10-K 1 d317953d10k.htm FORM 10-K FORM 10-K
Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

  þ ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)
  OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2011

OR

 

  ¨ TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)
  OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No. 001-31579

Doral Financial Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Puerto Rico   66-0312162

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. employer

identification no.)

1451 Franklin D. Roosevelt Avenue   00920-2717
San Juan, Puerto Rico   (Zip Code)

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:

(787) 474-6700

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value.

  New York Stock Exchange

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

Title of Each Class

7.00% Noncumulative Monthly Income Preferred Stock, Series A

8.35% Noncumulative Monthly Income Preferred Stock, Series B

7.25% Noncumulative Monthly Income Preferred Stock, Series C

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes  ¨         No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.     Yes  ¨         No  þ

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  þ         No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).     Yes  þ         No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405) 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.    ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨   Accelerated filer  þ    Non-accelerated filer  ¨   Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ¨         No  þ

State the aggregate market value of the voting and non-voting common equity held by nonaffiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.

$249,495,762, approximately, based on the last sale price of $1.96 per share on the New York Stock Exchange on June 30, 2011 (the last business day of the registrant’s most recently completed second fiscal quarter). For the purposes of the foregoing calculation only, all directors and executive officers of the registrant and certain related parties of such persons have been deemed affiliates.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 128,462,423 shares as of March 23, 2012.

Documents Incorporated by Reference:

Part III incorporates certain information by reference to the Proxy Statement for the 2012 Annual Meeting of Shareholders

EXPLANATORY NOTE

This Annual Report on Form 10-K incorporates certain changes made to financial information included in the earnings press release issued by Doral Financial Corporation (the “Company”) on January 19, 2012, which press release was furnished by the Company to the Securities and Exchange Commission in a Current Report on Form 8-K dated January 20, 2012. The changes made reduced the amount of loans and the allowance for loan and lease losses approximately $10.1 million as of December 31, 2011. This Form 10-K also incorporates these changes in the management discussion and analysis and financial statement disclosures related to loans, non-performing loans, allowance for loan and lease losses, charge-offs, allowance coverage ratios and deferred taxes, as appropriate. The amount of earnings reported in this From 10-K is unchanged from the earnings reported in the January 20, 2012 Form 8-K.

 

 

 

 


Table of Contents

DORAL FINANCIAL CORPORATION

2011 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

     Page  

FORWARD LOOKING STATEMENTS

     1   
PART I   

Item 1 — Business

     4   

Item 1A — Risk Factors

     37   

Item 1B — Unresolved Staff Comments

     54   

Item 2 — Properties

     55   

Item 3 — Legal Proceedings

     55   

Item 4 — Mine Safety Disclosures

     57   
PART II   

Item 5 —  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of             Equity Securities

     57   

Item 6 — Selected Financial Data

     62   

Item 7 —  Management’s Discussion and Analysis of Financial Condition and Results of Operations

     64   

Item 7A — Quantitative and Qualitative Disclosures About Market Risk

     137   

Item 8 — Financial Statements and Supplementary Data

     137   

Item 9 —  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     137   

Item 9A — Controls and Procedures

     137   

Item 9B — Other Information

     139   
PART III   

Item 10 — Directors, Executive Officers and Corporate Governance

     140   

Item 11 — Executive Compensation

     140   

Item 12 —  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder               Matters

     140   

Item 13 — Certain Relationships and Related Transactions and Director Independence

     140   

Item 14 — Principal Accounting Fees and Services

     140   
PART IV   

Item 15 — Exhibits and Financial Statement Schedules

     141   

Ex-12.1

  

Ex-12.2

  

Ex-21

  

Ex-23

  

Ex-31.1

  

Ex-31.2

  

Ex-32.1

  

Ex-32.2

  

 

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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, Doral Financial may make forward-looking statements in its press releases, other filings with the Securities and Exchange Commission (“SEC”) or in other public or shareholder communications and its senior management may make forward-looking statements orally to analysts, investors, the media and others.

These forward-looking statements may relate to the Company’s financial condition, results of operations, plans, objectives, future performance and business, including, but not limited to, statements with respect to the adequacy of the allowance for loan and lease losses, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings, tax legislation and tax rules, regulatory matters and new accounting standards and guidance on the Company’s financial condition and results of operations. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts, but instead represent the Company’s current expectations regarding future events. Such forward-looking statements may be generally identified by the use of words or phrases such as “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” “believe,” “expect,” “predict,” “forecast,” “anticipate,” “target,” “goal” and similar expressions and future or conditional verbs such as “would,” “should,” “could,” “might,” “can” or “may” or similar expressions.

Doral Financial cautions readers not to place undue reliance on any of these forward-looking statements since they speak only as of the date made and represent the Company’s expectations of future conditions or results and are not guarantees of future performance. The Company does not undertake and specifically disclaims any obligations to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of those statements.

Forward-looking statements are, by their nature, subject to risks and uncertainties and changes in circumstances, many of which are beyond the Company’s control. While there is no assurance that any list of risks and uncertainties or risk factors is complete, below are certain important factors that could cause actual results to differ materially from those contained in any forward-looking statement:

 

   

the continued recessionary conditions of the Puerto Rico economy and any deterioration in the performance of the United States of America (“United States” or “U.S.”) economy and capital markets that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits leading to, among other things, (i) a further deterioration in the credit quality of our loans and other assets, (ii) decreased demand for our products and services and lower revenue and earnings, (iii) reduction in our interest margins, and (iv) decreased availability and increased pricing of our funding sources, including brokered certificates of deposits;

 

   

the weakness of the Puerto Rico and United States real estate markets and of the Puerto Rico and United States consumer and commercial credit sectors and its impact on the credit quality of our loans and other assets which have contributed and may continue to contribute to, among other things, an increase in our non-performing loans, charge-offs and loan loss provisions and may subject the Company to further risk from loan defaults and foreclosures;

 

   

recent and/or future downgrades of the long-term debt ratings of the United States and the Commonwealth of Puerto Rico, which could adversely affect economic conditions in the United States and the Commonwealth of Puerto Rico;

 

   

a decline in the market value and estimated cash flows of our mortgage-backed securities and other assets may result in the recognition of other-than-temporary impairment of such assets under generally accepted accounting principles in the United States of America;

 

   

our ability to derive sufficient income to realize the benefit of our deferred tax assets;

 

   

uncertainty about the legislative and other measures adopted by the Puerto Rico government in response to its fiscal situation and the impact of such measures on different sectors of the Puerto Rico economy;

 

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uncertainty about the adopted changes to the Puerto Rico internal revenue code and other related tax provisions and the impact of such measures on different sectors of the Puerto Rico economy;

 

   

uncertainty about the effectiveness of the various actions undertaken to stimulate the United States economy and stabilize the United States financial markets, and the impact of such actions on our business, financial condition and results of operations;

 

   

uncertainty about the outcome of regular annual safety and soundness and compliance examinations by our primary regulators which may lead to, among other things, an increase in our charge-offs, loan loss provisions, and compliance costs, and an increased risk of being subject to additional regulatory actions;

 

   

changes in interest rates, which may result from changes in the fiscal and monetary policy of the federal government, and the potential impact of such changes in interest rates on our net interest income and the value of our loans and investments;

 

   

the commercial soundness of our various counterparties of financing and other securities transactions, which could lead to possible losses when the collateral held by us to secure the obligations of the counterparty is not sufficient or to possible delays or losses in recovering any excess collateral belonging to us held by the counterparty;

 

   

higher credit losses because of federal or state legislation or regulatory action that either (i) reduces the amount that our borrowers are required to pay us, or (ii) limits our ability to foreclose on properties or collateral or makes foreclosures less economically feasible;

 

   

developments in the regulatory and legal environment for public companies and financial services companies in the United States (including Puerto Rico) as a result of, among other things, the adoption in July 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the regulations adopted and to be adopted thereunder by various federal and state securities and banking regulatory agencies, and the impact of such developments on our business, business practices, capital requirements and costs of operations;

 

   

the exposure of Doral Financial, as originator of residential mortgage loans, sponsor of residential mortgage loan securitization transactions, or servicer of such loans or such transactions, or in other capacities, to government sponsored enterprises (“GSEs”), investors, mortgage insurers or other third parties as a result of representations and warranties made in connection with the transfer or securitization of such loans;

 

   

residential mortgage borrower performance different than that estimated in the cash flow forecasts for troubled debt restructured loans;

 

   

the risk of possible failure or circumvention of our controls, practices and procedures, including those designed to protect our networks, systems, computers and data from attack, damage or unauthorized access, and the risk that our risk management policies and/or processes may be inadequate;

 

   

the risk that the Federal Deposit Insurance Corporation (“FDIC”) may further increase deposit insurance premiums and/or require special assessments to replenish its insurance fund, causing an additional increase in the Company’s non-interest expense;

 

   

changes in our accounting policies or in accounting standards, and changes in how accounting standards are interpreted or applied;

 

   

general competitive factors and industry consolidation;

 

   

the strategies adopted by the FDIC and the three acquiring banks in connection with the resolution of the residential, construction and commercial real estate loans acquired in connection with the three Puerto Rico banks that failed in April 2010, which may adversely affect real estate values in Puerto Rico;

 

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to the extent we make any acquisitions, including FDIC-assisted acquisitions of assets and liabilities of failed banks, the risks and difficulties relating to combining the acquired operations with our existing operations;

 

   

potential adverse outcome in the legal or regulatory actions or proceedings described in Part I, Item 3 “Legal Proceedings” in this Annual Report on Form 10-K, as updated from time to time in the Company’s future reports filed with the SEC; and

 

   

the other risks and uncertainties detailed in Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K, as updated from time to time in the Company’s future reports filed with the SEC.

 

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PART I

 

Item 1. Business

GENERAL

Overview

Doral Financial Corporation (“Doral Financial” or the “Company”) was organized in 1972 under the laws of the Commonwealth of Puerto Rico and operates as a bank holding company. Doral Financial’s principal operations are conducted in Puerto Rico, with growing operations in the United States, specifically in the New York City metropolitan area and in northwest Florida. Doral Financial’s principal executive offices are located at 1451 F.D. Roosevelt Avenue, San Juan, Puerto Rico 00920-2717, and its telephone number is (787) 474-6700.

Doral Financial has three wholly-owned subsidiaries, which are Doral Bank (“Doral Bank”), Doral Insurance Agency, Inc. (“Doral Insurance Agency”), and Doral Properties, Inc. (“Doral Properties”). Doral Bank has three wholly-owned subsidiaries in operation, Doral Mortgage, LLC (“Doral Mortgage”), Doral Money, Inc. (“Doral Money”), principally engaged in commercial lending in the New York metropolitan area, and CB, LLC, an entity incorporated to dispose of a real estate project of which Doral Bank took possession during 2005. Doral Money also consolidates two variable interest entities (“VIEs”) created during 2010 for the purpose of entering into a collateralized loan arrangement with a third party. During 2008, Doral Investment International, LLC (“Doral Investment”) was organized to become a new subsidiary of Doral Bank. Currently, Doral Investment is not operational.

Effective October 1, 2011, the Company completed an internal reorganization by merging its two depository institution subsidiaries, Doral Bank, FSB (which was an FDIC-insured federal savings bank with its main office in New York, New York) and Doral Bank. Doral Bank was the surviving institution in the merger and the main office and branch offices of Doral Bank, FSB located in the states of New York and Florida are now operating as branches of Doral Bank.

Prior to 2011, Doral Financial managed its business through three operating segments that were organized by legal entity and aggregated by line of business: banking (including thrift operations), mortgage banking and insurance agency. During 2011, the Company reorganized its reportable segments consistent with its return to profitability plan. The Company now operates in four reportable segments, which are: Puerto Rico, United States, Liquidating Operations and Treasury. For additional information regarding the Company’s segments please refer to “Operating Segments” under Part II, Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note 41 of the accompanying Consolidated Financial Statements.

Puerto Rico

This segment is the Company’s principal market. Through its banking subsidiary, Doral Bank, a Puerto Rico commercial bank, Doral Financial accepts deposits from the general public and institutions, obtains borrowings, originates and invests in loans (primarily residential real estate mortgage loans), invests in mortgage-backed securities and other investment securities, and offers traditional banking services. Approximately 98% of the Puerto Rico segment loan portfolio is secured by real estate. Doral Bank operates 29 branch offices in Puerto Rico. Mortgage loans are originated through the Company’s mortgage banking entity, Doral Mortgage, which is primarily engaged in the origination of mortgage loans on behalf of Doral Bank. Loan origination activities are conducted through the branch office network and centralized loan departments. Internal mortgage loan originations are also supplemented by wholesale loan purchases from third parties. As of December 31, 2011, the Puerto Rico segment had total assets and total deposits of $6.2 billion and $1.8 billion, respectively. The Puerto Rico segment also includes Doral Insurance Agency, a subsidiary of Doral Financial, which offers property, casualty, life and title insurance as an insurance agency, primarily to its mortgage loan customers, and CB, LLC, a Puerto Rico limited liability company organized in connection with the receipt, in lieu of foreclosure, of real property securing an interim construction loan.

 

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United States

This segment is the Company’s principal source of growth in the current economic environment. It includes retail banking in the United States through Doral Bank US operations (“Doral Bank US”), a division of Doral Bank, with 7 branches in New York and Florida, and Doral Money, which engages in commercial and construction lending in the New York City metropolitan area. This segment also includes the Company’s middle market syndicated lending unit that is engaged in purchasing assigned interests in senior credit facilities in the U.S. syndicated leverage loan market and is the primary source of growth in the Company’s loan portfolio.

Liquidating Operations

This segment contains those activities and assets related to the Company’s liquidating portfolios, loan and other real estate owned of Puerto Rico construction and land portfolios, managed with the purposes of resolving the assets in a way that maximizes the Company’s returns on these assets. No growth or new loans are expected in the portfolios within this segment, except as part of working the loan out in the best interests of the Company.

Treasury

The Company’s Treasury function handles its investment portfolio, interest rate risk management and liquidity position. It also serves as a source of funding for the Company’s other lines of business.

Availability of Information on Website

Doral Financial’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are available free of charge, through its website, http://www.doralfinancial.com, as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. In addition, Doral Financial makes available on its website under the heading “Corporate Governance” its: (i) Code of Business Conduct and Ethics; (ii) Corporate Governance Guidelines; (iii) Information Disclosure Policy; and (iv) the charters of the Audit, Compensation, Corporate Governance and Nominating, and Risk Policy committees, and also intends to disclose on its website any amendments to its Code of Business Conduct and Ethics, or waivers of the Code of Business Conduct and Ethics on behalf of its Chief Executive Officer, Chief Financial Officer, and Principal Accounting Officer. The aforementioned reports and materials can also be obtained free of charge upon written request to the Secretary of the Company at 1451 F.D. Roosevelt Avenue, San Juan, Puerto Rico 00920-2717.

The public may read and copy any materials Doral Financial files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. In addition, the public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including Doral Financial, at its website (http://www.sec.gov).

 

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Holding Company Structure

Doral Financial conducts its activities primarily through its three wholly-owned subsidiaries, Doral Bank (including Puerto Rico and United States operations), Doral Insurance Agency, and Doral Properties. Doral Bank operates four wholly-owned subsidiaries: Doral Mortgage, Doral Money, Doral Investment and CB, LLC.

 

LOGO

Banking Activities

Doral Financial is engaged in retail banking activities in Puerto Rico and the United States through its banking subsidiary. Doral Bank operates 29 branches in Puerto Rico and 7 branches in New York and Florida and offers a variety of consumer loan products as well as deposit products and other retail banking services. Doral Bank’s strategy is to combine excellent service with an improved sales process to capture new clients and cross-sell additional products and provide solutions to existing clients. As of December 31, 2011, Doral Bank and its subsidiaries had a loan portfolio, classified as loans receivable, of approximately $5.6 billion, of which approximately $3.5 billion consisted of loans secured by residential real estate, including real estate development projects, and a loan portfolio classified as loans held for sale, of approximately $211.2 million.

Doral Bank’s lending activities in Puerto Rico have traditionally focused on the origination of residential mortgage loans. All residential mortgage origination activities in Puerto Rico are conducted by Doral Bank through its wholly-owned subsidiary Doral Mortgage.

Doral Money and the U.S. operations of Doral Bank are also engaged in the mortgage banking business in the New York City metropolitan area and are also engaged in purchasing assigned interests in senior credit facilities in the U.S. syndicated leverage loan market. Starting in 2011, a new healthcare finance product is providing asset-based, working capital lines of credit to providers of goods and services in the healthcare industry nationwide, including hospitals, home healthcare agencies and long-term care facilities with financing needs from $1.0 million to $20.0 million.

Doral Bank complements its lending activities by earning fee income, collecting service charges for deposit accounts and other traditional banking services.

For detailed information regarding the deposit accounts of Doral Financial’s banking subsidiary, refer to Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, “— Liquidity and Capital Resources” in this report.

 

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Consumer Lending

Consumer lending operations include residential mortgage lending and consumer loans. As of December 31, 2011, Doral Bank and its subsidiaries’ consumer loan portfolio totaled $3.2 billion, or 56.8%, of its loans receivable portfolio.

Residential Mortgage Lending

Doral Bank is an approved seller/servicer for the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”), an approved issuer for the Government National Mortgage Association (“GNMA”) and an approved servicer under the GNMA, FNMA and FHLMC mortgage-backed securities programs. Doral Financial is also qualified to originate mortgage loans insured by the Federal Housing Administration (“FHA”) or guaranteed by the Veterans Administration (“VA”) or by the Rural Housing Service (“RHS”).

Doral Bank originates a wide variety of mortgage loan products, some of which are held for investment and others which are held for sale, that are designed to meet consumer needs and competitive conditions. The principal residential mortgage products are 30-year and 15-year fixed rate first mortgage loans secured by single-family residential properties consisting of one-to-four family units. None of Doral Bank’s residential mortgage loans have adjustable interest rate features. Doral Financial generally classifies mortgage loans between those that are guaranteed or insured by FHA, VA or RHS and those that are not. The latter types of loans are referred to as conventional loans. Conventional loans that meet the underwriting requirements for sale or exchange under standard FNMA or FHLMC programs are referred to as conforming loans, while those that do not meet the requirements are referred to as non-conforming loans.

For additional information on Doral Financial’s mortgage loan originations, refer to Table I — Loan Production included in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.

Other Consumer

Doral Bank provides consumer loans that include consumer credit, personal loans, loans on savings deposits and other consumer loans. At December 31, 2011, these consumer loans totaled $37.2 million, or 0.7%, of its loans receivable, gross portfolio.

Doral Bank’s consumer loan portfolio is subject to certain risks, including: (i) amount of credit offered to consumers in the market; (ii) interest rate increases; (iii) consumer bankruptcy laws which allow consumers to discharge certain debts; and (iv) continued recessionary conditions and/or additional deterioration of the Puerto Rico and United States economies. Doral Bank attempts to reduce its exposure to such risks by: (i) individually reviewing each loan request and renewal; (ii) utilizing a centralized approval system for loans in excess of $25,000; (iii) strictly adhering to written credit policies; and (iv) conducting an independent credit review.

Financing Leases

Historically, Doral Financial has originated auto and equipment financing leases on a limited scale; however, during 2011, through its subsidiary, Doral Money, the Company continued its limited lease financing activity in the United States. As of December 31, 2011, the Company’s U.S. equipment financing lease portfolio totaled $5.8 million.

Commercial Lending

Commercial lending operations include commercial real estate, commercial and industrial and construction and land. As of December 31, 2011, Doral Bank and its subsidiaries’ commercial loan (including construction and land) portfolio totaled $2.4 billion, or 43.0%, of its loans receivable portfolio. Most of the growth in the commercial lending portfolio has been in the U.S. operations as economic conditions have improved on the mainland.

 

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Commercial Real Estate and Commercial and Industrial

Due to worsening economic conditions in Puerto Rico, Doral’s new commercial lending activity in Puerto Rico has been limited since early 2008. However, commercial lending activities in the U.S. have grown significantly beginning late in 2009. At December 31, 2011, commercial loans totaled $2.0 billion, or 36.4%, of Doral Bank and its subsidiaries’ loans receivable portfolio, which included $813.6 million in commercial loans secured by real estate. Commercial loans include lines of credit and term facilities to finance business operations and to provide working capital for specific purposes, such as to finance the purchase of assets, equipment or inventory. Since a borrower’s cash flow from operations is generally the primary source of repayment, Doral Bank’s analysis of the credit risk focuses heavily on the borrower’s debt repayment capacity.

Lines of credit are extended to businesses based on an analysis of the financial strength and integrity of the borrowers and collateral, if any, and are generally secured by real estate, accounts receivable or inventory, and have a maturity of one year or less. Such lines of credit bear a floating interest rate that is indexed to a base rate, such as, the prime rate, the London Interbank Offered Rate (“LIBOR”) or another established index.

Commercial term loans are typically made to finance the acquisition of fixed assets, provide permanent working capital or to finance the purchase of businesses. Commercial term loans generally have terms from one to five years. They may be collateralized by the asset being acquired or other available assets and bear a floating interest rate, indexed to the prime rate, LIBOR or another established index, or are fixed for the term of the loan.

As mentioned above, Doral Money’s syndicated lending unit began operations during the third quarter of 2009. Syndicated corporate loans are credit facilities sourced primarily from financial institutions that are acting as lead lenders and arrangers in these syndications. The U.S. based middle market syndicated lending strategy is to acquire syndicated interests in loans, primarily between $5.0 million to $15.0 million, mostly to U.S. mainland companies that are first underwritten by money center or regional banks, and re-underwritten by the Company’s U.S. based syndicated lending unit. Borrowers are either domiciled in the U.S. or the vast majority of their revenues are generated in the U.S. All borrowers have external public ratings or a rating letter from Standard & Poor’s and/or Moody’s.

The syndicated lending unit portfolio has been growing steadily since 2009. As of December 31, 2011, syndicated loans totaled $933.6 million, or 16.7%, of the consolidated Doral Bank loans receivable portfolio. For the year ended December 31, 2011, U.S. syndicated loans accounted for 43.2% of total loans originated during 2011.

Doral Financial’s portfolio of commercial loans is subject to certain risks, including: (i) continued recessionary conditions and/or additional deterioration of the Puerto Rico and United States economies; (ii) interest rate increases; (iii) the deterioration of a borrower’s or guarantor’s financial capabilities; and (iv) environmental risks, including natural disasters. Doral Financial attempts to reduce the exposure to such risks by: (i) reviewing each loan request and renewal individually; (ii) utilizing a centralized approval system for all unsecured and secured loans in excess of $100,000; (iii) strictly adhering to written loan policies; and (iv) conducting an independent credit review. In addition, loans based on short-term asset values are monitored on a monthly or quarterly basis.

Construction Lending

Due to market conditions in Puerto Rico, the Company has ceased financing new construction of single family residential and commercial real estate projects, including land development, in Puerto Rico. Doral will continue to evaluate and appraise market conditions to determine if and when it will resume such financing. Doral Bank had traditionally been a leading player in Puerto Rico in providing interim construction loans to finance residential development projects, primarily in the affordable and mid-range housing markets. In 2006, the Company reassessed its risk exposure to the sector and made a strategic decision to restrict construction lending to established clients with proven track records. In late 2007, as a result of the continued downturn in the Puerto Rico housing market, the Company determined that it would no longer underwrite new development projects and focus its efforts on collections, including assisting developers in marketing their properties to potential home buyers. As of December 31, 2011, Doral Bank and its subsidiaries had approximately $368.3 million in

 

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construction and land loans. Historically, construction loans extended by the Company to developers were typically adjustable rate loans, indexed to the prime rate, with terms generally ranging from 12 to 36 months.

Doral Bank, through its U.S. operations, and Doral Money extend interim, construction loans and bridge loans secured by multifamily apartment buildings and other commercial properties in the New York City metropolitan area and in northwest Florida. As of December 31, 2011, Doral Bank through its U.S. operations and Doral Money had a portfolio of $26.6 million and $71.2 million, respectively, in interim construction and bridge loans.

Doral Financial’s construction loan portfolio is subject to certain risks, including: (i) continued recessionary conditions and/or additional deterioration of the Puerto Rico economy and the United States economy; (ii) continued deterioration of the United States and Puerto Rico housing markets; (iii) interest rate increases; (iv) deterioration of a borrower’s or guarantor’s financial capabilities; and (v) environmental risks, including natural disasters. Doral Financial attempts to reduce the exposure to such risks by: (i) individually reviewing each loan request and renewal; (ii) utilizing a centralized approval system for secured loans in excess of $100,000; (iii) strictly adhering to written loan policies; and (iv) conducting an independent credit review.

Mortgage Origination Channels

Doral Bank’s strategy is to defend its mortgage servicing portfolio primarily by internal originations through its retail branch network. Doral Mortgage units are co-located in 27 of the 29 retail bank branches of Doral Bank in Puerto Rico. Doral Bank supplements retail originations with wholesale purchases of loans from third parties. The principal origination channels of Doral Financial’s loan origination units are summarized below.

Retail Channel.     Doral Bank, through its Doral Mortgage operations, originates loans through its network of loan officers located in 27 retail branches throughout Puerto Rico. Customers are sought through advertising campaigns in local newspapers and television, as well as direct mail and telemarketing campaigns. Doral Bank emphasizes quality customer service and offers extended operating hours to accommodate the needs of customers. Doral Bank works closely with residential housing developers and specializes in originating mortgage loans to provide permanent financing for the purchase of homes in new housing projects.

Wholesale Correspondent Channel.     Doral Bank maintains a centralized unit that purchases closed conventional residential mortgage loans from other financial institutions. Doral Bank underwrites each loan prior to purchase. For the years ended December 31, 2011, 2010, and 2009 loan purchases totaled approximately $77.0 million, $82.0 million and $126.0 million, respectively.

For more information on Doral Financial’s loan origination channels, refer to Table J — Loan Origination Sources in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.

Mortgage Loan Underwriting

Doral Bank’s underwriting standards are designed to comply with the relevant guidelines set forth by the Department of Housing and Urban Development (“HUD”), GNMA, RHS, VA, FNMA, FHLMC, Federal and Puerto Rico banking regulatory authorities, private mortgage investment conduits and private mortgage insurers, as applicable.

Doral Bank’s underwriting policies focus primarily on the borrower’s ability to pay and secondarily on collateral value. The maximum loan-to-value (“LTV”) ratio on conventional first mortgages generally does not exceed 80%. Doral Bank also offers certain first mortgage products with higher LTV ratios, which may require private mortgage insurance. In conjunction with a first mortgage, Doral Bank may also provide a borrower with additional financing through a closed end second mortgage loan, whose combined LTV ratio exceeds 80%. Doral Bank does not originate adjustable rate mortgages (“ARM”) or negatively amortizing loans. However, the Company has entered into certain loss mitigation arrangements that provide for a temporary reduction in interest rates. The Company uses external credit scores as a useful measure for assessing the credit quality of a borrower. These scores are supplied by credit information providers, based on statistical models that summarize an individual’s credit record. FICO® scores, developed by Fair Isaac Corporation, are the most commonly used credit scores.

 

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Doral Bank sells the majority of its conforming mortgage loan originations and retains the majority of its non-conforming loan originations in portfolio. The Company’s underwriting process is established to achieve a uniform rules-based standard while targeting high quality non-conforming loan originations which is consistent with the Company’s goal of retaining a greater portion of its mortgage loan production.

Mortgage Loan Servicing

When Doral Financial sells originated or purchased mortgage loans, it generally retains the right to service such loans and to receive the associated servicing fees. Doral Financial’s principal source of servicing rights has traditionally been its mortgage loan production. The Company also seeks to purchase servicing rights in bulk when it can identify attractive opportunities.

Doral believes that loan servicing for third parties is important to its asset/liability management tools because it provides an asset whose value in general tends to move in the opposite direction to the value of its loan and investment portfolio. The asset also provides additional fee income to help offset the cost of its mortgage operations.

Servicing rights represent a contractual right and not a beneficial ownership interest in the underlying mortgage loans. Failure to service the loans in accordance with contract requirements may lead to the termination of the servicing rights and the loss of future servicing fees. In general, Doral Bank’s servicing agreements are terminable by the investors for cause. However, certain servicing arrangements, such as those with FNMA and FHLMC, contain termination provisions that may be triggered by changes in the servicer’s financial condition that materially and adversely affect its ability to provide satisfactory servicing of the loans. As of December 31, 2011, approximately 28.0%, 6.0% and 32.1% of Doral Financial’s mortgage loans serviced for others related to mortgage servicing for FNMA, FHLMC and GNMA, respectively. As of December 31, 2011, Doral Bank serviced approximately $7.9 billion in mortgage loans on behalf of third parties. Termination of Doral Bank’s servicing rights by any of these agencies could have a material adverse effect on Doral Financial’s results of operations and financial condition. During 2011, no servicing agreements have been terminated. In certain instances, the Company also services loans with no contractual servicing fee. The servicing asset or liability associated with this type of servicing arrangement is evaluated solely based on ancillary income, float, late fees, prepayment penalties and costs.

Doral Bank’s mortgage loan servicing portfolio is subject to reduction by reason of normal amortization, prepayments and foreclosure of outstanding mortgage loans. Additionally, Doral Bank may sell mortgage loan servicing rights from time to time to other institutions if market conditions are favorable. For additional information regarding the composition of Doral Financial’s servicing portfolio as of each of the Company’s last three fiscal year-ends, refer to Table K — Loans Serviced for Third Parties in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in this report.

The degree of credit risk associated with a mortgage loan servicing portfolio is largely dependent on the extent to which the servicing portfolio is non-recourse or recourse. In non-recourse servicing, the principal credit risk to the servicer is the cost of temporary advances of funds. In recourse servicing, the servicer agrees to share credit risk with the owner of the mortgage loans, such as FNMA or FHLMC, or with a private investor, insurer or guarantor. Losses on recourse servicing occur primarily when foreclosure sale proceeds of the property underlying a defaulted mortgage loan are less than the outstanding principal balance and accrued interest of such mortgage loan and the cost of holding and disposing of the underlying property. Prior to 2006, Doral Financial often sold non-conforming loans on a partial recourse basis. These recourse obligations were retained by Doral Financial when Doral Bank assumed the servicing rights from Doral Financial. For additional information regarding recourse obligations, see Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, “— Off-Balance Sheet Activities” in this report.

Sale of Loans and Securitization Activities

Doral Financial sells or securitizes a portion of the residential mortgage loans that it originates and purchases to generate income. These loans are underwritten to investor standards, including the standards of FNMA, FHLMC, and GNMA. As described below, Doral Financial utilizes various channels to sell its mortgage

 

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products. Doral Financial issues GNMA-guaranteed mortgage-backed securities, which involve the packaging of FHA, RHS or VA loans into pools of $1.0 million or more for sale primarily to broker-dealers and other institutional investors. During the years ended December 31, 2011, 2010 and 2009, Doral Financial issued approximately $399.8 million, $311.8 million and $377.3 million, respectively, in GNMA-guaranteed mortgage-backed securities.

Conforming conventional loans are generally either sold directly to FNMA, FHLMC or private investors for cash, or are grouped into pools of $1.0 million or more in aggregate principal balance and exchanged for FNMA or FHLMC-issued mortgage-backed securities, which Doral Financial sells to broker-dealers. In connection with such exchanges, Doral Financial pays guarantee fees to FNMA and FHLMC. The issuance of mortgage-backed securities provides Doral Financial with flexibility in selling the mortgage loans that it originates or purchases and also provides income by increasing the value and marketability of such loans. For the years ended December 31, 2011, 2010 and 2009, Doral Financial securitized approximately $143.6 million, $92.8 million and $53.6 million, respectively, of loans into FNMA and FHLMC mortgage-backed securities. In addition, for the years ended December 31, 2011, 2010 and 2009, Doral Financial sold approximately $21.2 million, $30.7 million and $35.0 million, respectively, of loans through the FNMA and FHLMC cash window programs.

When the loans backing a GNMA security are initially securitized they are treated as sales and the Company continues to service the underlying loans. The Company is required to bring individual delinquent GNMA loans that it previously accounted for as sold back onto its books as loan assets when, under the GNMA Mortgage-Backed Securities Guide, the loan meets GNMA’s specified delinquency criteria and is eligible for repurchase. The rebooking of GNMA loans is required (together with a liability for the same amount) regardless of whether the Company, as seller-servicer, intends to exercise the repurchase (buy-back option) since the Company is deemed to have regained effective control over these loans.

At December 31, 2011, 2010 and 2009, the loans held for sale portfolio includes $168.5 million, $153.4 million and $128.6 million, respectively, related to defaulted loans backing GNMA securities for which the Company has an unconditional option (but not an obligation) to repurchase the defaulted loans. Payment on these loans is guaranteed by FHA.

Prior to the fourth quarter of 2005, Doral Financial’s non-conforming loan sales were generally made on a limited recourse basis. As of December 31, 2011, 2010 and 2009, Doral Financial’s maximum contractual exposure relating to its portfolio of loans sold with recourse was approximately $0.6 billion, $0.7 billion and $0.8 billion, respectively, which included recourse obligations to FNMA and FHLMC as of such dates of approximately $0.6 billion, $0.6 billion and $0.7 billion, respectively. As of December 31, 2011, 2010 and 2009, Doral Financial had a recourse liability of $11.0 million, $10.3 million and $9.4 million, respectively, to reflect estimated losses from such recourse arrangements.

Doral Financial estimates its liability from its recourse obligations based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment. The Company believes that it has an adequate valuation for its recourse obligation as of December 31, 2011 and 2010, but actual future recourse obligations may differ from expected results.

In the past the Company sold non-conforming loans to financial institutions in the U.S. mainland on a non-recourse basis, except recourse for certain early defaults. Since 2007, the Company is retaining all of its non-conforming loan production in its loan receivable portfolio. While the Company currently anticipates that it will continue to retain its non-conforming loan production in portfolio, in the future, the Company may seek to continue to diversify secondary market outlets for its non-conforming loan products both in the U.S. mainland and Puerto Rico.

In the ordinary course of business, Doral Financial makes certain representations and warranties to purchasers and insurers of mortgage loans at the time of the loan sales to third parties regarding the characteristics of the loans sold, and in certain circumstances, such as in the event of early or first payment default. To the extent the loans do not meet specified criteria, such as a breach of contract of a representation or warranty or an early payment default, Doral Financial may be required to repurchase the mortgage loan and bear any subsequent loss related to the loan. Doral Financial works with purchasers to review the claims and correct

 

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alleged documentation deficiencies. For the years ended December 31, 2011, 2010 and 2009, repurchases amounted to $9.0 million, $1.0 million and $13.7 million, respectively. Refer to Item 1A. Risk Factors, “Risks related to our business — Defective and repurchased loans may harm our business and financial condition,” and Item 7. Management’s Discussion and Analysis and Results of Operations, “— Liquidity and Capital Resources” for additional information.

Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment

In general, the Puerto Rico market for mortgage-backed securities is an extension of the U.S. market with respect to pricing, rating of investment instruments, and other matters. However, Doral Financial has benefited historically from certain tax incentives provided to Puerto Rico residents to invest in FHA and VA loans and GNMA securities backed by such loans.

Under the Puerto Rico Internal Revenue Code (the “PR Code”), the interest received on FHA and VA loans used to finance the original purchase of newly constructed housing in Puerto Rico and mortgage-backed securities backed by such loans is exempt from Puerto Rico income taxes. This favorable tax treatment allows Doral Financial to sell tax-exempt Puerto Rico GNMA mortgage-backed securities to local investors at higher prices than those at which comparable instruments trade in the U.S. mainland, and reduces its effective tax rate through the receipt of tax-exempt interest.

Insurance Agency Activities

In order to take advantage of the cross-marketing opportunities provided by financial modernization legislation enacted in 2000, Doral Financial entered the insurance agency business in Puerto Rico. Doral Insurance Agency currently earns commissions by acting as agent in connection with the sale of insurance policies issued by unaffiliated insurance companies. During 2011, 2010 and 2009, Doral Insurance Agency produced insurance fees and commissions of $13.3 million, $13.3 million and $12.0 million, respectively. Doral Insurance Agency’s activities are closely integrated with the Company’s mortgage loan originations with most policies sold to mortgage customers. Future growth of Doral Insurance Agency’s revenues will be tied to the Company’s level of mortgage originations, its ability to expand the products and services it provides and its ability to cross-market its services to Doral Financial’s existing customer base.

Puerto Rico Income Taxes

Until December 31, 2011, the maximum statutory corporate income tax rate in Puerto Rico was 39.00%.

Under the 1994 Puerto Rico Internal Revenue Code (as amended “1994 Code”), corporations are not permitted to file consolidated returns with their subsidiaries and affiliates. Doral Financial is entitled to a 100% dividend received deduction on dividends received from Doral Bank or any other Puerto Rico subsidiary subject to tax under the Puerto Rico tax code.

On March 9, 2009, the Governor of Puerto Rico signed into law the Special Act Declaring a State of Fiscal Emergency and Establishing an Integral Plan of Fiscal Stabilization to Save Puerto Rico’s Credit, Act No. 7 (the “Act”). Pursuant to the Act, section 1020A was introduced to the Code to impose a 5.00% surtax over the total tax determined for corporations, partnerships, trusts, estates, as well as individuals whose combined gross income exceeds $100,000 or married individuals filing jointly whose gross income exceeds $150,000. This surtax is effective for tax years commenced after December 31, 2008 and before January 1, 2012. This increased the Company’s income tax rate from 39.00% to 40.95% for tax years from 2009 through 2011.

On November 15, 2010, Act 171 was enacted into law (“Act 171”) generally providing, among other things: (i) a one year income tax credit equal to 7.00% of the “tax liability due” to corporations that paid the Christmas Bonus required by local labor laws, and (ii) extending to 10 years the carry forward term of net operating losses incurred for the years commenced after December 31, 2004 and before December 31, 2012.

On January 31, 2011, the Governor signed into law the Internal Revenue Code of 2011 (“2011 Code”) making the 1994 Code generally ineffective for years commenced after December 31, 2010. Under the provisions of the 2011 Code, the maximum statutory corporate income tax rate is 30.00% for years starting after

 

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December 31, 2010 and ending before January 1, 2014; if the government meets its income generation and expense control goals, for years started after December 31, 2013, the maximum corporate tax rate will be 25.00%. The 2011 Code eliminated the special 5.00% surtax on corporations for tax year 2011. In general, the 2011 Code maintains the extension in the carry forward periods for net operating losses from 7 to 10 years as provided for in Act 171; maintains the concept of the alternative minimum tax although it changed the way it is computed; allows limited liability companies to have flow-through treatment under certain circumstances; imposes additional restrictions on the use of net operating loss carry forwards after certain types of reorganizations and/or changes in control; and specifies what types of auditors’ report will be acceptable when audited financial statements are required to be filed with the income tax return. Additionally, the 2011 Code provides for changes in the implications of being in a controlled group of corporations and/or group of related corporations. Notwithstanding the 2011 Code, a corporation may be subject to the provisions of the 1994 Code if it so elects it by the time it files its income tax return for the first year commenced after December 31, 2010 and ending before January 1, 2012. If the election is made to remain subject to the provisions of the 1994 Code, such election will be effective that year and the next four succeeding years.

In computing its interest expense deduction, Doral Financial’s interest deduction is reduced in the same proportion that its average exempt obligations (including FHA and VA loans and GNMA securities) bear to its average total assets. Therefore, to the extent that Doral Financial holds FHA or VA loans and other tax exempt obligations, part of its interest expense may be disallowed for tax purposes.

The Company is evaluating the impact of the tax reform on its results of operations including the election to be taxed under the 1994 Code. Nevertheless, the Company recorded its deferred tax assets estimated to reverse after 2015 at the 30.00% tax rate required for all taxable earnings beginning in 2016, which is the latest taxable year that it would be permitted to elect taxation under the 1994 Code. Puerto Rico deferred tax asset subject to the maximum statutory tax rate and estimated to reverse prior to 2016, together with any related valuation allowance, are recorded at the 39.00% tax rate pursuant to the 1994 Code. Upon determination of which alternative treatment will be followed, the Company will adjust its deferred tax assets for any required tax rate change, if applicable. Adoption of the 2011 Code as of December 31, 2011, would represent an additional deferred tax expense of $7.6 million.

Refer to Note 28 of the accompanying consolidated financial statements for additional information.

United States Income Taxes

Except for the operations of Doral Bank US and Doral Money, substantially all of the Company’s operations are conducted through subsidiaries in Puerto Rico. Accordingly, Doral Financial and all of its Puerto Rico subsidiaries are generally required to pay U.S. income taxes only with respect to their income derived from the active conduct of a trade or business in the United States (excluding Puerto Rico) and certain investment income derived from U.S. assets. Any such tax is creditable, with certain limitations, against Puerto Rico income taxes. Doral Money is a U.S. corporation and is subject to U.S. income-tax on its income derived from all sources. After the completion of the merger of Doral Bank and Doral Bank, FSB on October 1, 2011, Doral Bank is now engaged in the active conduct of a trade or business in the United States. Refer to Note 28 of the accompanying consolidated financial statements for additional information.

Employees

As of December 31, 2011, Doral Financial employed 1,241 persons compared to 1,352 as of December 31, 2010. Of the total number of employees, 1,127 were employed in Puerto Rico and 114 employed in the U.S. as of December 31, 2011 compared to 1,281 employed in Puerto Rico and 71 employed in the U.S. as of December 31, 2010. As of December 31, 2011, of the total number of employees, 143 were employed in loan production, 166 in loan administration and servicing activities, 277 were involved in loan collections, 475 in branch operations and 180 in other operating and administrative activities . None of Doral Financial’s employees are represented by a labor union and Doral Financial considers its employee relations to be good.

 

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Segment Disclosure

For information regarding Doral Financial’s operating segments, refer to Note 41 of the accompanying consolidated financial statements, “Segment Information,” and the information provided under Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation, “Operating Segments” in this report.

Puerto Rico is the principal market for Doral Financial. Doral Financial’s Puerto Rico-based operations accounted for 77.7% of Doral Financial’s consolidated assets as of December 31, 2011. The Puerto Rico based operations net income before taxes totaled $8.0 million while the Company’s net loss before income taxes totaled $9.0 million.

The following table sets forth the geographic composition of Doral Financial’s loan originations for the periods indicated:

 

     Year Ended
December 31
 
     2011     2010     2009  

Puerto Rico

     31     55     74

United States

     69     45     26

The increase in originations in the U.S. is due primarily to loans originated by the syndicated lending unit.

Market Area and Competition

Puerto Rico is Doral Financial’s primary service area. The competition in Puerto Rico for the origination of loans and attracting of deposits is substantial. Competition comes not only from local commercial banks and credit unions, but also from banking affiliates of banks headquartered in the United States, Spain and Canada. In mortgage lending, the Company also faces competition from independent mortgage banking companies. Doral Financial competes principally by offering loans with competitive features, by emphasizing the quality of its service and by pricing its range of products at competitive rates.

Since 2009, Doral Financial has increased its business activities in the U.S. expanding its lending activities in the New York metropolitan area and establishing deposit taking and lending operations in northwest Florida. While these markets are competitive, Doral perceives that well managed community banks with appropriately priced products in the New York metropolitan area and northwest Florida markets can successfully compete for deposits and loans. The Company’s plans are to continue to expand its New York and northwest Florida business activities.

The Commonwealth of Puerto Rico

General.    The Commonwealth of Puerto Rico (the “Commonwealth”), an island located in the Caribbean, is approximately 100 miles long and 35 miles wide, with an area of 3,423 square miles. According to the information published by the United States Census Bureau, the population of Puerto Rico was 3,725,789 in 2010, a decrease of 2.2% when compared to 3,808,610 in 2000. Its capital, San Juan, is located approximately 1,600 miles southeast of New York City and according to the information published by the United States Census Bureau had a population of 395,326 in 2010, compared to 434,374 in 2000.

Relationship of Puerto Rico with the United States.    Puerto Rico has been under the jurisdiction of the United States since 1898. Puerto Rico’s constitutional status is that of a territory of the United States, and, pursuant to the territorial clause of the U.S. Constitution, the ultimate authority over Puerto Rico is the U.S. Congress. The United States and Puerto Rico share a common defense, market and currency. Puerto Rico exercises virtually the same control over its internal affairs as do the fifty states. It differs from the states, however, in its relationship with the federal government.

There is a federal district court in Puerto Rico and most federal laws are applicable to Puerto Rico. The United States postal service operates in Puerto Rico in the same manner as in the mainland United States. The people of Puerto Rico are citizens of the United States, but do not vote in national elections.

 

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They are represented in Congress by a Resident Commissioner who has a voice in the House of Representatives, and has limited voting rights in committees and sub-committees of the House of Representatives. Most federal taxes, except those, such as social security taxes, which are imposed by mutual consent, are not levied in Puerto Rico. No federal income tax is collected from Puerto Rico residents on ordinary income earned from sources within Puerto Rico, except for certain federal employees who are subject to taxes on their salaries. Income earned by Puerto Rico residents from sources outside of Puerto Rico, however, is subject to federal income tax. The official languages of Puerto Rico are Spanish and English.

Governmental Structure.    The Constitution of Puerto Rico provides for the separation of powers of the executive, legislative and judicial branches of government. The Governor is elected every four years. The Legislative Assembly consists of a Senate and a House of Representatives, the members of which are elected for four-year terms. The highest local court in Puerto Rico is the Supreme Court of Puerto Rico. Decisions of the Supreme Court of Puerto Rico may be appealed to the United States Supreme Court under the same conditions as decisions from state courts. Puerto Rico also constitutes a district in the federal judiciary and has its own United States District Court. Decisions of this federal district court may be appealed to the United States Court of Appeals for the First Circuit and from there to the United States Supreme Court. Governmental responsibilities assumed by the central government of Puerto Rico are similar in nature to those of the various state governments. In addition, the central government of Puerto Rico assumes responsibility for local police and fire protection, education, public health and welfare programs, and economic development.

The Economy.    The economy of Puerto Rico is closely linked to the United States economy, as most of the external factors that affect the Puerto Rico economy (other than the price of oil) are determined by the policies of, and economic conditions prevailing in, the United States. These external factors include exports, direct investment, the amount of federal transfer payments, the level of interest rates, the rate of inflation, and tourist expenditures. During the fiscal year ended June 30, 2010, approximately 68.1% of Puerto Rico’s exports went to the U.S. mainland, which was also the source of approximately 53.3% of Puerto Rico’s imports. In the past, the economy of Puerto Rico has generally followed economic trends in the overall United States economy. However, in recent years, economic growth in Puerto Rico has lagged behind growth in the United States. The dominant sectors of the Puerto Rico economy in terms of production and income are manufacturing and services. The manufacturing sector has undergone fundamental changes over the years as a result of an increased emphasis on higher-wage, high-technology industries, such as pharmaceuticals, biotechnology, computers, microprocessors, professional and scientific instruments, and certain high-technology machinery and equipment. The service sector, including finance, insurance, real estate, wholesale and retail trade, transportation, communications and public utilities, and other services, also plays a major role in the economy. It ranks second to manufacturing in contribution to Puerto Rico’s gross domestic product, but first in terms of contribution to Puerto Rico’s real gross national product. The service sector leads all sectors in providing employment.

Puerto Rico’s economy is currently in a recession that began in the fourth quarter of the fiscal year that ended June 30, 2006, a fiscal year in which the real gross national product grew by only 0.5%. Although the Puerto Rico economy is closely linked to the United States economy, in recent fiscal years the performance of the Puerto Rico economy has lagged the performance of the United States economy. For fiscal years 2007, 2008, 2009 and 2010, Puerto Rico’s real gross national product decreased by 1.2%, 2.9%, 4.0% and 3.8%, respectively. According to the Puerto Rico Planning Board’s latest projections made in March 2011, Puerto Rico’s real gross national product was projected to have contracted by 1.0% during fiscal year 2011. Puerto Rico’s real gross national product for fiscal year 2012, however, is projected to grow by 0.7%.

According to data published by the Puerto Rico Department of Labor, the number of persons employed in Puerto Rico during fiscal year 2011 averaged 1,077,000, a decrease of 2.3% compared to the previous fiscal year; and the unemployment rate averaged 15.9%. During the first four months of fiscal year 2012, total employment averaged 1,067,500, a decline of 1.2% with respect to the same period of the prior fiscal year; and the unemployment rate averaged 16.1%.

Future growth of the Puerto Rico economy will depend on several factors including the condition of the United States economy, the relative stability of the price of oil imports, the exchange value of the United States

dollar, the level of interest rates, the effectiveness of the recently approved changes to the Puerto Rico income tax

 

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code and other tax laws, and the continuing economic uncertainty generated by the Puerto Rico government’s fiscal condition described below.

Fiscal Condition.    Since 2000, Puerto Rico has faced a number of fiscal challenges, including an imbalance between its General Fund total revenues and expenditures. The imbalance reached its highest level in fiscal year 2009, when the deficit was approximately $3.3 billion. Prior to fiscal year 2009, the Commonwealth bridged such deficits through the use of non-recurring measures, such as borrowing from the Government Development Bank for Puerto Rico or in the bond market, postponing the payment of various government expenses, such as payments to suppliers and utilities providers, and other one-time measures such as the use of derivatives and borrowings collateralized with government owned real estate and uncollected General Fund revenues.

Fiscal Stabilization Plan.    In January 2009, the Puerto Rico developed and commenced implementing a multi-year Fiscal Stabilization and Economic Reconstruction Plan designed to achieve fiscal balance, restore sustainable economic growth and safeguard the investment-grade ratings of the Commonwealth.

The fiscal stabilization plan seeks to achieve budgetary balance, while addressing expected fiscal deficits in the intervening years through the implementation of a number of initiatives, including the following: (i) gradual operating expense-reduction plan through reduction of operating expenses, including payroll, which is the main component of government expenditures, and the reorganization of the Executive Branch; (ii) a combination of temporary and permanent revenue raising measures, coupled with additional tax enforcement measures; and (iii) certain financial measures which included (1) a bond issuance program through Puerto Rico Sales Tax Financing Corporation (“COFINA” by its Spanish-language acronym) and (2) restructuring of a portion of the Commonwealth’s debt service.

The financial measures were anchored on the bond-issuance program of COFINA. During fiscal years 2009 and 2010, COFINA issued approximately $5.6 billion and $3.6 billion, respectively, of revenue bonds payable from sales and use tax collections transferred to COFINA. The proceeds obtained from COFINA bond issuance program have been used (and are being used) to repay existing government debt (including debts with GDB), finance operating expenses of the Commonwealth for fiscal years 2009 through 2012, including costs related to the implementation of a workforce reduction plan, the funding of an economic stimulus plan, as described below, and for other purposes to address the fiscal imbalance while the fiscal stabilization plan was being implemented. During the fiscal year 2012, COFINA expects to issue approximately $2 billion of additional revenue bonds the proceeds of which will be mainly used to finance a portion of the government’s operating expenses for fiscal year 2012, refund outstanding debt obligations payable from Commonwealth appropriations, and refund certain outstanding COFINA bonds.

During the last three fiscal years, the Commonwealth has been able to reduce the deficit by both increasing its revenues and decreasing its expenditures. The Commonwealth’s ability to continue reducing the deficit will depend in part on its ability to continue increasing revenues and reducing expenditures, which in turn depends on a number of factors, including improvements in general economic conditions.

Economic Reconstruction Plan.    The Puerto Rico government administration also developed and implemented a short-term economic reconstruction plan. The cornerstone of this plan was the implementation of federal and local economic stimulus programs. Puerto Rico was awarded approximately $6.8 billion in stimulus funds under American Recovery and Reinvestment Act of 2009 (“ARRA”) enacted by the U.S. government to provide a stimulus to the U.S. economy in the wake of the global economic downturn. The funds awarded to Puerto Rico included tax relief, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, health care, and infrastructure, among other measures.

The administration complemented the federal stimulus with additional short- and medium-term supplemental stimulus measures seeking to address specific local challenges and providing investment in strategic areas. These measures included a local $500 million economic stimulus plan to supplement the federal plan. The local stimulus was composed of three main elements: (i) capital improvements; (ii) stimulus for small- and medium-sized businesses, and (iii) consumer relief in the form of direct payments to retirees, mortgage-debt restructuring for consumers that face risk of default, and consumer stimulus for the purchase of housing.

 

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Economic Development Plan.    The administration also developed the Strategic Model for a New Economy, which is a comprehensive long-term economic development plan aimed at improving Puerto Rico’s overall competitiveness and business environment and increasing private-sector participation in the Puerto Rico economy.

The administration is emphasizing the following initiatives to enhance Puerto Rico’s competitive position: (i) overhauling the permitting process; (ii) reducing energy costs; (iii) reforming the tax system; (iv) promoting the development of various projects through public-private partnerships; and (v) implementing strategic initiatives targeted at specific economic sectors and development of certain strategic/regional projects.

The first initiative, the reengineering of Puerto Rico’s permitting and licensing process, has already been achieved. On December 1, 2009, the Governor signed into law Act No. 161, which overhauls the existing permitting and licensing process in Puerto Rico in order to provide for a leaner and more efficient process the fosters economic development. In the short term, this restructuring is focused on eliminating the significant backlog of unprocessed permits that are currently in the pipeline of various government agencies. In the long term, the law seeks to significantly reduce the number of inter-agency processes and transactions that were required by creating a centralized, client-focused permit system that simplifies and shortens the permitting process for applicants.

With respect to the second initiative, reducing energy costs, the administration enacted Acts No. 82 and 83 in July 2010, which generally provide for a new energy policy that seeks to lower energy costs and reduce energy-price volatility by reducing Puerto Rico’s dependence on fuel oil and the promotion of diverse, renewable energy technologies. Act No. 82 focuses on reducing Puerto Rico’s dependence on fossil fuels, particularly fuel oil, through the promotion of diverse, renewable-energy technologies. Act No. 83 assembles under one law the incentives for the construction and use of renewable energy sources.

The third initiative involved a comprehensive review of the Commonwealth’s income tax system and approval of a tax reform directed at reducing personal and corporate income tax rates.

Legislation to implement the first phase of tax reform was enacted as Act No. 171 on November 15, 2010. Legislation to implement the second phase of tax reform was enacted as Act No. 1 on January 31, 2011. The tax reform is focused on providing tax relief to individuals and corporations, providing economic development and job creation, simplifying the tax system and reducing tax evasion through enhanced tax compliance measures. In general terms, the tax reform is intended to be revenue positive for the Commonwealth as it includes, among other things, a temporary excise tax on affiliates of multinational manufacturers operating in Puerto Rico, the elimination of certain incentives and tax credits, and enhanced tax compliance measures to finance the tax rate reductions for corporations and individuals.

To further stimulate economic development and cope with the fiscal crisis, the administration established a legal framework through Act No. 29 approved in June 2009 to authorize and promote the use of public-private partnerships to finance and develop infrastructure projects and operate and manage certain public assets. Public-private partnerships are long-term contracts between government and non-governmental entities to develop, operate, manage or maximize infrastructure projects and/or government services. Act No. 29, among other things, established the Puerto Rico Public-Private Partnerships Authority as the entity tasked with implementing the Commonwealth’s public policy with respect the public-private partnerships. During fiscal years 2010 and 2011 the administration evaluated and/or commenced procurement for several public-private partnership priority projects involving, among other things, the energy, transportation, water and public school infrastructure sectors.

As part of the government’s initiative, the Public Private Partnership Authority (“PPP Authority”) and the Puerto Rico Highways and Transportation Authority recently completed the procurement for a concession of two toll roads in Puerto Rico. The financial closing for the transaction was completed in September 2011, and as result of this transaction, the Puerto Rico Highways and Transportation Authority received lump-sum payment of $1.136 billion and a commitment to invest $56 million in immediate improvements and comply with world-class operating standards.

To modernize public school facilities throughout Puerto Rico and improve academic performance, the PPP Authority launched a program aimed at modernizing and building a selected number of public schools throughout

 

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Puerto Rico. As of June 2011, the PPP Authority had awarded approximately $464 million in contracts and construction had begun in approximately 57 schools.

In addition, during 2011 the PPP Authority and the Puerto Rico Ports Authority commenced the procurement process for a concession to finance, operate, maintain and improve the Luis Munoz Marin International Airport, the busiest airport in the Caribbean. In August 2011 they received statements of qualifications from twelve (12) world-class consortia. The PPP Authority and the Puerto Rico Ports Authority issued a request for proposals to six (6) of the potential bidders for the airport in October 2011 and expect to select a winning bidder in the first quarter of 2012.

The administration has also identified strategic initiatives to promote economic growth in various sectors of the economy where the Commonwealth has competitive advantages and several strategic/regional projects aimed as fostering balanced economic development throughout the island. These projects, some of which are ongoing, include tourism and urban redevelopment projects.

Unfunded Pension Benefit Obligations and Funding Shortfalls of the Retirement Systems.    One of the challenges every Puerto Rico administration has faced during the past twenty years is how to address the growing unfunded pension obligations and funding shortfalls of the three government retirements systems that are funded principally with budget appropriations from the Commonwealth’s General Fund. As of June 30, 2010, the date of the latest actuarial valuations of the three retirement systems, the unfunded actuarial accrued liability (including basic and system administered benefits) for the Employees Retirement System, the Teachers Retirement System and Judiciary Retirement System were $17.8 billion, $7.1 billion and $283 million, respectively, and the funded ratios were 8.5%, 23.9% and 16.4%, respectively.

Based on current employer and member contributions to the retirement systems, the unfunded actuarial accrued liabilities will continue to increase significantly, with a corresponding decrease in their funded ratios, since the annual contributions are not sufficient to fund pension benefits, and thus, are also insufficient to amortize the unfunded actuarial accrued liabilities. Because annual benefit payments and administrative expenses of the retirement systems have been significantly larger than annual employer and member contributions, the retirement systems have been forced to use investment income, borrowings and sale of investment portfolio assets to cover funding shortfalls. The funding shortfall (basic system benefits, administrative expenses and debt service in excess of contributions) for fiscal year 2011 for the Employees Retirement System, the Teachers Retirement System and Judiciary Retirement System were approximately $693 million, $268 million and $6.5 million, respectively. For fiscal year 2012, the funding shortfall is expected to be $741 million, $287 million and $8.5 million, respectively.

As a result, the assets of the retirement systems are expected to continue to decline and eventually be depleted during the next seven to nine years. Since the Commonwealth and other participating employers are ultimately responsible for any funding deficiency in the three retirement systems, the depletion of the assets available to cover retirement benefits will require the Commonwealth and other participating employers to cover such funding deficiency. It is estimated that the Commonwealth would be responsible for approximately 74% of the combined annual funding deficiency of the three retirement systems, with the balance being the responsibility of the municipalities and public corporations.

Ultimately, since the Commonwealth’s General Fund is required to cover a significant amount of the funding deficiency, the Commonwealth would have difficulty funding the required annual contributions unless it implements significant reforms to the retirement systems, obtains additional revenues, or takes other budgetary measures.

In order to address the growing unfunded benefit obligations and funding shortfalls of the three retirement systems, the Governor of Puerto Rico established in February 2010 a special commission to make recommendations for improving the fiscal solvency of the three retirement systems. The special commission delivered its recommendations to the Governor in October 2010.

As a result of the special commission’s report and the Government’s analysis, the Governor submitted two bills to the Legislative Assembly to address in part the retirement systems’ financial condition. One of the bills was enacted as Act No. 96 and resulted in the transfer of $162.5 million of funds to the Employees Retirement

 

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System which was invested in capital appreciation bonds issued by COFINA maturing annually from 2043 to 2048 and accreting interest at 7%. The principal of the COFINA bonds will grow to approximately $1.65 billion at their maturity dates.

The second bill was enacted as Act No. 114 and provides for an increase in employer contributions to the Employees Retirement System and the Teachers Retirement System of 1% of covered payroll in each of the next five fiscal years and by 1.25% of covered payroll in each of the following five fiscal years. As a result of these increases, the Employees Retirement System and the Teachers Retirement System would receive approximately $36 million and $14 million, respectively, in additional employer contributions during fiscal year 2012, and the additional employer contributions are projected to increase gradually each fiscal year to $494 million and $195 million, respectively, by fiscal year 2021. As a result of these increases in employer contributions to the Employees Retirement System and the Teachers Retirement System, the Administrator of the Retirement Systems projects that the period before depletion of assets of these two systems would be extended by three to four years.

REGULATION AND SUPERVISION

Described below are the material elements of selected federal and Puerto Rico laws and regulations applicable to Doral Financial and its subsidiaries. Many of these laws and regulations generally aim to protect our depositors and our customers, not necessarily our shareholders or our creditors. Any changes in applicable laws or regulations, and in their application by regulatory agencies, may materially affect our business and prospects. Proposed legislative or regulatory changes may also affect our operations. The following description summarizes some of the laws and regulations to which we are subject. References to applicable statutes and regulations are brief summaries, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The Dodd-Frank Act has had, and will have, a broad impact on the financial services industry, including significant regulatory and compliance changes including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased capital and liquidity requirements; (iii) increased regulatory examination fees; (iv) changes to assessments to be paid to the FDIC for federal deposit insurance; and (v) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC. A summary of certain provisions of the Dodd-Frank Act is set forth below, along with information set forth in other parts of this “Regulation and Supervision” section.

Increased Capital Standards and Enhanced Supervision.    The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards will be no lower than current regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher when established by the agencies. The FDIC and other federal banking agencies issued a joint notice on June 14, 2011 adopting a final rule that establishes a floor for the risk-based capital requirements applicable to the largest, internationally active banking organizations. The Dodd-Frank Act also increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

The Consumer Financial Protection Bureau (“Bureau”).    The Dodd-Frank Act created the Bureau within the Federal Reserve. The Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The Bureau has rulemaking authority over many of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and

 

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regulations that are more stringent than those regulations promulgated by the Bureau, and state attorneys general are permitted to enforce consumer protection rules adopted by the Bureau against state-chartered institutions.

Deposit Insurance.    The Dodd-Frank Act made permanent the $250,000 deposit insurance limit for insured deposits. Amendments to the Federal Deposit Insurance Act also revised the assessment base against which an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund (“DIF”) will be calculated. Under the amendments, the assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period. Additionally, the Dodd-Frank Act made changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. In December 2010, the FDIC increased the reserve ratio to 2.0 percent. The Dodd-Frank Act also provides that depository institutions are now permitted to pay interest on demand deposit accounts, and in this respect the Federal Reserve approved a final rule repealing Regulation Q on July 14, 2011.

Transactions with Affiliates.    The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Sections 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.

Transactions with Insiders.    Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.

Enhanced Lending Limits.     The Dodd-Frank Act strengthens the existing limits on a depository institution’s credit exposure to one borrower. Current banking law limits a depository institution’s ability to extend credit to one person (or group of related persons) in an amount exceeding certain thresholds. The Dodd-Frank Act expands the scope of these restrictions to include credit exposure arising from derivative transactions, repurchase agreements, and securities lending and borrowing transactions.

Compensation Practices.    The Dodd-Frank Act provides that the appropriate federal regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or other “covered financial institution” that provides an insider or other employee with “excessive compensation” or could lead to a material financial loss to such firm. On March 30, 2011, the FDIC and other federal banking and securities agencies issued a joint notice of proposed rulemaking on incentive-based compensation arrangements as required by the Dodd- Frank Act. The proposed rule has five key components: (i) requiring the deferral of at least 50% of incentive compensation for a minimum of three years for executive officers of financial institutions with consolidated assets of $50 billion or more; (ii) prohibiting incentive-based compensation arrangements for executive officers, employees, directors and principal shareholders (“covered persons”) of financial institutions with more than $1 billion in assets that would encourage inappropriate risks by providing excessive compensation; (iii) prohibiting incentive-based compensation arrangements for covered persons of financial institutions with more than $1 billion in assets that would expose the institution to inappropriate risks by providing compensation that could lead to material financial loss; (iv) requiring policies and procedures of financial institutions with more than $1 billion in assets for incentive-based compensation arrangements that are commensurate with the size and complexity of the institution; and (v) requiring annual reports on incentive compensation structures to the institution’s appropriate federal regulator.

Debit Card Interchange Fees and Routing.    The Dodd-Frank Act amends the Electronic Funds Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of the transaction to the issuer. In June 2011 the Federal Reserve issued the final rule, which generally became effective on October 1, 2011, that establishes standards for debit card interchange fees and prohibits network exclusivity

 

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arrangements and routing restrictions. Under the new Regulation II, the maximum permissible interchange fee that an issuer may receive for an electronic transaction will be the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. In accordance with the Dodd-Frank Act, issuers that, together with their affiliates, have assets of less than $10 billion are exempt from the debit card interchange fee standards. The new regulation also prohibits all issuers and networks from restricting the number of networks over which electronic debit transactions may be processed to less than two unaffiliated networks. Issuers and networks are also prohibited from inhibiting a merchant’s ability to direct the routing of the electronic debt transaction over any network that the issuer has enabled to process them.

We expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Mortgage Origination and Servicing Activities

Federal Regulation

Doral Financial’s mortgage origination and servicing operations are subject to the rules and regulations of the FHA, VA, RHS, FNMA, FHLMC, HUD and GNMA with respect to the origination, processing, selling and servicing of mortgage loans and the issuance and sale of mortgage-backed securities. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines, which include provisions for inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts, and with respect to VA loans, fix maximum interest rates. Moreover, lenders such as Doral Financial are required annually to submit to FHA, VA, RHS, FNMA, FHLMC, GNMA and HUD audited financial statements, and each regulatory entity has its own requirements. Doral Financial’s affairs are also subject to supervision and examination by FHA, VA, RHS, FNMA, FHLMC, GNMA and HUD at all times to ensure compliance with the applicable regulations, policies and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act, the Real Estate Settlement Procedures Act and the regulations promulgated thereunder which, among other things, prohibit discrimination and require the disclosure of certain basic information to mortgagors concerning credit terms and settlement costs.

The Dodd-Frank Act included certain provisions that, upon the approval of final regulations, create certain new standards for residential mortgage lenders. The principal restrictions are the following: (i) prohibits mortgage lenders and brokers from giving or receiving compensation that varies based on loan terms other than the principal amount of the loan (this prohibition effectively eliminates yield spread premiums); (ii) requires mortgage lenders to determine that the consumer has the reasonable ability to repay the loan according to its terms based upon a variety of factors (including credit history, current income, expected income, and current obligations); and (iii) creates a safe harbor for mortgage lenders with respect to “qualified mortgages” (a “qualified mortgage” is a mortgage that meets the following requirements: term does not exceed 30 years, the consumer may not defer the payment of principal, points and fees may not exceed 3% of the amount of the loan, negative amortization is not allowed, and no balloon payments are permitted except under certain circumstances). The Federal Reserve issued on April 19, 2011 a proposed rule under Regulation Z that would implement these requirements of the Dodd-Frank Act. The Federal Reserve noted that this rulemaking would be finalized by the Bureau rather than the Federal Reserve because rulemaking authority under Regulation Z was transferred to the Bureau on July 21, 2011.

Puerto Rico Regulation

Doral Mortgage and Doral Financial are licensed by the by the Office of the Commissioner of Financial Institutions of Puerto Rico (the “Office of the Commissioner”) as mortgage banking institutions. Such

 

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authorization to act as mortgage banking institutions must be renewed as of December 1 of each year. In the past, Doral Financial and its subsidiaries have not had any difficulty in renewing their authorizations to act as mortgage banking institutions and management is unaware of any existing practices, conditions or violations which would result in Doral Financial being unable to receive such authorization in the future. Doral Financial is also subject to regulation by the Office of the Commissioner, with respect to, among other things, maximum origination fees and prepayment penalties on certain types of mortgage loan products.

Doral Financial’s operations in the mainland United States are subject to regulation by state regulators in the states in which it conducts a mortgage loan business.

Effective in April 2011, Act No. 247 of 2010 became effective as the new law to regulate the business of mortgage loans in Puerto Rico and the licensing of persons and entities involved in making mortgage loans in Puerto Rico. Act No. 247 repealed the Puerto Rico Mortgage Banking Institutions Law of 1973, as amended. Act No. 247 requires the prior approval of the Office of the Commissioner for the acquisition of control of any mortgage banking institution licensed under such law. For purposes of Act No. 247, the term “control” means the power to direct or influence decisively, directly or indirectly, the management or policies of a mortgage banking institution. Act No. 247 provides that a transaction that results in the holding of less than 10% of the outstanding voting securities of a mortgage banking institution shall not be considered a change of control. Pursuant to Section 3.10 of the Act No. 247, upon receipt of notice of a proposed transaction that may result in a change of control, the Office of the Commissioner is obligated to make such investigations as it deems necessary to review the transaction.

On July 30, 2008, President Bush signed into law the Housing and Economic Recovery Act of 2008 (the “Housing Recovery Act”). Title V of the Housing Recovery Act, entitled The Secure and Fair Enforcement Mortgage Licensing Act of 2008 (“SAFE Act”), recognizes and builds on states’ efforts by requiring all mortgage loan originators, regardless of the type of entity they are employed by, to be either state-licensed or federally-registered. Under the SAFE Act, all states (including the Commonwealth of Puerto Rico) must implement a mortgage originator licensing process that meets certain minimum standards and must license mortgage originators through a Nationwide Mortgage Licensing System and Registry (the “NMLS”). As a result of this federal legislation, the Office of the Commissioner announced that it would begin accepting submissions through NMLS on April 2, 2009 and that all mortgage lenders/servicers or mortgage brokers operating in Puerto Rico were required to be duly registered through the NMLS commencing June 1, 2009. In terms of federal registrations, on January 31, 2011 the FDIC and other federal banking agencies issued a notice stating that the initial registration period for federal registrations of employees of banks and savings associations ran from January 31, 2011 to June 29, 2011. This Federal registration is required by the SAFE Act for employees of banks and savings associations that act as originators of residential mortgage loans and will also be accomplished through the NMLS.

Banking Activities

Federal Regulation

General

Doral Financial is a bank holding company subject to supervision and regulation by the Federal Reserve under the Bank Holding Company Act of 1956 (the “BHC Act”), as amended by the Gramm-Leach-Bliley Act of 1999 (the “Gramm-Leach-Bliley Act”). As a bank holding company, Doral Financial’s activities and those of its banking and non-banking subsidiaries are limited to banking activities and such other activities the Federal Reserve has determined to be closely related to the business of banking. Under the Gramm-Leach-Bliley Act, financial holding companies can engage in a broader range of financial activities than bank holding companies. Given the difficulties faced by Doral Financial following the restatement of its audited financial statements for the period from January 1, 2000 to December 31, 2004, the Company filed a notice with the Federal Reserve withdrawing its election to be treated as a financial holding company, which became effective on January 8, 2008. See “— Financial Modernization Legislation” below for a description of the expanded powers of financial holding companies. The withdrawal of its election to be treated as a financial holding company has not adversely affected and is not expected to adversely affect Doral Financial’s current operations, all of which are permitted

 

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for bank holding companies that have not elected to be treated as financial holding companies. Specifically, Doral Financial is authorized to engage in insurance agency activities in Puerto Rico pursuant to Regulation K promulgated by the Federal Reserve under the BHC Act. Under the BHC Act, Doral Financial may not, directly or indirectly, acquire the ownership or control of more than 5% of any class of voting shares of a bank or another bank holding company without the prior approval of the Federal Reserve.

Doral Bank is subject to supervision and examination by applicable federal and state banking agencies, including the FDIC and the Office of the Commissioner. Doral Bank is subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of other investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of Doral Financial’s banking and other subsidiaries. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve as it attempts to control the money supply and credit availability in order to influence the economy.

Federal and state banking laws grant substantial enforcement power to federal and state banking regulators. The enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities. On March 16, 2006, the Company and Doral Bank entered into consent orders with the Federal Reserve, the FDIC and the Office of the Commissioner. On January 14, 2008, the FDIC and the Office of the Commissioner jointly released Doral Bank from the March 16, 2006 consent order. The consent order between the Company and the Federal Reserve remains in effect. Please refer to Part I, Item 3, Legal Proceedings for additional information regarding regulatory enforcement matters.

Doral Financial’s banking and other subsidiaries are subject to certain regulations promulgated by the Federal Reserve including, but not limited to, Regulation B (Equal Credit Opportunity Act), Regulation DD (Truth in Savings Act), Regulation E (Electronic Funds Transfer Act), Regulation F (Limits on Exposure to Other Banks), Regulation Z (Truth-in-Lending Act), Regulation CC (Expedited Funds Availability Act), Regulation X (Real Estate Settlement Procedures Act), Regulation BB (Community Reinvestment Act) and Regulation C (Home Mortgage Disclosure Act). In general terms, these regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers in taking deposits and making loans. Doral Financial’s banking and other subsidiaries must comply with the applicable provisions of these regulations as part of their ongoing customer relations.

As mentioned above, the Dodd-Frank Act transferred rulemaking authority for number of consumer financial protection laws from the Federal Reserve and other federal agencies to the Consumer Financial Protection Bureau (the “Bureau”) as of July 21, 2011. During the last quarter of 2011, the Bureau commenced the process of republishing the regulations implementing these laws with technical and conforming changes to reflect the transfer of authority and certain other changes made by the Dodd-Frank Act. For example, the Bureau issued interim final rules that became effective on December 30, 2011 establishing the following new regulations: Regulation X (Real Estate Settlement Procedures Act), Regulation P (Privacy of Consumer Information), Regulation DD (Truth in Savings Act), Regulation V (Fair Credit Reporting Act), Regulation B (Equal Credit Opportunity Act), Regulation Z (Truth in Lending Act), and Regulation E (Electronic Funds Transfer Act). In general terms, the interim final rules substantially mirror the existing regulations being substituted and impose no new substantive obligations on the regulated entities.

Holding Company Structure

Doral Bank, as well as any other insured depository institution subsidiary organized by Doral Financial in the future, is subject to restrictions under federal law that governs transactions with Doral Financial or other non-banking subsidiaries of Doral Financial, whether in the form of loans, other extensions of credit, investments or asset purchases. Such transactions by Doral Bank with Doral Financial, or with any one of Doral Financial’s non-banking subsidiaries, are limited in amount to 10% of Doral Bank’s capital stock and surplus and, with respect to Doral Financial and all of its non-banking subsidiaries, to an aggregate of 20% of Doral Bank’s capital stock and surplus. Please refer to Transactions with Affiliates and Related Parties, below.

 

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Under Federal Reserve policy, which has been codified by the Dodd-Frank Act, a bank holding company such as Doral Financial is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each such subsidiary bank. This support may be required at times when, absent such policy, the bank holding company might not otherwise provide such support. In furtherance of this policy, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution of the bank holding company. Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiary if the bank regulatory authority determines that divestiture may aid the depository institution’s financial condition.

In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company’s reorganization in a Chapter 11 bankruptcy proceeding, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary depository institution will be assumed by the bankruptcy trustee and entitled to priority of payment.

As a bank holding company, Doral Financial’s right to participate in the assets of any subsidiary upon the latter’s liquidation or reorganization will be subject to the prior claims of the subsidiary’s creditors (including depositors in the case of depository institution subsidiaries), except to the extent that Doral Financial may itself be a creditor with recognized claims against the subsidiary.

Under the Federal Deposit Insurance Act (the “FDIA”), a depository institution, such as Doral Bank, the deposits of which are insured by the FDIC, can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution; or (ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured depository institution “in danger of default.” “Default” is defined generally as the appointment of a conservator or a receiver and “in danger of default” is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. In some circumstances (depending upon the amount of the loss or anticipated loss suffered by the FDIC), cross-guarantee liability may result in the ultimate failure or insolvency of one or more insured depository institutions in a holding company structure. Any obligation or liability owed by a subsidiary depository institution to its parent company is subordinated to the subsidiary bank’s cross-guarantee liability with respect to commonly controlled insured depository institutions.

On December 20, 2011 the Federal Reserve issued a proposed rule to strengthen regulation and supervision of large bank holding companies and systemically important nonbank financial firms. The proposed rule, which includes a wide range of measures addressing issues such as capital, liquidity, credit exposure, stress testing, risk management and early remediation requirements, is mandated by the Dodd-Frank Act. The proposed rule applies to all US bank holding companies with consolidated assets of $50 billion or more and any nonbank financial companies designated by the Financial Stability Oversight Council as systemically important nonbank financial companies.

The proposed requirement to conduct annual stress tests would apply to any financial company with more than $10 billion in total consolidated assets that is regulated by a primary federal financial regulatory authority. The proposed rule also states that the Federal Reserve may determine that any bank holding company, which is not a covered company under the proposed rule, shall be subject to one or more of the standards established under the proposed rule if the Federal Reserve determines that doing so is necessary or appropriate to promote the safety and soundness of such bank holding company or to promote financial stability. The Federal Reserve is proposing that covered firms would need to comply with many of the enhanced standards a year after they are finalized, and that the requirements relating to stress testing to take effect shortly after the proposed rule is finalized.

On January 17, 2012, the FDIC issued a proposed rule that would require certain large depository institutions to conduct annual capital adequacy stress tests. The proposed rule, which implements a requirement of the Dodd-Frank Act, would apply to state nonmember banks with total consolidated assets of more than $10 billion. The proposed rule defines “stress test” as a process to assess the potential impact of economic and

 

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financial conditions on the consolidated earnings, losses and capital of a bank over a set planning horizon, taking into account the current condition of the bank and its risks, exposures, strategies, and activities.

Financial Modernization Legislation

As discussed above, on January 8, 2008, Doral Financial withdrew its election to be treated as a financial holding company. Under the Gramm-Leach-Bliley Act, bank holding companies, all of whose depository institutions are “well capitalized” and “well managed,” as defined in the BHC Act, and which obtain satisfactory Community Reinvestment Act ratings, may elect to be treated as financial holding companies (“FHCs”). FHCs are permitted to engage in a broader spectrum of activities than those permitted to other bank holding companies. FHCs can engage in any activities that are “financial” in nature, including insurance underwriting and brokerage, and underwriting and dealing in securities without a revenue limit or other limits applicable to foreign securities affiliates (which include Puerto Rico securities affiliates for these purposes). As noted above, the withdrawal of financial holding company status has not adversely affected and is not expected to adversely affect Doral Financial’s current operations.

The Gramm-Leach-Bliley Act also modified other laws, including laws related to financial privacy and community reinvestment. The new financial privacy provisions generally prohibit financial institutions; including Doral Financial’s mortgage banking and banking subsidiaries, from disclosing non-public personal financial information to third parties unless customers have the opportunity to “opt out” of the disclosure.

Sarbanes-Oxley Act

The Sarbanes-Oxley Act of 2002 (“SOX”) implemented a range of corporate governance and accounting measures to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the adequacy and reliability of disclosures under federal securities laws. In addition, SOX established membership requirements and responsibilities for the audit committee, imposed restrictions on the relationship between the Company and external auditors, imposed additional responsibilities for the external financial statements on the chief executive officer and chief financial officer, expanded the disclosure requirements for corporate insiders, required management to evaluate its disclosure controls and procedures and its internal control over financial reporting, and required the auditors to issue a report on the internal control over financial reporting.

Since the 2004 Annual Report on Form 10-K, the Company has included in its annual report on Form 10-K its management’s assessment regarding the effectiveness of the Company’s internal control over financial reporting. The internal control report includes a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the Company, management’s assessment as to the effectiveness of the Company’s internal control over financial reporting based on management’s evaluation as of year-end; and the frame work used by management as criteria for evaluating the effectiveness of the Company’s internal control over financial reporting.

Capital Adequacy

Under the Federal Reserve’s risk-based capital guidelines for bank holding companies, the minimum guidelines for the ratio of qualifying total capital (“Total Capital”) to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. At least half of Total Capital is to be comprised of common equity, retained earnings, minority interests in unconsolidated subsidiaries, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, in the case of a bank holding company, less goodwill and certain other intangible assets discussed below (“Tier 1 Capital”). The remainder may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan and lease loss reserves (“Tier 2 Capital”).

In computing total risk-weighted assets, bank and bank holding company assets are given risk-weights of 0%, 20%, 50% and 100% (certain non-investment grade mortgage-backed securities and residual interests have risk-weights of 200%). In addition, certain off-balance sheet items are given similar credit conversion factors to convert them to asset equivalent amounts to which an appropriate risk-weight will apply. Most loans will be

 

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assigned to the 100% risk category, except for performing first mortgage loans fully secured by 1- to 4-family and certain multi-family residential property, which carry a 50% risk rating. Most investment securities (including, primarily, general obligation claims on states or other political subdivisions of the United States) will be assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% risk-weight, and direct obligations of the U.S. Treasury or obligations backed by the full faith and credit of the U.S. Government, which have a 0% risk-weight. In covering off-balance sheet items, direct credit substitutes, including general guarantees and standby letters of credit backing financial obligations, are given a 100% risk factor. Transaction-related contingencies such as bid bonds, standby letters of credit backing non-financial obligations, and undrawn commitments (including commercial credit lines with an initial maturity of more than one year) have a 50% risk factor. Short-term commercial letters of credit are converted at 20% and certain short-term unconditionally cancelable commitments have a 0% factor.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to total assets, less goodwill and certain other intangible assets (the “Leverage Ratio”) of 3% for bank holding companies that have the highest regulatory rating or have implemented the Federal Reserve’s market risk capital measure. All other bank holding companies are required to maintain a minimum Leverage Ratio of 4%. The guidelines also provide that banking organizations experiencing significant internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 Leverage Ratio” and other indicators of capital strength in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage ratio is the ratio of a banking organization’s Tier 1 Capital, less all intangibles, to average total assets, less all intangibles.

The FDIC has established regulatory capital requirements for state non-member insured banks, such as Doral Bank, that are substantially similar to those adopted by the Federal Reserve for bank holding companies.

On March 17, 2006, Doral Financial entered into a consent order with the Federal Reserve, pursuant to which Doral Financial submitted a capital plan in which it established a target minimum leverage ratio of 5.5% for Doral Financial and 6.0% for Doral Bank. Please refer to Part I, Item 3 Legal Proceedings for additional information regarding Doral Financial’s regulatory matters.

Set forth below are Doral Financial’s and Doral Bank’s capital ratios at December 31, 2011, based on existing Federal Reserve and FDIC guidelines:

 

      Doral
Financial
    Doral
Bank  (2)
    Well
Capitalized
Minimum
 

Total capital ratio (total capital to risk weighted assets)

     13.4     14.3     10.0

Tier 1 capital ratio (Tier 1 capital to risk weighted assets)

     12.2     13.0     6.0

Leverage ratio (1)

     9.1     8.6     5.0

 

(1) 

Tier 1 capital to average assets.

(2) 

Doral Bank’s capital ratios include Doral Bank’s U.S. operations figures pursuant to the merger transaction completed on October 1, 2011.

As of December 31, 2011, Doral Bank was in compliance with all the regulatory capital requirements that were applicable to it as a state non-member bank. Please refer to Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, “— Regulatory Capital Ratios” for additional information regarding Doral Financial’s regulatory capital ratios.

As of December 31, 2011, Doral Bank was considered a well-capitalized bank for purposes of prompt corrective action regulations adopted by the FDIC pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991. During the second and third quarters of 2010, the Board of Directors of Doral Financial approved capital contributions to Doral Bank totaling $194.0 million. During 2011 no capital contributions were made by Doral Financial to Doral Bank.

 

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Failure to meet minimum regulatory capital requirements could result in the initiation of certain mandatory and additional discretionary actions by banking regulators against Doral Financial and its banking subsidiary that, if undertaken, could have a material adverse effect on Doral Financial, such as a variety of enforcement remedies, including, with respect to an insured bank, the termination of deposit insurance by the FDIC, and to certain restrictions on its business. See “FDICIA” below.

Under the Dodd-Frank Act, federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards will be no lower than current regulatory capital and leverage standards currently applicable to insured depository institutions and may, in fact, be higher when established by the federal banking agencies. The FDIC and other federal banking agencies issued a joint notice on June 14, 2011 adopting a final rule that establishes a floor for the risk-based capital requirements applicable to the largest, internationally active banking organizations.

Basel Capital Standards

The current risk-based capital guidelines are based upon the 1988 capital accord of the International Basel Committee on Banking Supervision, a committee of central banks and bank supervisors and regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. A new international accord, referred to as Basel II, became mandatory for large or “core” international banks outside the U.S. in 2008 (total assets of $250 billion or more or consolidated foreign exposures of $10 billion or more) and emphasizes internal assessment of credit, market and operational risk, as well as supervisory assessment and market discipline in determining minimum capital requirements. It is optional for other banks. In September 2010, the Group of Governors and Heads of Supervisors of the Basel Committee on Banking Supervision, the oversight body of the Basel Committee, published its “calibrated” capital standards for major banking institutions, referred to as Basel III. Under these standards, when fully phased-in on January 1, 2019, banking institutions will be required to maintain heightened Tier 1 common equity, Tier 1 capital, and total capital ratios, as well as maintaining a “capital conservation buffer.” The Tier 1 common equity and Tier 1 capital ratio requirements will be phased-in incrementally between January 1, 2013 and January 1, 2015; the deductions from common equity made in calculating Tier 1 common equity will be phased-in incrementally over a four-year period commencing on January 1, 2014; and the capital conservation buffer will be phased-in incrementally between January 1, 2016 and January 1, 2019. The Basel Committee also announced that a countercyclical buffer of 0% to 2.5% of common equity or other fully loss-absorbing capital will be implemented according to national circumstances as an extension of the conservation buffer.

The U.S. banking agencies have not yet proposed regulations implementing Basel III. Notwithstanding the release of the Basel III framework as a final framework, the Basel Committee is considering further amendments to Basel III. In addition to Basel III, Dodd-Frank Act requires or permits the Federal banking agencies to adopt regulations affecting the capital requirements of financial institutions in a number of respects, including potentially more stringent capital requirements. The ultimate impact on Doral Financial and Doral Bank of the new capital and liquidity standards that may be adopted cannot be determined at this time and will depend on a number of factors, including the final regulatory actions taken by Federal banking regulators. However, any requirement that Doral Financial and Doral Bank maintain more capital, with common equity as a more predominant component, or meet new liquidity requirements, could significantly affect our financial condition, operations, capital position and ability to pursue certain business opportunities.

Prompt Corrective Action under FDICIA

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 and the regulations promulgated thereunder (“FDICIA”), federal banking regulators must take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. FDICIA and the regulations thereunder, establish five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” A depository institution is deemed to be well capitalized if it maintains a Leverage Ratio of at least 5%, a risk-based Tier 1 capital ratio of at least 6% and a risk-based Total Capital ratio of at least 10%, and is not subject to any written agreement or regulatory directive

 

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to meet a specific capital level. A depository institution is deemed to be adequately capitalized if it is not well capitalized but maintains a Leverage Ratio of at least 4% (or at least 3% if given the highest regulatory rating and not experiencing or anticipating significant growth), a risk-based Tier l capital ratio of at least 4% and a risk-based Total Capital ratio of at least 8%. A depository institution is deemed to be undercapitalized if it fails to meet the standards for adequately capitalized institutions (unless it is deemed to be significantly or critically undercapitalized). An institution is deemed to be significantly undercapitalized if it has a Leverage Ratio of less than 3%, a risk-based Tier 1 capital ratio of less than 3% or a risk-based Total Capital ratio of less than 6%. An institution is deemed to be critically undercapitalized if it has tangible equity equal to 2% or less of total assets. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives a less than satisfactory examination rating in any one of four categories.

At December 31, 2011, Doral Bank’s capital exceeded the well capitalized standards. Doral Bank’s capital categories, as determined by applying the prompt corrective action provisions of FDICIA, may not constitute an accurate representation of the overall financial condition or prospects of Doral Bank, and should be considered in conjunction with other available information regarding Doral Bank’s financial condition and results of operations.

FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution’s holding company must guarantee the capital plan, up to an amount equal to the lesser of (i) 5% of the depository institution’s assets at the time it becomes undercapitalized or (ii) the amount of the capital deficiency when the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. If a depository institution fails to submit an acceptable plan, it is treated as if it were significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.

The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions such as Doral Bank, but they are not directly applicable to bank holding companies, such as Doral Financial, which control such institutions. However, federal banking agencies have indicated that, in regulating bank holding companies, they may take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed upon subsidiary insured depository institutions pursuant to such provisions and regulations.

Interstate Banking

Effective June 1, 1997, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”) amended the FDIA and certain other statutes to permit state and national banks with different home states to merge across state lines, with the approval of the appropriate federal banking agency, unless the home state of a participating bank had passed legislation prior to May 31, 1997, expressly prohibiting interstate mergers. Under the Riegle-Neal Act amendments, once a state or national bank has established branches in a state, that bank may establish and acquire additional branches at any location in the state at which any bank involved in the interstate merger transaction could have established or acquired branches under applicable federal or state law. If a state opts out of interstate branching within the specified time period, no bank in any other state may establish a branch in the state which has opted out, whether through an acquisition or de novo.

Under the Dodd-Frank Act, national banks and state banks are now able to establish branches in any state if that state would permit the establishment of the branch by a state bank chartered in that state. The amendments now permit a state bank from any state to branch into any other state as if such bank were chartered in that state.

 

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Dividend Restrictions

The Company is subject to certain restrictions generally imposed on Puerto Rico corporations with respect to the declaration and payment of dividends (i.e., that dividends may be paid out only from the Company’s net assets in excess of capital or, in the absence of such excess, from the Company’s net earnings for such fiscal year and/or the preceding fiscal year). The Federal Reserve Board has also issued a policy statement that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fund fully the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.

On February 24, 2009, the Federal Reserve published a supervisory letter on “Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies” (the “Supervisory Letter”), which discusses the ability of bank holding companies to declare dividends and to redeem or repurchase equity securities. The Supervisory Letter is generally consistent with prior Federal Reserve supervisory policies and guidance, although it places greater emphasis on discussions with the regulators prior to dividend declarations and redemption or repurchase decisions even when not explicitly required by the regulations. The Federal Reserve provides that the principles discussed in the letter are applicable to all bank holding companies, but are especially relevant for bank holding companies that are experiencing financial difficulties.

The Supervisory Letter provides that a board of directors should “eliminate, defer, or severely limit” dividends if: (i) the bank holding company’s net income available to shareholders for the past four quarters, net of dividends paid during that period, is not sufficient to fully fund the dividends; (ii) the bank holding company’s rate of earnings retention is inconsistent with capital needs and overall macroeconomic outlook; or (iii) the bank holding company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Supervisory Letter further suggests that bank holding companies should inform the Federal Reserve in advance of paying a dividend that: (i) exceeds the earnings for the quarter in which the dividend is being paid; or (ii) could result in a material adverse change to the organization’s capital structure.

The payment of dividends to Doral Financial by Doral Bank may be affected by regulatory requirements and policies, such as the maintenance of adequate capital. If, in the opinion of the applicable regulatory authority, a depository institution under its jurisdiction is engaged in, or is about to engage in, an unsafe or unsound practice, (depending on the financial condition of the depository institution, could include the payment of dividends), such authority may require, after notice and hearing, that such depository institution cease and desist from such practice.

The FDIC has indicated that the payment of dividends would constitute unsafe and unsound practice if the payment would deplete a depository institution’s capital base to an inadequate level. Moreover, the FDIC has issued a policy statement that generally provides that insured banks should generally pay dividends only out of current operating earnings. In addition, all insured depository institutions are subject to the capital-based limitations required by FDICIA. Please refer to “-FDICIA” above for additional information.

On March 16, 2006, Doral Financial and Doral Bank entered into consent orders with the Federal Reserve, the FDIC and the Office of the Commissioner. The mutually agreed upon orders prohibit Doral Bank from paying dividends to Doral Financial without obtaining prior written approval from the FDIC and Federal Reserve, and the Federal Reserve Order prohibits Doral Financial from paying dividends to its stockholders without the prior written approval of the Federal Reserve. The FDIC and the Office of the Commissioner lifted their consent order on January 14, 2008. The consent order with the Federal Reserve remains in effect.

Please refer to “Regulation and Supervision — Banking Activities — Puerto Rico Regulation,” below, for a description of certain restrictions on Doral Bank’s ability to pay dividends under Puerto Rico law.

FDIC Insurance Assessments

The deposits of Doral Bank are insured by the Deposit Insurance Fund (DIF) of the FDIC, and are therefore subject to FDIC deposit insurance assessments.

 

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As mentioned above, the Dodd-Frank Act permanently raised the basic limit on deposit insurance by the FDIC from $100,000 to $250,000. The coverage limit is per depositor, per insured depository institution for each account ownership category. The Dodd-Frank Act also set a new minimum DIF reserve ratio at 1.35% of estimated insured deposits. The FDIC is required to attain this ratio by September 30, 2020. In December 2010, the FDIC approved a final rule raising its industry target ratio of reserves to insured deposits to 2%, 65 basis points above the statutory minimum, but the FDIC does not project that goal to be met until 2027.

In addition, the Dodd-Frank Act will have a significant impact on the calculation of deposit insurance assessment premiums going forward. Specifically, the Dodd-Frank Act generally requires the FDIC to define the deposit insurance assessment base for an insured depository institution as an amount equal to the institution’s average consolidated total assets during the assessment period minus average tangible equity. The FDIC issued a final rule that implements this change to the assessment calculation on February 7, 2011, but has said that the new assessment rate schedule should result in the collection of assessment revenue that is approximately revenue neutral (although the amounts that individual depository institutions will pay may change) even though the new assessment base under the Dodd-Frank Act is larger than the current assessment base. As presently done under the previous rule, the assessment rate of a depository institution will be determined according to its supervisory ratings and capital levels, with adjustments for the depository institution’s unsecured debt and brokered deposits. The deposit insurance rates for depository institutions under the new rule range from 2.5 to 45 basis points per $100 of the assessment base (average consolidated assets minus average tangible equity).

The new rule became effective for the quarter beginning April 1, 2011, and was reflected in the June 30, 2011 fund balance and the invoices for assessments due September 30, 2011. The FDIC rule also provides the FDIC’s board with the flexibility to adopt actual rates that are higher or lower than the total base assessment rates adopted without notice and comment, if certain conditions are met.

Under the previous rule, the amount of the assessment was a function of the institution’s risk category, of which there are four, and the assessment base. An institution’s risk category was determined according to its supervisory ratings and capital levels and was used to determine the institution’s assessment rate. The assessment rate for risk categories was calculated according to a formula, which relied on supervisory ratings and either financial ratios or long-term debt ratings. An insured bank’s assessment base was determined by the balance of its insured deposits. Because the system was risk-based, it allowed banks to pay lower assessments to the FDIC as their capital levels and supervisory ratings improve. By the same token, if these indicators deteriorate, the institution would have to pay higher assessments to the FDIC. Under the previous rule, deposit insurance rates for depository institutions ranged from 7 to 77.5 basis points per $100 of assessable deposits based upon assessment rates that were calculated based upon the depository institution’s risk rating as adjusted by its levels of unsecured debt, secured liabilities, and brokered deposits.

Under the FDIA, the FDIC also has the authority to impose special assessments upon insured depository institutions when deemed necessary by the FDIC’s board. The FDIC adopted a final rule, in May 2009, effective June 30, 2009, that imposed a special assessment of five cents for every $100 on each insured depository institution’s assets minus its Tier 1 capital as of June 30, 2009, subject to a cap equal to 10 cents per $100 of assessable deposits for the second quarter of 2009.

On November 12, 2009, the FDIC adopted the final rule implementing a prepayment assessment for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 in order to strengthen the cash position of the DIF. Our total prepaid assessment was $67.1 million, which according to the final rule was recorded as a prepaid expense as of December 30, 2009. The prepaid assessment will be amortized and recognized by Doral Financial as an expense over the period from 2010 to 2012. As of December 31, 2011 the amortized balance of the prepaid assessment was $29.6 million.

The Deposit Insurance Funds Act of 1996 separated the Financing Corporation assessment to service the interest on its bond obligations from the DIF assessments. The amount assessed on individual institutions by the Financing Corporation is in addition to the amount, if any, paid for deposit insurance according to the FDIC’s risk-related assessment rate schedules. The current Financing Corporation annual assessment rate is $0.0102 to

 

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$0.01004 cents per $100 of deposits. These assessments will continue until the Financing Corporation bonds mature in 2019.

As of December 31, 2011, Doral Bank had an FDIC-insurance assessment base of approximately $6.7 billion.

Temporary FDIC Insurance of Non-Interest Bearing Transaction Accounts

The Dodd-Frank Act amended the FDIA to fully insure the amounts deposited in non-interest bearing transaction accounts at all insured depository institutions from December 31, 2010 until December 31, 2012. This amendment became effective on December 31, 2010, which was the date that the FDIC’s former Transaction Account Guarantee (“TAG”) Program terminated. The new program applies to all insured depository institutions, while the TAG Program applied to only to insured depository institutions that opted in (Doral Bank had opted in to the TAG Program). Under the new program, low-interest checking (NOW) accounts will no longer be eligible for unlimited deposit insurance. This unlimited insurance coverage for non-interest bearing transaction accounts is separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution. FDIC-insured depository institutions are not permitted to opt out of this temporary insurance program and the FDIC will not charge a separate assessment for this coverage.

Community Reinvestment

Under the Community Reinvestment Act (“CRA”), each insured depository institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to help meet the credit needs of its entire community, including low-and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for such institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires each federal banking agency, in connection with its examination of an insured depository institution, to assess and assign one of four ratings to the institution’s record of meeting the credit needs of its community and to take such records into account in its evaluation of certain applications by the institution, including application for charters, branches and other deposit facilities, relocations, mergers, consolidations, and acquisitions of assets or assumptions of liabilities. The CRA also requires that all institutions make public disclosure of their CRA ratings. Doral Bank received a rating of satisfactory as of the most recent CRA report of the FDIC.

Safety and Soundness Standards

Section 39 of the FDIA, as amended by FDICIA, requires each federal banking agency to prescribe for all insured depository institutions that it supervises safety and soundness standards relating to internal control, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits and such other operational and managerial standards as the federal banking agency deems appropriate. If an insured depository institution fails to meet any of the standards described above, it may be required to submit to the appropriate federal banking agency a plan specifying the steps that will be taken to cure the deficiency. If the depository institution fails to submit an acceptable plan or fails to implement the plan, the appropriate federal banking agency will require the depository institution to correct the deficiency and, until it is corrected, may impose other restrictions on the depository institution, including any of the restrictions applicable under the prompt corrective action provisions of the FDICIA.

The FDIC and other federal banking agencies have adopted Interagency Guidelines Establishing Standards for Safety and Soundness that, among other things, set forth standards relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, employee compensation and benefits, asset growth and earnings.

Interagency Appraisal and Evaluation Guidelines

In December 2010, the federal banking agencies issued the Interagency Appraisal and Evaluation Guidelines. This guidance, which updated guidance originally issued in 1994, sets forth the minimum regulatory

 

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standards for appraisals. In incorporates previous regulatory issuances affecting appraisals, addresses advances in information technology used in collateral evaluation, and clarifies standards for use of analytical methods and technological tools in developing evaluations. This guidance also requires institutions to utilize strong internal controls to ensure reliable appraisals and evaluations and periodically update valuations of collaterals for existing real estate loans and transactions.

Brokered Deposits

FDIC regulations adopted under FDICIA govern the receipt of brokered deposits by insured depository institutions. Under these regulations, a bank cannot accept, roll over or renew brokered deposits (which term is defined also to include any deposit with an interest rate more than 75 basis points above certain prevailing rates specified by regulation) unless (i) it is well capitalized, or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that is adequately capitalized may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized. Doral Financial does not believe the brokered deposits regulation has had or will have a material effect on the funding or liquidity of Doral Bank, which is currently a well-capitalized institution. As of December 31, 2011 and 2010, Doral Bank had a total of approximately $2.2 billion and $2.4 billion of brokered deposits, respectively. Doral Bank generally uses brokered deposits as a less costly source of funding.

Federal Home Loan Bank System

Doral Bank is a member of the Federal Home Loan Bank (“FHLB”) system. The FHLB system consists of twelve regional Federal Home Loan Banks governed and regulated by the Federal Housing Finance Agency. The Federal Home Loan Banks serve as reserve or credit facilities for member institutions within their assigned regions. They are funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system, and they make loans (advances) to members in accordance with policies and procedures established by the FHLB system and the board of directors of each regional FHLB.

Doral Bank is a member of the FHLB of New York (“FHLB-NY”) and as such is required to acquire and hold shares of capital stock in the FHLB-NY for a certain amount, which is calculated in accordance with the requirements set forth in applicable laws and regulations. Doral Bank is in compliance with the stock ownership requirements of the FHLB-NY. All loans, advances and other extensions of credit made by the FHLB-NY to Doral Bank are secured by a portion of Doral Bank’s mortgage loan portfolio, certain other investments and the capital stock of the FHLB-NY held by Doral Bank.

Activity restrictions on state-chartered banks; Volcker Rule

Section 24 of the FDIA, as amended by FDICIA, generally provides that state-chartered banks and their subsidiaries are limited in their investments and activities engaged in as principal to those permissible under state law and that are permissible to national banks and their subsidiaries, unless such investments and principal activities are specifically permitted by the FDIA or the FDIC determines that such activity or investment would pose no significant risk to the DIF and the banks are, and continue to be, in compliance with applicable capital standards. Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity.

In October 2011, the FDIC and other banking and securities agencies jointly issued a proposed rule implementing the so-called “Volcker Rule” requirements of Section 619 of the Dodd-Frank Act. Section 619 prohibits (i) insured depository institutions, bank holding companies and their affiliates and subsidiaries from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments, subject to certain exceptions, and (ii) insured depository institutions, bank holding companies and their affiliates and subsidiaries from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exceptions. The Dodd-Frank Act also prohibits banking entities from entering into any transaction or engaging in any activity that would (i) involve or result in a material conflict of interest, (ii) result in a material exposure to high-risk assets or high-risk trading strategies, (iii) pose a threat to the safety or soundness of the banking entity, or (iv) pose a threat to the financial stability of the United States. The proposed

 

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rule clarifies the scope of the Dodd-Frank Act’s prohibitions and, as contemplated by the statute, provides certain exceptions to these prohibitions. The proposed rule would require banking entities to establish an internal compliance program that is designed to ensure and monitor compliance with the Dodd-Frank Act’s prohibitions and restrictions.

USA Patriot Act of 2001

On October 26, 2001, the President of the United States signed into law comprehensive anti-terrorism legislation known as the USA PATRIOT Act of 2001 (the “USA Patriot Act”). Title III of the USA Patriot Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department (“Treasury”) has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions, including Doral Bank. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.

Among other requirements, the USA Patriot Act and the related regulations require financial institutions to establish anti-money laundering programs that include, at a minimum:

 

   

internal policies, procedures and controls designed to implement and maintain the depository institution’s compliance with all of the requirements of the USA Patriot Act, the Bank Secrecy Act and related laws and regulations;

 

   

systems and procedures for monitoring and reporting of suspicious transactions and activities;

 

   

employee training;

 

   

an independent audit function to test the anti-money laundering program;

 

   

procedures to verify the identity of each customer upon the opening of accounts; and

 

   

heightened due diligence policies, procedures and controls applicable to certain foreign accounts and relationships.

Failure of a financial institution to comply with the USA Patriot Act’s requirements could have serious legal and reputational consequences for the institution. Doral Financial believes that the cost of complying with Title III of the USA Patriot Act is not likely to be material to Doral Financial. Doral Bank was subject to a consent order with the FDIC relating to failure to comply with certain requirements of the Bank Secrecy Act. The order required Doral Bank, among other things, to engage an independent consultant to review account and transaction activity from April 1, 2006 through March 31, 2007 to determine compliance with suspicious activity reporting requirements (the “Look Back Review”). The FDIC terminated the consent order on September 15, 2008. Since the Look Back Review was still ongoing, Doral Bank and the FDIC agreed to a Memorandum of Understanding that covered the remaining portion of the Look Back Review. On June 30, 2009, Doral Bank received a notification letter from the FDIC terminating the Memorandum of Understanding because the Look Back Review had been completed.

Transactions with Affiliates and Related Parties

Transactions between Doral Bank and any of its affiliates (including Doral Financial) are governed by sections 23A and 23B of the Federal Reserve Act. These sections are important statutory provisions designed to protect a depository institution from transferring to its affiliates the subsidy arising from the institution’s access to the Federal safety net on deposits. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. Generally, section 23A (1) limits the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of the bank’s capital stock and surplus, and limit such transactions with all affiliates to an amount equal to 20% of the bank’s capital stock and surplus, and (2) requires that all such transactions be on terms that are consistent with safe and sound banking practices. The term “covered transactions” includes the making of loans, purchase of or

 

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investment in securities issued by the affiliate, purchase of assets, issuance of guarantees and other similar types of transactions. Most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100 to 130 percent of the loan amount, depending on the nature of the collateral. In addition, section 23B requires that any covered transaction by a bank with an affiliate and any sale of assets or provision of services to an affiliate must be on terms that are substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Regulation W of the Federal Reserve Board comprehensively implements sections 23A and 23B. The regulation unified and updated Federal Reserve Board staff interpretations issued over the years prior to its adoption, incorporated several interpretative proposals (such as to clarify when transactions with an unrelated third party will be attributed to an affiliate), and addressed issues arising as a result of the expanded scope of non-banking activities engaged in by banks and bank holding companies and authorized for financial holding companies under the Gramm-Leach-Bliley Act.

The Dodd-Frank Act also changed the definition of “covered transaction” in sections 23A and 23B and established limitations on asset purchases from insiders. With respect to the definition of “covered transaction,” the Dodd-Frank Act defines that term to include the acceptance of debt obligations issued by an affiliate as collateral for a bank’s loan or extension of credit to another person or company. In addition, a “derivative transaction” with an affiliate is now deemed to be a “covered transaction” to the extent that such a transaction causes a bank or its subsidiary to have a credit exposure to the affiliate. A separate provision of the Dodd-Frank Act states that an insured depository institution may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties, and (2) if the proposed transaction represents more than 10 % of the capital stock and surplus of the insured institution, it has been approved in advance by a majority of the institution’s non-interested directors.

Sections 22(g) and (h) of the Federal Reserve Act set forth restrictions on loans by a bank to its executive officers, directors, and principal shareholders. Regulation O of the Federal Reserve Board implements these provisions. Under Section 22(h) and Regulation O, loans to a director, an executive officer and to a greater than 10% shareholder of a bank and certain of their related interests (“insiders”), and insiders of its affiliates, may not exceed, together with all other outstanding loans to such person and related interests, the bank’s single borrower limit (generally equal to 15% of the institution’s unimpaired capital and surplus).

Section 22(h) and Regulation O also require that loans to insiders and to insiders of affiliates be made on terms substantially the same as offered in comparable transactions to other persons, unless the loans are made pursuant to a benefit or compensation program that (i) is widely available to employees of the bank and (ii) does not give preference to insiders over other employees of the bank. Section 22(h) and Regulation O also require prior board of directors’ approval for certain loans, and the aggregate amount of extensions of credit by a bank to all insiders cannot exceed the institution’s unimpaired capital and surplus. Furthermore, Section 22(g) and Regulation O place additional restrictions on loans to executive officers.

Puerto Rico Regulation

General

As a commercial bank organized under the laws of the Commonwealth of Puerto Rico, Doral Bank is subject to supervision, examination and regulation by the Office of the Commissioner, pursuant to the Puerto Rico Banking Act of 1933, as amended (the “Banking Law”). Doral Bank is required to file reports with the Office of the Commissioner and the FDIC concerning its activities and financial condition, and it must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and opening or acquiring branch offices. The Office of the Commissioner and the FDIC conduct periodic examinations to assess Doral Bank’s compliance with various regulatory requirements. The regulatory authorities have extensive discretion in connection with the exercise of their supervisory and enforcement authorities, including the setting of policies with respect to the classification of assets and the establishment of adequate loan and lease loss reserves for regulatory purposes.

 

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Doral Bank derives its lending, investment and other powers primarily from the applicable provisions of the Banking Law and the regulations adopted thereunder. The Banking Law also governs the responsibilities of directors and officers of Puerto Rico banks, and the corporate powers, lending, capital and investment requirements and other activities of Puerto Rico banks. The Office of the Commissioner has extensive rulemaking power and administrative discretion under the Banking Law, and generally examines Doral Bank on an annual basis.

Section 27 of the Banking Law requires that at least 10% of the yearly net income of Doral Bank be credited annually to a reserve fund until such fund equals 100% of total paid-in capital (preferred and common). As of December 31, 2011, Doral Bank’s reserve fund complied with the legal requirement.

Section 27 of the Banking Law also provides that when a bank suffers a loss, the loss must first be charged against retained earnings, and the balance, if any, must be charged against the reserve fund. If the balance of the reserve fund is not sufficient to cover the loss, the difference shall be charged against the capital account of the bank and no dividend may be declared until the capital has been restored to its original amount and the reserve fund to 20% of the original capital of the institution. This reserve fund is reflected in Doral Financial’s consolidated financial statements as “Legal Surplus.”

Section 16 of the Banking Law requires every bank to maintain a reserve requirement which shall not be less than 20% of its demand liabilities, other than government deposits (federal, state and municipal) secured by actual collateral. The Office of the Commissioner can, by regulation, increase the reserve requirement to 30% of demand deposits.

Section 17 of the Banking Law generally permits Doral Bank to make loans to any one person, firm, partnership or corporation, up to an aggregate amount of 15% of the paid-in capital and reserve fund of the bank and of such other components as the Office of the Commissioner may permit from time to time. The Office of the Commissioner has permitted the inclusion of up to 50% of retained earnings to banks classified as “1” composite rating and well capitalized. As of December 31, 2011, the legal lending limit for Doral Bank under this provision based solely on its paid-in capital and reserve fund was approximately $100.4 million. If such loans are secured by collateral worth at least 25% more than the amount of the loan, the aggregate maximum amount may reach one third of the paid-in capital of the bank, plus its reserve fund and such other components as the Office of Commissioner may permit from time to time. As of December 31, 2011, the lending limit for Doral Bank for loans secured by collateral worth at least 25% more than the amount of the loan was $223.1 million. There are no restrictions under Section 17 on the amount of loans that are wholly secured by bonds, securities and other evidences of indebtedness of the Government of the United States or the Commonwealth, or by current debt bonds, not in default, of municipalities or instrumentalities of the Commonwealth. There are also no restrictions under Section 17 on the amount of loans made by a Puerto Rico bank to the Government of the United States or the Commonwealth or to any municipality, instrumentality, authority or dependency of the United States or the Commonwealth.

Section 14 of the Banking Law authorizes Doral Bank to conduct certain financial and related activities directly or through subsidiaries, including finance leasing of personal property, making and servicing mortgage loans and operating a small-loan company.

The Finance Board, which is a part of the Office of the Commissioner, but also includes as its members the Secretary of the Treasury, the Secretary of Economic Development and Commerce, the Secretary of Consumer Affairs, the President of the Planning Board, the President of the Government Development Bank for Puerto Rico, the President of the Economic Development Bank, the Commissioner of Insurance and the President of the Corporation for the Supervision and Insurance of Puerto Rico Cooperatives, has the authority to regulate the maximum interest rates and finance charges that may be charged on loans to individuals and unincorporated businesses in the Commonwealth. The current regulations of the Finance Board provide that the applicable interest rate on loans to individuals and unincorporated businesses is to be determined by free competition. The Finance Board also has the authority to regulate the maximum finance charges on retail installment sales contracts and credit cards. Currently, there is no maximum interest rate that may be charged on installment sales contracts or credit cards.

 

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On March 16, 2006, Doral Financial and Doral Bank entered into consent orders with the Federal Reserve, the FDIC and the Office of the Commissioner. The mutually agreed upon orders require Doral Financial and Doral Bank to conduct reviews of their mortgage portfolios, and to submit plans regarding the maintenance of capital adequacy and liquidity. The consent orders also prohibit Doral Financial and any of its non-banking affiliates, directly or indirectly, from entering into, participating, or in any other manner engaging in any covered transactions with Doral Bank. The consent order from the Office of the Commissioner was lifted on January 14, 2008, in a joint action with the FDIC. The consent order with the Federal Reserve remains in effect.

IBC Act

On December 16, 2008, Doral Investment was organized to become a new subsidiary of Doral Bank. Doral Investment International was granted license by the Office of the Commissioner to operate as an international banking entity (“IBE”) under the Puerto Rico International Banking Center Regulatory Act (the “IBC Act”) on February 2, 2010, but is not currently operational. Doral Investment is subject to the supervision, examination and regulation by the Office of the Commissioner under the IBC Act.

Under the IBC Act, no sale, encumbrance, assignment, merger, exchange or transfer of shares, interest or participation in the capital of an IBE may be initiated without the prior approval of the Office of the Commissioner, if by such transaction a person would acquire, directly or indirectly, control of 10% or more of any class of stock, interest or participation in the capital of the IBE. The IBC Act and the regulations issued thereunder by the Office of the Commissioner limit the business activities that may be carried out in an IBE. Such activities are generally limited to persons and assets located outside of Puerto Rico. The IBC Act provides that every IBE must have not less than $300,000 in unencumbered assets or acceptable financial securities in Puerto Rico.

Pursuant to the IBC Act and the regulations issued thereunder by the Office of the Commissioner, an international banking entity has to maintain books and records of all of its transactions in the ordinary course of business. International banking entities are also required to submit quarterly and annual reports of their financial condition and results of operations to the Office of the Commissioner.

The IBC Act empowers the Office of the Commissioner to revoke or suspend, after notice and hearing, a license issued to an international banking entity if, among other things, such entity fails to comply with the IBC Act, the applicable regulation or the terms of the license, or if the Office of the Commissioner finds that the business and affairs of the international banking entity are conducted in a manner that is not consistent with the public interest.

Certain Regulatory Restrictions on Investments in Common Stock

Because of Doral Financial’s status as a bank holding company, owners of Doral Financial’s common stock are subject to certain restrictions and disclosure obligations under various federal laws, including the BHC Act. Regulations pursuant to the BHC Act generally require prior Federal Reserve approval for an acquisition of control of an insured institution (as defined) or holding company thereof by any person (or persons acting in concert). Control is deemed to exist if, among other things, a person (or persons acting in concert) acquires more than 25% of any class of voting stock of an insured institution or holding company thereof. Control is presumed to exist subject to rebuttal, if a person (or persons acting in concert) acquires more than 10% of any class of voting stock and either (i) the company has registered securities under Section 12 of the Exchange Act, or (ii) no person will own, control or hold the power to vote a greater percentage of that class of voting securities immediately after the transaction. The concept of acting in concert is very broad and also is subject to certain rebuttable presumptions, including among others, that relatives, business partners, management officials, affiliates and others are presumed to be acting in concert with each other and their businesses.

Section 12 of the Banking Law requires the prior approval of the Office of the Commissioner with respect to a transfer of voting stock of a bank that result in a change of control of the bank. Under Section 12, a change of control is presumed to occur if a person or group of persons acting in concert, directly or indirectly, acquires more than 5% of the outstanding voting capital stock of the bank. The Office of the Commissioner has

 

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interpreted the restrictions of Section 12 as applying to acquisitions of voting securities of entities controlling a bank, such as a bank holding company. Under the Banking Law, the determination of the Office of the Commissioner whether to approve a change of control filing is final and non-appealable.

The provisions of Act No. 247 of 2010 (the Puerto Rico mortgage banking law) also require regulatory approval for the acquisition of more than 10% of Doral Financial’s outstanding voting securities. Please refer to “— Regulation and Supervision — Mortgage Origination and Servicing” above.

The above regulatory restrictions relating to investment in Doral Financial may have the effect of discouraging takeover attempts against Doral Financial and may limit the ability of persons, other than Doral Financial directors duly authorized by Doral Financial’s board of directors, to solicit or exercise proxies, or otherwise exercise voting rights, in connection with matters submitted to a vote of Doral Financial’s stockholders.

Insurance Operations

Doral Insurance Agency is registered as a corporate agent and general agency with the Office of the Commissioner of Insurance of Puerto Rico (the “Commissioner of Insurance”). The operations of Doral Insurance Agency are subject to the applicable provisions of the Puerto Rico Insurance Code and to regulation by the Commissioner of Insurance relating to, among other things, licensing of employees, sales practices, charging of commissions and obligations to customers. Doral Insurance Agency is subject to supervision and examination by the Commissioner of Insurance.

Changes to Legislation or Regulation

Changes to federal and local laws and regulations (including changes in interpretation and enforcement) can affect the operating environment of Doral Financial and its subsidiaries in substantial and unpredictable ways. From time to time, various legislative and regulatory proposals are introduced. These proposals, if adopted, may change laws and regulations and Doral Financial’s operating environment. If adopted, some of these laws and regulations could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings institutions, credit unions and other financial institutions. Doral Financial cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon our financial condition or results of operations. It is likely, however, that the current high level of enforcement and compliance-related activities of federal and Puerto Rico banking regulatory authorities will continue and potentially increase.

 

Item  1A    Risk Factors

Our business, financial condition, operating results and/or the market price of our common stock may be adversely affected by a number of risk factors. Readers should carefully consider, in connection with other information disclosed in this Annual Report on Form 10-K, the risk factors set forth below. The following discussion sets forth some of the more important risk factors that could affect our business, financial condition or results of operations. However, other risk factors and uncertainties not currently known to us or currently deemed immaterial by us, besides those discussed below or elsewhere in this Annual Report on Form 10-K or other of our reports filed with or furnished to the SEC, also could materially affect our business, financial condition or results of operations. We cannot assure that the risk factors described below or elsewhere in this document are a complete set of all the potential risks that we may face. These risk factors also serve to describe factors which may cause our results to differ materially from those discussed in any forward looking statements included herein or in other documents or statements that make reference to this Annual Report on Form 10-K. Please also refer to the section titled “Forward Looking Statements” in this Annual Report on Form 10-K.

 

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Risks related to the general business environment and our industry

Difficult market conditions have already affected us and our industry and may continue to adversely affect us.

Given that almost all of our business is in Puerto Rico and the United States and given the degree of interrelation between Puerto Rico’s economy and that of the United States, we are particularly exposed to downturns in the United States economy. Dramatic declines in the United States housing market over the past few years, with falling home prices and increasing foreclosures, unemployment and underemployment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as major commercial banks and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative and cash securities, in turn, have caused many financial institutions to seek additional capital from private and government entities, to merge with larger and stronger financial institutions and, in some cases, to fail.

Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors reduced or ceased providing funding to borrowers, including other financial institutions. This market turmoil and tightening of credit led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has already adversely affected our industry and has and may continue to adversely affect our business, financial condition and results of operations. We experienced increased levels of non-performing assets and OTTI charges on our non-agency mortgage-backed securities as a result of market conditions. We do not expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:

 

   

Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future behaviors.

 

   

The processes and models we use to estimate losses inherent in our credit exposure requires difficult, subjective, and complex judgments, including forecast of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans, which may no longer be capable of accurate estimation and which may, in turn, impact the reliability of the processes and models.

 

   

Regulatory agency views of market conditions and the effect of market conditions on our borrowers may differ from those of our management, and such variance in views, if any, may contribute to increases in charge-offs and loan loss provisions.

 

   

Our ability to borrow from other financial institutions or to engage in sales of mortgage loans to third parties (including mortgage loan securitization transactions with government sponsored entities) on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events, including deteriorating investor expectations.

 

   

Competition in our industry could intensify as a result of increasing consolidation of financial services companies in connection with current market conditions.

 

   

We expect to face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue certain business opportunities.

 

   

We may be required to pay in the future significantly higher FDIC assessments to insure our deposits if market conditions do not improve or if market conditions deteriorate.

 

   

We may face higher credit losses because of federal or state legislation or regulatory action that either (i) reduces the amount that our borrowers are required to pay us, or (ii) limits our ability to foreclose on properties or collateral or makes foreclosures less economically viable.

 

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If current levels of market disruption and volatility continue or worsen, our ability to access capital and our business, financial condition and results of operations may be materially adversely affected.

Adverse credit market conditions may affect our ability to meet our liquidity needs; unforeseen disruptions in the brokered deposits market could compromise our liquidity position.

The credit markets, although recovering, have experienced extreme volatility and disruption in recent years. At times during the past few years, the volatility and disruptions reached unprecedented levels. In some cases, the markets have exerted downward pressure on availability of liquidity and credit capacity of certain issuers, particularly for non-investment grade issuers like us.

We need liquidity to, among other things, pay our operating expenses, interest on our debt and dividends on our preferred stock (if dividends are declared and paid), maintain our lending activities and replace certain maturing liabilities. Without sufficient liquidity, we may be forced to curtail our operations. The availability of additional financing will depend on a variety of factors such as market conditions, the general availability of credit and our credit capacity. Our cash flows and financial condition could be materially affected by continued disruptions in the financial markets.

A relatively large portion of our funding is retail brokered deposits issued by Doral Bank. Our total brokered deposits as of December 31, 2011 were $2.2 billion. An unforeseen disruption in the brokered deposits market, stemming from factors such as legal, regulatory or financial risks, could adversely affect our ability to fund a portion of our operations and/or meet obligations.

Recent and/or future U.S. credit downgrades or changes in outlook by major credit rating agencies may have an adverse effect on financial markets, including financial institutions and the financial industry.

On August 5, 2011, Standard and Poor’s downgraded the United States long-term debt rating from its AAA rating to AA+. On August 8, 2011, Standard and Poor’s downgraded from AAA to AA+ the credit ratings of certain long-term debt instruments issued by Fannie Mae and Freddie Mac and other United States government agencies linked to long-term United States debt. It is difficult to predict the effect of these actions, or any future downgrades or changes in outlook by Standard & Poor’s or either of the other two major credit rating agencies. However, these events could impact the trading market for United States government securities, including agency securities, and the securities markets more broadly and consequently could impact the value and liquidity of financial assets, including assets in our investment portfolio. These actions could also create broader financial turmoil and uncertainty, which may negatively affect the global banking system and limit the availability of funding, including borrowing under repurchase agreements, at reasonable terms. In turn, this could have a material adverse effect on our liquidity, financial condition and results of operations.

We have been and could continue to be negatively affected by adverse economic conditions.

The United States and other countries recently faced a severe economic crisis, including a major recession. These adverse economic conditions have negatively affected, and are likely to continue to negatively affect for some time, our assets, including our loans and securities portfolios, capital levels, results of operations and financial condition. In response to the economic crisis, the United States and other governments established a variety of programs and policies designed to mitigate the effects of the crisis. These programs and policies appear to have stabilized the severe financial crisis that occurred in the second half of 2008, but the extent to which these programs and policies will assist in an economic recovery or may lead to adverse consequences, whether anticipated or unanticipated, is still unclear. If these programs and policies are ineffective in bringing about an economic recovery or result in substantial adverse developments, the economic conditions may again become more severe, or adverse economic conditions may continue for a substantial period of time. In addition, economic uncertainty that may result from the recent downgrading of United States long-term debt, from the fiscal imbalances in federal, state and local municipal finances combined with the political difficulties in resolving these imbalances, and from the debt and other economic problems of several European countries, may directly or indirectly adversely impact economic conditions faced by us and our customers. Any increase in the severity or duration of adverse economic conditions, including a double-dip recession in the United States or a further delay in the economic recovery of Puerto Rico, would adversely affect our financial condition and results of operations.

 

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Our credit quality may continue to be adversely affected by Puerto Rico’s current economic conditions and the fiscal condition of the Commonwealth of Puerto Rico.

Our business activities and credit exposure are concentrated in Puerto Rico. Consequently, our financial condition and results of operations are highly dependent on economic conditions in Puerto Rico.

Puerto Rico’s economy is currently in a recession that began in the fourth quarter of the fiscal year that ended June 30, 2006, a fiscal year in which Puerto Rico’s gross national product grew by only 0.5%. Puerto Rico’s real gross national product decreased by 1.2%, 2.9%, 4.0% and 3.8%, respectively, for fiscal years 2007, 2008, 2009 and 2010. According to the Puerto Rico Planning Board’s latest projections made in March 2011, Puerto Rico’s real gross national product was projected to have contracted by 1.0% during fiscal year 2011. Puerto Rico’s real gross national product for fiscal year 2012, however, is projected to grow by 0.7%.

According to data published by the Puerto Rico Department of Labor, the number of persons employed in Puerto Rico during fiscal year 2011 averaged 1,077,000, a decrease of 2.3% compared to the previous fiscal year; and the unemployment rate averaged 15.9%. During the first four months of fiscal year 2012, total employment averaged 1,067,500, a decline of 1.2% with respect to the same period of the prior fiscal year; and the unemployment rate averaged 16.1%.

Since 2000, the Government of Puerto Rico has experienced a structural imbalance between recurring government revenues and total expenditures. The structural imbalance was exacerbated during fiscal years 2008 and 2009, with recurring government expenditures significantly exceeding recurring government revenues. Prior to fiscal year 2009, the Puerto Rico government bridged the deficit resulting from the structural imbalance through the use of non-recurring measures, such as borrowing from the Government Development Bank for Puerto Rico or in the bond market, postponing the payment of various government expenses, such as payments to suppliers and utilities providers, and other one-time measures such as the use of derivatives and borrowings collateralized with government assets such as real estate and uncollected General Fund revenues. Since March 2009, the government has taken multiple steps to address and resolve the structural imbalance.

For fiscal year 2009, the deficit was approximately $3.3 billion, consisting of the difference between revenues and expenses for such fiscal year. For fiscal year 2010, the deficit was approximately $2.1 billion and the deficit for fiscal year 2011 was approximately $1.0 billion. The deficit for fiscal year 2012 has been estimated at $610 million. Measures that the Government of Puerto Rico has implemented to reduce the deficit have included reducing expenses, including public sector employment through layoffs of employees. Since the Government of Puerto Rico is the largest source of employment in Puerto Rico, these measures have had the effect of increasing unemployment and could have the effect of intensifying the current recessionary cycle.

On August 8, 2011, Moody’s downgraded the general obligation bond rating of the Commonwealth of Puerto Rico from “A3” to “Baa1” with a negative outlook. The downgrade also applies to those ratings that are determined by or linked to that of the general obligation bond rating of the Commonwealth of Puerto Rico. Moody’s based its decision on its strong concerns with the continued deterioration of the severely underfunded government retirement systems, continued weak economic trends, and weak finances, with a historical trend of funding budget gaps with borrowings. A payment or other material default by the Government of Puerto Rico or any of its agencies, public corporations or instrumentalities with respect to their municipal bond or note obligations could have a material adverse effect on our financial condition and results of operations.

The current state of the Puerto Rico economy and continued uncertainty in the public and private sectors has had an adverse effect on the credit quality of our loan portfolios and reduced the level of our originations in Puerto Rico. The continuation of the economic slowdown would cause those adverse effects to continue, as delinquency rates may continue to increase in the short term, until sustainable growth of the Puerto Rico economy resumes. Also, potential reduction in consumer spending as a result of continued recessionary conditions may also impact growth in our other interest and non-interest revenue sources.

 

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A prolonged economic slowdown or decline in the residential real estate market in the United States mainland and/or Puerto Rico and an increase in unemployment in the United States mainland and/or Puerto Rico could continue to adversely affect our results of operations.

The residential mortgage loan origination business has historically been cyclical, enjoying periods of strong growth and profitability followed by periods of shrinking volumes and industry-wide losses. The market for residential mortgage loan originations is currently in decline and this trend could also reduce the level of mortgage loans we may produce in the future and adversely affect our business. During periods of rising interest rates, refinancing originations for many mortgage products tend to decrease as the economic incentives for borrowers to refinance their existing mortgage loans are reduced. In addition, the residential mortgage loan origination business is impacted by home values. Over the past four years, residential real estate values in many areas of the United States have decreased significantly, which has led to lower volumes and higher losses across the industry, adversely impacting our mortgage business.

The actual rates of delinquencies, foreclosures and losses on loans have been higher during the recent economic slowdown. Rising unemployment and declines in housing prices have had a greater negative effect on the ability of borrowers to repay their mortgage loans. Any sustained period of increased delinquencies, foreclosures or losses could continue to harm our ability to sell loans, the prices we receive for loans, the values of mortgage loans held for sale or residual interests in securitizations, which could continue to harm our financial condition and results of operations. In addition, any additional material decline in real estate values would further weaken the collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such loan arising from borrower defaults to the extent not covered by third-party credit enhancement.

Our business concentration in Puerto Rico imposes risks.

We conduct our operations in a geographically concentrated area, as our main market is in Puerto Rico. This imposes risks from lack of diversification in the geographical portfolio. Our financial condition and results of operations are highly dependent on the economic conditions of Puerto Rico, where adverse political or economic developments or natural disasters, among other things, could affect the volume of loan originations, increase the level of non-performing assets, increase the rate of foreclosure losses and reduce the value of our loans and loan servicing portfolio.

The soundness of other financial institutions could affect us.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, investment companies and other institutional clients. In certain of these transactions, we are required to post collateral to secure our obligations to the counterparties. In the event of a bankruptcy or insolvency proceeding involving one of such counterparties, we may experience delays in recovering the assets posted as collateral or may incur a loss to the extent that the counterparty was holding collateral in excess of the obligation to such counterparty.

Many of these transactions expose us to credit risk in the event of a default by our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to us. Any such losses could materially and adversely affect our business, financial condition and results of operations.

Monetary policies and regulations of the Federal Reserve could adversely affect our business, financial condition and results of operations.

In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are

 

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open market operations in U.S. government securities, adjustments of the discount rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.

On January 6, 2010, the member agencies of the Federal Financial Institutions Examination Council, which includes the Federal Reserve and the FDIC, issued an interest rate risk advisory reminding banks to maintain sound practices for managing interest rate risk, particularly in the current environment of historically low short-term interest rates.

The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our business, financial condition and results of operations may be adverse.

Our income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the Federal Reserve). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the value of loans, investment securities and mortgage servicing assets, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits or other sources of funding.

The Dodd-Frank Wall Street Reform and Consumer Protection Act will affect our business.

On July 21, 2010, President Obama signed into law the Dodd-Frank Act. The legislation made significant structural reforms to the financial services industry. The legislation, among other things, did the following:

 

  (i) establishes a Bureau of Consumer Financial Protection having broad authority to regulate providers of credit, savings and other consumer financial products and services, narrows the scope of federal preemption of state consumer laws and expands the authority of state attorneys general to bring actions to enforce federal consumer protection legislation;

 

  (ii) creates a structure to regulate systematically important financial companies, and provides regulators with the power to require such companies to sell or transfer assets and terminate activities if the regulators determine the size or the scope of the activities of such companies pose a threat to the safety and soundness of such companies or the financial stability of the United States;

 

  (iii) requires more comprehensive regulation of the over-the-counter derivatives market, including providing for more strict capital and margin requirements, the central clearing of standardized over-the-counter derivatives, and heightened supervision of all over-the-counter derivatives dealers and major market participants;

 

  (iv) limits the ability of banking entities to engage in certain proprietary trading activities and restricts their ownership of, investment in or sponsorship of hedge funds and private equity funds;

 

  (v) restricts the interchange fees payable on debit card transactions;

 

  (vi) abolishes the Office of Thrift Supervision (“OTS”) and transfers its functions and responsibilities regarding the supervision of federal savings banks to the Office of the Comptroller of the Currency (“OCC”);

 

  (vii) strengthens the regulatory oversight of securities and capital markets activities by the SEC and enhances the safety and soundness of the securitization process, including a requirement that securitizers and originators retain a portion of the credit risk for any asset that they securitize or originate;

 

  (viii) permanently increases the federal deposit insurance from $100,000 to $250,000, permits depository institutions to pay interest on demand deposit accounts (such as commercial checking accounts) and permits de novo interstate branching by federal and state depository institutions alike; and

 

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  (ix) strengthens existing laws and regulations applicable to public companies governing corporate accountability, giving shareholders “say on pay” and other corporate governance rights, and imposes limitations on certain executive compensation practices.

Some of the provisions of the legislation have already become effective.

Other provisions will have extended implementation periods and delayed effective dates, and will be required to be implemented through regulatory action of various federal regulatory authorities. Because many of the provisions require future regulatory actions for their implementation, the ultimate impact of the legislation on the financial services industry and on our business, are not completely known at this time. The implementation of many of the provisions of the legislation will affect our business and are expected to add new regulatory risk and compliance burdens and costs on the financial services industry and us. The implementation of this legislation could result in loss of revenue, limit our ability to pursue certain business opportunities we might otherwise consider engaging in, impact the value of some of the assets we hold, require us to change certain of our business practices, impose additional costs on us, establish more stringent capital, liquidity and leverage ratio requirements, or otherwise adversely affect our business.

We operate within a highly regulated industry and our business and results are significantly affected by the regulations to which we are subject; changes in statutes and regulations could adversely affect us.

We operate within a highly regulated environment. The regulations to which we are subject will continue to have a significant impact on our operations and the degree to which we can grow and be profitable. Certain regulators which supervise us have significant power in reviewing our operations and approving our business practices. These powers include the ability to place limitations or conditions on activities in which we engage or intend to engage. Particularly in recent years, our businesses have experienced increased regulation and regulatory scrutiny, often requiring additional resources. If we do not comply with governmental regulations, we may subject to fines, penalties, lawsuits or material restrictions on our businesses in the jurisdiction where the violation occurred, which may adversely affect our business operations.

In addition, new proposals for legislation continue to be introduced in the United States Congress or the Puerto Rico Legislature that could further increase regulation of the financial services industry and impose restrictions on the operations and general ability of firms within the industry to conduct business consistent with historical practices. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied.

We cannot predict the substance or impact of any change in regulation, whether by regulators or as a result of legislation enacted by the United States Congress or by the Puerto Rico Legislature, or in the way such statutory or regulatory requirements are interpreted or enforced. Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business practices, require us to increase our regulatory capital and limit our ability to pursue certain business opportunities in an efficient manner.

Further increases in the FDIC insurance assessment premiums or required reserves may have a significant impact on us.

The FDIC insures deposits at FDIC-insured depository institutions up to certain limits. The FDIC charges insured depository institutions premiums to maintain the Deposit Insurance Fund (the “DIF”). Current economic conditions have resulted in higher bank failures and expectations of future bank failures. In the event of a bank failure, the FDIC takes control of a failed bank and ensures payment of deposits up to insured limits (which were permanently increased to $250,000 by the Dodd-Frank Act) using the resources of the DIF. The FDIC is required by law to maintain adequate funding of the DIF, and the FDIC may increase premium assessments to maintain such funding.

On November 12, 2009, the FDIC adopted the final rule implementing a prepayment assessment for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 in order to strengthen the cash position of the DIF. Our total prepaid assessment was $67.1 million, which according to the final rule was recorded as a prepaid expense as of December 30, 2009. The prepaid assessment will be amortized and recognized by Doral Financial as an

 

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expense over the period from 2010 to 2012. As of December 31, 2011 the unamortized balance of the prepaid assessment was $29.6 million.

The Dodd-Frank Act requires the FDIC to increase the DIF’s reserves against future losses, which will necessitate increased deposit insurance premiums that are expected to be borne primarily by institutions with assets of greater than $10 billion. In October 2010, the FDIC addressed plans to bolster the DIF by increasing the required reserve ratio for the industry to 1.35 percent (ratio of reserves to insured deposits) by September 30, 2020, as required by the Dodd-Frank Act. In December 2010, the FDIC approved a final rule raising its industry target ratio of reserves to insured deposits to 2 percent, 65 basis points above the statutory minimum, but the FDIC does not project that goal to be met until 2027.

On February 7, 2011, the FDIC approved a final rule that amended the deposit insurance assessment regulations. The final rule implemented a provision in the Dodd-Frank Act that changes the assessment base for deposit insurance premiums from one based on domestic deposits to one based on average consolidated total assets minus average Tier 1 capital. The final rule also changed the assessment rate schedules for insured depository institutions so that approximately the same amount of revenue would be collected under the new assessment base as would be collected under the then current rate schedule and the schedules previously proposed by the FDIC in October 2010. The final rule also revised the risk-based assessment system for all large insured depository institutions (generally, institutions with at least $10 billion in total assets). Under the final rule, the FDIC will use a scorecard method to calculate assessment rates for all large insured depository institutions.

As noted by the FDIC in the final rule it adopted, the final rule should keep the overall amount collected from the industry very close to unchanged, although the amounts that individual institutions pay will be different. The new large bank pricing system is expected to result in higher assessments for banks with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure.

We are generally unable to control the amount of assessments that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, or if our risk rating deteriorates for purposes of determining the level of our FDIC insurance assessments, we may be required to pay even higher FDIC insurance assessments than the recently increased levels. Any future increases in FDIC insurance assessments may materially adversely affect our results of operations.

The consolidation of the Puerto Rico banking industry as a result of bank failures in 2010 may adversely affect us.

In April 2010, the FDIC closed three Puerto Rico banks and sold some of their assets and liabilities to other banks in Puerto Rico. In the future, there may be additional bank failures, mergers and acquisitions in our industry. Any business combinations could significantly alter industry conditions and competition within the Puerto Rico banking industry and could have a material adverse effect on our financial condition and results of operations.

In addition, the strategies adopted by the FDIC and the three acquiring banks in connection with some of the residential, construction and commercial real estate loans acquired may adversely affect residential and commercial real estate values in Puerto Rico. This in turn may adversely affect the value of some of our residential, construction and commercial real estate loans, and our ability to sell or restructure some of our residential, construction and commercial real estate loans.

Changes in accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies may adversely affect our financial statements.

Our financial statements are subject to the application of generally accepted accounting principles in the United States (“GAAP”), which are periodically revised and/or expanded. Accordingly, from time to time we are required to adopt new or revised accounting standards and updates thereto issued by the Financial Accounting Standards Board (the “FASB”). The impact of accounting pronouncements that have been issued but not yet implemented is disclosed by us in our filings with the SEC. An assessment of proposed standards and updates thereto is not provided as such proposals are still subject to change. It is possible that future accounting standards and updates thereto that we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a material adverse effect on our financial condition and results of operations.

 

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Risks related to our business

Deteriorating credit quality has adversely impacted us and may continue to adversely impact us.

We have experienced a downturn in credit quality since 2006. Our credit quality has continued to be under pressure during 2010 and 2011 as a result of continued recessionary conditions in Puerto Rico and the recent slow-down in consumer activity and economic growth in the United States that have led to, among other things, higher unemployment levels, much lower absorption rates for new residential construction projects and further declines in property values. We expect that credit conditions and the performance of our loan portfolio will continue to be under pressure in the near future.

Our business depends on the creditworthiness of our customers and counterparties and the value of the assets securing our loans or underlying our investments. If the credit quality of the customer base materially decreases, if the risk profile of a market, industry or group of customers changes materially, our business, financial condition, allowance levels, asset impairments, liquidity, capital and results of operations could be adversely affected.

Our allowance for loan losses may not be sufficient to cover actual losses, and we may be required to increase our allowance, which may affect our capital, financial condition and results of operations.

We are subject to risk of loss from loan defaults and foreclosures with respect to the loans that we originate or purchase. We establish an allowance for loan and lease losses at a level estimated as the amount of incurred losses inherent in the loan portfolio as of the related financial statement date based upon analysis of past portfolio default trends, severity experience, and fair value estimates, and record a provision for loan and lease losses which adjusts the allowance for loan and lease loss balance to the estimated amount as a charge to current period income.

We establish a provision for loan losses, which leads to reductions in our income from operations, in order to maintain our allowance for inherent loan losses at a level which we deem to be appropriate based upon an assessment of the quality of our loan portfolio.

Although we strive to utilize our best judgment in providing for loan losses, we may fail to accurately estimate the level of inherent loan losses or may have to increase our provision in the future as a result of new information regarding existing loans, future increases in non-performing loans, changes in economic and other conditions affecting borrowers or for other reasons beyond our control. In addition, bank regulatory agencies, such as FDIC and the Office of the Commissioner, periodically review the adequacy of our allowance for loan and lease losses and may require an increase in the provision for loan and lease losses or loan charge-offs, based on judgments different from those of our management.

The determination of the appropriate level of the allowance for loan and lease losses inherently involves a high degree of subjectivity and requires us to make significant estimates and judgments regarding credit risks and future trends, all of which may undergo substantial changes. If our estimates prove to be incorrect, our allowance for loan and lease losses may not be sufficient to cover losses in our loan portfolio and our expense relating to the additional provision for credit losses could increase substantially. Any such increase in our provision for loan losses would have an adverse effect on our future financial condition and results of operations.

Changes in collateral values of properties located in distressed economies may require increased reserves.

Substantially all of our loans are located within the boundaries of the United States economy. Whether the collateral for a loan is located in Puerto Rico or the United States mainland, the performance of our loan portfolio and the collateral value backing the loan transactions are dependent upon the performance of and conditions within each specific real estate market. Puerto Rico entered its sixth straight year of economic recession in 2011. Sustained weak economic conditions that have affected Puerto Rico and the United States over the last several years have resulted in declines in collateral values.

We measure the impairment of a loan based on the fair value of the collateral, if collateral dependent, which is generally obtained from appraisals. Updated appraisals are requested when we determine that loans are

 

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impaired and are updated annually thereafter. In addition, appraisals are also obtained for certain residential mortgage loans on a spot basis based on specific characteristics such as delinquency levels, age of the appraisal and LTV ratios. The appraised value of the collateral may decrease or we may not be able to recover collateral at its appraised value. In the absence of a current appraisal, Doral estimates the change in collateral value since the most recent appraisal using changes in value over similar time periods experienced on appraisals received. A significant decline in collateral valuations for collateral dependent loans may require increases in our specific provision for loan losses and an increase in the general valuation allowance. Any such increase would have an adverse effect on our future financial condition and results of operations.

Interest rate shifts may reduce net interest income.

Shifts in short-term interest rates may reduce net interest income, which is the principal component of our earnings. Net interest income is the difference between the amounts received by us on our interest-earning assets and the interest paid by us on our interest-bearing liabilities. When interest rates rise, the rate of interest we pay on our liabilities generally rises more quickly than the rate of interest that we receive on our interest-bearing assets, which may cause our profits to decrease. The impact on earnings is more adverse when the slope of the yield curve flattens, that is, when short-term interest rates increase more than long-term interest rates or when long-term interest rates decrease more than short-term interest rates.

Increases in interest rates may reduce the value of our holdings of securities and demand for our mortgage and other loans.

Fixed-rate securities acquired by us are generally subject to decreases in market value when interest rates rise, which may require recognition of a loss (e.g., the identification of other-than-temporary impairment on our investments portfolio), thereby adversely affecting our results of operations. Market related reductions in value also influence our ability to finance these securities. Higher interest rates also increase the cost of mortgage and other loans to consumers and businesses and may reduce demand for such loans, which may negatively impact our profits by reducing the amount of our loan origination income.

Doral Financial and Doral Bank are subject to the supervision and regulation of various banking regulators and have entered into consent orders with these regulators, and these regulators could take additional actions against Doral Financial or Doral Bank.

As a regulated financial services firm, our good standing with our regulators is of fundamental importance to the continuation and growth of our businesses. Doral Financial is subject to supervision and regulation by the Federal Reserve and the Office of the Commissioner, and Doral Bank is subject to supervision and regulation by the FDIC, the Office of the Commissioner and the state banking regulatory authorities of the states in which it has operations.

Federal banking regulators, in the performance of their supervisory and enforcement duties, have significant discretion and power to initiate enforcement actions for violations of laws and regulations and unsafe or unsound practices. The enforcement powers available to federal banking regulators include, among others, the ability to assess civil monetary penalties, to issue cease-and-desist or removal orders, to require written agreements and to initiate injunctive actions.

Doral Financial and Doral Bank have entered into consent orders with the Federal Reserve, the FDIC and the Office of the Commissioner, which, among other things, prohibited Doral Bank from paying dividends to the parent company, prohibited Doral Financial from paying dividends to its common and preferred shareholders without regulatory approval, and required Doral Bank to take various actions to ensure compliance with the provisions of the Bank Secrecy Act. While the FDIC and the Office of the Commissioner have lifted their consent orders, these banking regulators could take further action with respect to Doral Financial or Doral Bank and, if any such further action were taken, such action could have a material adverse effect on Doral Financial. Doral Financial’s consent order with the Federal Reserve is still in effect and Doral Financial’s banking regulators could take additional actions to protect Doral Bank or to ensure that the holding company remains as a source of financial and managerial strength to Doral Bank, and such action could have adverse effects on Doral Financial or its stockholders.

 

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Doral Financial and Doral Bank are subject to regulatory capital adequacy and other supervisory guidelines, and if we fail to meet those guidelines our business and financial condition would be adversely affected.

Under regulatory capital adequacy guidelines and other regulatory requirements, Doral Financial and Doral Bank must meet guidelines that include quantitative measures of assets, liabilities and certain off balance sheet items, subject to quantitative judgments by regulators regarding components, risk weightings and other factors. Supervisory guidelines also address, among other things, asset quality and liquidity. If either Doral Financial or Doral Bank fail to meet these minimum capital adequacy requirements or any other supervisory and regulatory requirements, our business and financial condition will be adversely affected. A failure to meet regulatory capital adequacy guidelines, among other things, would affect Doral Bank’s ability to accept or rollover brokered deposits and could result in supervisory actions by federal and/or Puerto Rico banking authorities.

The hedging transactions that we enter into may not be effective in managing the exposure to interest rate risk.

We use derivatives, to a limited extent, to manage part of our exposure to market risk caused by changes in interest rates. The derivative instruments that we may use also have their own risks, which include: (i) basis risk, which is the risk of loss associated with variations in the spread between the asset yield and funding and/or hedge cost; (ii) credit or default risk, which is the risk of insolvency or other inability of the counterparty to a particular transaction to perform its obligations; and (iii) legal risk, which is the risk that we are unable to enforce the terms of such instruments. All or any of these risks could expose us to losses.

Management has identified several material weaknesses in Doral Financial’s internal control over financial reporting.

Doral Financial’s management has concluded that the Company’s internal control over financial reporting was not effective as of December 31, 2011, due to several material weaknesses described in this Annual Report on Form 10-K. A discussion of the material weaknesses that have been identified by management can be found in Item 9A of Part II of this Annual Report on Form 10-K. Each material weakness results in more than a remote likelihood that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected.

Doral Financial’s management, with the oversight of the Audit Committee, will complete the work necessary to remedy the identified material weaknesses in the Company’s internal control over financial reporting as expeditiously as possible.

Our controls and procedures may fail or be circumvented, our risk management policies and procedures may be inadequate and operational risk could adversely affect our consolidated results of operations.

We may fail to identify and manage risks related to a variety of aspects of our business, including, but not limited to, operational risk, interest rate risk, trading risk, fiduciary risk, legal and compliance risk, liquidity risk and credit risk. We have adopted various controls, procedures, policies and systems to monitor and manage risk. If our risk management controls, procedures, policies and systems, including those designed to protect our networks, systems, computers and data from attack, damage or unauthorized access, were to fail or be circumvented, we could incur losses or suffer reputational damage or find ourselves out of compliance with applicable regulatory mandates or expectations.

Some of our methods for managing risks and exposures are based upon the use of observed historical market behavior or statistics based upon historical models. As a result, these methods may not fully predict future exposures, which could be significantly greater than our historical measures indicate. Other risk management methods depend upon the evaluation of information regarding markets, clients or other matters that is publicly available or otherwise accessible to us. This information may not always be accurate, complete, up-to-date or properly evaluated.

We may also be subject to disruptions from external events that are wholly or partially beyond our control, which could cause delays or disruptions to operational functions, including information processing and financial

 

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market settlement functions. In addition, our customers, vendors and counterparties could suffer from such events. Should these events affect us, or the customers, vendors or counterparties with which we conduct business, our consolidated results of operations could be adversely affected. When we record balance sheet reserves for probable loss contingencies related to operational losses, we may be unable to accurately estimate our potential exposure, and any reserves we establish to cover operational losses may not be sufficient to cover our actual financial exposure, which may have a material impact on our consolidated results of operations or financial condition for the periods in which we recognize the losses.

A breach in the security of our systems could disrupt our business, result in the disclosure of confidential information, damage our reputation and create significant financial and legal exposure for us.

Our businesses are dependent on our ability and the ability of our third party service providers to process, record and monitor a large number of transactions. If the financial, accounting, data processing or other operating systems and facilities fail to operate properly, become disabled, experience security breaches or have other significant shortcomings, we could be materially adversely affected.

Although we and our third party service providers devote significant resources to maintain and regularly upgrade our systems and processes that are designed to protect the security of computer systems, software, networks and other technology assets and the confidentiality, integrity and availability of information belonging to us and our customers, there is no assurance that our security systems and those of our third party service providers will provide absolute security. Financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage systems, often through the introduction of computer viruses or malware, cyber-attacks and other means. Despite our efforts and those of our third party service providers to ensure the integrity of these systems, it is possible that we or our third party service providers may not be able to anticipate or to implement effective preventive measures against all security breaches of these types, especially because techniques used change frequently or are not recognized until launched, and because security attacks can originate from a wide variety of sources.

A successful breach of the security of our systems or those of our third party service providers could cause serious negative consequences to us, including significant disruption of our operations, misappropriation of our confidential information or the confidential information of our customers, or damage to our computers or operating systems, and could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss in confidence in our security measures, customer dissatisfaction, litigation exposure, and harm to our reputation, all of which could have a material adverse effect on us.

The preparation of our financial statements requires the use of estimates that may vary from actual results.

The preparation of consolidated financial statements in conformity with GAAP requires management to make significant estimates that affect our financial statements. Four of Doral Financial’s most critical estimates are the level of the allowance for loan and lease losses, the valuation of mortgage servicing rights, the valuation of the interest only securities, and the amount of its deferred tax asset. Due to the inherent nature of these estimates we may significantly increase the allowance for loan and lease losses and/or sustain credit losses that are significantly higher than the provided allowance, and may recognize a significant provision for impairment of our mortgage servicing rights or interest only securities. If Doral Financial’s allowance for loan and lease losses turns out to be insufficient to cover actual losses in our loan portfolio, our business, financial condition, including our liquidity and capital, and results of operations could be materially adversely affected. Additionally, in the future, Doral Financial may have to increase its allowance for loan and lease losses, which could have a material adverse effect on its capital and results of operations.

As of December 31, 2011, we had a deferred tax asset of approximately $111.0 million. The deferred tax asset is net of a valuation allowance of $432.9 million. The realization of our deferred tax asset ultimately depends on the existence of sufficient taxable income to realize the value of this asset. Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that we will be required to record adjustments to the valuation allowance

 

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in future reporting periods. Our results of operations would be negatively impacted if we determine that increases to our deferred tax asset valuation allowance are required in a future reporting period.

Governmental agencies that have supervisory authority over the Company and Doral Bank can review the quality of our Tier 1 capital and may determine to reduce all or a portion of the increase to our Tier 1 capital caused by our agreement with the Commonwealth of Puerto Rico regarding our deferred tax asset.

We recently entered into an agreement with the Commonwealth of Puerto Rico in which the Commonwealth of Puerto Rico recognized a prepayment of income taxes of approximately $230 million from us relating to our past overpayment of taxes. We believe that this agreement will result in an increase in our reported Tier 1 regulatory capital by approximately $200 million. The Federal Reserve and the Federal Deposit Insurance Corporation have supervisory oversight authority over the Company and Doral Bank, including the quality of our Tier I regulatory capital, and as such there can be no assurance that the Federal Deposit Insurance Corporation or Federal Reserve may not seek to reduce in the future our Tier 1 regulatory capital including the increase caused by the agreement with the Commonwealth of Puerto Rico. If either regulatory agency reduces our Tier 1 regulatory capital our operations may be materially adversely effected.

Defective and repurchased loans may harm our business and financial condition.

In connection with the sale and securitization of mortgage loans, we are generally required to make a variety of customary representations and warranties regarding us and the loans being sold or securitized. Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and they relate to, among other things:

 

   

compliance with laws and regulations;

 

   

underwriting standards;

 

   

the accuracy of information in the loan documents and loan file; and

 

   

the characteristics and enforceability of the loan.

A loan that does not comply with these representations and warranties may take longer to sell, may impact our ability to obtain third-party financing for the loan, and be unsalable or salable only at a significant discount. If such a loan is sold before we detect a noncompliance, we may be obligated to repurchase the loan and bear any associated loss directly, or we may be obligated to indemnify the purchaser against any such loss, either of which could reduce our cash available for operations and liquidity. Our management believes that it has established controls to ensure that loans are originated in accordance with the secondary market’s requirements, but mistakes may be made, or certain employees may deliberately violate our lending policies. We seek to minimize repurchases and losses from defective loans by correcting flaws, if possible, and selling or re-selling such loans. We do not have a reserve on our financial statements for possible losses related to repurchases resulting from representation and warranty violations because we do not expect any such losses to be significant. Losses associated with defective loans may adversely impact our results of operations or financial condition.

We are exposed to credit risk from mortgage loans held pending sale and mortgage loans that have been sold subject to recourse arrangements.

We are generally at risk for mortgage loan defaults from the time we fund a loan until the time the loan is sold or securitized into a mortgage-backed security. In the past, we retained, through recourse arrangements, part of the credit risk on sales of mortgage loans that did not qualify for GNMA, FNMA or FHLMC sale or exchange programs and consequently may suffer losses on these loans. We suffer losses on these loans when the proceeds from a foreclosure sale of the property underlying a defaulted mortgage loan are less than the outstanding principal balance of the loan and the costs of holding and disposing of the related property. We estimate the fair value of the retained recourse obligation or of any liability incurred at the time of sale, and include such obligation with the net proceeds from the sale, resulting in lower gain-on-sale recognition. We evaluate the fair

 

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value of our recourse obligation based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behavior and market environment.

We are subject to risks in servicing loans for others.

Our profitability may also be adversely affected by mortgage loan delinquencies and defaults on mortgage loans that we service for third parties. Under many of our servicing contracts, we must advance all or part of the scheduled payments to the owner of an outstanding mortgage loan, even when mortgage loan payments are delinquent. In addition, in order to protect their liens on mortgaged properties, owners of mortgage loans usually require that we, as servicer, pay mortgage and hazard insurance and tax payments on schedule even if sufficient escrow funds are not available. We generally recover our advances from the mortgage owner or from liquidation proceeds when the mortgage loan is foreclosed. However, in the interim, we must absorb the cost of the funds we advance during the time the advance is outstanding. We must also bear the costs of attempting to collect on delinquent and defaulted mortgage loans. In addition, if a default is not cured, the mortgage loan will be canceled as part of the foreclosure proceedings and we will not receive any future servicing income with respect to that loan.

As a result of our credit ratings, we may be subjected to increased collateral requirements and other measures that could have an adverse impact on our results of operations and financial condition.

We have previously sold or securitized mortgage loans in transactions with FNMA and other counterparties subject to partial or full recourse. As of December 31, 2011, the maximum contractual exposure to us if we were required to purchase all loans sold subject to partial or full recourse was $0.6 billion, $0.5 billion of which consisted of exposure to FNMA. Our contractual agreements with FNMA authorize FNMA to require us to post additional collateral to secure our recourse obligations with FNMA, and FNMA has the contractual right to request collateral for the full amount of our recourse obligations when, as now, we do not maintain an investment grade rating. In January 2006, we agreed to post with FNMA $44.0 million in collateral to secure our recourse obligations. In addition, certain of our servicing agreements, such as those with FNMA, FHLMC, and GNMA, contain provisions triggered by changes in our financial condition or failure to maintain required credit ratings. We do not currently maintain the credit ratings required by GNMA and possibly other counterparties, which may result in increased collateral requirements and/or require us to engage a substitute fund custodian, or could result in termination of our servicing rights. Termination of our servicing rights, requirements to post additional collateral or the loss of custodian funds could reduce our liquidity and have an adverse impact on our operating results.

Our ability to sell loans and other mortgage products to government-sponsored entities could be impacted by changes in our financial condition or the historical performance of our mortgage products.

Our ability to sell mortgage products to government-sponsored entities (“GSEs”), such as FNMA, FHLMC and GNMA, depends, among other things, on our financial condition and the historical performance of our mortgage products. To protect our ability to continue to sell mortgage products to GNMA and other GSEs, we have and may in the future repurchase defaulted loans from such counterparties. During 2011 and 2010, we repurchased $54.7 million and $68.7 million, respectively, of defaulted FHA guaranteed loans from GNMA. Any such repurchases in the future may negatively impact our liquidity and operating results. Termination of our ability to sell mortgage products to the GSEs would have a material adverse effect on our results of operations and financial condition.

We may engage in FDIC-assisted transactions, which could present additional risks to our business.

We may have opportunities to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. Although these transactions typically provide for FDIC assistance to an acquirer to mitigate certain risks, such as sharing exposure to loan losses and providing indemnification against certain liabilities of the failed institution, we would still be subject to many of the same risks we would face in acquiring another bank in a negotiated transaction, including risks associated with maintaining customer relationships and failure to realize the anticipated acquisition benefits in the amounts and within the timeframes we expect.

 

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In addition, because these transactions are structured in a manner that would not allow us the time and access to information normally associated with preparing for and evaluating a negotiated transaction, we may face additional risk in FDIC-assisted transactions, including additional strain on management resources, management of problem loans, problems related to integration of personnel and operating systems and impact to our capital resources requiring us to raise additional capital. We may not be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions. Our inability to overcome these risks could have a material effect on our business, financial condition and results of operations.

We may fail to retain and attract key employees and management personnel.

Our success has been and will continue to be influenced by our ability to retain and attract key employees and management personnel, including senior and middle management. Our ability to attract and retain key employees and management personnel may be adversely affected as a result of the workload and stress associated with our business transformation efforts, and related regulatory risks and uncertainties; the consolidation of the Puerto Rico banking industry; or by additional work relating to any potential or actual acquisition.

Competition with other financial institutions could adversely affect the profitability of our operations.

We face significant competition from other financial institutions, many of which have significantly greater assets, capital and other resources. As a result, many of our competitors have advantages in conducting certain businesses and providing certain services. This competitive environment could force us to increase the rates we offer on deposits or lower the rates we charge on loans and, consequently, could adversely affect the profitability of our operations.

Damage to our reputation could damage our businesses.

Maintaining a positive reputation for Doral Financial is critical to our ability to attract and maintain customers, investors and employees. Damage to our reputation can therefore cause significant harm to our business and prospects. Harm to our reputation can arise from numerous sources, including, among others, employee misconduct, litigation or regulatory outcomes, failing to deliver minimum standards of service and quality, compliance failures, unethical behavior, and the activities of customers and counterparties. Negative publicity regarding Doral Financial, whether or not true, may also result in harm to our prospects.

We must respond to rapid technological changes, and these changes may be more difficult or expensive than anticipated.

If competitors introduce new products and services embodying new technologies, or if new industry standards and practices emerge, our existing product and service offerings, technology and systems may become obsolete. Further, if we fail to adopt or develop new technologies or to adapt our products and services to emerging industry standards, we may lose current and future customers, which could have a material adverse effect on our business, financial condition and results of operations. The financial services industry is changing rapidly and in order to remain competitive, we must continue to enhance and improve the functionality and features of our products, services and technologies. These changes may be more difficult or expensive than we anticipate. In addition, our networks, systems, computers and data could become vulnerable to attack, damage or unauthorized access as a result of rapid technological changes.

Doral Financial has been the subject of an investigation by the U.S. Attorney’s Office for the Southern District of New York, which could require it to pay substantial fines or penalties.

On August 24, 2005, Doral Financial received a grand jury subpoena from the U.S. Attorney’s Office for the Southern District of New York regarding the production of certain documents, including financial statements and corporate, auditing and accounting records prepared during the period relating to the restatement of Doral Financial’s financial statements. Doral Financial cannot predict when this investigation will be completed or what the results of this investigation will be. The effects and results of this investigation could have a material adverse effect on Doral Financial’s business, results of operations, financial condition and liquidity. Adverse

 

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developments related to this investigation, including any expansion of its scope, could negatively impact Doral Financial and could divert efforts and attention of its management team from Doral Financial’s ordinary business operations. Doral Financial may be required to pay material fines, judgments or settlements or suffer other penalties, each of which could have a material adverse effect on its business, results of operations, financial condition and liquidity. This investigation could adversely affect Doral Financial’s ability to obtain, and/or increase the cost of obtaining, directors’ and officers’ liability insurance and/or other types of insurance, which could have a material adverse effect on Doral Financial’s businesses, results of operations and financial condition.

Doral Financial may be required to advance significant amounts to cover the reasonable legal and other expenses of its former officers and directors.

Under Doral Financial’s by-laws, Doral Financial is obligated to pay in advance the reasonable expenses incurred by former officers and directors in defending civil or criminal actions or proceedings pending final disposition of such actions.

Since 2005, Doral Financial has been advancing funds on behalf of various former officers and directors in connection with the grand jury proceeding referred to above and ongoing investigations by the SEC relating to the restatement of Doral Financial’s financial statements.

On March 6, 2008, a former treasurer of Doral Financial was indicted for alleged criminal violations involving securities and wire fraud. On April 29, 2010, the former treasurer of Doral Financial was convicted on three of the five counts of securities and wire fraud he was facing after a five-week jury trial.

On August 13, 2009, the former treasurer of Doral Financial filed a complaint against Doral Financial in the Supreme Court of the State of New York. The complaint alleges that Doral Financial breached a contract with the plaintiff and Doral Financial’s by-laws by failing to advance payment of certain legal fees and expenses that the former treasurer has incurred in connection with a criminal indictment filed against him in the U.S. District Court for the Southern District of New York. Further, the complaint claims that Doral Financial fraudulently induced the plaintiff to enter into agreements concerning the settlement of a civil litigation arising from the restatement of Doral Financial’s financial statements for fiscal years 2000 through 2004. The complaint seeks declaratory relief, damages, costs and expenses. The former treasurer further moved for preliminary injunctive relief. On December 16, 2009, the parties entered into a Settlement Agreement. On December 17, 2009, the former treasurer’s motion for a preliminary injunction was denied as moot, and all further proceedings were stayed, but the procedures for future disputes between the parties and outlined in the Settlement Agreement were not affected by the stay. The amounts required to be advanced in an appeal of the criminal conviction could be substantial and could materially adversely affect Doral Financial’s results of operations.

Our businesses may be adversely affected by litigation or regulatory enforcement.

From time to time, our customers, or the government on their behalf, may make claims and take legal action relating to our performance of fiduciary or contractual responsibilities. We may also face employment lawsuits or other legal claims. In any such claims or actions, demands for substantial monetary damages may be asserted against us resulting in financial liability or an adverse effect on our reputation among investors or on customer demand for our products and services. We may be unable to accurately estimate our exposure to litigation risk when we record balance sheet reserves for probable loss contingencies. As a result, any reserves we establish to cover any settlements or judgments may not be sufficient to cover our actual financial exposure, which may have a material impact on our consolidated results of operations or financial condition.

In the ordinary course of our business, we are also subject to various regulatory, governmental and law enforcement inquiries, investigations and subpoenas. These may be directed generally to participants in the businesses in which we are involved or may be specifically directed at us. In regulatory enforcement matters, claims for disgorgement, the imposition of penalties and the imposition of other remedial sanctions are possible.

The resolution of legal actions or regulatory matters, if unfavorable, could have a material adverse effect on our consolidated results of operations for the period in which such actions or matters are resolved or a reserve is established.

 

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Risks related to our common stock

Additional issuances of common stock or securities convertible into common stock may further dilute existing holders of our common stock.

We may determine that it is advisable, or we may encounter circumstances where we determine it is necessary, to issue additional shares of our common stock, securities convertible into or exchangeable for shares of our common stock, or common-equivalent securities to fund strategic initiatives or other business needs or to raise additional capital. Depending on our capital needs, we may make such a determination in the near future or in subsequent periods. The market price of our common stock could decline as a result of any such future offering, as well as other sales of a large block of shares of our common stock or similar securities in the market thereafter, or the perception that such sales could occur.

In addition, such additional equity issuances would reduce any earnings available to the holders of our common stock and the return thereon unless our earnings increase correspondingly. We cannot predict the timing or size of future equity issuances, if any, or the effect that they may have on the market price of our common stock. The issuance of substantial amounts of equity, or the perception that such issuances may occur, could adversely affect the market price of our common stock.

Dividends on our common stock have been suspended; Doral Financial may not be able to pay dividends on its common stock in the future.

Holders of our common stock are only entitled to receive such dividends as our board of directors may declare out of funds legally available for such payments.

On April 25, 2006, we announced that, as a prudent capital management decision designed to preserve and strengthen our capital, our board of directors had suspended the quarterly dividend on our common stock. In addition, we will be unable to pay dividends on our common stock unless and until we resume payments of dividends on our preferred stock, which were suspended by the Board of Directors in March 2009.

The Company is subject to certain restrictions generally imposed on Puerto Rico corporations with respect to the declaration and payment of dividends (i.e., that dividends may be paid out only from the Company’s net assets in excess of capital or, in the absence of such excess, from the Company’s net earnings for such fiscal year and/or the preceding fiscal year). The Federal Reserve Board has also issued a policy statement that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fund fully the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.

In February 2009, the Federal Reserve published the Supervisory Letter, which, among other things, discusses the ability of bank holding companies to declare dividends and to redeem or repurchase equity securities. The Supervisory Letter is generally consistent with prior Federal Reserve supervisory policies and guidance, although it places greater emphasis on discussions with the regulators prior to dividend declarations even when not explicitly required by the regulations. The Federal Reserve provides that the principles discussed in the letter are applicable to all bank holding companies, but are especially relevant for bank holding companies that are experiencing financial difficulties.

The Supervisory Letter provides that a board of directors should “eliminate, defer, or severely limit” dividends if: (i) the bank holding company’s net income available to shareholders for the past four quarters, net of dividends paid during that period, is not sufficient to fully fund the dividends; (ii) the bank holding company’s rate of earnings retention is inconsistent with capital needs and overall macroeconomic outlook; or (iii) the bank holding company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Supervisory Letter further suggests that bank holding companies should inform the Federal Reserve in advance of paying a dividend that: (i) exceeds the earnings for the quarter in which the dividend is being paid; or (ii) could result in a material adverse change to the organization’s capital structure.

Under an existing consent order with the Federal Reserve, we are restricted from paying dividends on our capital stock without the prior written approval of the Federal Reserve. We are required to request permission for

 

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the payment of dividends on our common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date. We may not receive approval for the payment of such dividends in the future or, even with such approval, our board of directors may not resume payment of dividends.

The price of our common stock may be subject to fluctuations and volatility.

The market price of our common stock could be subject to significant fluctuations because of factors specifically related to our businesses and general market conditions. Factors that could cause such fluctuations, many of which could be beyond our control, include the following:

 

   

changes or perceived changes in the condition, operations, results or prospects of our businesses and market assessments of these changes or perceived changes;

 

   

announcements of strategic developments, acquisitions and other material events by us or our competitors;

 

   

changes in governmental regulations or proposals, or new government regulations or proposals, affecting us, including those relating to general market or economic conditions and those that may be specifically directed to us;

 

   

the continued decline, failure to stabilize or lack of improvement in general market and economic conditions in our principal markets;

 

   

the departure of key personnel;

 

   

changes in the credit, mortgage and real estate markets;

 

   

operating results that vary from expectations of management, securities analysts and investors;

 

   

operating and stock price performance of companies that investors deem comparable to us;

 

   

changes in financial reports by securities analysts;

 

   

developments related to investigations, proceedings, or litigation that involves us; and

 

   

the occurrence of major catastrophic events, including terrorist attacks.

All of our debt obligations and our preferred stock will have priority over our common stock with respect to payment in the event of a liquidation, dissolution or winding up.

In any liquidation, dissolution or winding up of Doral Financial, our common stock would rank below all debt claims against us and all of our outstanding shares of preferred stock. As a result, holders of our common stock will not be entitled to receive any payment or other distribution of assets upon our liquidation or dissolution until after our obligations to our debt holders and holders of preferred stock have been satisfied.

Our certificate of incorporation, our by-laws and certain banking law provisions contain provisions that could discourage an acquisition or change of control of Doral Financial.

Certain provisions under Puerto Rico and federal banking laws and regulations, together with certain provisions of our certificate of incorporation and by-laws, may make it more difficult to effect a change in control of our company, to acquire us or to replace incumbent management. These provisions could potentially deprive our stockholders of opportunities to sell shares of our common stock at above-market prices.

Our suspension of preferred stock dividends could result in the expansion of our board of directors.

On March 20, 2009, our board of directors announced that it had suspended the declaration and payment of all dividends on all outstanding series of our convertible preferred stock and our noncumulative preferred stock. The suspension of dividends for our noncumulative preferred stock was effective and commenced with the dividends for the month of April 2009. The suspension of dividends for our convertible preferred stock was effective and commenced with the dividends for the quarter commencing in April 2009.

 

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Since we have not paid dividends in full on our noncumulative preferred stock for at least eighteen consecutive monthly periods, or paid dividends in full on our convertible preferred stock for consecutive dividend periods containing in the aggregate a number of days equivalent to at least six fiscal quarters, the holders of our preferred stock, all acting together as a single class, have the right to elect two additional members to our board of directors. We called a special meeting of our preferred stockholders to be held on August 3, 2011 to permit holders of our preferred stock to nominate and seek to have elected the two additional members to our board of directors. Due to the lack of a quorum, the Special Meeting was not able to be held. The holders of 10% of the total number of outstanding shares of our preferred stock, all acting together as a single class, are entitled to call a special meeting for the election of two additional members to our board of directors.

Item 1B.    Unresolved Staff Comments.

On October 21, 2011 the Company received a comment letter from the staff of the Division of Corporate Finance of the Securities and Exchange Commission (“October 2011 SEC Letter”). The sixteen (16) comments from the staff included in the October 2011 SEC Letter relate to their review of the Company’s Annual Reports on Form 10-K for the years ended December 31, 2009 and 2010, the quarterly reports for the three quarters filed by the Company for 2010 and the quarterly reports for the first two quarters filed by the Company for 2011. The Company had previously received comment letters from the staff relating to some of these filings dated September 8, 2010, March 3, 2011 and May 9, 2011. The Company has responded in a timely manner to the staff comments included in the October 2011 SEC Letter and the previous staff comment letters.

In general terms, the pending comments from the staff in the October 2011 SEC Letter relate to disclosures provided by the Company in its filings relating to loans held for sale and loans receivable, credit quality and non-performing loans, loan modifications and troubled debt restructurings, provisions for loan and lease losses, the allowance for loan and lease losses and other real estate owned. The Company responded to the pending comments in the October 2011 SEC Letter in a letter dated November 9, 2011 with what it understands to be sufficient supplemental information and analyses to address all of the comments from the staff. In addition, the Company has updated its disclosures in its filings with the SEC, as requested by the staff in the October 2011 SEC Letter and the previous staff comment letters.

As of the date of this Annual Report on Form 10-K, the Company has not received confirmation from the staff of the Division of Corporate Finance of the SEC that their filing review process relating to the October 2011 SEC Letter had been completed.

Item 2.    Properties.

Doral Financial maintains its principal administrative and executive offices in an office building known as the Doral Financial Plaza, located at 1451 Franklin D. Roosevelt Avenue in San Juan, Puerto Rico. The Doral Financial Plaza is owned in fee simple by Doral Properties, Inc., a wholly-owned subsidiary of Doral Financial, and has approximately 200,000 square feet of office and administrative space. The cost of the building, related improvements and land was approximately $48.4 million. The building is subject to a mortgage in the amount of $37.4 million.

In addition, Doral Financial maintains 29 retail banking branches in Puerto Rico at which mortgage origination offices are co-located in 27 of these branches. Of the properties on which the 29 branch locations are located, 9 properties are owned by Doral Financial and 20 properties are leased by Doral Financial from third parties.

The administrative and executive offices of Doral Money and the U.S. operations of Doral Bank are located at 623 Fifth Avenue in New York, New York, where it leases approximately 32,500 square feet. Doral Bank and Doral Money currently operate two branches in the metropolitan area of New York City and five branches in the northwest area of Florida. These branches are leased by Doral Bank and Doral Money from third parties, with the exception of three branches in Florida, which are owned by Doral Bank. In addition to its branch network, the U.S. operations of Doral Bank also include loan processing/administrative offices in New York, Florida and Oregon.

Doral Financial considers that its properties are generally in good condition, are well maintained and are generally suitable and adequate to carry on Doral Financial’s business.

 

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Item 3.    Legal Proceedings.

Doral Financial and its subsidiaries are defendants in various lawsuits or arbitration proceedings arising in the ordinary course of business, including employment related matters. Management believes, based on the opinion of legal counsel, that the aggregated liabilities, if any, arising from such actions will not have a material adverse effect on the financial condition or results of operations of Doral Financial.

Since 2005, Doral Financial became a party to various legal proceedings, including regulatory and judicial investigations and civil litigation, arising as a result of the Company’s restatement.

Legal Matters

On August 24, 2005, the U.S. Attorney’s Office for the Southern District of New York served Doral Financial with a grand jury subpoena seeking the production of certain documents relating to issues arising from the restatement, including financial statements and corporate, auditing and accounting records prepared during the period from January 1, 2000 to the date of the subpoena. Doral Financial is cooperating with the U.S. Attorney’s Office in this matter. Doral Financial cannot predict the outcome of this matter and is unable to ascertain the ultimate aggregate amount of monetary liability or financial impact to Doral Financial of this matter.

On August 13, 2009, Mario S. Levis, the former Treasurer of Doral, filed a complaint against the Company in the Supreme Court of the State of New York. The complaint alleges that the Company breached a contract with the plaintiff and the Company’s by-laws by failing to advance payment of certain legal fees and expenses that Mr. Levis has incurred in connection with a criminal indictment filed against him in the U.S. District Court for the Southern District of New York. Further, the complaint claims that Doral Financial fraudulently induced the plaintiff to enter into agreements concerning the settlement of a civil litigation arising from the restatement of the Company’s financial statements for fiscal years 2000 through 2004. The complaint seeks declaratory relief, damages, costs and expenses. On December 16, 2009, the parties entered into a Settlement Agreement. On December 17, 2009, Mr. Levis’ motion for a preliminary injunction was denied as moot, and all further proceedings were stayed, but the procedures for future disputes between the parties and outlined in the Settlement Agreement were not affected by the stay.

Lehman Brothers Transactions

Prior to 2011, Doral Financial Corporation and Doral Bank (together and for purposes of this transaction defined as “Doral”), had counterparty exposure to Lehman Brothers, Inc. (“LBI”) in connection with repurchase financing agreements and forward To-Be-Announced (“TBA”) agreements. LBI was placed in a Securities Investor Protection Corporation (“SIPC”) liquidation proceeding after the filing for bankruptcy of its parent Lehman Brothers Holdings, Inc. The filing of the SIPC liquidation proceeding was an event of default under the repurchase agreements and the forward TBA agreements resulting in their termination as of September 19, 2008.

The termination of the agreements led to a reduction in the Company’s total assets and total liabilities of approximately $509.8 million and caused Doral to recognize a previously unrealized loss on the value of the securities subject to the agreements, resulting in a $4.2 million charge during 2008. During 2009, Doral timely filed customer claims against LBI in the SIPC liquidation proceeding for LBI that it was owed approximately $43.3 million.

Based on the information available in the fourth quarter of 2008, Doral determined that the process would likely take more than a year and that mounting legal and operating costs would likely impair the ability of LBI to pay 100% of the claims filed against it, especially for general creditors. As a result, as of December 31, 2008, Doral accrued a loss of $21.6 million against the $43.3 million owed by LBI.

Based on the information available in the second quarter of 2010, Doral recognized an additional loss of $10.8 million against the $43.3 million owed by LBI. A net receivable of $10.9 million was recorded in “Accounts Receivable” on the Company’s consolidated statements of financial condition.

During the fourth quarter of 2010, Doral sold and assigned to a third party all of Doral’s rights, title, and interest in and to its claims in the SIPC proceeding, including all of its rights to prosecute its claims, as a result of which Doral recognized a loss of $1.5 million on financial disposition of the net receivable.

 

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Banking Regulatory Matters

On March 16, 2006, Doral Financial entered into a consent cease and desist order with the Federal Reserve. The mutually agreed upon order required Doral Financial to conduct reviews of its mortgage portfolio, and to submit plans regarding the maintenance of capital adequacy and liquidity. The consent order contains restrictions on Doral Financial from obtaining extensions of credit from, or entering into certain asset purchase and sale transactions with its banking subsidiary, without the prior approval of the Federal Reserve. The consent order restricts Doral Financial from receiving dividends from the banking subsidiaries without the approval of the respective primary banking regulatory agency. Doral Financial is also required to request permission from the Federal Reserve for the payment of dividends on its common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date and requires Doral Financial and Doral Bank to submit plans regarding the maintenance of minimum levels of capital and liquidity. Doral Financial has complied with these requirements and no fines or civil money penalties were assessed against the Company under the order.

Effective January 14, 2008, the FDIC and the Office of the Commissioner terminated a cease and desist order that had been entered by these regulatory agencies with Doral Bank on March 16, 2006 (the “Former Order”). The Former Order was similar to the consent order of Doral Financial with the Federal Reserve described above, and related to safety and soundness issues in connection with the announcement by Doral Financial in April 2005 of the need to restate its financial statements for the period from January 1, 2000 to December 31, 2004.

Doral Financial and Doral Bank have undertaken specific corrective actions to comply with the requirements of the terminated enforcement actions and the single remaining enforcement action, but cannot give assurance that such actions are sufficient to prevent further enforcement actions by the banking regulatory agencies.

Item 4.    Mine Safety Disclosures

Not applicable

PART II

Item 5.    Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of                 Equity Securities.

Doral Financial’s common stock, $0.01 par value per share (the “Common Stock”), is traded and quoted on the New York Stock Exchange (“NYSE”) under the symbol “DRL.”

The following table sets forth, for the calendar quarters indicated, the high and low closing sales prices of Doral’s Common Stock:

 

      Calendar      Price Range  

Year

   Quarter      High      Low  

2011

     4th       $ 1.38       $ 0.57   
     3rd         2.60         1.08   
     2nd         2.12         1.04   
     1st         1.64         1.06   

2010

     4th       $ 1.82       $ 1.23   
     3rd         2.70         1.13   
     2nd         6.48         2.28   
     1st         5.04         3.13   

As of March 23, 2012 the approximate number of record holders of Doral Financial’s Common Stock was 186, which does not include beneficial owners whose shares are held in record names of brokers and nominees. The last sales price for the Common Stock as quoted on the NYSE on such date was $1.56 per share.

 

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Preferred Stock

Doral Financial has three outstanding series of nonconvertible preferred stock: 7.25% noncumulative monthly income preferred stock, Series C (liquidation preference $25 per share); 8.35% noncumulative monthly income preferred stock, Series B (liquidation preference $25 per share); and 7% noncumulative monthly income preferred stock, Series A (liquidation preference $50 per share) (collectively, the “Noncumulative Preferred Stock”).

During 2003, Doral Financial issued 1,380,000 shares of its 4.75% perpetual cumulative convertible preferred stock (the “Convertible Preferred Stock”) having a liquidation preference of $250 per share in a private offering to qualified institutional buyers pursuant to Rule 144A. Each share of Convertible Preferred Stock is currently convertible into 0.31428 shares of common stock, subject to adjustment under specific conditions. The Convertible Preferred Stock ranks on parity with Doral Financial’s outstanding Noncumulative Preferred Stock with respect to dividend rights and rights upon liquidation, winding up or dissolution. As of December 31, 2011, there were 813,526 shares issued and outstanding of the Convertible Preferred Stock.

The terms of Doral Financial’s outstanding preferred stock do not permit Doral Financial to declare, set apart or pay any dividends or make any other distribution of assets, or redeem, purchase, set apart or otherwise acquire shares of the Common Stock, or any other class of Doral Financial’s stock ranking junior to the preferred stock, unless all accrued and unpaid dividends on the preferred stock and any parity stock, at the time those dividends are payable, have been paid and the full dividend on the preferred stock for the current dividend period is contemporaneously declared and paid or set aside for payment. The terms of the preferred stock provide that if Doral Financial is unable to pay in full dividends on the preferred stock and other shares of stock of equal rank as to the payment of dividends, all dividends declared upon the preferred stock and such other shares of stock be declared pro rata.

On May 7, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock and a cash payment in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on May 7, 2009 and expired on June 8, 2009. Each of the series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement that was filed with the SEC on May 7, 2009, as amended. The transaction was settled on June 11, 2009. As a result of the exchange offer, Doral issued an aggregate of 3,953,892 shares of common stock and paid an aggregate of $5.0 million in cash premium payments and recognized a non-cash credit to retained earnings (with a corresponding charge to additional paid in capital) of $9.4 million that was added to net income available to common shareholders in calculating earnings per share. This exchange resulted in an increase in common equity of $100.6 million and a decrease in preferred stock of $105.6 million.

On October 20, 2009, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock for a limited number of its Convertible Preferred Stock. The offer to exchange commenced on October 20, 2009 and expired on December 9, 2009. The transaction was settled on December 14, 2009. Pursuant to the terms of the offer to exchange, the Company issued 4,300,301 shares of common stock in exchange for 208,854 shares of Convertible Preferred Stock. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of $52.2 million, as well as a non-cash charge to retained earnings of $18.0 million (with a corresponding credit to additional paid in capital) that was deducted from net income available to common shareholders in calculating earnings per share.

On February 11, 2010, the Company announced the commencement of an offer to exchange a stated amount of its shares of common stock in exchange for a limited number of its shares of outstanding preferred stock. The offer to exchange commenced on February 11, 2010 and expired on March 19, 2010. Each of the four series of outstanding preferred stock of Doral Financial were eligible to participate in the exchange offer, subject to all terms and conditions set forth in the Tender Offer Statement and Prospectus that were filed with the SEC. The transaction was settled on March 24, 2010. As a result of the exchange offer, Doral issued an aggregate of 5,219,066 shares of common stock in exchange for 1,689,459 of the Company’s preferred stock that were retired in connection with this exchange. This exchange resulted in an increase in common equity and a corresponding decrease in preferred stock of approximately $63.3 million.

 

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On April 19, 2010, the Company announced that it had entered into a definitive Stock Purchase Agreement with various purchasers of the Company’s common stock, including certain direct and indirect investors in Doral Holdings, the Company’s controlling shareholder at the time, to raise up to $600.0 million of new equity capital for the Company through a private placement. Shares were sold in two tranches: (i) a $180.0 million non-contingent tranche consisting of approximately 180,000 shares of the Company’s Mandatorily Convertible Non-Cumulative Non-Voting Preferred Stock (the “Mandatorily Convertible Preferred Stock”), $1.00 par value and $1,000 liquidation preference per share and (ii) a $420.0 million contingent tranche consisting of approximately 13.0 million shares of the Company’s common stock and approximately 359,000 shares of the Mandatorily Convertible Preferred Stock. In addition, as part of the non-contingent tranche, the Company issued into escrow 105,002 shares of Mandatorily Convertible Preferred Stock with a liquidation value of $105.0 million, to be released to purchasers if the Company did not complete an FDIC assisted transaction.

Doral used the net proceeds from the placement of the shares in the Non-Contingent Tranche to provide additional capital to the Company to facilitate the Company (through its wholly owned subsidiary, Doral Bank) qualifying as a bidder for the acquisition of certain assets and assumption of certain liabilities of one or more Puerto Rico banks from the FDIC, as receiver.

The Company was approved to bid on the assets and liabilities of any or all of the three Puerto Rico banks that failed in April 2010. On April 30, 2010, the Company announced it had been out-bid and would not be acquiring any of the assets or liabilities of any of the three Puerto Rico failed banks resolved in separate FDIC assisted purchase and assumption transactions. As a result, pursuant to the Stock Purchase Agreement and the related escrow agreement, the 105,002 shares of the Mandatorily Convertible Preferred Stock and the $420.0 million of contingent funds were released from escrow to the purchasers and the contingent tranche of securities was not issued. After giving effect to the release of the 105,002 shares of the Mandatorily Convertible Preferred Stock from escrow, the shares of the Mandatorily Convertible Preferred Stock issued in the capital raise had an effective sale price of $3.00 per common share equivalent.

In connection with the Stock Purchase Agreement, the Company also entered into a Cooperation Agreement with Doral Holdings, Doral Holdings L.P. and Doral GP Ltd. pursuant to which Doral Holdings made certain commitments including the commitment to vote in favor of converting the Mandatorily Convertible Preferred Stock to common stock and registering the shares issued pursuant to this capital raise and other previously issued unregistered shares of common stock and to dissolve Doral Holdings pursuant to certain terms and conditions.

Accordingly, during the third quarter of 2010, the Company converted 285,002 shares of Mandatorily Convertible Non-Voting Preferred Stock into 60,000,386 shares of common stock. In addition, during the third quarter of 2010, Doral Holdings LLC, previously the controlling shareholder of the Company, distributed its shares in Doral Financial to its investors and dissolved. As a result of the conversion of the shares of Preferred Stock and the dissolution of Doral Holdings LLC, the Company is no longer a controlled company.

Refer to Note 34 of the accompanying consolidated financial statements for additional information.

Dividends

On April 25, 2006, Doral Financial announced that, as a prudent capital management decision designed to preserve and strengthen the Company’s capital, the Board of Directors had suspended the quarterly dividend on the Common Stock. As a result, Doral Financial has not declared or paid dividends on its Common Stock since the first quarter of 2006.

Doral Financial’s ability to pay dividends on the shares of Common Stock in the future is limited by various regulatory requirements and policies of bank regulatory agencies having jurisdiction over Doral Financial and its banking subsidiary, its earnings, cash resources and capital needs, general business conditions and other factors deemed relevant by Doral Financial’s Board of Directors.

Under an existing consent order with the Federal Reserve, Doral Financial is restricted from paying dividends on its capital stock without the prior written approval of the Federal Reserve. Doral Financial is required to request permission for the payment of dividends on its common stock and preferred stock not less than 30 days prior to a proposed dividend declaration date. For the years ended December 31, 2008 and 2007,

 

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Doral Financial received permission from the Federal Reserve to pay all of the regular monthly cash dividends on the Noncumulative Preferred Stock and the quarterly cash dividends on the Convertible Preferred Stock, but cannot provide assurance that it will receive approval for the payment of such dividends in the future if it decided to declare dividends.

On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-cumulative preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock.

The Puerto Rico internal revenue code generally imposes a 10% withholding tax on the amount of any dividends paid by Doral Financial to individuals, whether residents of Puerto Rico or not, trusts, estates, special partnerships and non-resident foreign corporations and partnerships. Prior to the first dividend distribution for the taxable year, individuals who are residents of Puerto Rico may elect to be taxed on the dividends at the regular graduated rates, in which case the special 10% tax will not be withheld from such year’s distributions.

United States citizens who are not residents of Puerto Rico may also make such an election except that notwithstanding the making of such election, a 10% withholding will still apply to the amount of any dividend distribution unless the individual files with Doral Financial’s transfer agent, prior to the first distribution date for the taxable year, a certificate to the effect that said individual’s gross income from sources within Puerto Rico during the taxable year does not exceed $1,300 if single, or $3,000 if married, in which case dividend distributions will not be subject to Puerto Rico income taxes.

U.S. income tax law permits a credit against U.S. income tax liability, subject to certain limitations, for Puerto Rico income taxes paid or deemed paid with respect to such dividends.

Special U.S. federal income tax rules apply to distributions received by U.S. citizens on stock of a passive foreign investment company (“PFIC”) as well as amounts retained from the sale or exchange of stock of a PFIC. Based upon certain provisions of the Internal Revenue Code of 1986, as amended (the “Code”) and proposed Treasury Regulations promulgated thereunder, Doral Financial understands that it has not been a PFIC for any of its prior taxable years.

For information regarding securities authorized for issuance under Doral Financial’s stock-based compensation plans, please refer to the information included in Part III, Item 12 of this Annual Report on Form 10-K, which is incorporated by reference from the 2012 Proxy Statement, and to Note 35, “Stock Options and Other Incentive Plans” of the accompanying consolidated financial statements of Doral Financial, which are included as an Exhibit in Part IV, Item 15 of this Annual Report on Form 10-K.

Sales of unregistered securities during 2011

There were no sales of unregistered securities by the Company during 2011.

Stock Repurchase

No purchases of Doral Financial’s equity securities were made by or on behalf of Doral Financial for the year ended December 31, 2011.

 

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STOCK PERFORMANCE GRAPH

The following Performance Graph shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act of 1933, as amended (the “Securities Act”) or the Exchange Act, except to the extent that Doral Financial specifically incorporates this information by reference, and shall not otherwise be deemed filed under these Acts.

The following performance graph compares the yearly percentage change in Doral Financial’s cumulative total stockholder return on its common stock to that of the Center for Research in Security Prices, Booth School of Business, the University of Chicago (“CRSP”) NYSE Market Index (U.S. Companies) and the CRSP Index for NYSE Depository Institutions (SIC 6000-6099 U.S. Companies) (the “Peer Group”). The Performance Graph assumes that $100 was invested on December 31, 2006 in each of Doral Financial’s common stock, the NYSE Market Index (U.S. Companies) and the Peer Group. The comparisons in this table are set forth in response to SEC disclosure requirements, and are therefore not intended to forecast or be indicative of future performance of Doral Financial’s common stock.

 

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Item 6.    Selected Financial Data.

The following table sets forth certain selected consolidated financial data as of the dates and for the periods indicated. This information should be read in conjunction with Doral Financial’s consolidated financial statements and the related notes thereto.

 

     Year ended December 31,  
     2011     2010     2009     2008     2007  
     (In thousands, except for share and per share data)  

Selected Income Statement Data:

          

Interest income

   $ 364,955      $ 401,521      $ 458,265      $ 524,674      $ 578,960   

Interest expense

     178,722        240,917        290,638        347,193        424,619   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     186,233        160,604        167,627        177,481        154,341   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Provision for loan and lease losses

     67,525        98,975        53,663        48,856        78,214   

Net interest income after provision for loan and lease losses

     118,708        61,629        113,964        128,625        76,127   

Non-interest income (loss)(1)

     122,386        (14,076     87,201        79,529        (75,397

Non-interest expenses

     250,077        324,564        243,786        240,412        303,492   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income taxes

     (8,983     (277,011     (42,621     (32,258     (302,762

Income tax expense (benefit)

     1,707        14,883        (21,477     286,001        (131,854
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (10,690   $ (291,894   $ (21,144   $ (318,259   $ (170,908
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to common shareholders(2)

   $ (20,350   $ (274,418   $ (45,613   $ (351,558   $ (204,207
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Accrued dividends:

          

Preferred stock

   $ 9,660      $ 9,109      $ 15,841      $ 33,299      $ 33,299   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock exchange inducement, net

   $      $ 26,585      $ (8,628   $      $   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss per common share(2)(3)

   $ (0.16   $ (2.96   $ (0.81   $ (6.53   $ (7.45
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Book value per common share

   $ 3.80      $ 4.01      $ 7.41      $ 6.17      $ 14.37   

Preferred shares outstanding at end of period

     5,811,391        5,811,391        7,500,850        9,015,000        9,015,000   

Weighted average common shares outstanding

     127,321,477        92,657,003        56,232,026        53,810,110        27,415,242   

Common shares outstanding at end of period

     128,295,756        127,293,756        62,064,303        53,810,110        53,810,110   

Selected Balance Sheet Data at Year End:

          

Cash and cash equivalents (including restricted cash)

   $ 489,246      $ 512,426      $ 820,277      $ 187,517      $ 789,169   

Investment securities

     597,652        1,550,094        2,836,903        3,681,028        2,198,402   

Total loans, net(4)

     6,138,645        5,784,188        5,695,964        5,506,303        5,344,756   

Allowance for loan and lease losses

     102,609        123,652        140,774        132,020        124,733   

Servicing assets, net

     112,303        114,342        118,493        114,396        150,238   

Total assets

     7,975,165        8,646,354        10,231,952        10,138,867        9,304,378   

Deposits

     4,394,716        4,636,418        4,655,080        4,423,314        4,300,179   

Borrowings

     2,476,554        2,896,213        4,470,056        4,526,091        3,363,522   

Total liabilities

     7,135,011        7,784,159        9,356,908        9,233,696        7,957,671   

Preferred equity

     352,082        352,082        415,428        573,250        573,250   

Common equity

     488,072        510,113        459,616        331,921        773,457   

Total stockholders’ equity

     840,154        862,195        875,044        905,171        1,346,707   

Selected Average Balance Sheet Data for Period End:(5) 

          

Total investment securities

   $ 1,073,718      $ 2,215,613      $ 3,381,446      $ 3,325,813      $ 3,446,510   

Total loans

     5,993,411        5,894,546        5,680,428        5,566,644        5,156,667   

Total interest-earning assets

     7,567,062        8,765,849        9,515,945        9,422,614        9,647,512   

Total assets

     8,254,484        9,477,943        10,066,305        10,263,563        10,544,286   

Total deposits

     4,431,150        4,709,835        4,210,138        4,274,695        4,097,519   

Borrowings

     2,690,705        3,534,294        4,578,019        4,342,235        4,945,837   

Total interest-bearing liabilities

     6,837,643        7,990,149        8,539,622        8,345,566        8,717,948   

Preferred equity

     352,082        410,616        511,650        573,250        573,250   

Common equity

     505,369        508,137        355,014        668,224        554,823   

Total stockholders’ equity

     857,451        918,753        866,664        1,241,474        1,128,073   

Operating Data:

          

Loan production

   $ 1,763,792      $ 1,439,333      $ 1,147,742      $ 1,327,521      $ 1,332,000   

Loan servicing portfolio(6)

   $ 7,898,328      $ 8,208,060      $ 8,655,613      $ 9,460,350      $ 10,073,000   

Selected Financial Ratios:

          

Performance:

          

Net interest margin

     2.46     1.83     1.76     1.88     1.60

Efficiency ratio

     87.85     119.73     97.61     83.93     167.76

Return on average assets

     (0.13 )%      (3.08 )%      (0.21 )%      (3.10 )%      (1.62 )% 

Return on average common equity

     (4.03 )%      (59.24 )%      (10.42 )%      (52.61 )%      (36.81 )% 

Dividend payout ratio for common stock

                    

 

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     Year ended December 31,  
     2011     2010     2009     2008     2007  
     (In thousands, except for share and per share data)  

Capital:

          

Leverage ratio

                    9.13                    8.56                    8.43                    7.59                  10.80

Tier 1 risk-based capital ratio

     12.18     13.25     13.82     13.80     16.52

Total risk-based capital ratio

     13.44     14.51     15.08     17.07     17.78

Asset quality:

          

NPAs as percentage of the net loan portfolio (excluding GNMA defaulted loans) and OREO

     12.41     14.88     16.65     14.42     12.78

NPAs as percentage of consolidated total assets

     9.47     9.86     9.21     7.69     7.22

NPLs to total loans (excluding GNMA defaulted loans and FHA/VA guaranteed loans)

     9.84     11.63     15.19     13.19     11.93

ALLL to period-end loans receivable

     1.73     2.21     2.55     2.51     2.47

ALLL to period-end loans receivable (excluding FHA/VA guaranteed loans and loans on savings deposits)

     1.76     2.29     2.63     2.54     2.49

ALLL plus partial charge-offs and discounts to loans receivable (excluding FHA/VA guaranteed loans and loans on savings deposits )

     4.49     4.02     3.42        n/a        n/a   

ALLL to NPLs (excluding NPLs held for sale)

     18.08     19.79     16.91     18.69     19.91

ALLL plus partial charge-offs and discounts to NPLs (excluding NPLs held for sale)

     31.97     32.36     22.15        n/a        n/a   

ALLL to net charge-offs

     115.85     106.51     313.47     317.59     602.17

Provision for loan and lease losses to net charge-offs

     76.24     85.25     119.49     117.53     377.59

Net annualized charge-offs to average loan receivable

     1.55     2.08     0.85     0.80     0.50

Recoveries to charge-offs

     1.83     1.54     5.52     2.37     3.73

Other ratios:

          

Average common equity to average assets

     6.13     5.36     3.53     6.11     4.83

Average total equity to average assets

     10.40     9.69     8.61     12.10     10.70

Tier 1 common equity to risk-weighted assets

     6.24     6.94     7.16     6.00     6.66

 

 

 

(1) 

Included net credit related OTTI losses of $4.3 million, $14.0 million, $27.6 million and $0.9 million for the years ended December 31, 2011, 2010, 2009 and 2008, respectively. Also, includes net gain on trading activities of $3.8 million and $13.7 million for the years ended December 31, 2011 and 2010, respectively, and a net loss on trading activities of $7.5 million for the year ended December 31, 2009.

 

(2) 

For the years ended December 31, 2010 and 2009, includes $26.6 million and $8.6 million, respectively, related to the net effect of the conversions of preferred stock during the years indicated.

 

(3)

For the years ended December 31, 2011, 2010, 2009, 2008 and 2007, net loss per common share represents the basic and diluted loss per share, respectively.

 

(4)

Includes loans held for sale.

 

(5)

Average balances are computed on a daily basis.

 

(6) 

Represents the total portfolio of loans serviced for third parties. Excludes $4.4 billion, $4.4 billion, $4.4 billion, $4.2 billion and $3.6 billion of mortgage loans owned by Doral Financial at December 31, 2011, 2010, 2009, 2008, and 2007, respectively.

Doral Financial’s ratios of earnings to fixed charges and earnings to fixed charges and preferred stock dividends on a consolidated basis for each of the years ended December 31, 2011, 2010, 2009, 2008 and 2007 are as follows:

 

      Year Ended December 31,  
      2011     2010     2009     2008     2007  

Ratio of Earnings to Fixed Charges

          

Including interest on deposits

     (A     (A     (A     (A     (A

Excluding interest on deposits

     (A     (A     (A     (A     (A

Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends

          

Including interest on deposits

     (A     (A     (A     (A     (A

Excluding interest on deposits

     (A     (A     (A     (A     (A

 

 

  (A)  During 2011, 2010, 2009, 2008 and 2007, earnings were not sufficient to cover fixed charges or preferred dividends and the ratios     were less than 1:1. The Company would have had to generate additional earnings of $17.1 million, $285.7 million, $74.6 million,     $35.6 million and $361.7 million, to achieve ratios of 1:1 in 2011, 2010, 2009, 2008 and 2007, respectively.

For purposes of computing these consolidated ratios, earnings consist of pre-tax income from continuing operations plus fixed charges and amortization of capitalized interest, less interest capitalized. Fixed charges

 

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consist of interest expensed and capitalized, amortization of debt issuance costs, and Doral Financial’s estimate of the interest component of rental expense. Ratios are presented both including and excluding interest on deposits. The term “preferred stock dividends” is the amount of pre-tax earnings that is required to pay dividends on Doral Financial’s outstanding preferred stock.

On March 20, 2009, the Board of Directors of Doral Financial announced that it had suspended the declaration and payment of all dividends on all of Doral Financial’s outstanding series of cumulative and non-cumulative preferred stock. The suspension of dividends was effective and commenced with the dividends for the month of April 2009 for Doral Financial’s three outstanding series of non-cumulative preferred stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock. For the years ended December 31, 2011 and 2010, the Company accrued $9.7 million and $9.1 million, respectively, related to the cumulative preferred stock. For the year ended December 31, 2009, the Company accrued $15.8 million related to the cumulative preferred stock of which $8.3 million was paid during the first quarter of 2009 prior to the suspension of preferred stock dividends.

The principal balance of Doral Financial’s long-term obligations (excluding deposits) and the aggregate liquidation preference of its outstanding preferred stock as of December 31 of each of the five years in the period ended December 31, 2011 is set forth below:

 

     Year ended December 31,  
     2011      2010      2009      2008      2007  
     (In thousands)  

Long-term obligations

   $  2,119,495       $  2,429,489       $  2,457,944       $  3,459,246       $  2,885,164   

Cumulative preferred stock

   $  203,382       $ 203,382       $ 218,040       $ 345,000       $ 345,000   

Non-cumulative preferred stock

   $ 148,700       $ 148,700       $ 197,388       $ 228,250       $ 228,250   

Item 7.    Managements Discussion and Analysis of Financial Condition and Results of Operations.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help you understand Doral Financial and its subsidiaries. This MD&A is provided as a supplement to and should be read in conjunction with Doral Financial’s consolidated financial statements and the accompanying notes. The MD&A includes the following sections:

OVERVIEW OF RESULTS OF OPERATIONS:    Provides a brief summary of the most significant events and drivers affecting Doral Financial’s results of operations during 2011.

CRITICAL ACCOUNTING POLICIES:    Provides a discussion of Doral Financial’s accounting policies that require critical judgment, assumptions and estimates.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009:    Provides an analysis of the consolidated results of operations for 2011 compared to 2010, and 2010 compared to 2009.

OPERATING SEGMENTS:    Provides a description of Doral Financial’s operating segments and an analysis of the results of operations for each of these segments.

BALANCE SHEET AND OPERATING DATA ANALYSIS:    Provides an analysis of the most significant balance sheet items and operational data that impact Doral Financial’s financial statements and business. This section includes a discussion of the Company’s liquidity and capital resources, regulatory capital ratios, off-balance sheet activities and contractual obligations.

RISK MANAGEMENT:    Provides an analysis of the most significant risks to which Doral Financial is exposed; specifically interest rate risk, credit risk, operational risks and liquidity risk.

MISCELLANEOUS:    Provides disclosure about various matters.

Investors are encouraged to carefully read this MD&A together with Doral Financial’s consolidated financial statements, including the notes to the consolidated financial statements.

 

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As used in this report, references to the “Company”, “Doral” or “Doral Financial” refer to Doral Financial Corporation and its consolidated subsidiaries unless otherwise indicated.

OVERVIEW OF RESULTS OF OPERATIONS

Net loss for the year ended December 31, 2011 totaled $10.7 million, compared to net losses of $291.9 million and $21.1 million for the years 2010 and 2009, respectively. Doral Financial’s performance for the year ended December 31, 2011, compared to the corresponding 2010 period was primarily due to an improvement of $121.2 million in net gains on sales of investment securities, a reduction of $74.5 million in non-interest expenses, and a reduction of $31.5 million in the provision for loan and lease losses.

The significant events affecting the Company’s financial results for the year ended December 31, 2011 included the following:

 

   

Net loss attributable to common shareholders for the year ended December 31, 2011 totalled $20.4 million, and resulted in a net loss per share of $0.16, compared to a net loss attributable to common shareholders for the corresponding 2010 and 2009 periods of $274.4 million and $45.6 million, or a loss per share of $2.96 and $0.81, respectively. For additional information please refer to Note 36 of the accompanying consolidated financial statements.

 

   

Net interest income for the year ended December 31, 2011 was $186.2 million, compared to $160.6 million and $167.6 million for the corresponding 2010 and 2009 periods, respectively. The increase of $25.6 million in net interest income during 2011, compared to 2010, was due to a reduction in interest expense of $62.2 million, partially offset by a reduction in interest income of $36.6 million. The decrease in interest expense was driven by decreases of: (i) $31.5 million in interest expense on securities sold under agreements to repurchase as Doral renegotiated $1.1 billion in advances from FHLB and repurchase agreements in the first and second quarters of 2011, and retired $219.5 million of repurchase agreements upon the sale of $679.2 million of investment securities, and (ii) $22.6 million on deposits as the Company replaced the volume of higher cost brokered certificates of deposit with lower brokered money market deposits. The decrease in interest income was driven by a decrease in interest on mortgage backed and investment securities of $39.7 million from the sale of securities to deliver the bank and decrease the bank’s sensitivity to increasing interest rates.

 

   

Doral Financial’s provision for loan and lease losses for the year ended December 31, 2011 amounted to $67.5 million, compared to $99.0 million and $53.7 million for the corresponding 2010 and 2009 periods, respectively. The $67.5 million provision for loan and lease losses in 2011 resulted from: (i) $31.6 million for non-guaranteed residential loans as new loans became delinquent, previously delinquent loans reached later delinquency stages, and Doral changed its cash flow estimates for TDR loans; (ii) $23.8 million from construction and land largely due to new valuations on properties collateralizing impaired loans received in the second half of the year and some deterioration of loan performance; (iii) $32.1 million for growth in the U.S. commercial and industrial loan portfolio; and (iv) $9.0 million for commercial real estate and other consumer for adverse loan performance of largely previously performing loans experienced during the year.

 

   

Non-interest income for the year ended December 31, 2011 was $122.4 million, compared to non-interest loss of $14.1 million and non-interest income of $87.2 million for the corresponding 2010 and 2009 periods, respectively. The $136.5 million improvement in non-interest income during 2011 when compared to 2010 resulted largely from the following: (i) an improvement of $121.2 million in gain on sale of investment securities available for sale as the Company reported a loss of $93.7 million in 2010 driven by a loss of $136.7 million on the sale of $378.0 million of certain non-agency collateralized mortgage obligations (“CMO”), (ii) a $13.7 improvement in net gain on loans securitized and sold and capitalization of mortgage servicing as the Company increased the volume of sales of mortgage loans by $129.3 million when compared to 2010, (iii) a decrease of $9.7 million in other-than-temporary impairment (“OTTI”) losses as the Company sold during 2010 a significant portion of the non-agency CMOs that had OTTI, (iv) partially offset by a $9.8 million decrease in net gains from trading activities resulting mainly from a decrease of $6.0 million in gains from the MSR economic hedge and a $2.5 million increase in losses from hedging activities.

 

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Non-interest expense for the year ended December 31, 2011 was $250.1 million, compared to $324.6 million and $243.8 million for the years ended December 31, 2010 and 2009, respectively. The $74.5 million decrease in non-interest expense during 2011 compared to 2010, was due largely to: (i) a decrease of $30.0 million in OREO expenses mainly due to the $17.0 million provision recorded in the second quarter of 2010 when the Company reduced the pricing of the properties to accelerate sales, (ii) a decrease of $13.5 million in professional services driven by a decrease of $7.9 million in defense litigation costs and a decrease of $7.0 million in lower advisory services, (iii) lower FDIC insurance expense of $5.5 million related to a lower deposit base and a change in the method of computing the assessment, and (iv) a decrease of $3.9 million in advertising expense as the Company incurred higher expenses in 2010 due to the campaigns to gain market share in deposits and mortgage originations subsequent to the local market bank failures and asset acquisitions in April of 2010.

 

   

Income tax expense of $1.7 million for the year ended December 31, 2011 compared to an income tax expense of $14.9 million and an income tax benefit of $21.5 million for the corresponding 2010 and 2009 periods. The decrease in income tax expense of $13.2 million is due mainly to the tax benefit recorded during 2011, as well as funding Doral Money lending activities by U.S. based funding sources and eliminating the withholding tax on debt payments from the U.S. based lending operations to the Puerto Rico based funding operations.

 

   

The Company reported other comprehensive loss of $5.4 million for the year ended December 31, 2011, compared to other comprehensive income of $115.6 million and $11.7 million for the corresponding 2010 and 2009 periods. The negative variance in other comprehensive income for the year ended December 31, 2011 compared to the 2010 period resulted principally from the sales of available for sale securities during 2011 that drove the realization of gains of $121.2 million during 2011.

 

   

Doral Financial’s loan production for the year ended December 31, 2011 was $1.8 billion, compared to $1.4 billion and $1.1 billion for the comparable 2010 and 2009 periods. The production increase resulted mainly from the U.S. loan originations production in commercial and industrial loans, which represented 56% of the 2011 loan production.

 

   

Total assets as of December 31, 2011 totalled $8.0 billion compared to $8.6 billion as of December 31, 2010. The decrease is mainly due to the sale of $1.4 billion of mortgage backed securities in 2011, which have been offset in part by net growth in loans and the purchases of $0.9 billion in agency securities. These sales were conducted pursuant to the Company’s deleveraging of the balance sheet and the substitution of lower yielding loans for higher yielding loans.

 

   

Total deposits as of December 31, 2011 of $4.4 billion decreased $0.2 billion from deposits of $4.6 billion as of December 31, 2010. The decrease is mainly due to the reduction of $0.2 billion in brokered deposits as part of the Company’s strategy to reduce funding costs.

 

   

Non-performing loans, excluding FHA/VA loans guaranteed by the U.S. government as of December 31, 2011 were $569.6 million, a decrease of $57.8 million from December 31, 2010. The reduction in NPLs was a result of continued emphasis on collections and restructures to optimize performance of the loan portfolio during 2011.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in Doral Financial’s consolidated financial statements and accompanying notes. Certain of these estimates are critical to the presentation of Doral Financial’s financial condition since they are particularly sensitive to the Company’s judgment and are highly complex in nature. Doral Financial believes that the judgments, estimates and assumptions used in the preparation of its consolidated financial statements are appropriate given the factual circumstances as of December 31, 2011. However, given the sensitivity of Doral Financial’s consolidated financial statements to these estimates, the use of other judgments, estimates and assumptions could result in material differences in Doral Financial’s results of operations or financial condition.

 

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Various elements of Doral Financial’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. Note 2 to Doral Financial’s consolidated financial statements contains a summary of the Company’s significant accounting policies followed in the preparation of its consolidated financial statements. The accounting policies that have a significant impact on Doral Financial’s consolidated financial statements and that require the most judgment are set forth below.

Fair Value Measurements

The Company uses fair value measurements to state certain assets and liabilities at fair value and to support fair value disclosures. Securities held for trading, securities available for sale, derivatives and servicing assets are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record other financial assets at fair value on a nonrecurring basis, such as loans held for sale, loans receivable and certain other assets. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.

The Company discloses for interim and annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not in the statement of financial condition.

Fair Value Hierarchy

The Company categorized its financial instruments based on the priority of inputs to the valuation technique into a three level hierarchy described below:

 

   

Level 1 — Valuation is based upon unadjusted quoted prices for identical instruments traded in active markets.

 

   

Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market, or are derived principally from or corroborated by observable market data, by correlation or by other means.

 

   

Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Determination of Fair Value

The Company bases fair values on the price that would be received upon sale of an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. It is Doral Financial’s intent to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in the current accounting guidance.

Fair value measurements for assets and liabilities where there is limited or no observable market data are based primarily upon the Company’s estimates, and are generally calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the fair values represent management’s estimates and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

The Company relies on appraisals for valuation of collateral dependent impaired loans and other real estate owned. An appraisal of value is obtained at the time the loan is originated. New estimates of collateral value are obtained when a loan that has been performing becomes delinquent and is determined to be collateral dependent, and at the time an asset is acquired through foreclosure. Updated reappraisals are requested at least every two years for collateral dependent loans and other real estate owned.

 

 

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Residential mortgage loans are considered collateral dependent when they are 180 days past due (collateral dependent residential loans are those past due loans whose borrower’s financial condition has deteriorated to the point that Doral considers only the collateral when determining its ALLL estimate). An updated estimate of the property’s value is obtained when the loan is 180 days past due and a second assessment of value is obtained when the loan is 360 days past due. The Company generally uses broker price opinions (“BPOS”) as an assessment of value of collateral dependent residential mortgage loans.

As it takes a period of time for commercial loan appraisals to be completed once they are ordered, Doral must at times estimate its allowance for loan and lease losses for an impaired loan using a dated, or stale, appraisal. Puerto Rico has experienced some decrease in property values during its extended recession; therefore, the reported values of the stale appraisals must be adjusted to recognize the “fade” in market value. In order to estimate the value of collateral with stale appraisals, Doral has developed separate collateral price indices for small commercial loans and large commercial loans that are used to measure the market value fade in appraisals completed in one year to the current year. The indices provide a measure of how much the property value has changed from the year in which the most recent appraisal was received to the current year. In estimating its ALLL on collateral dependent loans using outdated appraisals, Doral uses the original appraisal as adjusted for the estimated fade in property value less selling costs to estimate the current fair value of the collateral. That current adjusted estimated fair value is then compared to the reported investment, and if the adjusted fair value is less than reported investment, that amount is included in the ALLL estimate.

Residential development construction loans that are collateral dependent present unique challenges to the estimating the fair value of the underlying collateral. Residential development construction loans are partially completed with additional construction costs to be incurred, have units being sold and released from the construction loan, and may have additional land collateralizing the loan on which the developer hopes or expects to build additional units. Therefore, the value of the collateral is regularly changing and any appraisal has a limited useful life. Doral uses an internally developed estimate of value that considers Doral’s exit strategy of foreclosing and completing the construction started and selling the individual units constructed for residential buildings, and separately uses the most recent appraised value for any remnant land adjusted for the fade in value since the appraisal date as described above. This internally developed estimate is prepared in conjunction with a third party servicer of the portfolio, who validates and determines the inputs used to arrive at the estimate of value (e.g. units sold, expected sales, cost to complete, etc.)

In the second quarter of 2011, Doral adopted the practice of charging-off the portion deemed uncollectible of the difference between the loan balance before charge-off and the estimated fair value of the property collateralizing the loan prior to receipt of a third party appraisal due to the long delays to receive such appraisals in Doral’s Puerto Rico market.

Once third party appraisals are obtained, the previously estimated property values are updated with the actual values reflected in the appraisals and any additional loss incurred is recognized in the period when the appraisal is received. The internally developed collateral price index is also updated and any changes resulting from the update in the index are also recognized in the period.

Refer to Note 38 of the accompanying consolidated financial statements for a discussion about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used and its impact on earnings.

Gain or Loss on Mortgage Loan Sales

The Company generally sells or securitizes a portion of the residential mortgage loans that it originates. FHA and VA loans are generally securitized into GNMA mortgage-backed securities and held as trading securities. After holding these securities for a period of time, usually less than one month, Doral Financial sells these securities for cash through broker-dealers. Conforming conventional loans are generally sold directly to FNMA, FHLMC or institutional investors or exchanged for FNMA or FHLMC-issued mortgage-backed securities, which Doral Financial also sells for cash through broker-dealers.

 

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As part of its mortgage loan sale and securitization activities, Doral Financial generally retains the right to service the mortgage loans it sells. Doral Financial determines the gain on sale of a mortgage-backed security or loan pool by allocating the carrying value, also known as basis, of the underlying mortgage loans between the mortgage-backed security or mortgage loan pool sold and its retained interests, based on their relative estimated fair values. The gain on sale reported by Doral Financial is the difference between the proceeds received from the sale and the cost allocated to the loans sold. The proceeds include cash and other assets received in the transaction (primarily MSRs) less any liabilities incurred (i.e., representations and warranty provisions). The amount of gain on sale is therefore influenced by the values of the MSRs and retained interest recorded at the time of sale. See “-Retained Interest Valuation” below for additional information.

If in a transfer of financial assets in exchange for cash or other consideration (other than beneficial interests in transferred assets), Doral Financial has not surrendered control over the transferred assets, Doral Financial accounts for the transfer as a secured borrowing (loan payable) with a pledge of collateral.

Retained Interest Valuation

The Company routinely originates, securitizes and sells mortgage loans into the secondary market. The Company generally retains the servicing rights and, in the past, also retained IOs. MSRs represent the estimated present value of the normal servicing fees (net of related servicing costs) expected to be received on a loan being serviced over the expected term of the loan. MSRs entitle Doral Financial to a future stream of cash flows based on the outstanding principal balance of the loans serviced and the contractual servicing fee. The annual servicing fees generally range between 25 and 50 basis points, less, in certain cases, any corresponding guarantee fee. In addition, MSRs may entitle Doral Financial, depending on the contract language, to ancillary income including late charges, float income, and prepayment penalties net of the appropriate expenses incurred for performing the servicing functions. In certain instances, the Company also services loans with no contractual servicing fee. The servicing asset or liability associated with such loans is evaluated based on ancillary income, including float, late fees, prepayment penalties and costs. The Company’s interests that continue to be held (“retained interest”) are subject to prepayment and interest rate risk. MSRs are classified as servicing assets in Doral Financial’s consolidated statements of financial condition. Any servicing liability recognized is included as part of accrued expenses and other liabilities in Doral Financial’s consolidated statements of financial condition.

The fair value of the Company’s MSRs is determined based on a combination of market information (servicing trades and broker valuations), benchmarking of servicing assets (valuation surveys) and cash-flow modeling. The valuation of the Company’s MSRs incorporate two sets of assumptions: (i) market derived assumptions for discount rates, servicing costs, escrow earnings rate, float earnings rate and cost of funds and (ii) market derived assumptions adjusted for the Company’s loan characteristics and portfolio behavior for escrow balances, delinquencies and foreclosures, late fees, prepayments and prepayment penalties. For the year ended December 31, 2011, the fair value of the MSRs totaled to $112.3 million, which reflects a decline of $10.7 million when compared to December 31, 2010. The decline in the MSR is the result of the MSR amortization of $13.2 million offset by an increase in fair value of $2.5 million.

IOs represent the estimated present value of cash flows retained by the Company that are generated by the underlying fixed rate mortgages (as adjusted for prepayments) after subtracting: (i) the interest rate payable to the investor (adjusted for any embedded cap, if applicable); and (ii) a contractual servicing fee. As of December 31, 2011, the carrying value of the IOs of $43.9 million is related to $223.2 million of outstanding principal balance of mortgage loans sold to investors. IOs are classified as securities held for trading in Doral Financial’s consolidated statements of financial condition.

To determine the value of its portfolio of variable IOs, Doral Financial uses an internal valuation model that forecasts expected cash flows using forward LIBOR rates derived from the LIBOR/Swap yield curve at the date of the valuation. The characteristics of the variable IOs result in an increase in cash flows when LIBOR rates fall and a reduction in cash flows when LIBOR rates rise. This provides a mitigating effect on the impact of prepayment speeds on the cash flows, with prepayments expected to rise when long-term interest rates fall reducing the amount of expected cash flows and the opposite when long-term interest rise. Prepayment assumptions incorporated into the valuation model for variable and fixed IOs are based on publicly available,

 

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independently verifiable, prepayment assumptions for FNMA mortgage pools and statistically derived prepayment adjusters based on observed relationships between the Company’s and FNMA’s U.S. mainland mortgage pool prepayment experiences.

This methodology resulted in a CPR of 8.21% for 2011, 9.0% for 2010 and 10.4% for 2009.

The Company continues to benchmark its assumptions for setting its liquidity/credit risk premium to a third party valuation provider. This methodology resulted in a discount rate 13.0% that was used for the years ended December 31, 2011, 2010 and 2009, respectively.

For IOs, Doral Financial recognizes as interest income (through the life of the IO) the excess of all estimated cash flows attributable to these interests over their recorded balance using the effective yield method. The Company updates its estimates of expected cash flows periodically and recognizes changes in calculated effective yield on a prospective basis.

Valuation of Trading Securities and Derivatives

Doral Financial’s net gain (loss) on trading activities includes gains and losses, whether realized or unrealized, on securities accounted for as held for trading, including IOs, as well as various other financial instruments, such as derivative contracts, that Doral Financial uses to manage its interest rate risk. Securities held for trading and derivatives are recorded at fair values with increases or decreases in such values reflected in current earnings. The fair values of many of Doral Financial’s trading securities (other than IOs) are based on market prices obtained from market data sources. For instruments not traded on a recognized market, Doral Financial generally determines fair value by reference to quoted market prices for similar instruments. The fair values of derivative instruments are obtained using internal valuation models based on financial modeling tools and using market derived assumptions obtained from market data sources.

Until the second quarter of 2009, securities accounted as held for trading included U.S. Treasury security positions, taken as economic hedges against the valuation adjustment of the Company’s capitalized mortgage servicing rights (“MSR”). Subsequently, the U.S. Treasury positions were unwound and other derivative instruments were used as economic hedges on the MSR.

Generally, derivatives are financial instruments with little or no initial net investment in comparison to their notional amount and whose value is based on the value of an underlying asset, index, reference rate or other variable. They may be standardized contracts executed through organized exchanges or privately negotiated contractual agreements that can be customized to meet specific needs, including certain commitments to purchase and sell mortgage loans and mortgage-backed securities. The fair value of derivatives is generally reported net by counterparty, provided that a legally enforceable master agreement exists. Derivatives in a net asset position are reported as part of securities held for trading, at fair value. Similarly, derivatives in a net liability position are reported as part of accrued expenses and other liabilities, at fair value.

For those derivatives not designated as an accounting hedge, fair value gains and losses are reported as part of net gain (loss) on trading activities in the consolidated statements of operations.

Other Than Temporary Impairment

The Company performs an assessment of other-than-temporary impairment whenever the fair value of an investment security is less that its amortized cost basis at the balance sheet dates. Amortized cost basis includes adjustments made to the cost of a security for accretion, amortization, collection of cash, previous OTTI recognized into earnings (less any cumulative effect adjustments) and fair value hedge accounting adjustments. OTTI is considered to have occurred under the following circumstances:

 

  (i) if the Company intends to sell the investment security and its fair value is less than its amortized cost;

 

  (ii) if, based on available evidence, it is more likely than not that the Company will decide or be required to sell the investment security before the recovery of its amortized cost basis; and

 

  (iii)

if the Company does not expect to recover the entire amortized cost basis of the investment security. This occurs when the present value of cash flows expected to be collected is less than the amortized cost basis of the security. In determining whether a credit loss exists, the Company uses its best

 

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  estimate of the present value of cash flows expected to be collected from the investment security. Cash flows expected to be collected are estimated based on a careful assessment of all available information. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.

The Company evaluates its individual available for sale investment securities for OTTI on at least a quarterly basis. As part of this process, the Company considers its intent to sell each investment security and whether it is more likely than not that it will be required to sell the security before its anticipated recovery.

If either of these conditions is met, the Company recognizes an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities that meet neither of these conditions, an analysis is performed to determine if any of these securities are at risk for OTTI. To determine which securities are at risk for OTTI and should be quantitatively evaluated utilizing a detailed cash flow analysis, the Company evaluates certain indicators which consider various characteristics of each security including, but not limited to, the following: (i) the credit rating and related outlook or status of the securities; (ii) the creditworthiness of the issuers of the securities; (iii) the value and type of underlying collateral; (iv) the duration and level of the unrealized loss; (v) any credit enhancements; and (vi) other collateral-related characteristics such as the ratio of credit enhancements to expected credit losses. The relative importance of this information varies based on the facts and circumstances surrounding each security, as well as the economic environment at the time of assessment. The amount of estimated credit loss is determined as the amount by which the amortized cost basis exceeds the present value of expected cash flows.

Once a credit loss is recognized, the investment will be adjusted to a new amortized cost basis equal to the previous amortized cost basis less the amount recognized in earnings. For the investment securities for which OTTI was recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted as interest income.

Interest Income Recognition on Loans

Doral recognizes interest income on loans receivable on an accrual basis unless it is determined that collection of all contractual principal or interest is unlikely. Doral discontinues recognition of interest income when a loan receivable is 90 days delinquent on principal or interest. For mortgage loans Doral discontinues recognition of interest income when the loan is four payments in arrears, except for mortgage loans insured by FHA/VA that are placed in non-accrual when the loans have ten payments in arrears. Loans determined to be well collateralized so that ultimate collection of principal and interest is not in question (for example, when the outstanding loan and interest balance as a percentage of current collateral value is less than 60%) are not placed on non-accrual status, and Doral continues to recognize interest income. When a loan is placed on non-accrual, all accrued but unpaid interest is reversed against interest income in that period. Loans return to accrual status when principal and interest are current, or when the loan is both well-secured and in the process of collection and collectability is no longer doubtful. In the case of troubled debt restructuring agreements, the Company continues to place the loans in non-accrual status and reports the loans as non-performing loans unless the Company expects to collect all contractual principal and interest and the loans have proven repayment capacity for a sufficient amount of time. Previously reversed or not accrued interest will be credited to income in the period of recovery. Interest income is recognized when a payment is received on a non-accrual loan if ultimate collection of principal is not in doubt.

Accrued interest receivable on impaired loans is reversed when a loan is placed on non-accrual status. Interest collections on non-accruing loans, for which the ultimate collectability of principal is uncertain, are applied as principal reductions. The judgment as to ultimate collectability is based upon collateral valuation, delinquency status, and management judgment of ultimate loan collectability, which may be based upon knowledge of specific borrower circumstances. Otherwise, such collections are credited to interest income when received. These loans may be restored to accrual status when all principal and interest is current and full repayment of the remaining contractual principal and interest is expected, or when the loan otherwise becomes

 

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well-secured and is in the process of collection. The judgment as to returning a loan to accrual status considers recent collateral valuations, recent payment performance, borrowers’ other assets, and management’s estimate as to future loan performance, which may be based upon knowledge of specific borrower circumstances. Loans whose contractual terms have been modified in a TDR and are performing at the time of restructuring remain on accrual status if there is demonstrated performance prior to the restructuring and payment in full under the restructured terms is expected. Otherwise, the loans are placed on non-accrual status and reported as non-performing until there is sustained repayment performance for a reasonable period.

For consumer loans (primarily residential real estate), all of Doral’s loss mitigation tools require that the borrower demonstrate the intent and ability to pay all principal and interest on the loan. Doral must receive at least three consecutive monthly payments prior to qualifying the borrower for a loss mitigation product. The Company’s loss mitigation specialists must be reasonably assured of the borrower’s future repayment and performance from their review of the borrower’s circumstances and, when all the conditions are met, the customer could be approved for a loss mitigation product. Following approval of the loss mitigation, Doral must receive from the borrower three additional consecutive payments prior to returning the loan to accrual status. Consumer loans delinquent less than 90 days that are eligible for loss mitigation products are subject to these requirements, except that the three consecutive payments prior to the restructure is waived.

Allowance for Loan and Lease Losses

Doral Financial maintains an allowance for loan and lease losses to absorb probable credit-related losses inherent on its loans receivable portfolio.

The allowance consists of specific and general components and is based on Doral Financial’s assessment of default probabilities, internal risk ratings (based on borrowers’ financial stability, external credit ratings, management strength, earnings and operating environment), probable loss and recovery rates, and the degree of risk inherent in the loans receivable portfolio. The allowance is maintained at a level that Doral Financial considers appropriate to absorb probable losses. Credit losses are charged and recoveries are credited to the allowance, while increases to the allowance are charged to operations. Unanticipated increases in the allowance for loan and lease losses could adversely impact Doral Financial’s net income in the future.

The Company estimates and records its ALLL on a quarterly basis. For all performing loans and non-performing small balance homogeneous loans (including residential mortgages, consumer, construction, commercial real estate and commercial under $1.0 million; and performing construction, commercial real estate and commercial greater than $1.0 million) the ALLL is estimated based upon estimated probability of default and loss given default by shared product characteristics using the Company’s historical experience. For larger construction, commercial real estate and commercial loans (loan balance greater than $1.0 million) that are 90 or more days past due or are, otherwise considered to be impaired, management estimates the related ALLL based upon an analysis of each individual loans’ characteristics. The ALLL estimate methodologies are described in the following paragraphs.

Residential mortgage — The general allowance for residential mortgage loans is calculated based on the probability that loans within different delinquency buckets will default and, in the case of default, the extent of losses that the Company expects to realize. In determining the probabilities of default, the Company considers the historical migration of loans to default status. In determining the allowance for loan and lease losses for residential mortgage loans, for purposes of forecasting the future behavior of the portfolio, the Company considers the migration analysis for periods beginning January 2004, but more heavily weights the most recent experience. Consideration of both older and more recent experience ensures that the resulting reserve reflects the challenging economic conditions in Puerto Rico from 2006 through 2010, the leveling of the economy in 2011, and the effect of the Company’s increased collections efforts. Only using the older historical performance would yield lower probabilities of default that may not reflect recent macroeconomic trends and management changes. Severity of loss is calculated based on historical results from short sales and foreclosure sales. Historical results are adjusted for the Company’s expectation of housing prices. Severity assumptions for the residential portfolio range between 10% and 42% depending on the size of the loan and loan-to-value ratios, and up to 100% for second mortgages. For all loans whose terms have been modified and are considered troubled debt restructured

 

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loans, the loans are pooled and cash flows are forecasted (including estimated future defaults), and the cash flows are discounted back to a present value using the average pool original yield.

Construction, commercial real estate, commercial and industrial and land — The ALLL for performing construction, commercial real estate, commercial and industrial and land loans is estimated considering either the probability of the loan defaulting in the next twelve months and the estimated loss incurred in the event of default or the loan quality assigned to each loan and the estimated expected loss associated with that loan grade. The probability of a loan defaulting is based upon the Company’s experience in its current portfolio. The loss incurred upon default is based upon the Company’s actual experience in resolving defaulted loans.

The Company evaluates impaired loans and estimates the allowance based on current accounting guidance. Commercial and construction loans over $1.0 million that are classified more than 90 days past due, or when management is concerned about the collection of all contractual amounts due, are evaluated individually for impairment. Loans are considered impaired when, based on current information and events it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement.

During 2011, as part of its continuous efforts to improve its ALLL estimates and to reflect the availability of new data and tools to analyze portfolio and borrower behavior, Doral implemented several changes and enhancements to its ALLL estimation process. Most notably, Doral (i) in the first quarter reviewed and expanded the appraisals received and included in the Puerto Rico CPI used to temporarily estimate real estate values of properties in the absence of a current updated estimate of value, (ii) received a significant number of new commercial real estate and construction loan appraisals during the third quarter, and (iii) changed the calculation to estimate the cash flows on residential mortgage loans that had been modified in a troubled debt restructuring. These changes in estimate affected the provision for loan and lease losses by reducing the provision $8.6 million for the CPI update and increasing the provision for loan and lease losses by $19.1 million for receiving updated commercial real estate and construction loan appraisals in the third quarter, and increasing the provision $18.6 million for revising the cash flow estimates based on new analysis of the residential mortgage loan portfolio.

During 2010, management individually reviewed for impairment all commercial loans over $50,000 that were over 90 days past due. The impairment measurement of these smaller balance loans is now performed annually, with approximately one-fourth of the population reviewed each quarter. The impairment loss, if any, on each individual loan identified as impaired is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent. If foreclosure is probable, accounting guidance requires the measurement of impairment to be based on the fair value of the collateral.

If the loan is collateral dependent, regulatory guidance requires the impairment to be based upon the fair value. When current appraisals are not available on properties subject to impairment measurement at quarter end, management determined its loss reserve estimates for these loans by estimating the fair value of the collateral. In doing so, management considers: (a) a number of factors including the price at which individual units could be sold in the current market; the period of time over which the units would be sold, the estimated cost to complete the units, the risks associated with completing and selling the units, the required rate of return on investment a potential acquirer may have and current market interest rates in the Puerto Rico market; or (b) uses an internal index of previously received appraisals from the same geography (typically Puerto Rico) covering the same time period since the stale appraisal was received to estimate the decline in value since the date of the most recent appraisal.

Consumer — The ALLL for consumer loans is estimated based upon the historical charge-off rate using the Company’s historical experience. The ALLL is supplemented by the Company’s policy to charge-off all amounts in excess of the collateral value when the loan principal or interest is 120 days or more days past due.

TDRs — In accordance with accounting guidance, loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. For residential mortgage loans determined to be TDRs, the Company pools TDRs with similar characteristics and performs an impairment analysis of discounted cash flows. If a pool yields a present value below the recorded investment in the pool of

 

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loans, the impairment is recognized by a charge to the provision for loan and lease losses and a credit to the allowance for loan and lease losses. For loss mitigated loans without a concession in the interest rate, the Company performs an impairment analysis of discounted cash flows giving consideration to the probability of default and loss given foreclosure on those estimated cash flows, and records the impairment by charging the provision for loan and lease losses with a corresponding credit to the ALLL.

Generally, the percentage of the allowance for loan and lease losses to non-performing loans will not remain constant due to the nature of the Company’s loan portfolios, which are primarily collateralized by real estate. The collateral for each non-performing mortgage loan is analyzed to determine potential loss exposure, and, in conjunction with other factors, this loss exposure contributes to the overall assessment of the adequacy of the allowance for loan and lease losses. On an ongoing basis, management monitors the loan portfolio and evaluates the adequacy of the ALLL. In determining the adequacy of the ALLL, management considers such factors as default probabilities, internal risk ratings (based on borrowers’ financial stability, external credit ratings, management strength, earnings and operating environment), probable loss and recovery rates, cash flow forecasts and the degree of risk inherent in the loan portfolios. Allocated general reserves are supplemented by a macroeconomic or emerging risk reserve. This portion of the total allowance for loan and lease losses reflects management’s evaluation of conditions that are not directly reflected in the loss factors used in the determination of the ALLL. The conditions evaluated in connection with the macroeconomic and emerging risk allowance include national and local economic trends, industry conditions within the portfolios, recent loan portfolio performance, loan growth, changes in underwriting criteria and the regulatory and public policy environment.

Loans, or portions of loans, estimated by management to be uncollectible are charged to the allowance for loan and lease losses. Recoveries on loans previously charged-off are credited to the allowance. Provisions for loan and lease losses are charged to expenses and credited to the ALLL in amounts estimated by management based upon its evaluation of the known and inherent risks in the loan portfolio. While management believes that the current ALLL is maintained at a level believed appropriate to provide for inherent probable losses in the loan portfolio, future additions to the allowance may be necessary. If economic conditions or borrower behavior deviate substantially from the assumptions used by the Company in determining the allowance for loan and lease losses further increases in the allowance may be required.

The Company also engages in the restructuring and/or modifications of the debt of borrowers, who are delinquent due to economic or legal reasons, if the Company determines that it is in the best interest for both the Company and the borrower to do so. In some cases, due to the nature of the borrower’s financial condition, the restructure or loan modification fits the definition of Troubled Debt Restructuring (“TDR”). Such restructures are identified as TDRs and accounted for as impaired loans.

Estimated Recourse Obligation

In the past, the Company sold mortgage loans and MBS subject to recourse provisions. Pursuant to these recourse arrangements, the Company agreed to retain or share the credit risk with the purchaser of such mortgage loans for a specified period or up to a certain percentage of the total amount in loans sold. The Company estimates the fair value of the retained recourse obligation or any liability incurred at the time of sale and includes such obligation with the net proceeds from the sale, resulting in a lower gain on sale recognition. Doral estimates the fair value of its recourse obligation based on historical losses from foreclosure and disposition of mortgage loans adjusted for expectations of changes in portfolio behaviour and market environment.

Income Taxes

The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities based on current tax laws.

To the extent tax laws change, deferred tax assets and liabilities are adjusted, as necessary, in the period that the tax change is enacted. The Company recognizes income tax benefits when the realization of such benefits is probable. A valuation allowance is recognized for any deferred tax asset which, based on management’s evaluation, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax

 

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asset will not be realized. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded against deferred tax assets. In assessing the realization of deferred tax assets, the Company considers the expected reversal of its deferred tax assets and liabilities, projected future taxable income, cumulative losses in recent years and tax planning strategies. The determination of a valuation allowance on deferred tax assets requires judgment based on weight of all available evidence and considering the relative impact of negative and positive evidence. These estimates are projected through the life of the related deferred tax assets based on assumptions that we believe to be reasonable and consistent with current operating results. Changes in future operating results not currently forecasted may have a significant impact on the realization of deferred tax assets.

The Company classifies all interest and penalties related to tax uncertainties as income tax expense.

Income tax benefit or expense includes: (i) deferred tax expense or benefit, which represents the net change in the deferred tax assets or liability balance during the year plus any change in the valuation allowance, if any; and (ii) current tax expense.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009

Net Interest Income

Net interest income is the excess of interest earned by Doral Financial on its interest-earning assets over the interest incurred on its interest-bearing liabilities. Doral Financial’s net interest income is subject to interest rate risk due to the repricing and maturity mismatch in the Company’s assets and liabilities. Generally, Doral Financial’s residential mortgage assets have a longer maturity and a later repricing date than its liabilities, though its growing U.S.-based commercial loan portfolio is dominated by variable rate assets. The net effect is Doral will experience lower net interest income in periods of rising short-term interest rates and higher net interest income in periods of declining short-term interest rates. Refer to “Risk Management” below for additional information on the Company’s exposure to interest rate risk.

Net interest income for the years 2011, 2010 and 2009, was $186.2 million, $160.6 million and $167.6 million, respectively.

2011 compared to 2010 — Total interest income for the years ended December 31, 2011 and 2010 was $365.0 million and $401.5 million, respectively. Interest income decreased by $36.5 million, or 9.1%, for the year ended December 31, 2011 compared to the corresponding 2010 period. Significant variances impacting interest income for the year ended December 31, 2011, when compared to the corresponding 2010 period, are as follows:

 

   

An increase of $6.0 million in interest income on loans due to:

 

   

The impact of loans leaving non-accrual status due to collection efforts and loss mitigation transactions on non-performing loans excluding FHA/VA loans guaranteed by the U.S. government, of approximately $57.8 million as of December 31, 2011 compared to the same period in 2010.

 

   

A positive variance in interest income on commercial and industrial loans of $24.2 million primarily due to an increase in the average balance of commercial and industrial loans of $411.8 million during 2011 as a result of the growth in the U.S. syndicated loan portfolio partially offset by a decrease of $19.7 million in interest income on residential loans primarily due to a reduction in the average balance of $215.9 million for the year ended December 31, 2011 compared to the same period in 2010.

 

   

A decrease of $2.7 million in other interest earning assets, primarily due to a net decrease of $155.8 million in the average balance of other interest earning assets resulting from the sale of these instruments to finance the acquisition of investment securities. The average rate of other interest-earning assets decreased by 20 basis points during 2011 compared to the corresponding 2010 period.

 

   

A decrease of $39.7 million in interest income on mortgage backed and investment securities primarily due to a reduction of $1.1 billion in the average balance of mortgage backed and investment securities resulting from the sale of agency CMOs and other mortgage backed securities during 2011. Total mortgage backed and investment securities’ sales amounted to $1.4 billion during 2011, partially offset

 

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by purchases of $0.9 billion primarily of agency securities as part of the interest rate risk management strategies. The yield on mortgage backed and investment securities decreased 30 basis points for the year ended December 31, 2011 compared to the same period in 2010 mainly due to the Company strategy to de-lever and reposition the balance sheet.

Total interest expense for the years ended December 31, 2011 and 2010 was $178.7 million and $240.9 million, respectively.

Interest expense decreased by approximately $62.2 million, or 25.8%, for the year ended December 31, 2011 compared to the corresponding 2010 period. Significant variances impacting interest expense for the year ended December 31, 2011 when compared to the corresponding 2010 period, are as follows:

 

   

A decrease of $22.6 million in interest expense on deposits driven by the rollover of maturing brokered certificates of deposit at lower current market rates as well as shifts in the composition of the Company’s retail deposits. The average balance of interest bearing deposits increased $110.8 million during 2011, while the cost of interest bearing deposits decreased 53 basis points compared to the same period in 2010. The average balance of brokered deposits decreased $419.7 million during 2011, when compared to the corresponding 2010 period, primarily due to the early termination of $178.5 million of high cost callable brokered deposits during 2011 and developing additional channels to gather deposits.

 

   

A reduction of $31.5 million in interest expense on securities sold under agreements to repurchase was driven by a decrease of $912.6 million in the average balance of repurchase agreements during 2011 and a reduction of 32 basis points in the average interest cost during 2011.

 

   

A reduction of $10.0 million in interest expense on advances from FHLB resulted from the decrease in the average balance of advances from FHLB of $23.1 million and a decrease of 80 basis points in average cost during 2011 primarily due to strategic restructuring of Doral’s FHLB borrowing during the first and second quarters of 2011 to increase term to maturity and reduce rates.

 

   

A decrease of $0.8 million in interest expense on loans payable directly related to a reduction of $24.8 million in the average balance of loans payable as a result of the normal repayment of borrowings. The average cost on loans payable during 2011 decreased by 8 basis points compared to the corresponding 2010 period mostly due to the general decline in interest rates, which reflects the re-pricing nature of most of the Company’s loans payable, which are floating rate notes indexed to the 3-month LIBOR.

 

   

An increase of $2.7 million in interest expense on notes payable related to the net increase of $122.0 million in average balance of notes payable resulting from a $250.0 million debt issued by Doral CLO I, Ltd. in 2010 at a rate of 3-month LIBOR plus 1.85%.

2010 compared to 2009 — Total interest income for the years ended December 31, 2010 and 2009 was $401.5 million and $458.3 million, respectively, a decrease of $56.7 million, or 12.4%. Significant variances impacting interest income for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follows:

 

   

A reduction of $2.8 million in interest income on loans due to:

 

   

A reduction in interest on mortgage loans of $9.4 million driven by: (i) reversal of interest income on loans entering non-accrual of approximately $12.0 million; (ii) reversal of interest income due to loss mitigation on loans in early delinquency stages, together with the impact of yield concessions on these loans of approximately $3.8 million; and (iii) partially offset by the impact of loans leaving non-accrual due to collection efforts and loss mitigation transactions on non-performing loans of approximately $6.4 million.

 

   

A reduction in interest on construction and land loans of $3.3 million as a result of lower average construction and land loans related to the sale of a construction loan portfolio to a third party and run-off of the portfolio.

 

   

A reduction of $3.1 million in interest income on consumer loans due primarily to charge-offs and run-off of the portfolio.

 

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Partially offset by an increase of $13.0 million in interest income on commercial loans primarily driven by increases in the U.S. syndicated loan portfolio.

 

   

A decrease of $54.5 million in interest income on mortgage backed and investment securities primarily due to a reduction of $1.2 billion in the average balance of mortgage backed and investment securities during 2010 resulting from the sale of non-agency CMOs and other mortgage backed securities during the second and third quarters of 2010. Total mortgage backed and investment securities’ sales amounted to $2.3 billion during 2010, partially offset by purchases of $1.6 billion primarily of shorter duration as part of the interest rate risk management strategies. The average interest rate on mortgage backed and investment securities decreased 51 basis points for the year ended December 31, 2010 compared to the same period in 2009.

Total interest expense for the years ended December 31, 2010 and 2009 was $240.9 million and $290.6 million, respectively, a decrease of approximately $49.7 million, or 17.1%. Significant variances impacting interest expense for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follows:

 

   

A decrease of $14.3 million in interest expense on deposits driven by the rollover of maturing brokered certificates of deposit at lower current market rates as well as shifts in the composition of the Company’s retail deposits. The average balance of interest bearing deposits increased $494.3 million during 2010, while the cost of deposits decreased 67 basis points for the same period. These shifts were driven by the Company’s pricing strategy and campaigns to expand its deposit base as a result of bank failures in Puerto Rico during the second quarter of 2010.

 

   

A decrease of $18.1 million in the interest expense on securities sold under agreements to repurchase was driven by a reduction of $248.5 million in the average balance of repurchase agreements during 2010 and a general decline in interest rates that also resulted in a reduction of 53 basis points in the average interest cost during 2010.

 

   

A reduction of $15.8 million in interest expense on advances from FHLB resulted from the decrease in the average balance of advances from FHLB of $421.7 million and partially offset by an increase of 8 basis points in average cost during 2010.

 

   

A decrease of $1.2 million in interest expense on other short-term borrowings. There were no borrowings outstanding at any month end during 2010.

 

   

A decrease of $3.1 million in interest expense on loans payable directly related to a reduction of $33.2 million in the average balance of loans payable as a result of the regular repayment of borrowings. The average cost on loans payable during 2010 decreased by 69 basis points compared to the corresponding 2009 period as a result of the general decline in interest rates, which reflects the re-pricing nature of most of the Company’s loans payable, which are floating rate notes indexed to the 3-month LIBOR.

 

   

An increase of $2.8 million in interest expense on notes payable related to the increase of $114.6 million in average balance of notes payable resulting from a $250.0 million debt issued by Doral CLO I, Ltd. in July 2010 at a rate of 3-month LIBOR plus 1.85%.

The following table presents Doral Financial’s average balance sheet for the years indicated, the total dollar amount of interest income from its average interest-earning assets and the related yields, as well as the interest expense on its average interest-bearing liabilities, expressed in both dollars and rates, and the net interest margin

 

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and spread. The table does not reflect any effect of income taxes. Average balances are based on average daily balances.

Table A — Average Balance Sheet and Summary of Net Interest Income

 

    2011     2010     2009  
     Average
Balance
    Interest     Average
Yield/
Rate
    Average
Balance
    Interest     Average
Yield/
Rate
    Average
Balance
    Interest     Average
Yield/
Rate
 
    (Dollars in thousands)  

Assets:

                 

Interest-earning assets:

                 

Loans:

                 

Consumer:

                 

Residential(1)

  $ 3,858,920      $ 205,970        5.34   $ 4,074,864      $ 225,635        5.54   $ 4,019,254      $ 235,679        5.86

Consumer

    46,523        6,947        14.93     64,051        8,892        13.88     81,678        11,439        14.00
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    3,905,443        212,917        5.45     4,138,915        234,527        5.67     4,100,932        247,118        6.03

Lease financing receivables

    4,450        373        8.38     8,725        413        4.73     16,926        945        5.58

Commercial:

                 

Commercial real estate

    773,196        42,858        5.54     777,131        41,577        5.35     826,869        44,892        5.43

Commercial and industrial

    891,492        49,857        5.59     479,687        25,672        5.35     161,753        8,807        5.44

Construction and land

    418,830        18,552        4.43     490,088        16,387        3.34     573,948        19,622        3.42
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans (2)

    5,993,411        324,557        5.42     5,894,546        318,576        5.40     5,680,428        321,384        5.66

Mortgage-backed and investment securities

    1,029,399        30,061        2.92     2,170,199        69,785        3.22     3,332,573        124,266        3.73

Interest-only strips

    44,319        6,025        13.59     45,414        6,186        13.62     48,873        6,142        12.57

Other interest-earning assets

    499,933        4,312        0.86     655,690        6,974        1.06     454,071        6,473        1.43
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets/interest income

    7,567,062      $ 364,955        4.82     8,765,849      $ 401,521        4.58     9,515,945      $ 458,265        4.82
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Total non-interest-earning assets

    687,422            712,094            550,360       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 8,254,484          $ 9,477,943          $ 10,066,305       
 

 

 

       

 

 

       

 

 

     

Liabilities and Stockholders’ Equity:

  

               

Interest-bearing liabilities:

                 

Deposits:

                 

Interest bearing deposits

  $ 1,920,111      $ 26,268        1.37   $ 1,809,298      $ 34,324        1.90   $ 1,587,396      $ 37,316        2.35

Brokered deposits

    2,226,827        62,018        2.79     2,646,557        76,514        2.89     2,374,207        87,817        3.70
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total deposits

    4,146,938        88,286        2.13     4,455,855        110,838        2.49     3,961,603        125,133        3.16

Repurchase agreements

    733,185        21,119        2.88     1,645,805        52,654        3.20     1,894,329        70,712        3.73

Advances from FHLB

    1,151,314        37,129        3.22     1,174,411        47,155        4.02     1,596,087        62,948        3.94

Other short-term borrowings

                      5,027        15        0.30     459,887        1,212        0.26

Loans payable

    295,490        5,964        2.02     320,313        6,742        2.10     353,556        9,881        2.79

Notes payable

    510,716        26,224        5.13     388,738        23,513        6.05     274,160        20,752        7.57
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities/interest expense

    6,837,643      $ 178,722        2.61     7,990,149      $ 240,917        3.02     8,539,622      $ 290,638        3.40
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Non-interest bearing deposits

    284,212            253,980            248,535       

Other non-interest bearing liabilities

    275,178            315,061            411,484       
 

 

 

       

 

 

       

 

 

     

Total non-interest-bearing liabilities

    559,390            569,041            660,019       
 

 

 

       

 

 

       

 

 

     

Total liabilities

    7,397,033            8,559,190            9,199,641       

Stockholders’ equity

    857,451            918,753            866,664       
 

 

 

       

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 8,254,484          $ 9,477,943          $ 10,066,305       
 

 

 

       

 

 

       

 

 

     

Net interest-earning assets

  $ 729,419          $ 775,700          $ 976,323       
 

 

 

       

 

 

       

 

 

     

Net interest income on a non-taxable equivalent basis

    $ 186,233          $ 160,604          $ 167,627     
   

 

 

       

 

 

       

 

 

   

Interest rate spread(3)

        2.21         1.56         1.42
     

 

 

       

 

 

       

 

 

 

Interest rate margin(4)

        2.46         1.83         1.76
     

 

 

       

 

 

       

 

 

 

Net interest-earning assets ratio(5)

        110.67         109.71         111.43
     

 

 

       

 

 

       

 

 

 

 

 

(1) Average loan balances include the average balance of non-accruing loans, on which interest income is recognized when collected. Also includes the average balance of GNMA defaulted loans for which the Company has an unconditional buy-back option.

 

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(2) Interest income on loans includes $0.3 million, $0.6 million and $1.1 million for 2011, 2010 and 2009, respectively, of income from prepayment penalties related to the Company’s loan portfolio.

 

(3) Interest rate spread represents the difference between Doral Financial’s weighted-average yield on interest-earning assets and the weighted-average rate on interest-bearing liabilities.

 

(4) Interest rate margin represents net interest income on an annualized basis as a percentage of average interest-earning assets.

 

(5) Net interest-earning assets ratio represents average interest-earning assets as a percentage of average interest-bearing liabilities.

The following table presents the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Doral Financial’s interest income and interest expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: (i) changes in volume (change in volume multiplied by prior year rate); (ii) changes in rate (change in rate multiplied by prior year volume); and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated in proportion to the absolute dollar amounts of the changes due to rate and volume.

Table B — Net Interest Income Variance Analysis

 

     2011 Compared to 2010     2010 Compared to 2009  
     Increase (Decrease) Due To:     Increase (Decrease) Due To:  
      Volume     Rate     Total     Volume     Rate     Total  
     (In thousands)  

Interest Income Variance

            

Loans

   $ 4,899      $ 1,082      $ 5,981      $ 12,048      $ (14,856   $ (2,808

Mortgage-backed and investment securities

     (36,858     (2,866     (39,724     (41,448     (13,033     (54,481

Interest-only strips

     (148     (13     (161     (451     495        44   

Other interest-earning assets

     (1,484     (1,178     (2,662     2,440        (1,939     501   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest Income Variance

   $ (33,591   $ (2,975   $ (36,566   $ (27,411   $ (29,333   $ (56,744

Interest Expense Variance

            

Deposits

   $ (7,309   $ (15,243   $ (22,552   $ 14,370      $ (28,665   $ (14,295

Repurchase agreements

     (26,717     (4,818     (31,535     (8,669     (9,389     (18,058

Advances from FHLB

     (902     (9,124     (10,026     (17,037     1,244        (15,793

Other short-term borrowings

     (8     (7     (15     (1,354     157        (1,197

Loans payable

     (522     (256     (778     (865     (2,274     (3,139

Notes payable

     6,644        (3,933     2,711        7,495        (4,734     2,761   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest Expense Variance

   $ (28,814   $ (33,381   $ (62,195   $ (6,060   $ (43,661   $ (49,721
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income Variance

   $ (4,777   $ 30,406      $ 25,629      $ (21,351   $ 14,328      $ (7,023
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average interest-earning assets decreased from $8.8 billion for the year ended December 31, 2010 to $7.6 billion for the corresponding 2011 period, while average interest-bearing liabilities also decreased from $8.0 billion to $6.8 billion, respectively. The sales of MBS during the second and third quarters of 2011, as well as the shifts in the composition of average interest- bearing liabilities from higher cost borrowing to less expensive sources of financing, such as new money market accounts with a cost of less than 0.4%, is part of the execution of the Company strategy to de-lever the balance sheet. The repositioning of the balance sheet during 2011, and other management actions, resulted in a 63 basis point improvement in net interest margin from 1.83% for the year ended December 31, 2010 to 2.46% for the corresponding 2011 period.

Average interest-earning assets decreased from $9.5 billion for the year ended December 31, 2009 to $8.8 billion for the corresponding 2010 period, while average interest-bearing liabilities also decreased from $8.5 billion to $8.0 billion, respectively. The sales of MBS and other debt securities during the second and third quarters of 2010 and the purchase of investments of shorter duration, as well as the shifts in the composition of average interest-bearing liabilities from higher cost borrowing to less expensive sources of financing, such as

 

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new money market accounts with a cost of less than 0.4%, is part of the execution of the Company strategy to de-lever the balance sheet. The repositioning of the balance sheet during 2010, and other management actions, resulted in a 7 basis point improvements in net interest margin from 1.76% for the year ended December 31, 2009 to 1.83% for the corresponding 2010 period.

Provision for Loan and Lease Losses (“PLLL”)

The provision for loan and lease losses is charged to earnings to bring the total allowance for loan and lease losses to a level considered appropriate by management considering all losses inherent in the portfolio and based on Doral Financial’s historical loss experience, current delinquency rates, known and inherent risks in the loan portfolio, individual assessment of significant impaired loans, the estimated value of the underlying collateral or discounted expected cash flows, and an assessment of current economic conditions and emerging risks. While management believes that the current allowance for loan and lease losses is maintained at a level believed appropriate, future additions to the allowance could be necessary if economic conditions change or if credit losses increase substantially from those estimated by Doral Financial in determining the allowance. Unanticipated increases in the allowance for loan and lease losses could materially affect Doral Financial’s net income in future periods.

2011 compared to 2010.    Doral Financial’s provision for loan and lease losses for the year ended December 31, 2011 decreased by $31.5 million, or 31.8%, to $67.5 million compared to $99.0 million for 2010. The decrease in the PLLL in 2011 resulted from decreases in all products but mainly in the commercial real estate portfolio. Refer to the discussions under Credit Risk for further analysis of the allowance for loan and lease losses and non-performing assets and related ratios.

The provision for loan and lease losses for the commercial real estate portfolio decreased by $19.2 million for the year ended December 31, 2011, when compared to the corresponding 2010 period due to the decrease in the rate of credit quality deterioration. In 2010 the amount of non-performing commercial real estate loans increased $63.4 million, reflecting adverse portfolio performance in a year the Puerto Rico gross domestic product decreased 3.8%. One loan in the amount of approximately $38.0 million which became non-performing in 2010, accounts for approximately $9.0 million of the variance. In 2011, the amount of non-performing commercial real estate loans decreased $24.9 million, reflecting significantly less decline in quality in the year.

The lower PLLL for residential mortgage loans resulted from lower charge-offs in 2011 ($29.7 million in 2011, compared to $31.0 million in 2010) offset in part by reserves required to reflect the increase in non-performing residential loan balances up $17.8 million in 2011.

The provision for loan and lease losses on the construction and land loan portfolio decreased $2.7 million during 2011. The decrease is mainly due to a charge-off of $12.6 million that the Company recorded when transferring certain construction loans to loans held for sale before subsequently selling them during 2010. During 2011 the Company’s construction and land non-performing loans decreased by $50.6 million; however, Doral recorded a provision of $23.9 million during 2011 largely resulting from updated valuations of existing impaired loans.

The provisions for the other consumer loan portfolio and the commercial and industrial loan portfolio reflected decreases of $2.7 million and $2.0 million, respectively in 2011 compared to 2010. The decrease in the provision for the consumer loan portfolio was due to the runoff of the portfolio and better collection efforts. For commercial and industrial loans the reduction is the result of stabilizing credit quality in the portfolio as non-performing loans increased only $0.3 million during 2011, and net charge-offs declined $2.7 million.

2010 compared to 2009.    Doral Financial’s provision for loan and lease losses for the year ended December 31, 2010 increased by $45.3 million, or 84.4%, to $99.0 million compared to $53.7 million for 2009. The higher provision for loan and lease losses in 2010 was driven by increases in the provision for residential, commercial real estate and construction and land portfolios. Please refer to the discussions under Credit Risk for further analysis of the allowance for loan and lease losses and non-performing assets and related ratios.

 

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The provision for loan and lease losses for the residential mortgage portfolio increased by $12.3 million, or 52.9%, from $23.2 million for 2009 to $35.5 million for the year ended December 31, 2010. The higher provision for residential mortgage loans was driven by the level of loan modifications considered TDRs and for which a temporary interest reduction was granted. These TDRs are measured individually for impairment based on the discounted cash flow method. The use of the discounted cash flow method resulted in higher levels of allowance when compared with the general reserve, depending on the level of concession granted. The increase in the provision for loan losses on residential mortgage loans was driven by: (i) an increase of $6.8 million due to TDRs individually evaluated for impairment; (ii) an increase of $3.0 million related to the impact of net charge offs on the allowance; (iii) $6.3 million due to transfers of foreclosed loans to OREO; and this was partially offset by $3.8 million due to delinquency improvement.

The provision for loan and lease losses for the commercial real estate portfolio increased by $25.5 million for the year ended December 31, 2010, when compared to the corresponding 2009 period due to (i) a $4.5 million provision related to a reduction in the threshold for individually evaluating impaired loans from $1.0 million to $50,000, (ii) an $8.4 million provision due to the adverse classification of a participation interest in a current paying loan of $37.7 million for which a charge-off over allowance was recorded during the year, (iii) an $8.2 million additional provision on loans individually measured for impairment, (iv) a $1.0 million provision due to TDRs during the year which are individually evaluated for impairment, and (v) a $2.5 million provision as loans rolled to delinquency.

The provision for loan and lease losses on the construction and land loan portfolio increased $10.7 million during 2010 primarily due to the sale of a construction portfolio to a third party during the third quarter of 2010 that resulted in additional provisions of $12.7 million, this was partially offset by the release of $2 million in reserve as one project loan was worked-out.

The provisions for the other consumer loan portfolio and the commercial and industrial loan portfolio reflected decreases of $2.3 million and $0.8 million, respectively in 2010 compared to 2009. The decrease in the provision for the consumer loan portfolio was due to lower delinquency and the runoff of the portfolio. For commercial and industrial loans the reduction is also the result of reduction in the Puerto Rico portfolio.

The provision for loan and lease losses was also impacted by the effect of charge-offs related to foreclosed loans, higher loss mitigation volume and an increase in severities (in the determination of the provision) due to strategic decision to accelerate OREO dispositions.

The provision for loan and lease losses was offset by net charge-offs of $116.1 million for the year ended December 31, 2010 which included $35.8 million related to the sale of certain construction loans, $8.8 million related to a classified participation interest as well as charge-offs of previously reserved balances and the implementation of the Company’s real estate valuation policy.

Non-interest income (loss)

A summary of non-interest income (loss) for the years ended December 31, 2011, 2010 and 2009 is provided below.

Table C — Non-interest income (loss)

 

     Year Ended December 31,  
                       Variance  
      2011     2010     2009     2011 vs. 2010      2010 vs. 2009  
                 (In thousands)  

Net other-than-temporary impairment losses

   $ (4,290   $ (13,961   $ (27,577   $ 9,671       $ 13,616   

Net gain on loans securitized and sold and capitalization of mortgage servicing

     34,066        20,375        13,863        13,691         6,512   

 

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     Year Ended December 31,  
                       Variance  
      2011     2010     2009     2011 vs. 2010     2010 vs. 2009  
                 (In thousands)  

Servicing income:

          

Servicing fees

     27,117        27,961        29,179        (844     (1,218

Late charges

     7,467        10,110        8,482        (2,643     1,628   

Prepayment penalties and other servicing fees

     1,727        1,686        874        41        812   

Interest loss on serial notes and others

     (5,758     (6,764     (6,067     1,006        (697

Amortization and market valuation of servicing asset

     (12,074     (12,087     (3,131     13        (8,956
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total servicing income

     18,479        20,906        29,337        (2,427     (8,431

Trading activities:

          

Gain on IO valuation

     7,481        8,811        2,780        (1,330     6,031   

Gain (loss) on MSR economic hedge

     1,464        7,476        (8,678     (6,012     16,154   

Loss on hedging derivatives

     (5,110     (2,611     (1,594     (2,499     (1,017
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net gain (loss) on trading activities

     3,835        13,676        (7,492     (9,841     21,168   

Commissions, fees and other income:

          

Retail banking fees

     27,211        28,595        29,088        (1,384     (493

Insurance agency commissions and other income

     13,279        13,306        12,024        (27     1,282   

Other income

     5,407        4,489        3,042        918        1,447   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commissions, fees and other income

     45,897        46,390        44,154        (493     2,236   

Net loss on early repayment of debt

     (3,068     (7,749            4,681        (7,749

Net gain (loss) on sale of investment securities

     27,467        (93,713     34,916        121,180        (128,629
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest income (loss)

   $ 122,386      $ (14,076   $ 87,201      $ 136,462      $ (101,277
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

2011 compared to 2010.    Significant variances in non-interest income for the year ended December 31, 2011, when compared to the corresponding 2010 period, are as follow:

 

   

An improvement in gain on sale of investment securities of $121.2 million. For the year ended December 31, 2011, the Company reported a gain on sale of investment securities of $27.5 million as a result of the deleveraging of the balance sheet. During 2010, the Company reported a loss on sale of securities of $93.7 million driven by a loss of $136.7 million on the sale of $378.0 million of certain non-agency CMOs.

 

   

An improvement in OTTI of $9.7 million. During 2010, the deterioration in estimated future cash flows of certain non-agency CMOs resulted in an OTTI of $13.3 million. These securities were subsequently sold during 2010 and the unrealized loss in OCI was realized. OTTI of approximately $4.3 million recognized in 2011 and was related to the impairment of Doral’s residual interest retained in a residential mortgage loan securitization completed in 2006.

 

   

A positive variance of $13.7 million on net gains on loans securitized and sold and capitalization of mortgage servicing, which was driven by an increase of $14.9 million in net gains from securities held for trading and a $1.9 million increase in the capitalization of mortgage servicing rights partially offset by

 

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decreases of $1.2 million in origination and discount fees and $1.9 million in gain on sale of mortgage loans and deferred origination fees.

 

   

Net gains on trading assets and derivatives decreased $9.8 million due mainly to reductions of $6.0 million and $2.5 million in gains on the MSR economic hedge and increases in losses on hedging activities, respectively.

 

   

A $4.7 million decrease in net losses on early repayment of debt. During 2010, the Company recorded net losses on early repayment of debt of $7.7 million due to the early payment of securities sold under agreements to repurchase resulting from a sale of certain non-agency CMOs and retirement of callable certificates of deposit.

2010 compared to 2009.    Significant variances in non-interest income for the year ended December 31, 2010, when compared to the corresponding 2009 period, are as follow:

 

   

During 2010 OTTI losses were recognized on eight of the Company’s non-agency CMOs totaling $14.0 million for the year ended December 31, 2010. Five of the eight OTTI securities resulted in the recognition of an OTTI loss of $13.3 million during the first quarter of 2010. These five securities were sold during the second quarter of 2010. Three securities from the Puerto Rico non-agency CMO portfolio with an amortized cost of $11.1 million as of December 31, 2010 reflected an OTTI loss of $0.7 million. Refer to Note 9 in the accompanying notes to the consolidated financial statements for additional information on OTTI.

 

   

An increase of $6.5 million in net gain on mortgage loan sales and fees due to higher loan basis during 2010. A gain on sale of GNMA and FNMA securities consisting of loans originated by the Company of $11.8 million as a result of higher MBS cupon prices during 2010. During 2009 average loan basis was approximately 98.8%, while the average loan basis during 2010 was close to par.

 

   

An increase of $21.1 million on net gain (loss) on trading activities resulted from:

 

   

A gain on the IO valuation of $8.8 million related to decreases in the market interest rates.

 

   

A gain on MSR economic hedge of $7.5 million compared to a loss of $8.7 million in 2009, primarily related to a change in the hedging strategy during the second quarter of 2009 from the use of U.S. Treasuries to forward contracts and to the decrease in forecasted prepayment speeds.

 

   

A net loss on sale of investment securities of $93.7 million resulted from a loss of $136.7 million during the second quarter of 2010, from the sale of certain non-agency CMOs with an amortized cost basis of $378.0 million, offset in part by the sale of certain agency securities in the first and third quarters of 2010 that generated net gains of $26.4 million and $17.1 million, respectively, together with a net loss of an early repayment debt of $7.7 million.

 

   

A reduction of $8.4 million in servicing income during 2010 driven by a decrease in value of the mortgage servicing assets due to changes in valuation inputs or assumptions and a reduction in loan balances.

 

   

An increase in total commission, fees and other income of $2.2 million related to a gain of $3.0 million on redemption of shares of VISA, Inc.

 

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Non-interest expense

A summary of non-interest expense for the years ended December 31, 2011, 2010 and 2009 is provided below.

Table D — Non-interest expense

 

     Year Ended December 31,  
                  Variance  
      2011      2010      2009      2011 vs. 2010     2010 vs. 2009  
                   (In thousands)  

Compensation and benefits

   $ 73,431       $ 75,080       $ 68,724       $ (1,649   $ 6,356   

Professional services

     40,360         53,902         31,582         (13,542     22,320   

Occupancy expenses

     19,056         17,658         15,232         1,398        2,426   

Communication expenses

     15,145         17,019         16,661         (1,874     358   

FDIC insurance expense

     14,316         19,833         18,238         (5,517     1,595   

Depreciation and amortization

     13,228         12,689         12,811         539        (122

EDP expenses

     12,480         14,197         13,727         (1,717     470   

Taxes, other than payroll and income taxes

     11,645         11,177         10,051         468        1,126   

Corporate insurance

     5,669         5,664         4,662         5        1,002   

Advertising

     4,985         8,917         6,633         (3,932     2,284   

Office expenses

     3,978         5,490         5,303         (1,512     187   

Other

     14,949         18,864         15,094         (3,915     3,770   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 
     229,242         260,490         218,718         (31,248     41,772   

OREO expenses and other provisions:

                       

Other real estate owned expense

     10,713         40,711         14,542         (29,998     26,169   

Foreclosure expenses

     4,920         4,250         2,423         670        1,827   

Provision loss for LBI claim receivable

             12,359                 (12,359     12,359   

Provisions for other credit related expenses

     5,202         6,754         8,103         (1,552     (1,349
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 
     20,835         64,074         25,068         (43,239     39,006   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total non-interest expense

   $ 250,077       $ 324,564       $ 243,786       $ (74,487   $ 80,778   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

2011 compared to 2010.    Non-interest expense decreased $74.5 million for the year ended December 31, 2011 compared to the corresponding 2010 period. This decrease was the result of the Company’s cost reduction efforts during 2011 as well as improvements resulting from transactions made in 2010, as follows:

 

   

OREO expenses totaled $10.7 million in 2011 compared to $40.7 million for the same period in 2010, a decrease of $30.0 million. Higher OREO expenses in 2010 were mainly related to an additional provision for OREO losses of $17.0 million established during 2010 to recognize the effect of management’s strategic decision to reduce pricing to stimulate property sales, market value adjustments driven by lower values of certain OREO properties, and higher maintenance costs to maintain the properties in saleable condition. The favorable decrease is also due to better pricing on the sales of OREO, resulting in lower losses during 2011.

 

   

A decrease of $13.5 million in professional services was driven by lower defense litigation costs of $7.9 million, lower advisory services of $0.6 million related to the dissolution of Doral Holdings and Doral Holdings L.P., and lower advisory services of $7.0 million in 2011 compared to 2010 which were incurred during 2010 in relation to the sale of certain construction loans as well as expenses incurred for the Company’s participation in bidding for FDIC assisted transactions.

 

   

A decrease of $12.4 million in the provision loss for the Company’s claim receivable on LBI that was established in 2010. The claim was subsequently sold to a third party during the fourth quarter of 2010.

 

   

Lower FDIC insurance expense of $5.5 million related to a lower deposit base and a change in the method of computing the assessment as prescribed by the regulator.

 

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Lower advertising expense of $3.9 million as the Company incurred higher expenses in 2010 due to the campaigns to gain market share in deposits and mortgage originations subsequent to the local market bank failures and asset acquisitions in April of 2010.

2010 compared to 2009.    Non-interest expense increased $80.8 million for the year ended December 31, 2010 compared to the corresponding 2009 period. Approximately, $39.0 million of the non-interest expense increase resulted from costs incurred to collect, restructure or modify certain loans, to recognize decreases in estimated values, or recognize the costs of estimated Doral credit related obligations. These credit related costs were incurred to support the Company’s efforts to reduce its non-performing loans and improve the quality of the Company’s balance sheet.

The credit related expenses are included within compensation and employee benefits, professional services, other and OREO expenses and other provisions and are described in more detail below.

 

   

An increase of $6.4 million in compensation and employee benefits was due to: (i) higher salary expenses of $1.0 million, (ii) higher benefits of $3.7 million and (iii) lower deferral of compensation costs related