase in the average escrow balance resulting from the purchase of bulk loan servicing totaling $1.9 billion during the latter half of 2002. Total other income decreased $98.4 million for 2003 primarily due to an increase of $49.6 million in the amortization of mortgage servicing rights in 2003. This was due to the payoff of $7.8 billion in principal balances in the loan servicing portfolio and a $14.8 million intersegment charge for impairment of mortgage servicing rights on originated loans and purchased servicing. Also, a decrease of $5.4 million on the net gains on sales of warehouse loans was due to the competitive interest rate market conditions in 2003. Total other expense increased $10.2 million for the year ended December 31, 2003, compared to 2002 due to increased loan origination costs from mortgage loan originations of $611 million over the 2002 activity and increased servicing costs due to mid month loan payoffs, which increased $5.8 million in 2003 over 2002. The change in net income for the Mortgage Banking segment was also significantly affected by a shift from income tax expense of $21.1 million in 2002 to an income tax benefit of $14.7 million for 2003.

 

For the year ended December 31, 2002 compared to 2001, net interest income increased $18.7 million. This increase was primarily due to increases in the credit the Mortgage Banking segment received in 2002 compared

 

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to 2001 from increases in its custodial cash earnings that were credited using an internal cost of funds rate. The custodial cash earnings increased due to increases in escrow balances primarily from the significant mortgage refinancing activity. Total other income increased $15.3 million for 2002 primarily due to net gains on the sales of warehouse loans partially offset by an increase in amortization of mortgage servicing rights in 2002 over 2001. Total other expense increased $3.5 million for 2002 compared to 2001 primarily due to the allocated portion of the net gain from exit costs and termination benefits totaling $3.3 million during 2001.

 

Treasury

 

The Treasury segment is responsible for managing corporate interest rate risk through asset and liability management strategies. The Treasury segment manages the Corporation’s investments in single-family residential mortgage loans, mortgage servicing rights, investment and mortgage-backed securities, and certain funding sources including wholesale deposits, advances from the Federal Home Loan Bank and all other borrowings. The Treasury segment reported net income of $65.8 million for year ended December 31, 2003, compared to net income of $22.4 million and $27.0 million, respectively, for the years ended December 31, 2002 and 2001.

 

Net interest income decreased $70.9 million for 2003 compared to 2002 due primarily to the lower yields earned on the Treasury segment’s total interest-earning assets portfolio and a reduction in the average size of the portfolio comparing 2003 to 2002. The provision for loan losses decreased $3.6 million for 2003 compared to 2002 due primarily to an overall reduction in the expected loss rate applied to the segment’s loans. Total other income increased $131.4 million for 2003 primarily as a result of the credit relating to the valuation allowance for mortgage servicing rights totaling $49.6 million, intersegment loan prepayment fees totaling $17.8 million generated from the Commercial Banking segment (which was implemented in 2003) and the intersegment revenue totaling $18.6 million in 2003 from the Mortgage Banking and Retail Banking segments (also implemented in 2003) from the impairment of mortgage servicing rights purchased during 2003. These increases to total other income were partially offset by decreases in net gains and losses on sales of securities and changes in fair values of derivatives totaling $13.8 million compared to 2002. Total other expense for 2003 is a net credit balance of $355,000 compared to expense of $6.5 million for 2002 due to the increase in deferred expense from mortgage loan originations. The change in net income for the Treasury segment was also impacted by a shift from an income tax benefit of $4.6 million in 2002 to an income tax expense of $23.0 million for 2003.

 

For the year ended December 31, 2002 compared to 2001, net interest income decreased $9.6 million due primarily to the higher average balances of investment and mortgage-backed securities for 2002 compared to 2001 with lower yields in 2002, and to higher average balances of borrowed funds partially offset by lower rates in 2002 over 2001. The provision for loan losses decreased $17.2 million for 2002 compared to 2001 due to a better allocation of the overall Bank risk to the Retail Banking and Commercial Banking segments. For 2002, total other income was a loss of $52.7 million compared to a loss of $37.0 million for 2001. This increase in the loss recorded in other income is due primarily to valuation adjustments for impairment of mortgage servicing rights totaling $60.4 million recorded in 2002 compared to $19.1 million recorded in 2001. Total other expense for 2002 is $6.5 million compared to $3.5 million for 2001. This net change is primarily due to the allocated portion of the net gain from exit costs and termination benefits totaling $2.1 million during 2001.

 

Consolidated Results of Operations

 

Comparison of Consolidated Results of Operations

 

Net income for the year ended December 31, 2003, was $89.0 million or $2.02 per diluted share ($2.04 per basic share), compared to net income of $107.0 million or $2.33 per diluted share ($2.36 per basic share), for the year ended December 31, 2002, and net income of $96.8 million, or $1.92 per diluted shared ($1.94 per basic share) for the year ended December 31, 2001. The decrease in net income comparing 2003 to 2002 is primarily due to a decrease of $52.2 million in net interest income caused by margin compression as interest rates reached

 

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historically low levels during 2003. In turn, higher volumes of prepayments on higher-yielding mortgage and consumer home equity loans and mortgage-backed securities during the year repriced much of the asset base to a lower overall yield, while deposit costs had minimal capacity for further downward repricing during 2003. In addition to the reduction of interest income on higher-yielding assets, increases in the amortization levels of net deferred loan costs and premiums on loans and mortgage-backed securities, which are fully amortized against interest income when a loan pays off, further magnified the compression to net interest margin. The 2003 results were also impacted by an increase of $11.3 million in general and administrative expenses primarily related to higher loan production costs as consumers took advantage of lower interest rates to refinance or originate mortgage loans. Partially offsetting these decreases to net income was an increase of $26.2 million in total other income primarily due to recording a mortgage servicing rights valuation adjustment recovery of $28.7 million for 2003, compared to a valuation adjustment loss of $60.4 million for 2002, relating to an increase in market interest rates that occurred during the latter part of 2003. This mortgage servicing rights valuation recovery was offset by higher amortization of mortgage servicing rights which increased to $75.0 million for 2003 compared to $31.0 million for 2002. The increase in mortgage servicing rights amortization was caused by the significantly higher levels of mortgage loan prepayments which occurred during 2003. Net gains on the sales of loans decreased to $23.9 million in 2003 compared to $36.2 million in 2002 primarily as a result of a reduction in the volume of loans held for sale and smaller pricing spreads during the latter part of 2003 as interest rates began to stabilize. These fluctuations in non-interest income related to mortgage servicing rights and gains on sales of loans were partially offset by net gains on the sales of available-for-sale securities and changes in the fair value of derivatives of $26.8 million in 2003 compared to net gains of $40.6 million for 2002. Another favorable increase impacting 2003 pre-tax income compared to 2002 was a decrease of $9.0 million in the provision for loan losses reflecting the strength of the Corporation’s credit quality.

 

The increase in net income for 2002 over 2001 is primarily due to an increase of $20.3 million in net interest income and decreases of $9.0 million in the amortization of intangible assets and $7.9 million in the provision for loan losses. The favorable increase in net interest income reflects the impact of the declining interest rate environment during which time interest-bearing liabilities were repricing downward faster than interest-earning assets and a shift was occurring in the mix of interest-earning assets and interest-bearing liabilities. The $9.0 million decrease in the amortization of intangible assets relates to the change in the accounting treatment for goodwill which was effective January 1, 2002 while the $7.9 million improvement in the provision for loan losses reflects the improvement in asset quality which occurred during 2002. These increases to net income were partially offset by an increase of $25.6 million in general and administrative expenses primarily resulting from a net gain for exit costs and termination benefits of $15.6 million which reduced expenses in 2001 and an increase of $8.9 million in compensation and benefits expense in 2002. Net income for 2002 includes pre-tax gains on the sales of available-for-sale securities totaling $35.9 million and mortgage loans totaling $36.2 million, compared to respective net gains of $18.3 million and $8.7 million for 2001. Loan servicing fees, net of amortization expense on mortgage servicing rights, totaled $8.1 million for 2002 compared to $22.7 million for 2001. The decrease in these loan servicing fees resulted from the lower interest rates in 2002 which also effected the valuation allowances for impairment losses of mortgage servicing rights. Valuation adjustment losses totaling $60.4 million in the mortgage servicing rights portfolio were recorded during 2002 compared to $19.1 million for 2001. The valuation adjustments are due to increases in loan prepayment speeds resulting from rapidly declining interest rates.

 

Net Interest Income

 

Net interest income for the year ended December 31, 2003, totaled $275.6 million compared to $327.7 million for the year ended December 31, 2002, a decrease of $52.1 million, or 15.9%; and compared to $307.4 million for the year ended December 31, 2001. During 2003, 2002 and 2001, the net interest rate spreads inclusive of non-interest-bearing deposits were 2.43%, 2.76% and 2.59%, respectively, a decrease of 33 basis points comparing 2003 and 2002, and an increase of 17 basis points comparing 2002 to 2001. The net yield on interest-earning assets was 2.38% for 2003 compared to 2.74% and 2.62%, respectively, for 2002 and 2001, a decrease of 36 basis points comparing 2003 to 2002 and an increase of 12 basis points comparing 2002 to 2001.

 

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The decreases in the interest rate spread and the net yield earned on interest-earning assets comparing 2003 to 2002 were due primarily to an 88 basis point decrease in the yield earned on interest-earning assets resulting from historically low market interest rates driven by the Federal Reserve’s reduction of the targeted federal funds rate to the lowest level in over 40 years. Earning assets contractually repriced downward during 2003 and higher-yielding assets were replaced with lower-yielding assets as the Corporation’s customers took advantage of the historically low interest rates to originate or refinance loans. The decrease in yield was further magnified by the acceleration of amortization of net deferred costs and premiums on mortgage loans and mortgage-backed securities, which are fully amortized against interest income when a loan or mortgage-backed security pays off. The decrease in yield for interest-earning assets was partially offset by a 55 basis point decline in the rate incurred on total deposits and interest-bearing liabilities. This decrease was also due to the downward repricing of interest-bearing liabilities in response to lower market interest rates, but at a slower rate than the repricing of interest-earning assets. The cost of interest-bearing liabilities reflects the effects of certain derivative positions, which have effectively locked in long term fixed rates of interest, that are now at higher costs than current market interest rates. See the following section entitled “Asset/Liability Management” of this Management Discussion and Analysis and Note 13 “Derivative Financial Instruments” for a discussion of the Corporation’s use of derivative financial instruments in managing its interest rate risk.

 

Management anticipates that the Corporation’s interest rate spread and net yield on interest-earning assets will gradually increase during 2004. This anticipated increase is due to the Corporation’s decision to strategically reduce the size of its balance sheet during the latter half of 2003 to decrease certain residential mortgage loan and available-for-sale securities portfolios that were lower margin contributors to net interest income along with a corresponding decrease in higher-costing FHLB advances. Additionally, during the latter half of 2003, the Corporation executed other debt restructuring and derivative strategies that have started to favorably impact net interest income. As the Corporation continues to change the mix of the loan portfolio to carry a greater share of higher-yielding commercial operating and consumer loans, and continues to focus on growth in lower costing core deposits, management anticipates that net interest income will further experience favorable increases as a result of these objectives. Future trends in interest rate spreads and net interest income will be dependent upon and influenced by changes in and levels of and the interplay among short-term and long-term market interest rates, loan prepayment volumes, the composition and size of the Corporation’s interest-earning assets and interest-bearing liabilities, the interest rate risk exposure of the Corporation and the maturity and repricing activity of interest-sensitive assets and liabilities.

 

Net interest income increased $20.3 million for 2002 compared to 2001 due to (i) the lower interest rate environment in which costing liabilities were repricing downward at a faster rate than earning assets were repricing, (ii) the continued shift in the asset mix toward higher yielding commercial and consumer loans and (iii) a shift in funding from certificates of deposit primarily to FHLB advances and to checking accounts and money market accounts in the latter part of 2002. The increase in the interest rate spread comparing 2002 to 2001 was due primarily to a 109 basis point decrease in the rate incurred on total deposits and interest-bearing liabilities partially offset by a 92 basis point decline in the yield received on interest-earning assets. Total interest expense decreased $114.6 million comparing the year ended December 31, 2002, to December 31, 2001, primarily due to lower market interest rates. At the same time, comparing 2002 to 2001, the average balance of interest-bearing liabilities increased $204.3 million, primarily due to increases in FHLB advances and securities sold under agreements to repurchase totaling $939.0 million and $271.8 million, respectively, partially offset by a decrease of $846.1 million in certificates of deposit. Total interest income decreased $94.3 million comparing 2002 to 2001 due to the lower yields on interest-earning assets, even though the average balance of interest-earning assets increased $205.4 million over the same time periods.

 

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The following table presents average interest-earning assets and average interest-bearing liabilities, interest income and interest expense, average yields earned on interest-earning assets and average rates incurred on total deposits and interest-bearing liabilities during the years ended December 31:

 

     2003

    2002

    2001

 
     Average
Balance


    Interest

   Yield/
Rate


    Average
Balance


    Interest

   Yield/
Rate


    Average
Balance


   Interest

   Yield/
Rate


 
     (Dollars in Thousands)  

Interest-earning assets:

                                                              

Loans—(1)

                                                              

Residential real estate

   $ 4,413,645     $ 242,915    5.50 %   $ 4,799,413     $ 304,460    6.34 %   $ 5,185,711    $ 374,036    7.21 %

Commercial real estate

     1,870,574       129,688    6.84       1,707,469       135,507    7.83       1,531,330      127,449    8.21  

Construction

     492,376       35,571    7.13       519,790       39,469    7.49       497,309      45,529    9.03  

Commercial operating and other (2)

     433,873       24,032    5.47       283,473       18,909    6.59       296,312      22,650    7.54  

Consumer home equity

     826,128       56,701    6.86       784,117       60,875    7.76       785,613      68,789    8.76  

Consumer other

     667,725       47,544    7.12       587,139       48,150    8.20       530,361      47,027    8.87  
    


 

  

 


 

  

 

  

  

Total loans

     8,704,321       536,451    6.13       8,681,401       607,370    7.00       8,826,636      685,480    7.77  

Mortgage-backed securities

     1,362,145       49,836    3.66       1,799,174       93,047    5.17       1,690,967      109,657    6.49  

Investments

     1,490,856       64,457    4.32       1,494,011       76,636    5.13       1,251,559      76,237    6.09  
    


 

  

 


 

  

 

  

  

Total interest-earning assets

     11,557,322       650,744    5.61       11,974,586       777,053    6.49       11,769,162      871,374    7.41  
    


 

  

 


 

  

 

  

  

Non-interest bearing checking

     1,059,562       —      —         728,774       —      —         599,205      —      —    

Interest-bearing deposits:

                                                              

Interest-bearing checking

     540,489       2,523    .47       549,767       1,364    .25       520,014      4,180    .80  

Savings (3)

     1,416,203       60,226    4.25       1,802,558       77,896    4.32       1,958,022      92,513    4.73  

Money market

     893,820       14,137    1.58       314,243       4,144    1.32       335,798      9,299    2.77  
    


 

  

 


 

  

 

  

  

Interest-bearing core deposits

     2,850,512       76,886    2.70       2,666,568       83,404    3.13       2,813,834      105,992    3.77  

Certificates of deposit

     2,719,225       70,204    2.58       2,862,960       96,192    3.36       3,709,030      204,375    5.51  
    


 

  

 


 

  

 

  

  

Total interest-bearing deposits

     5,569,737       147,090    2.64       5,529,528       179,596    3.25       6,522,864      310,367    4.76  
    


 

  

 


 

  

 

  

  

Total deposits

     6,629,299       147,090    2.22       6,258,302       179,596    2.87       7,122,069      310,367    4.36  

Advances from FHLB (4)

     4,542,015       210,045    4.56       5,204,501       243,710    4.68       4,265,468      234,213    5.49  

Securities sold under agreements to repurchase

     352,492       10,624    2.97       353,977       13,895    3.93       82,215      4,374    5.32  

Other borrowings

     173,905       7,415    4.27       227,861       12,124    5.32       241,038      14,991    6.22  
    


 

  

 


 

  

 

  

  

Total interest-bearing liabilities

     10,638,149       375,174    3.50       11,315,867       449,325    3.94       11,111,585      563,945    5.05  
    


 

  

 


 

  

 

  

  

Net earnings balance, net interest income and net interest rate spread

     919,173       275,570    2.11       658,719       327,728    2.55       657,577      307,429    2.36  
    


 

  

 


 

  

 

  

  

Total deposits and interest-bearing liabilities

     11,697,711       375,174    3.18       12,044,641       449,325    3.73       11,710,790      563,945    4.82  
    


 

  

 


 

  

 

  

  

Net earnings balance, net interest income and net interest rate spread including non-interest-bearing deposits

   $ (140,389 )   $ 275,570    2.43 %   $ (70,055 )   $ 327,728    2.76 %   $ 58,372    $ 307,429    2.59 %
    


 

  

 


 

  

 

  

  

Net yield on interest-earning assets

                  2.38 %                  2.74 %                 2.62 %
                   

                

               


(1)   Includes nonaccruing loans averaging $65.8 million, $76.2 million and $84.5 million for the respective periods as interest-earning assets at a yield of zero percent.
(2)   In addition to commercial operating loans, includes small business, agricultural and Nebraska Investment Finance Authority loans.
(3)   Includes interest expense incurred on interest rate swap agreements totaling $48.6 million, $50.4 million and $28.1 million for the respective periods.
(4)   Includes interest expense incurred on interest rate swap and swaption agreements totaling $72.0 million, $66.0 million and $18.7 million respectively, for the years ended December 31, 2003, 2002 and 2001.

 

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During the year ended December 31, 2003, the Corporation’s deposits and interest-bearing liabilities exceeded its interest-earning assets, resulting in a negative net earnings balance of $140.4 million. The Corporation’s average net earnings balance decreased $70.3 million during 2003 compared to 2002. This decrease in the net earnings balance is primarily due to cash outlays during 2003 for the Corporation’s repurchases of its common stock and income tax payments. The Corporation’s average net earnings balance decreased $128.4 million during 2002 compared to 2001 also primarily due to cash outlays for the Corporation’s repurchases of its common stock and income tax payments.

 

The following table presents the dollar amount of changes in interest income and expense for each major component of interest-earning assets and interest-bearing liabilities, and the amount of change in each attributable to: (i) changes in volume (change in volume multiplied by prior year rate), and (ii) change in rate (change in rate multiplied by prior year volume). The net change attributable to change in both volume and rate, which cannot be segregated, has been allocated proportionately to the change due to volume and the change due to rate.

 

     2003 Compared to 2002

    2002 Compared to 2001

 
     Increase (Decrease) Due to     Increase (Decrease) Due to  
     Volume

    Rate

    Total

    Volume

    Rate

    Total

 
     (In Thousands)  

Interest income:

                                                

Loans—

                                                

Residential real estate

   $ (21,232 )   $ (40,315 )   $ (61,547 )   $ (29,714 )   $ (39,862 )   $ (69,576 )

Commercial real estate

     11,308       (17,127 )     (5,819 )     13,979       (5,921 )     8,058  

Construction

     (1,980 )     (1,917 )     (3,897 )     1,707       (7,767 )     (6,060 )

Commercial operating and other

     8,225       (3,102 )     5,123       (681 )     (3,060 )     (3,741 )

Consumer home equity

     2,883       (7,058 )     (4,175 )     (116 )     (7,798 )     (7,914 )

Consumer other

     5,738       (6,343 )     (605 )     4,656       (3,533 )     1,123  
    


 


 


 


 


 


Total loans

     4,942       (75,862 )     (70,920 )     (10,169 )     (67,941 )     (78,110 )

Mortgage-backed securities

     (15,989 )     (27,222 )     (43,211 )     6,677       (23,287 )     (16,610 )

Investments

     462       (12,640 )     (12,178 )     13,484       (13,085 )     399  
    


 


 


 


 


 


Interest income

     (10,585 )     (115,724 )     (126,309 )     9,992       (104,313 )     (94,321 )
    


 


 


 


 


 


Interest expense:

                                                

Non-interest bearing and interest-bearing checking

     (43 )     1,202       1,159       74       (2,890 )     (2,816 )

Savings

     (16,431 )     (1,239 )     (17,670 )     (6,872 )     (7,745 )     (14,617 )

Money market

     9,167       826       9,993       (284 )     (4,871 )     (5,155 )
    


 


 


 


 


 


Core deposits

     (7,307 )     789       (6,518 )     (7,082 )     (15,506 )     (22,588 )

Certificates of deposit

     (3,712 )     (22,276 )     (25,988 )     (39,908 )     (68,275 )     (108,183 )
    


 


 


 


 


 


Total deposits

     (11,019 )     (21,487 )     (32,506 )     (46,990 )     (83,781 )     (130,771 )

Advances from FHLB

     (30,636 )     (3,029 )     (33,665 )     47,590       (38,093 )     9,497  

Securities sold under agreements to repurchase

     (45 )     (3,226 )     (3,271 )     10,975       (1,454 )     9,521  

Other borrowings

     (2,479 )     (2,230 )     (4,709 )     (787 )     (2,080 )     (2,867 )
    


 


 


 


 


 


Interest expense

     (44,179 )     (29,972 )     (74,151 )     10,788       (125,408 )     (114,620 )
    


 


 


 


 


 


Effect on net interest income

   $ 33,594     $ (85,752 )   $ (52,158 )   $ (796 )   $ 21,095     $ 20,299  
    


 


 


 


 


 


 

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Asset/Liability Management

 

The net interest income of the Corporation is subject to the risk of interest rate fluctuations to the extent that there is a difference, or mismatch, between the amount of the Corporation’s interest-earning assets and interest-bearing liabilities which mature or reprice in specified periods. When interest rates change, to the extent the Corporation’s interest-earning assets have longer maturities or effective repricing periods than its interest-bearing liabilities, the interest income realized on the Corporation’s interest-earning assets will adjust more slowly than the interest expense on its interest-bearing liabilities. This mismatch in the maturity and repricing characteristics of assets and liabilities is commonly referred to as the “gap.” A gap is considered positive when the interest rate sensitive assets maturing or repricing during a specified period exceed the interest rate sensitive liabilities maturing or repricing during the same period. A gap is considered negative when the interest rate sensitive liabilities maturing or repricing during a specified period exceed the interest rate sensitive assets maturing or repricing during the same period. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income while a positive gap would result in an increase to net interest income. Similarly, during a period of declining interest rates, a negative gap would result in an increase in net interest income while a positive gap would adversely affect net interest income.

 

The Corporation generally invests in interest-earning assets that reprice more slowly than its interest-bearing liabilities. This mismatch exposes the Corporation to interest rate risk. In a rising rate environment, interest-bearing liabilities will reprice faster than interest-earning assets, thereby decreasing net interest income. The Corporation seeks to control its exposure to interest rate risk by emphasizing shorter-term assets such as commercial and consumer loans. In addition, the Corporation utilizes longer-term advances from the FHLB to extend the repricing characteristics of its interest-bearing liabilities. The Corporation also enters into interest rate swap agreements in order to lengthen synthetically its short-term debt obligations.

 

In connection with its asset/liability management program, the Corporation has interest rate swap agreements with other counterparties under terms that provide for an exchange of interest payments on the outstanding notional amount of the swap agreement. These agreements are primarily used to synthetically lengthen the maturity of certain deposit liabilities and FHLB advances. In accordance with these arrangements the Corporation pays fixed rates and receives variable rates of interest, or receives fixed rates and pays variable rates, according to a specified index. The Corporation had swap agreements to pay fixed and receive variable rates of interest with notional principal amounts of $1.3 billion at December 31, 2003, compared to $2.5 billion and $2.6 billion, respectively at December 31, 2002 and 2001. The Corporation also had a swap agreement to receive fixed and pay variable rates of interest with a notional amount of $100.0 million at December 31, 2003. For the years ended December 31, 2003, 2002 and 2001, the Corporation recorded $120.6 million, $116.4 million and $46.8 million, respectively, in net interest expense from its interest rate swap agreements. The swap agreements outstanding as of December 31, 2003, have maturities ranging from September 2004 to March 2012.

 

During the second half of 2003, the Corporation reduced the size of its balance sheet as part of a strategic plan to reduce available-for-sale investment and mortgage-backed securities that were lower margin contributors to net interest income. This plan also included paying down a portion of FHLB advance debt. During the third quarter of 2003, the Corporation recognized a $29.4 million loss on the termination of certain swap agreements that were previously hedging the adjustable interest payments related to the $300.0 million in adjustable rate FHLB advances that were paid off in connection with this plan.

 

During the fourth quarter of 2003, the Corporation restructured $1.1 billion of convertible fixed-rate FHLB advances by extending the maturities beyond their original 2009 maturity date and modifying the interest rate terms. Subsequent to the restructure, $100.0 million of these advances mature each year beyond the original 2009 maturity date. After 2009, the fixed-rate on these FHLB advances will be replaced by a floating rate. The outcome of this transaction was such that both the Corporation and the FHLB were in the same fundamental economic position at the conclusion of the restructuring.

 

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The Corporation entered into swaption agreements beginning in 2001 to hedge the exposure to changes in the fair value of the call options embedded in certain fixed rate FHLB advances. All terms of the swaption agreements exactly match the terms of these FHLB advances. In the event any of these FHLB advances are called, the Corporation will exercise its corresponding option to enter into a swap agreement paying a fixed rate of interest and receiving a variable rate of interest. In November 2003, the Corporation terminated swaption agreements with a notional amount of $1.1 billion. These terminations occurred in conjunction with the aforementioned restructuring of terms of fixed-rate callable FHLB advances for which the embedded call options were being hedged by these terminated swaption agreements. See Note 13 “Derivative Financial Instruments” for additional information regarding the Corporation’s swap and swaption agreements.

 

During the fourth quarter of 2003, the Corporation terminated interest rate swap agreements that were previously designated as cash flow hedges of adjustable interest payments related to $500.0 million in adjustable rate savings deposits. These terminations occurred as part of management’s asset/liability strategy to maintain a balanced interest rate risk position after the sale of investments that occurred in conjunction with the restructuring of the Corporation’s balance sheet during the third quarter of 2003.

 

The following table represents management’s projected maturity and repricing of the Bank’s interest-earning assets and interest-bearing liabilities at December 31, 2003. The amounts of interest-earning assets, interest-bearing liabilities and interest rate swap agreements presented which mature or reprice within a particular period were determined in accordance with the contractual terms and expected behavior over time of such assets, liabilities and interest rate swap agreements. Adjustable-rate loans and mortgage-backed securities are included in the period in which they are first scheduled to adjust and not in the period in which they mature. All loans and mortgage-backed securities are adjusted for prepayment rates based on information provided by independent sources as of December 31, 2003, and the Bank’s historical prepayment experience. Fixed-rate savings accounts, checking accounts and non-indexed money market accounts are assumed to reprice or mature according to the decay rates defined by regulatory guidelines. Indexed money market accounts are deemed to reprice or mature within the 90-day category. Management believes that these assumptions approximate actual experience and considers such assumptions reasonable; however, the actual interest rate sensitivity of the Bank’s interest-earning assets and interest-bearing liabilities may vary substantially if actual experience differs from the assumptions used.

 

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Within

90 Days


   

91 Days

to 1 Year


   

Over 1

to 3 Years


   

3 Years

and Over


    Total

 
     (Dollars in Thousands)  

Interest-earning assets:

                                        

Fixed-rate mortgage
loans (1)

   $ 519,222     $ 752,538     $ 827,003     $ 616,900     $ 2,715,663  

Other loans (2)

     2,013,296       1,695,068       2,124,163       1,097,896       6,930,423  

Investments (3)

     424,125       305       15,270       917,340       1,357,040  
    


 


 


 


 


Interest-earning assets

     2,956,643       2,447,911       2,966,436       2,632,136       11,003,126  
    


 


 


 


 


Total deposits and interest-bearing liabilities:

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