10-K 1 d466677d10k.htm FORM 10-K FORM 10-K
Table of Contents
Index to Financial Statements

 

 

 

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, 2012

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 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

 

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 Act).    Yes  ¨        No  þ

State the aggregate market value of the voting and non-voting common equity held by non-affiliates 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.

$192,690,635, approximately, based on the last sale price of $1.50 per share on the New York Stock Exchange on June 29, 2012 (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: 128,460,423 shares as of March 4, 2013.

Documents Incorporated by Reference:

Part III incorporates certain information by reference to the Proxy Statement for the 2013 Annual Meeting of Shareholders

 

 

 


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DORAL FINANCIAL CORPORATION

2012 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

     PAGE  

FORWARD LOOKING STATEMENTS

     1   

PART I

  

Item 1

  

Business

     4   

Item 1A

  

Risk Factors

     38   

Item 1B

  

Unresolved Staff Comments

     54   

Item 2

  

Properties

     54   

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

     63   

Item 7

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     65   

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

     138   

Item 9B

  

Other Information

     139   

PART III

  

Item 10

  

Directors, Executive Officers and Corporate Governance

     139   

Item 11

  

Executive Compensation

     139   

Item 12

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      139   

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

     140   
  

Ex-12.1

  
  

Ex-12.2

  
  

Ex-21.1

  
  

Ex-23

  
  

Ex-31.1

  
  

Ex-31.2

  
  

Ex-32.1

  
  

Ex-32.2

  

 

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Doral Financial Corporation provides the following list of acronyms as a tool for the reader. The acronyms identified below are used in Management’s Discussion and Analysis of Financial Condition and Results of Operations, the consolidated financial statements and in the notes to consolidated financial statements.

 

AFICA

   Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority

ALLL

   Allowance for loan and lease losses

ARM

   Adjustable Rate Mortgage

ASC

   Accounting Standards Codification

CLO

   Collateralized loan obligation

CMO

   Collateralized mortgage obligations

CPR

   Constant prepayment rate

DTA

   Deferred tax asset

DTL

   Deferred tax liability

FASB

   Financial Accounting Standards Board

FHA/VA/FRM

   Federal Housing Administration/Veteran Administration/Farm Credit Administration

FHLB

   Federal Home Loan Bank of New York

FHLMC

   Federal Home Loan Mortgage Corporation

FNMA

   Federal National Mortgage Association

FRBNY

   Federal Reserve Bank of New York

GAAP

   Generally accepted accounting principles in the United States of America

GNMA

   Government National Mortgage Association

GSE

   Government sponsored enterprises

HUD

   U.S. Department of Housing and Urban Development

IOs

   Interest-only securities

LIBOR

   London Interbank Offered Rate

LTV

   Loan-to-value

MBS

   Mortgage-backed securities

MSR

   Mortgage servicing right

NOL

   Net operating loss

NOW

   Negotiable order of withdrawal

NPL

   Non-performing loan

OTTI

   Other-than-temporary impairment

PR

   Puerto Rico

RHS

   Rural Housing Service

SEC

   Securities and Exchange Commission

SPE

   Special purpose entity

TDR

   Troubled debt restructuring

US

   United States of America

VIE

   Variable Interest Entity

FTP

   Funds Transfer Pricing

NYSE

   New York Stock Exchange

DIF

   Depository Insurance Fund

PLLL

   Provision for loan and lease losses

REVE

   Real estate valuation estimate

UPB

   Unpaid principal balance


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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, as amended. In addition, Doral Financial may make forward-looking statements in its press releases, other filings with the Securities and Exchange Commission 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, prospects, objectives, future performance and business, including, but not limited to, statements with respect to the adequacy of the allowance for loan and lease losses, delinquency trends, market risk and the impact of general economic conditions, interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal or regulatory proceedings, tax legislation and tax rules, deferred tax assets and related reserves, compliance and 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 Doral Financial’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,” “plan,” “outlook,” “target,” “goal,” and similar expressions and future 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 Doral Financial’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, other than as required by law, including the requirements of applicable securities laws.

Forward-looking statements are, by their nature, subject to risks and uncertainties and changes in circumstances, many of which are beyond Doral Financial’s control. While there is no assurance that any list of risks and uncertainties or risk factors is complete, below are certain important factors (including our management’s ability to identify and manage these and other risks) that could cause actual results to differ materially from those contained in any forward-looking statements:

 

   

the continued recessionary conditions and economic contraction of the Puerto Rico economy and any deterioration in the performance of the United States economy and capital markets that adversely affect the general economy, housing prices and absorption, 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 in 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;

 

   

uncertainty about whether Doral Financial and Doral Bank will be able to fully comply with the terms and conditions of the written agreement dated September 11, 2012 (the “Written Agreement”) that Doral Financial entered into with the Federal Reserve Bank of New York (the “FRBNY”) and the consent order dated August 8, 2012 (the “Consent Order”) that Doral Bank entered into with the Federal Deposit Insurance Corporation (the “FDIC”) and the Office of the Commissioner of Financial Institutions of Puerto Rico (the “Office of the Commissioner”);

 

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uncertainty as to whether the FRBNY, FDIC and/or the Office of the Commissioner will continue to allow us to diversify our business operations through the development of our banking operations in New York and Florida;

 

   

the operating and other conditions imposed by the FDIC and the Office of the Commissioner under the Consent Order and by the FRBNY under the Written Agreement, 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, as well as additional actions resulting from future regular annual safety and soundness and compliance examinations by these federal and state regulators;

 

   

our reliance on brokered certificates of deposit and our ability to obtain, on a periodic basis, approval from the FDIC to issue brokered CDs to fund operations and provide liquidity in accordance with the terms of the Consent Order;

 

   

uncertainty as to what additional actions the FRBNY, the FDIC and/or the Office of the Commissioner may take against us if we fail to comply with the Written Agreement, the Consent Order or any other operating condition imposed by any such regulator or if any such regulator determines our financial condition has significantly deteriorated;

 

   

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;

 

   

uncertainty about the legislative and other measures adopted and expected to be 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;

 

   

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;

 

   

our capital and liquidity requirements (including under regulatory capital standards, such as the Basel III capital proposals, as determined and interpreted by applicable banking regulatory authorities) and our ability to generate capital internally or raise new capital on favorable terms;

 

   

the extent of our success in our loan modification efforts, as well as the effects of regulatory requirements or guidance regarding loan modifications or changes in such requirements or guidance;

 

   

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 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;

 

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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, 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;

 

   

an increase in our non-interest expense as a result of increases in our FDIC assessments brought about by (i) additional increases in FDIC deposit insurance premiums and/or special assessments by the FDIC to replenish its insurance fund, or (ii) additional deterioration in our FDIC assessment rating;

 

   

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

 

   

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;

 

   

an adverse change in our ability to attract new clients and retain existing clients;

 

   

general competitive factors and industry consolidation;

 

   

the strategies adopted by the FDIC and the three banks who purchased in April 2010, three other failed banks in Puerto Rico in connection with the resolution of the residential, construction and commercial real estate loans acquired in connection with those “forced sales”, which may adversely affect real estate values in Puerto Rico;

 

   

potential adverse outcome in the legal or regulatory actions or proceedings described in Part I, Item 3 “Legal Proceedings” in this 2012 Annual Report on Form 10-K, as updated from time to time in the Company’s quarterly and other reports filed with the SEC; and

 

   

the other risks and uncertainties detailed in Part I, Item 1A “Risk Factors” in this 2012 Annual Report on Form 10-K, as updated from time to time in the Company’s quarterly and other reports filed with the SEC.

 

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PART I

 

Item 1. Business

GENERAL

Overview

Doral Financial Corporation (“Doral Financial,” the “Company”, “we” or “us”) 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, LLC (“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 three variable interest entities created for the purpose of entering into collateralized loan arrangements with third parties.

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 39 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 26 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, 2012, the Puerto Rico segment had total assets and total deposits of $4.4 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 8 branches (including an administrative office) 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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All website addresses given in this document are for information purposes only and are not intended to be an active link or to incorporate any website information into this Annual Report on Form 10-K.

 

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 26 branches in Puerto Rico and 8 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, 2012, Doral Bank and its subsidiaries had a loan portfolio, classified as loans receivable, of approximately $5.9 billion, of which approximately $2.9 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 $345.4 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 in purchasing assigned interests in senior credit facilities in the U.S. syndicated leverage loan market. Since 2011, a new healthcare finance product has been 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.

Consumer Lending

Consumer lending operations include residential mortgage lending and consumer loans. As of December 31, 2012, Doral Bank and its subsidiaries’ consumer loan portfolio totaled $2.9 billion, or 50.03%, of its loans receivable portfolio.

 

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Residential Mortgage Lending

Doral Bank is an approved seller/servicer for the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association an approved issuer for the Government National Mortgage Association 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 or guaranteed by the Veterans Administration or by the Rural Housing Service.

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. Doral Bank does not originate adjustable rate mortgages or negatively amortizing loans. However, the Company has entered into certain loss mitigation arrangements that provide for a temporary reduction in interest rates. 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, 2012, these consumer loans totaled $24.7 million, or 0.42%, of its loans receivable 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.

Commercial Lending

Commercial lending operations include commercial real estate, commercial and industrial and construction and land. As of December 31, 2012, Doral Bank and its subsidiaries’ commercial loan (including construction and land) portfolio totaled $2.9 billion, or 49.97%, 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.

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, 2012, commercial loans totaled $2.6 billion, or 44.85%, of Doral Bank and its subsidiaries’ loans receivable portfolio, which included $1.1 billion 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.

 

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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, 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, 2012, syndicated loans totaled $1.1 billion, or 19.40%, of the consolidated Doral Bank loans receivable portfolio. For the year ended December 31, 2012, U.S. syndicated loans accounted for 24.32% of total loans originated during 2012.

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, in 2007 the Company ceased financing new construction of single family residential and commercial real estate projects, including land development in Puerto Rico. The Company continues to underwrite construction real estate loans in the New York metropolitan area. Doral will continue to evaluate and appraise market conditions to determine if and when it will resume such financing in Puerto Rico. 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, 2012, Doral Bank and its subsidiaries had approximately $301.1 million in construction and land loans of which $140.3 million are exposures to Puerto Rico, and $160.8 million are exposures to U.S. borrowers. 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, 2012, Doral Bank through its U.S. operations and Doral Money had a portfolio of $145.8 million and $15.0 million, respectively, in interim construction and bridge loans.

 

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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

One of Doral Bank’s strategies is to maintain its mortgage servicing portfolio, which it does primarily by internal originations through its retail branch network. Doral Mortgage units are co-located in 26 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 26 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, 2012, 2011, and 2010 loan purchases totaled approximately $164.5 million, $77.0 million and $82.0 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, 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 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 or negatively amortizing loans. However, the Company has entered into certain loss mitigation arrangements that provide for a temporary reduction in interest rates and other concessions to increase the likelihood of a full recovery of the loan. 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.

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.

 

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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, 2012, approximately 28.8%, 5.0% and 34.5% of Doral Financial’s mortgage loans serviced for others related to mortgage servicing for FNMA, FHLMC and GNMA, respectively. As of December 31, 2012, Doral Bank serviced approximately $7.6 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 2012, 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 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, 2012, 2011 and 2010, Doral Financial issued approximately $536.8 million, $399.8 million and $311.8 million, respectively, in GNMA-guaranteed mortgage-backed securities.

 

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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, 2012, 2011 and 2010, Doral Financial securitized approximately $228.5 million, $122.4 million and $62.1 million, respectively, of loans into FNMA and FHLMC mortgage-backed securities. In addition, for the years ended December 31, 2012, 2011 and 2010, Doral Financial sold approximately $32.3 million, $21.2 million and $30.7 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, 2012, 2011 and 2010, the loans held for sale portfolio includes $213.7 million, $168.5 million and $153.4 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, 2012, 2011 and 2010, Doral Financial’s maximum contractual exposure relating to its portfolio of loans sold with recourse was approximately $0.5 billion, $0.6 billion and $0.7 billion, respectively, which included recourse obligations to FNMA and FHLMC as of such dates of approximately $0.4 billion, $0.6 billion and $0.6 billion, respectively. As of December 31, 2012, 2011 and 2010, Doral Financial had a recourse liability of $8.8 million, $11.0 million and $10.3 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, 2012 and 2011, 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 alleged documentation deficiencies. For the years ended December 31, 2012, 2011 and 2010, repurchases related to representation and warranties amounted to $10.2 million, $9.0 million and $1.0 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.

 

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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 2012, 2011 and 2010, Doral Insurance Agency produced insurance fees and commissions of $14.9 million, $13.3 million and $13.3 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 39.0%. 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 January 31, 2011, the Governor of Puerto Rico 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 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.

 

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The Company made the election to remain subject to the provisions of the 1994 Code for Doral Financial Corporation, Doral Bank and Doral Mortgage on their respective 2011 tax returns. However, the Company elected to use the 2011 Code for Doral Insurance Agency, Doral Properties, CB, LLC and Doral Investment. In addition, effective November 1, 2012, Doral Insurance Agency converted to an LLC and elected to be consolidated with its parent in future returns pursuant to the 2011 tax law. 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 assets 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. By electing to change to the 2011 Code, during the second quarter of 2012, the Company realized a tax benefit of $1.2 million due to the reduced tax rate provided under the 2011 Code at Doral Insurance Agency for deferred tax assets that were previously recorded at the higher 39.00% rate.

Refer to note 27 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 27 of the accompanying consolidated financial statements for additional information.

Employees

As of December 31, 2012, Doral Financial had 1,417 employees, compared to 1,241 as of December 31, 2011. Of the total number of employees, 1,230 were employed in Puerto Rico and 187 employed in the U.S. as of December 31, 2012 compared to 1,127 employed in Puerto Rico and 114 employed in the U.S. as of December 31, 2011. As of December 31, 2012, of the total number of employees, 186 were employed in loan production, 203 in loan administration and servicing activities, 327 were involved in loan collections, 441 in branch operations and 260 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.

Segment Disclosure

For information regarding Doral Financial’s operating segments, refer to note 39 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 70.10% of Doral Financial’s consolidated assets as of December 31, 2012. The Puerto Rico based operations net loss before taxes totaled $67.7 million while the Company’s net loss before income taxes totaled $164.8 million.

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

 

     Year ended
December  31
 
     2012     2011     2010  

Puerto Rico

     42     31     54

United States

     58     69     46

 

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The 2012 increase in Puerto Rico loan originations is the result of originating a higher volume of saleable guaranteed residential mortgage loans. The decrease in originations in the U.S. is due primarily to fewer new loans originated by the syndicated lending unit in compliance with Doral’s decision to limit the Company’s syndicated loan exposure.

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, an island located in the Caribbean, is approximately 130 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, and the population estimate as of July 1, 2012 reflects an additional reduction of 58,705 or 1.4% to 3,667,084.

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 source of power 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.

The people of Puerto Rico 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.

 

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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, 2011, approximately 70.7% of Puerto Rico’s exports went to the U.S. mainland, which was also the source of approximately 46.1% 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 entered into 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%. For fiscal years 2007, 2008, 2009, 2010 and 2011, Puerto Rico’s real gross national product decreased by 1.2%, 2.9%, 3.8%, 3.4% and 1.5%, respectively. According to the Puerto Rico Planning Board’s latest projections made in April 2012, real gross national product for fiscal years 2012 and 2013 was expected to increase by 0.9% and 1.1%, respectively. In connection with government transition process hearings held during November 2012, the Puerto Rico Planning Board reduced these projections to increases of the real gross national product of 0.4% and 0.6% in fiscal years 2012 and 2013, respectively.

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

Fiscal Imbalance.    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. In January 2009, the previous Puerto Rico government administration developed and commenced implementing a multi-year plan designed to achieve fiscal balance, restore sustainable economic growth and safeguard the investment-grade ratings of the Commonwealth bonds. The plan included certain expense reduction measures that, together with various temporary and permanent revenue raising measures, have allowed the Puerto Rico government to reduce its deficit during the last three fiscal years 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 previous 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 $7.1 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 ARRA 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.

 

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The previous Puerto Rico government 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.

Economic Development Plan.    The previous Puerto Rico government administration also developed what it called 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 previous administration emphasized 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.

As part of this plan, the Puerto Rico government enacted legislation which overhauled the permitting and licensing process in Puerto Rico in order to provide for a leaner and more efficient process that fosters economic development, and legislation which provided 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.

The Puerto Rico government also enacted legislation establishing a clear public policy and legal framework for the establishment of public-private partnerships to finance and develop infrastructure projects and operate and manage certain public assets. The Puerto Rico government has already completed the concession of toll roads PR-22 and PR-5, has awarded contracts for the construction and maintenance of a selected number of public schools throughout Puerto Rico, and entered into a concession agreement for the Luis Munoz Marin International Airport (which was approved by the Federal Aviation Administration during the month of February 2013).

Another 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.

The previous Puerto Rico government administration also identified strategic initiatives to promote economic growth in various sectors of the economy where the Commonwealth understands that it has competitive advantages and several strategic/regional projects aimed at 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, 2011, 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 $23.7 billion, $9.1 billion and $319 million, respectively, and the funded ratios were 6.8%, 20.8% and 16.7%, respectively.

 

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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 shortfalls were estimated 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 six 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 previous 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 previous 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 System which was invested in capital appreciation bonds issued by Puerto Rico Sales Tax Financing Corporation (“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.

In addition to these measures, on August 8, 2011, the Board of Trustees of the Employees Retirement System adopted a new regulation relating to the concession of personal loans to its members, which, among other changes, lowers the maximum amount of those loans from $15,000 to $5,000. This change is expected to improve gradually the liquidity of the Employees Retirement System.

On February 27, 2013 the new Puerto Rico government announced a series of measures that are being presented to the Puerto Rico Legislature to reform and stabilize the finances of the Employees Retirement System. Among other things, the proposed reforms would (i) extend the retirement age for all public employees covered under such plan; (ii) move public employees from a defined benefit plan to a hybrid plan that includes accrued benefits under the existing defined benefit plan (accrual of benefits under the defined plan would end on June 30, 2013) and new benefits to accrue under a new defined contribution plan; (iii) increase the contributions made by employees to the plan from 8.275% to 10% of their compensation; and (iv) modify certain additional benefits given to retired public employees (such as summer and Christmas bonuses and contributions for medical plan coverage).

 

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Ratings of Commonwealth General Obligation Bonds.    On December 13, 2012, Moody’s Investors Service (“Moody’s”) lowered its rating on the Commonwealth’s unenhanced general obligation bonds to “Baa3” from “Baa1” and also maintained its negative outlook. According to Moody’s the primary drivers of the downgrade were (i) Puerto Rico economic growth prospects remain weak and could be furthered dampened by efforts to control spending and reform its retirement systems, (ii) debt levels are very high and continue to grow; (iii) financial performance has been weak, including lackluster revenue growth and large structural budget gaps, and (iv) lack of meaningful pension reform and no clear timetable to do so. On August 8, 2011, Moody’s had lowered its rating on the Commonwealth’s unenhanced general obligation bonds to “Baa1” with a negative outlook from “A3.”

On November 9, 2012, Standard & Poor’s Rating Services, a Standard & Poor’s Financial Services LLC company (“S&P”), issued a statement that the election of a new Governor of Puerto Rico had no immediate impact on its rating of the Commonwealth’s general obligation debt. Nonetheless, it noted that there was at least a one in three chance that it may lower its rating by early 2013. It also noted that its current rating of “BBB” was predicated on the assumption that Commonwealth officials will remain committed not only to the maintenance of fiscal discipline, but also to the adoption of swift and comprehensive fiscal measures relating to its unfunded pension liabilities. On June 6, 2012, S&P had affirmed its “BBB” rating on the Commonwealth’s unenhanced general obligation bonds and revised its outlook to negative. On March 7, 2011, S&P had raised its rating on the Commonwealth’s unenhanced general obligation bonds to “BBB” with a stable outlook from “BBB-” with a positive outlook.

On February 21, 2013, Fitch, Inc. (“Fitch”) placed the ratings of the Commonwealth’s general obligation bonds and related debt on ratings watch negative. On December 18, 2012, Fitch had stated that maintenance of the Commonwealth’s general obligation debt rating will require policy decisions from the new Commonwealth government administration to continue the significant fiscal progress of the Commonwealth to achieve budget balance and a slowing in the growth of long-term liabilities, including passing significant pension reform. On June 5, 2012, Fitch had reaffirmed its rating of “BBB+” with a stable outlook on the Commonwealth’s general obligation bonds, which rating and outlook had been assigned by Fitch on January 19, 2011.

On February 27, 2013, the new Puerto Rico government announced a series of measures that are being presented to the Puerto Rico Legislature to reform and stabilize the finances of the Employees Retirement System. Among other things, the proposed reforms would (i) extend the retirement age for all public employees covered under such plan; (ii) move public employees from a defined benefit plan to a hybrid plan that includes accrued benefits under the existing defined benefit plan (accrual of benefits under the defined plan would end on June 30, 2013) and new benefits to accrue under a new defined contribution plan; (iii) increase the contributions made by employees to the plan from 8.275% to 10% of their compensation; and (iv) modify certain additional benefits given to retired public employees (such as summer and Christmas bonuses and contributions for medical plan coverage).

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. In general terms, 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 continue to have, a broad impact on the financial services industry, including significant regulatory and compliance changes such as,

 

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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.

In June 2012, the Federal Reserve, Office of the Comptroller of the Currency and FDIC (collectively, the “Agencies”) each issued Notices of Proposed Rulemaking (“NPRs”) that would revise and replace the Agencies’ current capital rules to align them with the Basel III capital standards and meet certain requirements of the Dodd-Frank Act. Certain proposed requirements of the NPRs would establish more restrictive requirements for instruments to qualify as capital, higher risk-weightings for certain asset classes (including non-performing loans, certain commercial real estate loans, and certain types of residential mortgage loans), capital buffers and higher minimum capital ratios. The NPRs provided for a comment period through October 22, 2012 and the proposals are subject to further modification by the Agencies prior to being issued in final form. The proposals suggested an effective date of January 1, 2013, but on November 9, 2012 the Agencies issued a statement saying that given the volume of comments and wide range of views expressed, the Agencies did not expect that any of the proposed rules would become effective on January 1, 2013.

Consumer Financial Protection Bureau (“CFPB”).    The Dodd-Frank Act created the CFPB within the Federal Reserve. The CFPB 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 CFPB 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 regulations that are more stringent than those regulations promulgated by the CFPB, and state attorneys general are permitted to enforce consumer protection rules adopted by the CFPB 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.

Securitization.    The Dodd-Frank Act directed the SEC and other regulators to prescribe rules seeking to better align the interests of securitizers of asset-backed securities with investors and to require more

 

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disclosure in the securitization process. The SEC has promulgated several rules to implement the aspects of the Dodd-Frank Act directed at increasing disclosure in the securitization process. Also, the SEC has proposed several rules regarding risk retention (requiring securitizers to retain an economic interest in the credit risk (generally 5%) of any asset transferred to a third party through an asset-backed security), conflicts of interest and asset-level disclosure.

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 amended 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 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

 

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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 that will become effective 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 CFPB, 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 CFPB rather than the Federal Reserve because rulemaking authority under Regulation Z was transferred to the CFPB on July 21, 2011. The CFPB issued the final rules on January 10, 2013, which final rules generally become effective on January 10, 2014.

The final rule issued by the CFPB establishes a general ability-to-pay requirement that a creditor shall not make a loan that is a covered transaction (includes mortgage loans secured by a dwelling) unless the creditor makes a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms. The final rule also created a safe harbor (conclusive presumption of compliance with the ability to pay rule) for qualified mortgage loans that have an annual percentage rate that does not exceed the applicable average prime offer rate by 1.5 or more percentage points

 

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(3.5 or more percentage points for junior lien loans). The criteria for qualified mortgage loans include: (i) the loan must provide for regular periodic payments, with no interest-only, negative amortization or balloon payment features; (ii) the loan term may not exceed 30 years; (iii) the consumer’s debt-to-income ratio must not exceed 43%; (iv) the lender must underwrite the loan based on the maximum interest rate that may apply during the five-year period after the first regular periodic payment is due, and based on a periodic payment of principal and interest; and (v) the points and fees may not exceed 3% of the loan amount (although there is an exclusion for certain bona fide discount points).

On January 17, 2013, the CFPB issued new mortgage servicing rules under the provisions of the Truth in Lending Act and Real Estate Settlement Procedures Act amended by the Dodd-Frank Act. The final mortgage servicing rules become effective on January 10, 2014. The new rules cover nine major areas dealing with the following mortgage servicing matters: (i) requirement to provide periodic billing statements (generally monthly); (ii) requirement to provide certain advance interest-rate adjustment notices in adjustable rate mortgages; (iii) requirements relating to prompt payment processing and prompt issuance of mortgage payoff statements; (iv) limitations relating to forced placed insurance; (v) procedural requirements for responding to written information requests or complaints of errors; (vi) requirement to establish general servicing policies and procedures; (vii) requirements involving early intervention with delinquent borrowers (including notification of loss mitigation alternatives); (viii) requirements to assure continuity of contact with delinquent borrowers; and (ix) requirement to follow certain specified loss mitigation procedures for mortgage loans secured by a borrower’s principal residence (dual tracking-when the servicer moves forward with foreclosure while simultaneously working with the borrower to avoid foreclosure-is restricted).

Puerto Rico Regulation

Doral Mortgage and Doral Financial are licensed by the Office of the Commissioner as mortgage banking institutions. Such 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 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

 

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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 ongoing supervision, examination 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”) and the Dodd-Frank 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 general 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 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.

Doral Financial is required to file with the Federal Reserve and the SEC periodic reports and other information concerning its own business operations and those of its subsidiaries. Under the provisions of the BHC Act, a bank holding company is required to obtain the approval of the Federal Reserve before it acquires direct or indirect ownership or control of more than 5% of the voting shares of another bank, or merges or consolidates with another bank holding company. The Federal Reserve also has authority under certain circumstances to issue cease and desist orders against bank holding companies and their non-bank subsidiaries.

Doral Bank is subject to supervision and examination by applicable federal and state banking agencies, including the FDIC, the Office of the Commissioner and the banking regulatory authorities of the states of Florida and New York where Doral Bank has bank branches. Doral Bank is subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, the timing and availability of deposited funds, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, collateral for certain loans, the scope of the bank’s businesses, and limitations on the types of 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.

 

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On August 8, 2012, the members of the Board of Directors of Doral Bank entered into a Consent Order with the FDIC and the Office of the Commissioner (the “Consent Order”). The FDIC has also notified Doral Bank that it deems Doral Bank to be in troubled condition. Doral Financial entered into a Written Agreement with the Federal Reserve Bank of New York (“FRBNY”) dated September 11, 2012 (the “Written Agreement”), which replaced and superseded the then still effective Cease and Desist Order entered into by Doral Financial with the Board of Governors of the Federal Reserve System on March 16, 2006. 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 and the CFPB, including, but not limited to, Regulation B (Equal Credit Opportunity Act), Regulation DD (The 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 a number of consumer financial protection laws from the Federal Reserve and other federal agencies to the CFPB as of July 21, 2011. During the last quarter of 2011, the CFPB 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 CFPB issued interim final rules that became effective on December 30, 2011 establishing the following 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 adopted by the CFPB substantially mirrored the existing regulations that were being substituted and imposed no new substantive obligations on regulated entities.

During 2012 and the beginning of 2013, the CFPB has reviewed and adopted substantive amendments to some of its regulations such as Regulation X (Real Estate Settlement Procedures Act), Regulation V (Fair Credit Reporting Act), Regulation C (Home Mortgage Disclosure Act), Regulation Z (Truth in Lending Act), and Regulation E (Electronic Funds Transfer Act). In addition, during the last half of 2012 the CFPB has made several proposals to amend rules relating to mortgage lending and mortgage servicing. Most of these regulations were completed during January 2013 with an effective date in January 2014 at which time they will be implementing substantial changes to mortgage lending and mortgage servicing practices.

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.

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

 

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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.

On December 20, 2011, the Federal Reserve issued proposed rules to strengthen regulation and supervision of large bank holding companies and systemically important nonbank financial firms. The proposed rules, which include a range of measures addressing issues such as capital, liquidity, concentration and credit exposure limits, stress testing, risk management and early remediation requirements, are mandated by the Dodd-Frank Act. The proposed rules cover a wide, diverse array of regulatory areas, each of which is highly complex. In some cases the proposed rules would implement financial regulatory requirements being proposed for the first time. The proposed rules apply 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 the proposed rule is finalized, and that the requirements relating to stress testing to take effect shortly after the proposed rule is finalized. On October 9, 2012, the Federal Reserve issued the final rules with the stress testing requirements that, among other things, apply to bank holding companies with more than $10 billion in consolidated assets.

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 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. The FDIC issued on October 9, 2012 the final rule on stress tests for insured state depository institutions with more than $10 billion in consolidated assets.

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.

 

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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 of customers 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 public companies 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 framework 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 existing 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 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% conversion 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% conversion 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

 

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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.

The Consent Order with the FDIC and the Office of the Commissioner requires that Doral Bank submit a written capital plan to the FDIC and the Office of the Commissioner that details the manner in which Doral Bank shall meet and maintain a Tier 1 Capital Ratio of at least 8%, a Tier 1 Risk-Based Capital Ratio of at least 10% and Total Risk-Based Capital Ratio of at least 12%. The Written Agreement with the Federal Reserve Bank of NY requires that Doral Financial submit to the Federal Reserve Bank of NY an acceptable written plan to maintain sufficient capital at Doral Financial on a consolidated basis. 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, 2012, based on existing Federal Reserve and FDIC guidelines, respectively:

 

     Doral
Financial
    Doral
Bank
    Well Capitalized
Minimum
Under FDICIA’s
Prompt Corrective
Action Provisions
 

Total capital ratio (Total capital to risk weighted assets)

     13.2     12.8     10.0

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

     11.9     11.5     6.0

Leverage ratio (Tier 1 capital to adjusted average assets)

     9.4     8.2     5.0

As of December 31, 2012, Doral Bank was in compliance with all the regulatory capital requirements that were applicable to it as a state non-member bank as well as those minimums related to the Consent Order and Written Agreement. Please refer to note 31 to the accompanying consolidated financial statements.

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 “Prompt Corrective Action under 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 III 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

 

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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.

As mentioned above, in June 2012, the Agencies each issued NPRs that would revise and replace the Agencies’ current capital rules to align them with the Basel III capital standards and meet certain requirements of the Dodd-Frank Act. Certain proposed requirements of the NPRs would establish more restrictive requirements for instruments to qualify as capital, higher risk-weightings for certain asset classes (including non-performing loans, certain commercial real estate loans, and certain types of residential mortgage loans), capital buffers and higher minimum capital ratios. The NPRs provided for a comment period through October 22, 2012 and the proposals are subject to further modification by the Agencies prior to being issued in final form. The proposals suggested an effective date of January 1, 2013, but on November 9, 2012, the Agencies issued a statement saying that given the volume of comments and wide range of views expressed, the Agencies did not expect that any of the proposed rules would become effective on January 1, 2013.

It is also expected that during 2013, the US bank regulatory agencies will propose liquidity standards for US banking organizations because, under Basel III, these standards will begin to come into effect starting in 2015. The liquidity requirements under Basel III relating to liquidity were issued in final form on January 7, 2013.

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 the US bank regulatory agencies. 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 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.

 

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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, 2012, Doral Bank met the minimum regulatory capital requirements to be considered well capitalized, and is considered to be adequately capitalized based on the elevated capital requirements of the Consent Order. 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.

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 has also issued a policy statement saying that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless

 

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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 the “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 Supervisory 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 (which, 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 Federal Reserve and the FDIC have issued policy statements that generally provide that insured banks and bank holding companies 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 “— Prompt Corrective Action under FDICIA” above for additional information.

The Consent Order and the Written Agreement prohibit Doral Bank from paying dividends to Doral Financial without obtaining prior written approval from the FDIC, the Office of the Commissioner and the FRBNY, and the Written Agreement prohibits Doral Financial from paying dividends to its stockholders without the prior written approval of the FRBNY and the Director of the Division of Bank Supervision and Regulation of the Federal Reserve.

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 of the FDIC, and are therefore subject to FDIC deposit insurance assessments.

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. On October 9, 2012 the FDIC stated that it had updated its loss, income and reserve ratio projections for the DIF over the next several years and concluded that

 

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the DIF reserve ratio is on track to meet the minimum target of 1.35% 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 of 1.35%, but at the time the FDIC noted that it does not project that goal to be met until 2027.

In addition, the Dodd-Frank Act has had 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 (rather than the previous assessment based on the institution’s insured deposits). The FDIC issued a final rule that implements this change to the assessment calculation on February 7, 2011. As 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 cents 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 FDIA, the FDIC also has the authority to impose special assessments upon insured depository institutions when deemed necessary by the FDIC’s board. 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. Doral’s 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 was amortized and recognized by Doral Financial as an expense over the period from 2010 to 2012.

The Deposit Insurance Funds Act of 1996 separated the Financing Corporation (“FICO”) assessment to service the interest on its bond obligations from the DIF assessments. The amount assessed on individual institutions by FICO is in addition to the amount, if any, paid for deposit insurance according to the FDIC’s risk-related assessment rate schedules. The current FICO annual assessment rate is 0.64 cents per $100 of the assessment base (average consolidated assets minus average tangible equity). These assessments will continue until FICO bonds mature in 2019.

As of December 31, 2012, Doral Bank had an FDIC-insurance assessment base of approximately $7.1 billion.

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,

 

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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 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 standards for appraisals. It 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.

As of December 31, 2012 and 2011, Doral Bank had a total of approximately $2.0 billion and $2.2 billion of brokered deposits, respectively. Doral Bank generally uses brokered deposits as a source of less costly funding.

Doral Bank’s liquidity relies in part upon brokered deposits. Under the Consent Order Doral Bank must obtain a waiver from the FDIC prior to accepting, renewing or rolling over any brokered deposits. If the FDIC does not approve the acceptance, renewal or rolling over of brokered deposits, or limits Doral Bank’s ability in any material way, Doral Bank’s liquidity, operations and ability to meet its obligations will be materially adversely affected.

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.

 

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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 investment 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 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 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,

 

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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 limits 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 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 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 depository institution, it has been approved in advance by a majority of the insured depository 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.

 

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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.

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.

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). 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. As a result of losses suffered by Doral Bank in recent years, the current reserve fund balance is zero.

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.

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, 2012, the legal lending limit for Doral Bank under this provision based solely on its paid-in capital and reserve fund was approximately $100.5 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, 2012, the lending limit for Doral Bank for loans secured by collateral worth at least 25% more than the amount of the loan was $223.4 million. There are no restrictions under the Banking Law 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 the Banking Law 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.

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.

 

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The Banking Law prohibits Puerto Rico commercial banks from making loans secured by their own stock, and from purchasing their own stock, unless such purchase is made pursuant to a stock repurchase program approved by the Office of the Commissioner or is necessary to prevent losses because of a debt previously contracted in good faith.

The Banking Law provides that no officers, directors, agents or employees of a Puerto Rico commercial bank may serve as an officer, director, agent or employee of another Puerto Rico commercial bank, financial corporation, savings and loan association, trust company, corporation engaged in granting mortgage loans or any other institution engaged in the money lending business in Puerto Rico. This prohibition is not applicable to affiliates of a Puerto Rico commercial bank.

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.

As mentioned above, on August 8, 2012, the members of the Board of Directors of Doral Bank entered into the Consent Order with the FDIC and the Office of the Commissioner. The Consent Order requires the board of directors of Doral Bank to oversee Doral Bank’s compliance with the Consent Order through specified meetings and notifications to the FDIC and the Office of the Commissioner. In addition, the Consent Order requires the bank to have and retain qualified management acceptable to the FDIC, and also requires Doral Bank to undertake through a third party consultant an assessment of its board and management needs as well as a review of the qualifications of the current directors and senior executive officers. The Consent Order also requires Doral Bank to establish plans, policies or procedures acceptable to the FDIC and the Office of the Commissioner relating to its capital (as well as a contingency plan for the sale, merger or liquidation of Doral Bank in the event its capital falls below required levels), profit and budget plan, ALLL, loan policy, loan review program, loan modification program, appraisal compliance program and its strategic plan that comply with the requirements set forth in the Consent Order. Doral Bank cannot pay a dividend without the approval of the Regional Director of the FDIC and the Office of the Commissioner. The Board of Directors of Doral Bank is required to establish a compliance committee to oversee Doral Bank’s compliance with the Consent Order and Doral Bank is required to provide quarterly updates to the Regional Director of the FDIC and the Office of the Commissioner of its compliance with the Consent Order. Please refer to Part I, Item 3, Legal Proceedings for additional information regarding regulatory enforcement matters.

IBC Act

On December 16, 2008, Doral Investment International LLC was organized to become a new subsidiary of Doral Bank. Doral Investment International LLC 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 International LLC is subject to 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.

 

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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 which results in a change of control of the bank. Under Section 12, a change of control is presumed to occur if a person or group of persons acting in concert, directly or indirectly, acquires more than 5% of the outstanding voting capital stock of the bank. The Office of the Commissioner has interpreted the restrictions of Section 12 as applying to acquisitions of voting securities of entities controlling a bank, such as a bank holding company. Under the 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, obligations to customers and reporting requirements. Doral Insurance Agency is subject to supervision and examination by the Commissioner of Insurance.

Changes to Legislation or Regulation

Changes to federal, state, Commonwealth 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

 

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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, state 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. These risk factors and other presently unforeseen risk factors could cause our actual results to differ materially from those stated in any forward-looking statements included in this Annual Report on Form 10-K or included in our other filings with the SEC. In addition, these risk factors and other presently unforeseen risk factors could have a material adverse effect on our business, financial condition and results of operations.

The risk factors described below are not the only risks faced by the Company. Additional risks and uncertainties not currently known to the Company or currently deemed by the Company to be immaterial also may materially affect the Company’s business, financial condition or results of operations. Please also refer to the section titled “Forward Looking Statements” in this Annual Report on Form 10-K.

Risks Related to our Business and Operations

Operating restrictions and conditions under the Consent Order and the Written Agreement will increase Doral Financial’s operating costs and adversely affect Doral Financial’s results of operations.

Doral Bank entered into the Consent Order with the FDIC and the Office of the Commissioner on August 8, 2012, and Doral Financial entered into the Written Agreement with the FRBNY on September 11, 2012. The Consent Order and the Written Agreement impose operating restrictions and conditions on Doral Bank and Doral Financial. Both the Consent Order and the Written Agreement increase the reporting obligations of Doral Financial and Doral Bank to their regulators.

We anticipate that we will need to continue to dedicate significant resources to our efforts to comply with the Consent Order and the Written Agreement, which are expected to increase our operational costs and adversely affect the amount of time our management has to conduct our business. The additional operating costs to comply with, and the restrictions under, the Consent Order and the Written Agreement will adversely affect Doral Financial’s results of operations.

Under the Consent Order and the Written Agreement the FRBNY, FDIC and the Office of the Commissioner may impose conditions on Doral Financial and/or Doral Bank that one or both entities may not be able to comply with, or even if complied with may materially adversely affect Doral Financial’s and/or Doral Bank’s operations and liquidity and capital resources, as well as their ability to meet their regulatory or financial obligations. If we fail to comply with the Consent Order or the Written Agreement in the future, or if, in the opinion of the FRBNY, FDIC, or the Office of the Commissioner, our financial condition has significantly deteriorated, we may become subject to additional regulatory enforcement actions up to and including the appointment of a receiver or conservator for Doral Bank.

Doral Financial and Doral Bank are subject to the supervision and regulation of various banking regulators and have entered into the Written Agreement and the Consent Order 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

 

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FRBNY 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 the Written Agreement and the Consent Order with the FRBNY, the FDIC and the Office of the Commissioner. 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. The operating and other conditions of the Consent Order and the Written Agreement could lead to an increased risk of being subject to additional regulatory actions, as well as additional actions resulting from future regular annual safety and soundness and compliance examinations by these federal and state regulators. 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 actions could have adverse effects on Doral Financial.

Our ability to diversify our business operations by expanding in the United States is dependent upon approval of our operating plans by the FRBNY, the FDIC and/or the Office of the Commissioner. If we do not continue to receive the approval of the FRBNY, the FDIC and/or the Office of the Commissioner to develop our operations in the United States our business and results of operations will be materially adversely affected.

Because of the weak economic conditions in Puerto Rico we are diversifying our business operations through the development of our banking operations in New York and Florida. Currently, approximately 27.81% of all our assets are in New York and Florida. Because Doral Financial is party to the Written Agreement with the FRBNY and Doral Bank is party to the Consent Order with the FDIC and the Office of the Commissioner, we may be required to seek approval to take some actions under our operating plans, including developing our banking operations in New York and Florida. If the FRBNY, the FDIC and/or the Office of the Commissioner do not approve the continued development of our banking operations in New York and Florida, our business and results of operations will be materially adversely affected.

Doral Bank is required to obtain the approval from the FDIC prior to accepting, renewing or rolling over any brokered deposits. If the FDIC does not allow Doral Bank to accept, renew or rollover any brokered deposits, Doral Bank may not be able to meet its liquidity needs or future obligations.

Doral Bank’s liquidity relies in part upon brokered deposits. Under the Consent Order with the FDIC, Doral Bank must obtain a waiver from the FDIC prior to accepting, renewing or rolling over any brokered deposits. If the FDIC does not approve the acceptance, renewal or rolling over of brokered deposits, or limits Doral Bank’s ability in any material way, Doral Bank’s liquidity, operations and ability to meet its obligations will be materially adversely affected.

Our decisions regarding credit risk and the allowance for loan and lease losses may materially and adversely affect our business and results of operations. If we need to materially increase our allowance for loan and lease losses, our business and results of operations will be materially adversely affected.

Making loans is an essential element of our business, and there is a risk that the loans will not be repaid. This default risk is affected by a number of factors, including:

 

   

the duration of the loan;

 

   

credit risk of a particular borrower;

 

   

changes in economic or industry conditions; and

 

   

in the case of a collateral loan, risks resulting from uncertainties about the future value of collateral.

 

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We strive to maintain an appropriate allowance for loan and lease losses to provide for probable losses inherent in the loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors such as default frequency, internal risk ratings, expected future cash collections, loss recovery rates, severity experience, fair value estimates and general economic factors, among others.

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

We believe our allowance for loan and lease losses is currently sufficient given the constant monitoring of the risk inherent in the loan portfolio. However, there is no precise method of predicting loan losses and therefore we always face the risk that charge-offs in future periods will exceed the allowance for loan and lease losses and that additional provisions to increase the allowance for loan and lease losses will be required. In addition, the FDIC as well as the Office of the Commissioner may require us to establish additional reserves. Additions to the allowance for loan and lease losses would adversely affect our results of operations and our financial condition.

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 2012 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 may continue to deteriorate 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.

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 has been in recessionary conditions since 2006. 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 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. 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

 

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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 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 (including those requirements set forth in the Consent Order and the Written Agreement), our business and financial condition will be adversely affected. A failure to meet regulatory capital adequacy guidelines, among other things, would further affect Doral Bank’s ability to accept or rollover brokered deposits and could result in additional 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.

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, and we currently believe that our risk management policies and procedures are effective. Nonetheless, 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.

 

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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 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 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.

We could incur increased costs or reductions in revenue or suffer reputational damage in the event of misuse of information.

Our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks regarding our customers and their accounts. To provide these products and services, we use information systems and infrastructure that we and third party service providers operate. As a financial institution, we also are subject to and examined for compliance with an array of data protection laws, regulations and guidance, as well as to our own internal privacy and information security policies and programs.

Information security risks for financial institutions like us have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions and the increased sophistication and activities of organized crime, hackers and other external parties. Our technologies and systems may become the target of cyber-attacks or other attacks that could result in the misuse or destruction of our or our customers’ confidential, proprietary or other information or that could result in disruptions to the business operations of us or our customers or other third parties. Also, our customers, in order to access some of our products and services, may use personal computers, smart mobile

 

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phones, tablet PCs and other devices that are beyond our controls and security systems. Further, a breach or attack affecting one of our third-party service providers or partners could impact us through no fault of our own. In addition, because the methods and techniques employed by perpetrators of fraud and others to attack systems and applications change frequently and often are not fully recognized or understood until after they have been launched, we and our third-party service providers and partners may be unable to anticipate certain attack methods in order to implement effective preventative measures.

While we have policies and procedures designed to prevent or limit the effect of the possible security breach of our information systems, if unauthorized persons were somehow to get access to confidential or proprietary information in our possession or to our proprietary information, it could result in significant legal and financial exposure, damage to our reputation or a loss of confidence in the security of our systems that could adversely affect our business.

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. Three of Doral Financial’s most critical estimates are the level of the allowance for loan and lease losses, the valuation of mortgage servicing rights and the reserve for deferred tax assets.

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. 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. Maintaining deferred tax assets without reserves requires generation of future taxable income levels that provides for use of the deferred tax assets in the future.

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.

 

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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 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, 2012, the maximum contractual exposure to us if we were required to purchase all loans sold subject to partial or full recourse was $476.7 million, $388.9 million 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, and currently have $44.9 million pledged to FNMA as collateral.

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 2012 and 2011, we repurchased $42.0 million and $54.7 million, respectively, of defaulted FHA guaranteed loans from GNMA. Any

 

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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 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; and the consolidation of the Puerto Rico banking industry.

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 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.

 

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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 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, which conviction he is appealing.

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 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.

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 affect to our reputation among investors or to 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.

Risks Related to the General Business Environment and our Industry

Our credit quality may continue to be adversely affected by Puerto Rico’s recessionary economic conditions.

Because a majority of our business activities and credit exposure are still concentrated in Puerto Rico, our financial condition and results of operations are highly dependent on economic conditions in Puerto Rico.

 

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The economy of Puerto Rico entered into a recession in the fourth quarter of the government’s fiscal year ended June 30, 2006. For fiscal years 2007, 2008, 2009, 2010 and 2011, Puerto Rico’s real gross national product decreased by 1.2%, 2.9%, 3.8%, 3.4% and 1.5%, respectively. According to the projections of the Puerto Rico Planning Board, a government agency, made in November 2012, real gross national product for fiscal years 2012 and 2013 is expected to increase by 0.4% and 0.6%, respectively, although there can be no assurance this will prove accurate.

The long recession in Puerto Rico has resulted in, among other things, a reduction in lending activity and an increase in the rate of default in commercial loans, commercial real estate loans, construction loans, consumer loans and residential mortgages. We have also experienced significant losses on our Puerto Rico loan portfolio due to a higher level of defaults on commercial loans, commercial real estate loans, construction loans, consumer loans and residential mortgages. The prolonged recessionary economic environment in Puerto Rico accelerated the devaluation of properties and increased portfolio delinquency when compared with previous periods.

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. Additional economic weakness in Puerto Rico and the U.S. mainland could further pressure residential property values, loan delinquencies, foreclosures and the cost of repossessing and disposing of real estate collateral.

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 development, continued recessionary economic conditions 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.

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 under-employment, 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.

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 and losses on our non-agency mortgage-backed securities as a result of past market conditions. 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.

 

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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 our FDIC assessment ratings continue to deteriorate or if market conditions do not improve or worsen.

 

   

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.

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.

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 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.

Our business could be adversely affected if we cannot maintain access to stable funding sources.

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.

Our business requires continuous access to various funding sources. We need liquidity to, among other things, pay our operating expenses, pay interest on our debt, maintain our lending and investment activities and

 

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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 disruptions in the financial markets.

We are generally able to fund our operations through deposits as well as through advances from the FHLB and other alternative sources such as repurchase agreements, loans and brokered deposits. We expect to have continued access to credit from the foregoing sources of funds. However, there can be no assurance that such financing sources will continue to be available or will be available on favorable terms. In a period of financial disruption, or if negative developments occur with respect to us, the availability and cost of funding sources could be adversely affected. Our efforts to monitor and manage liquidity risk may not be successful to deal with dramatic or unanticipated changes in the global markets or other reductions in liquidity driven by us or market-related events. In the event that such sources of funds are reduced or eliminated and we are not able to replace them on a cost-effective basis, we may be forced to curtail our loan origination and investment activities, which would have a material adverse effect on our operations and financial condition.

Brokered deposits are typically sold through an intermediary to retail investors. Our ability to continue to attract brokered deposits is subject to variability based on a number of factors, including volume and volatility in the global markets, our credit rating and the relative interest rates that we are prepared to pay for these liabilities. Brokered deposits are generally considered a less stable source of funding than core deposits obtained through retail bank branches. Investors in brokered deposits are generally more sensitive to interest rates and will generally move funds from one depository institution to another based on small differences in interest rates on deposits. 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.

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

 

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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 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.

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. 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.

Implementation of BASEL III could reduce our regulatory capital ratios and increase regulatory capital requirements.

In June 2012, Agencies issued NPRs that would revise and replace the Agencies’ current capital rules to align with the BASEL III capital standards and meet certain requirements of the Dodd-Frank Act. Certain requirements of the proposed NPRs would establish more restrictive requirements for instruments to qualify as capital, higher risk-weightings for certain asset classes (including non-performing loans, certain commercial real estate loans, and certain types of residential mortgage loans), capital buffers and higher minimum capital ratios. The proposed NPRs provided for a comment period through October 22, 2012 and the proposals are subject to further modification by the Agencies prior to being issued in final form. The proposals suggested an effective date of January 1, 2013, but on November 9, 2012 the Agencies issued a statement saying that given the volume of comments and wide range of views expressed, the Agencies did not expect that any of the proposed rules would become effective on January 1, 2013.

The proposed revisions would, among other things, include implementation of a new common equity Tier 1 minimum capital requirement and apply limits on a banking organization’s capital distributions and certain

 

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discretionary bonus payments if the banking organization does not hold a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The NPRs also would establish more conservative standards for including an instrument in regulatory capital. The revisions set forth in these NPRs are consistent with section 171 of the Dodd-Frank Act, which requires the Agencies to establish minimum risk-based and leverage capital requirements. The Agencies are also proposing to revise their rules for calculating risk-weighted assets to enhance risk sensitivity and address weaknesses identified over recent years. The revisions include methodologies for determining risk-weighted assets for residential mortgages, securitization exposures, and counterparty credit risk.

The implementation of the NPRs as proposed could reduce our regulatory capital ratios.

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. We are also subject to the requirements and limitations of the Consent Order and the Written Agreement. If we do not comply with governmental regulations and other supervisory requirements, we may become 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 DIF. Recent 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.

The Dodd-Frank Act requires the FDIC to increase the DIF’s reserves against future losses, which will necessitate increased deposit insurance premiums. 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

 

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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.

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 US GAAP, which is 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 FASB. Market conditions have prompted accounting standard setters to promulgate new requirements that further interpret or seek to revise accounting pronouncements related to financial instruments, structures or transactions as well as to revise standards to expand disclosures. The impact of accounting pronouncements that have been issued but not yet implemented is disclosed by us in footnotes to our financial statements included 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.

Risks related to our common stock

Our common stock may be delisted from the New York Stock Exchange

On November 8, 2012, we were notified by the NYSE that the average per share closing price of our common stock during the 30 trading-day period ending October 31, 2012 was below the NYSE’s continued listing standard relating to minimum average closing share price. The NYSE’s Listed Company Manual provides that we will be considered to be below compliance standards if the average closing price of our common stock is less than $1.00 over a consecutive 30 trading-day period.

We have six months from receipt of the notice to regain compliance with the NYSE’s price condition and bring our share price and average share price back above $1.00 per share. We notified the NYSE that we intend to regain compliance with the NYSE’s price condition and bring our share price and average share price back above $1.00 per share. Among other things, if we effectuate a reverse stock split vote at our next annual meeting of stockholders to cure the condition, the condition will be deemed cured if the price promptly exceeds $1.00 per share, and the price remains above the level for at least the following 30 trading days.

 

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It is not certain that we will be able to regain compliance with the NYSE’s price condition within the time frame allotted. Delisting from the NYSE would have an adverse effect on the liquidity of our common stock and, as a result, the market price of our common stock would be adversely affected.

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 our board of directors in March 2009.

Our ability to pay dividends in the future is limited by various regulatory requirements and policies of bank regulatory agencies having jurisdiction over Doral Financial and such other factors deemed relevant by our board of directors. Under the Written Agreement, we are restricted from paying dividends on our capital stock without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve. We are required to request permission for 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 governmental 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;

 

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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 developments relating to the Consent Order and the Written Agreement; 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.

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.

None.

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 $49.4 million. The building is subject to a mortgage in the amount of $36.3 million.

 

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In addition, Doral Bank maintains 26 retail banking branches in Puerto Rico, at which mortgage origination offices are co-located in all of these branches. Of the properties on which the 26 branch locations are situated, 9 properties are owned by Doral Financial and 17 properties are leased by Doral Financial from third parties.

As of December 31, 2012, Doral Bank was in the process of opening an administrative office in the Brickell World Plaza building located at 600 Brickell Avenue in Miami, Florida where it leases approximately 20,000 square feet of office space.

The administrative 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 currently operates 3 branches in the metropolitan area of New York City and 5 branches in the northwest area of Florida. These branches are leased by Doral Bank from third parties, with the exception of three branches in Florida, which are owned by Doral Bank.

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.

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.

Legal Matters

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.

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.

On April 12, 2012, Mario L. Levis voluntarily dismissed the case pending before the Supreme Court of New York. Mr. Levis immediately thereafter filed a new complaint against the Company in the Superior Court of Puerto Rico. In his complaint Mr. Levis does not specify the exact amount of money and damages claimed, but he alleges that the Company owes him money and requests the fulfillment of the obligation to advance payment for the litigation costs concerning the defense of an indictment returned against him by a Grand Jury of the United States District Court for the Southern District of New York, which charged him with various counts of securities and wire fraud. The case is in its early stages and discovery has commenced. Mr. Levis and the Company’s dispositive motions are pending resolution of the Superior Court of Puerto Rico.

 

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Lehman Brothers Transactions

Prior to 2012, 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, stating 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.

Banking Regulatory Matters

On August 8, 2012, the members of the board of directors of Doral Bank entered into a Consent Order with the FDIC and the Commissioner of Financial Institutions of Puerto Rico (the “Commissioner”). The FDIC has also notified Doral Bank that it deems Doral Bank to be in troubled condition. The Consent Order with the FDIC requires the board of directors of Doral Bank to oversee Doral Bank’s compliance with the Consent Order through specified meetings and notifications to the FDIC and the Commissioner. In addition, the Consent Order requires the bank to have and retain qualified management acceptable to the FDIC. The Consent Order also requires Doral Bank to undertake through a third party consultant an assessment of its board and management needs as well as a review of the qualifications of the current directors and senior executive officers. The Consent Order requires Doral Bank to eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” by the FDIC and the Commissioner. Doral Bank also is required to establish and provide to the FDIC for review a Delinquent and Classified Asset Plan to reduce Doral Bank’s risk position in each loan in excess of $1 million which is more than 90 days delinquent or classified “Substandard” or “Doubtful” in a report of examination by the FDIC and the Commissioner. The Consent Order also requires Doral Bank to establish plans, policies or procedures acceptable to the FDIC and the Commissioner relating to its capital (as well as a contingency plan for the sale, merger or liquidation of Doral Bank in the event its capital falls below required levels), profit and budget plan, ALLL, loan policy, loan review program, loan modification program, appraisal compliance program and its strategic plan that comply with the requirements set forth in the Consent Order. Doral Bank is required to obtain a waiver from the FDIC before it may accept brokered deposits or extend credit to certain delinquent borrowers. Doral Bank cannot pay a dividend without the approval of the Regional Director of the FDIC and the Commissioner. The board of directors of Doral Bank is required to establish a compliance committee to oversee Doral Bank’s compliance with the consent order and Doral Bank is required to provide quarterly updates to the Regional Director of the FDIC and the Commissioner of its compliance with the Consent Order.

Doral Financial also entered into a written agreement dated September 11, 2012 with its primary supervisor, the FRBNY, which replaces and supersedes the Cease and Desist Order entered into by Doral with the Board of Governors of the Federal Reserve System on March 16, 2006. The Written Agreement, among other things,

 

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requires the Company to: (a) take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to Doral Bank, including steps to ensure that Doral Bank complies with any supervisory action taken by Doral Bank’s federal and state regulators; (b) undertake a management and staffing review to aid in the development of a suitable management structure that is adequately staffed by qualified and trained personnel; (c) establish programs, policies and procedures acceptable to the FRBNY relating to credit risk management practices, credit administration, loan grading, asset improvement, other real estate owned, allowance for loan and lease losses, accounting and internal controls, and internal audit; (d) not declare any dividends without the prior written approval of the FRBNY and the Director of Banking Supervision and Regulation of the Board of Governors; (e) not directly or indirectly take any dividends or any other form of payment representing a reduction of capital from Doral Bank without the prior approval of the FRBNY; (f) not, directly or indirectly, incur, increase or guarantee any debt without the prior written approval of the FRBNY; (g) submit to the FRBNY an acceptable written plan to maintain sufficient capital at Doral Financial on a consolidated basis; and (h) seek regulatory approval prior to the appointment of a new director or senior executive officer, any change in a senior executive officer’s responsibilities, or making certain severance or indemnification payments to directors, executive officers or other affiliated persons.

As a result of these regulatory actions, Doral and Doral Bank will require significant management and third party consultant resources to comply with Doral’s Written Agreement with the FRBNY and Doral Bank’s Consent Order with the FDIC and the Commissioner. Doral has already added significant resources to meet the monitoring and reporting obligations imposed by the Consent Order and the Written Agreement. Doral expects these incremental administrative and third party costs as well as the operational restrictions imposed by the Consent Order and the Written Agreement to adversely affect Doral’s results of operations. The Consent Order and the Written Agreement do not currently mandate that Doral or Doral Bank raise additional capital or increase its reserves; however, there can be no assurance that in the future either the FRBNY or the FDIC and the Commissioner will not impose such conditions. Finally, Doral and Doral Bank must also seek regulatory approval prior to the appointment of a new director or senior executive officer, any change in a senior executive officer’s responsibilities, or making certain severance or indemnification payments to directors, executive officers or other affiliated persons.

These banking regulators could take further actions with respect to Doral Financial or Doral Bank and, if such further actions were taken, such actions could have a material adverse effect on Doral Financial. The operating and other conditions of the Consent Order and the Written Agreement could lead to an increased risk of being subject to additional regulatory actions, as well as additional actions resulting from future regular annual safety and soundness and compliance examinations by these federal and state regulators that further downgrade the regulatory ratings of Doral Financial and/or Doral Bank. If Doral Financial and/or Doral Bank fail to comply with the requirements of the Written Agreement or the Consent Order in the future, Doral Financial and/or Doral Bank may be subject to additional regulatory enforcement actions up to and including the appointment of a receiver or conservator for Doral Bank.

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 under the symbol “DRL.”

On November 8, 2012, the Company was notified by the NYSE that the average per share closing price of its common stock during the 30 trading-day period ending October 31, 2012 was below the NYSE’s continued listing standard relating to minimum average closing share price. The Company has six months from receipt of notice to regain compliance with the NYSE’s price condition and bring its share price and average share price back above $1.00 per share.

 

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The Company can regain compliance at any time during the six-month cure period if, on the last trading day of any calendar month during the six-month cure period, the Company has a closing share price of at least $1.00 and an average closing share price of at least $1.00 over the 30 trading-day period ending on the last trading day of that month. The Company can also regain compliance if, at the expiration of the six-month cure period, both a $1.00 closing share price on the last trading day of the cure period and a $1.00 average closing share price over the consecutive 30 trading-day period ending on the last trading day of the cure period, are attained. If the Company effectuates a reverse stock split vote at its next annual meeting of stockholders to cure the condition, the condition will be deemed cured if the price promptly exceeds $1.00 per share, and the price remains above the level for at least the following 30 trading days.

Subject to NYSE’s rules, during the cure period, shares of the Company’s common stock will continue to be listed and will trade on the NYSE, subject to the Company’s continued compliance with the NYSE’s other applicable listing rules. Until the Company is able to cure this deficiency, shares of the Company’s common stock will trade under the symbol “DRL.BC”. The Company is currently in compliance with all other NYSE listing rules.

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  

2012

     4th       $ 1.02      $ 0.57  
     3rd         1.54        0.94  
     2nd         1.92        1.21  
     1st         1.64        1.03  

2011

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

As of March 4, 2013 the approximate number of record holders of Doral Financial’s Common Stock was 195, 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 $0.54 per share.

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, 2012, 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

 

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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.

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

 

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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 35 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.

Under the Written Agreement, Doral Financial is restricted from paying dividends on its capital stock without the prior written approval of the FRBNY and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve. Doral Financial is required to request permission for the payment of dividends on our Common Stock and preferred stock not less than 30 days prior to a proposed dividend declaration date. Doral Financial may not receive approval for the payment of such dividends in the future or, even with approval, Doral Financial’s board of directors may not resume the payment of 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 Noncumulative 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 Noncumulative Preferred Stock, and the dividends for the second quarter of 2009 for Doral Financial’s one outstanding series of cumulative preferred stock.

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.

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.

 

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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 in 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 2013 Proxy Statement, and to note 36, “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

There were no sales of unregistered securities by the Company during 2012.

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, 2012.

 

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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, 2007 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,  

(In thousands, except for share and per share data)

  2012     2011     2010     2009     2008  

Selected Income Statement Data:

         

Interest income

  $ 368,477      $ 367,617     $ 405,269     $ 461,035     $ 527,179  

Interest expense

    147,952       178,722       240,917       290,638       347,193  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

    220,525       188,895       164,352       170,397       179,986  

Provision for loan and lease losses

    176,098       67,525       98,975       53,663       48,856  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan and lease losses

    44,427       121,370       65,377       116,734       131,130  

Non-interest income (loss)

    85,779       118,827       (18,558     83,948       76,636  

Non-interest expenses

    294,986       249,180       323,830       243,303       240,024  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income taxes

    (164,780     (8,983     (277,011     (42,621     (32,258

Income tax (benefit) expense

    (161,481     1,707       14,883       (21,477     286,001  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

  $ (3,299   $ (10,690   $ (291,894   $ (21,144   $ (318,259
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to common shareholders(1)

  $ (12,960   $ (20,350   $ (274,418   $ (45,613   $ (351,558
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Accrued dividends:

         

Preferred stock

  $ 9,661     $ 9,660     $ 9,109     $ 15,841     $ 33,299  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock exchange inducement, net

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss per common share(1)(2)

  $ (0.10   $ (0.16   $ (2.96   $ (0.81   $ (6.53
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Book value per common share

  $ 3.76     $ 3.80     $ 4.01     $ 7.41     $ 6.17  

Preferred shares outstanding at end of period

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

Weighted average common shares outstanding

    128,443,574       127,321,477       92,657,003       56,232,026       53,810,110  

Common shares outstanding at end of period

    128,460,423       128,295,756       127,293,756       62,064,303       53,810,110  

Selected Balance Sheet Data at Year End:

         

Cash and cash equivalents (including restricted cash)

  $ 729,037     $ 495,445     $ 519,040     $ 825,690     $ 196,416  

Investment securities

    393,832       597,652       1,550,094       2,836,903       3,681,028  

Total loans, net(3)

    6,477,522       6,138,645       5,784,183       5,695,964       5,506,303  

Allowance for loan and lease losses

    135,343       102,609       123,652       140,774       132,020  

Servicing assets, net

    99,962       112,303       114,342       118,493       114,396  

Total assets

    8,478,246       7,981,364       8,652,963       10,237,365       10,147,766  

Deposits

    4,628,008       4,411,289       4,648,213       4,667,591       4,441,803  

Borrowings

    2,683,975       2,476,554       2,896,213       4,470,056       4,526,091  

Total liabilities

    7,642,573       7,141,210       7,790,768       9,362,321       9,242,595  

Preferred equity

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

Common equity

    483,591       488,072       510,113       459,616       331,921  

Total stockholders’ equity

    835,673       840,154       862,195       875,044       905,171  

Operating Data:

         

Loan production

  $ 2,409,457     $ 1,763,792     $ 1,439,333     $ 1,147,742     $ 1,327,521  

Loan servicing portfolio(4)

  $ 7,594,352     $ 7,898,328     $ 8,208,060     $ 8,655,613     $ 9,460,350  

Selected Financial Ratios:

         

Performance:

         

Net interest margin

    2.95     2.50     1.87     1.76     1.88

Efficiency ratio

    94.79     86.64     123.97     98.50     91.78

Return on average assets

    (0.04 )%      (0.13 )%      (3.08 )%      (0.21 )%      (3.10 )% 

Return on average common equity

    (2.77 )%      (4.03 )%      (59.24 )%      (10.42 )%      (52.61 )% 

Capital:

         

Leverage ratio

    9.39     9.13     8.56     8.43     7.59

Tier 1 risk-based capital ratio

    11.93     12.18     13.25     13.82     13.80

Total risk-based capital ratio

    13.19     13.44     14.51     15.08     17.07

 

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    Year ended December 31,  

(In thousands, except for share and per share data)

  2012     2011     2010     2009     2008  

Asset quality:

         

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

                 14.55                  12.62                  14.88                  16.65                  14.42

NPAs as percentage of consolidated total assets

    10.56     9.40     9.86     9.21     7.69

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

    12.15     9.67     11.63     15.19     13.19

ALLL to period-end loans receivable

    2.19     1.73     2.21     2.55     2.51

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

    2.21     1.76     2.29     2.63     2.54

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

    5.65     4.49     4.02     3.42     n/a   

ALLL to NPLs (excluding NPLs held for sale)

    18.22     18.20     19.79     16.91     18.69

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

    41.41     31.97     32.36     22.15     n/a   

ALLL to net charge-offs

    94.41     115.85     106.51     313.47     317.59

Provision for loan and lease losses to net charge-offs

    122.83     76.24     85.25     119.49     117.53

Net annualized charge-offs to average loan receivable

    2.36     1.55     2.08     0.85     0.80

Recoveries to charge-offs

    2.89     1.83     1.54     5.52     2.37

Other ratios:

         

Average common equity to average assets

    5.67     6.12     5.36     3.53     6.11

Average total equity to average assets

    9.94     10.38     9.69     8.61     12.10

Tier 1 common equity to risk-weighted assets

    6.53     6.24     6.94     7.16     6.00

 

 

 

(1) 

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

 

(2) 

For the years ended December 31, 2012, 2011, 2010, 2009 and 2008, net loss per common share represents the basic and diluted loss per share, respectively.

 

(3) 

Includes loans held for sale.

 

(4) 

Represents the total portfolio of loans serviced for third parties. Excludes $3.8 billion, $4.4 billion, $4.4 billion, $4.4 billion and $4.2 billion of mortgage loans owned by Doral Financial at December 31, 2012, 2011, 2010, 2009, and 2008, 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, 2012, 2011, 2010, 2009 and 2008, are as follows:

 

     Year ended December 31,  
     2012     2011     2010     2009     2008  

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

     (B     (B     (B     (B     (B

Excluding interest on deposits

     (B     (B     (B     (B     (B

 

  (A) During 2012, 2011, 2010, 2009 and 2008, earnings were not sufficient to cover fixed charges and the ratios were less than 1:1. The Company would have had to generate additional earnings of $164.8 million, $9.0 million, $277.0 million, $42.6 million and $32.3 million, to achieve ratios of 1:1 in 2012, 2011, 2010, 2009 and 2008, respectively.

 

  (B) During 2012, 2011, 2010, 2009 and 2008, earnings were not sufficient to cover preferred dividends and the ratios were less than 1:1. The Company would have had to generate additional earnings of $180.6 million, $20.5 million, $286.6 million, $50.5 million and $362.0 million to achieve a ratio of 1:1 in 2012, 2011, 2010, 2009 and 2008, respectively.

 

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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 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, 2012, 2011 and 2010, the Company accrued $9.7 million, $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 for each of the years ended December 31, 2012, 2011, 2010, 2009 and 2008 are set forth below:

 

    Year ended December 31,  

(In thousands)

  2012     2011     2010     2009     2008  

Long-term obligations

  $ 2,358,658     $ 2,119,495     $ 2,429,489     $ 2,457,944     $ 3,459,246  

Cumulative preferred stock

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

Non-cumulative preferred stock

  $ 148,700     $ 148,700     $ 148,700     $ 197,388     $ 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 2012.

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, 2012, 2011 AND 2010:    Provides an analysis of the consolidated results of operations for 2012 compared to 2011, and 2011 compared to 2010.

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 risk 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

There are two significant trends affecting our business in 2013. First, we anticipate that we will need to continue to dedicate significant resources to our efforts to comply with the Consent Order and the Written Agreement, which are expected to increase our operational costs and adversely affect the amount of time our management has to conduct our business. The additional operating costs to comply with, and the restrictions under, the Consent Order and the Written Agreement will adversely affect Doral Financial’s results of operations.

Second, since 2009 and in response to the weak economic conditions and prospects in Puerto Rico we have sought to diversify our business operations by significantly expanding our banking operations in the mainland United States. At the end of 2009 our total assets in the United States totaled $0.5 million or 5.0% of our total assets. At the end of 2012 our total assets in the United States totaled $2.4 billion or 27.81% of our total assets. In addition, for 2009 our Net Loss Before Income Taxes in the United States was $2.3 million of our total Net Loss Before Income Taxes. For 2012, Net Income Before Income Taxes in the United States was $47.2 out of our total Net Loss Before Income Taxes. We expect our business operations in the United States to continue to represent an increasing percentage of our total business. As a result of our expansion in the United States, we now account for our operations in four principal segments: Puerto Rico, United States, Treasury and Liquidating Operations. We intend to continue to build our profitable mortgage origination, mortgage servicing and branch office business in Puerto Rico and our profitable New York and Florida commercial loan and branch office business in the United States while seeking to manage our impaired assets and mitigating our losses through our Liquidating Operations.

Net loss for the year ended December 31, 2012 totaled $3.3 million, compared to net losses of $10.7 million and $291.9 million for the years 2011 and 2010, respectively. When comparing 2012 to 2011 results, Doral Financial’s performance improvement resulted from the following: (i) an increase in net interest income of $31.6 million; (ii) an increase of $108.6 million in the provision for loan and lease losses; (iii) a $33.0 million decrease in non-interest income; (iv) an increase of $45.8 million in non-interest expense; and (v) an improvement of $163.2 million in income tax expense (benefit).

Net loss attributable to common shareholders for the year ended December 31, 2012 totaled $13.0 million, and resulted in a net loss per share of $0.10, compared to a net loss attributable to common shareholders for the corresponding 2011 and 2010 periods of $20.4 million and $274.4 million, and a loss per share of $0.16 and $2.96, respectively.

The significant events or transactions that have influenced the Company’s financial results for the year ended December 31, 2012 included the following:

 

   

Net interest income for the year ended December 31, 2012 was $220.5 million, compared to $188.9 million and $164.4 million for the corresponding 2011 and 2010 periods, respectively. The increase of $31.6 million in net interest income during 2012, compared to 2011, was due to a reduction in deposits interest expense of $24.9 million and in securities sold under agreements to repurchase of $11.0 million, and an increase in loans interest income of $19.2 million, partially offset by a decrease of $17.7 million in mortgage-backed securities interest income.

 

   

Doral Financial’s provision for loan and lease losses for the year ended December 31, 2012 totaled $176.1 million, compared to $67.5 million and $99.0 million for the corresponding 2011 and 2010 periods, respectively. The provision for loan and lease losses in 2012 resulted from: (i) $112.0 million for non-guaranteed residential loans as new loans became delinquent, previously delinquent loans reached later delinquency stages and valuations were received on properties securing loans more than 180 days past due; (ii) $23.8 million from construction and land largely due to valuations on properties collateralizing impaired loans and continued deterioration of loan performance; (iii) $4.3 million for

 

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growth in the U.S. commercial and industrial loan portfolio; and (iv) $35.3 million for commercial real estate related to valuations received on properties securing delinquent loans and adverse loan performance experienced during the year. Also affecting the 2012 provision was Doral’s revision of its future Puerto Rico portfolio performance expectations due to the continuing underperformance of Puerto Rico’s economy and the current regulatory environment.

 

   

Non-interest income for the year ended December 31, 2012 was $85.8 million, compared to $118.9 million and a non-interest loss of $18.6 million for the corresponding 2011 and 2010 periods, respectively. The $33.0 million decrease in non-interest income during 2012 when compared to 2011 resulted largely from the following: (i) a decrease of $21.6 million in gain on sale of investment securities available for sale; (ii) a decrease of $15.2 million in servicing income mostly related to a decrease of $11.1 million in the change in the fair value of the servicing asset; and (iii) a decrease of $6.4 million in net gains from trading activities resulting mainly from a decrease of $3.5 million in gain on IO valuation and a $1.9 million increase in losses from hedging activities.

 

   

Non-interest expense for the year ended December 31, 2012 was $295.0 million, compared to $249.2 million and $323.8 million for the years ended December 31, 2011 and 2010, respectively. The $45.8 million increase in non-interest expense during 2012, compared to 2011, was due largely to: (i) an increase of $13.1 million in OREO expenses mainly due to an increase of $10.1 million in the provision for OREO losses; (ii) an increase of $12.3 million in professional services mostly related to non-recurring professional service expenses incurred to perform certain reviews under the supervision of the Company’s board of directors and legal expenses relating to commercial loan workouts; (iii) an increase of $7.4 million in compensation and benefits mostly related to additional headcount in the U.S. operations and growth in the P.R. collections efforts as well as stock based compensation of $5.2 million; (iv) an increase of $4.3 million in electronic data processing expenses mostly related to outsourcing of the retail banking core application process; (v) an increase of $3.0 million in occupancy related to new leases lease contracts for the Company’s U.S. operations and: (vi) an increase of $3.2 million in FDIC insurance expense as a result of the increase in the assessment rate.

 

   

Income tax benefit of $161.5 million for the year ended December 31, 2012 compared to an income tax expense of $1.7 million and $14.9 million for the corresponding 2011 and 2010 periods. The improvement in income tax expense (benefit) of $163.2 million is due mainly to the release of valuation allowance of $113.7 million as the Company entered into a Closing Agreement with the Commonwealth of Puerto Rico related to certain tax payments from prior years and a $50.6 million deferred tax benefit recorded during the fourth quarter of 2012 that resulted from the release of a portion of the deferred tax assets valuation allowance at Doral Financial Corporation, based on our evaluation of all available evidence in determining whether the valuation allowance for deferred tax assets at Doral Financial Corporation was needed. This decrease was partially offset by the income tax expense of $5.3 million related to U.S. operations.

 

   

The Company reported an increase in other comprehensive income to $3.2 million from 2011 to 2012, compared to a decrease in other comprehensive loss of $5.4 million from 2010 to 2011. The positive variance in other comprehensive income (loss) for the year ended December 31, 2012 compared to the 2011 period resulted principally from an increase in the unrealized gain in securities available for sale of $5.4 million partially offset by a decrease of $2.4 million related to the maturity of the positions used for the cash flow hedge.

 

   

Doral Financial’s loan production for the year ended December 31, 2012 was $2.4 billion, compared to $1.8 billion and $1.4 billion for the comparable 2011 and 2010 periods. The production increase resulted mainly from the U.S. loan originations production in commercial and industrial loans of $1.4 billion, which represented 61% of the 2012 loan production.

 

   

Total assets as of December 31, 2012 were $8.5 billion compared to $8.0 billion as of December 31, 2011. The increase of $496.9 million was mostly related to increases in the loans receivable, net of $338.9 million, cash of $233.6 million and prepaid income tax of $227.4 million partially offset by a decrease of $203.8 million in investment securities. Decreases of $62.3 million, $12.3 million, $11.5 million, $8.2

 

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million and $6.3 million were also seen in deferred tax assets, servicing assets, real estate held for sale, accrued interest receivable and premises and equipment, respectively.

 

   

Total deposits as of December 31, 2012 of $4.6 billion increased $0.2 billion from deposits of $4.4 billion as of December 31, 2011. The increase is mainly due to growth in the Company’s retail deposits by $378.3 million partially offset by a decrease of $161.6 million in brokered deposits as part of the Company’s strategy to reduce reliance on wholesale funding sources.

 

   

Non-performing loans, excluding FHA/VA loans guaranteed by the U.S. government as of December 31, 2012 were $742.8 million, an increase of $179.1 million from December 31, 2011. The increase in NPLs is a result of higher delinquency on non-FHA residential mortgage loans of $139.2 million and total commercial loans of $39.9 million.

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 the Company’s consolidated financial statements. Various elements of the Company’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. Understanding the Company’s accounting policies and the extent to which the Company uses management judgment and estimates in applying these policies is integral to understanding the Company’s consolidated financial statements. The Company provides a summary of its Significant Accounting Policies in “note 2 — Summary of Significant Accounting Policies” to the Company’s consolidated financial statements.

The Company has identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters. The use of reasonably different estimates and assumptions could have a material impact on the Company’s reported results of operations or financial condition. These critical accounting policies govern:

 

   

Income Recognition

 

   

Allowance for Loan and Lease Losses

 

   

Fair Value

 

   

Mortgage Servicing Rights and Retained Interests

 

   

Mortgage Loan Repurchase Losses

 

   

Income Taxes

The Company evaluates its critical accounting policies and judgments on an ongoing basis, and updates them as necessary based on changing conditions. Management has reviewed and approved these critical accounting policies and has discussed these policies with the Audit and Risk Committees of the Board of Directors. The Company 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, 2012.

INCOME RECOGNITION ON LOANS

Accrual Status

The Company recognizes interest income on loans receivable on an accrual basis unless it is determined that collection of all contractual principal or interest is unlikely.

The Company discontinues accrual recognition of interest income on loans when the full and timely collection of interest or principal becomes uncertain, generally when a loan receivable is 90 days delinquent on principal or interest. The Company discontinues accrual recognition of interest income when a mortgage loan is four payments (ten payments for mortgage loans insured by FHA/VA) past due for interest or principal. Loans determined to be well collateralized such that the 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 the Company continues to accrue interest income on that loan.

 

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When the Company places a loan on non-accrual status, it reverses the accrued unpaid interest receivable against interest income in that period, and suspends amortization of any net deferred fees or costs. Interest income on a non-accrual loan is recognized under the cash basis method (i.e. income recognized when an interest payment is received), if ultimate collection of principal is not in doubt. If the ultimate collectability of a non-accrual loan is in doubt, interest received is applied as a reduction to principal, in accordance with the cost recovery method. The determination as to the ultimate collectability of the loan involves significant management judgement based upon consideration of collateral valuation, delinquency status, and knowledge of specific borrower circumstances.

Non-accrual loans may be restored to accrual status when all delinquent principal and interest becomes current under the terms of the loan agreement, or when the loan is both well-secured and in the process of collection and the collectability of remaining principal and interest is no longer doubtful. The determination of restoring a non-accrual loan to accrual status involves significant management judgement and is based on recent collateral valuations, recent payment performance, borrowers’ other assets, and knowledge of specific borrower circumstances. Upon returning a loan to accrual status, previously-reversed, non-accrued interest is credited to income in the period of recovery.

Restoring Accrual Income Recognition on TDR Loans

Residential or other consumer or commercial loan modifications are returned to accrual status when the criteria for returning a loan to performing status are met (refer to Doral’s non-accrual policies previously described). Loan modifications also increase Doral’s interest income by returning a non-performing loan to performing status and cash flows by providing for payments to be made by the borrower, and decreases foreclosure and real estate owned costs by decreasing the number of foreclosed properties. Doral continues to report a modified loan considered to be a TDR as a non-performing asset until the borrower has made at least six contractual payments after the modification and is current in accordance with the modification terms. At such time the loan will not be reported as a non-performing asset and will be treated as any other performing TDR loan.

Effective January 1, 2012, Doral changed how it reports the balance of loans considered TDRs. Modified loans (including mortgage loans which have reset) are removed from amounts reported as TDRs, but continue to be accounted for as TDRs, if: (a) they were modified during the prior year, (b) they have made at least six consecutive payments in accordance with their modified terms, and (c) the effective yield was at least equal to the market rate of similar credit at the time of modification. In addition to these, the loan must not have a payment reset pending. Prior period balances were not adjusted in order to reflect this change.

Effective January 1, 2012, Doral changed how it estimates whether a TDR performing loan is accounted for as a non-accrual loan. Doral’s non-accrual loans now include loans that are performing, but which have been modified to temporarily or permanently reduce the payment amount, and such current monthly payment is at least 25% or more lower than the payment prior to reset and either the borrower’s mortgage debt service to income ratio exceeds 40% or the property loan-to-value is greater than 80%. Doral believes loans meeting the defined criteria are at greater risk of not being able to meet their contractual obligations in the future and therefore are reported as non-accrual.

ALLOWANCE FOR LOAN AND LEASE LOSSES

The Company maintains an allowance for loan and lease losses to absorb probable credit-related losses inherent in the portfolio of loans receivable as of each balance sheet date. The allowance involves significant management judgment and consists of specific and general components based on the Company’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 the Company considers appropriate to absorb probable losses.

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

 

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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 estimates and records its ALLL on a quarterly basis. Management estimates the ALLL separately for each product and geography, and combines the amounts in reaching its estimate for the full portfolio. ALLL includes both unimpaired and impaired loans, but excludes loans that are carried at fair value, or subject to lower of cost or market, as the fair value of these loans (as such loans are measured at the lower of amortized cost or fair value) already reflect a credit component. 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, probable loss and recovery rates, cash flow forecasts and the degree of risk inherent in the loan portfolios.

Management’s loss reserve estimate for performing loans is assessed based upon: (i) the probability of the performing loan defaulting at some future period; (ii) the likelihood of the loan curing or resuming payment versus the likelihood of the collateral being foreclosed upon and sold or a short sale; and (iii) Doral’s historical experience of recoveries on sale of OREO related to the contractual principal balance at the time the collateral is repossessed.

During the first quarter of 2012, Doral reviewed its ALLL estimate assumptions and calculations, and adopted a more conservative outlook as to future loan performance considering new information developed during the quarter, and the uncertain economic and regulatory environments. The resulting changes in estimate are reflected in the 2012 provision and allowance for loan and lease losses. Significant changes in assumptions and calculations include reducing the definition of a defaulted loan by 90 days, increasing the expectation that long term delinquent loans are foreclosed, emphasizing the consideration of more recent experience in determining the probability of default and loss given default, adjusting factors considered in estimating the expected loss and reducing the estimated prepayment speed on TDR loans. The Company also adopted a more conservative view on the estimated collectability of significantly aged residential mortgage loans and began utilizing a market analysis on land use completed in late March 2012 which provides information necessary for appraisers to value undeveloped land in Puerto Rico.

For non-performing loans, the reserve is estimated either by: (i) considering the loans’ current level of delinquency and the probability that the loan will be foreclosed upon from that delinquency stage, and the loss that will be realized assuming foreclosure (mortgage loans); (ii) considering the loans’ book value less discounted forecasted cash flows; or (iii) measuring impairment for individual loans considering the specific facts and circumstances of the borrower, guarantors, collateral, legal matters, market matters, and other circumstances that may affect the borrower’s ability to repay their loan, Doral’s ability to repossess and liquidate the collateral, and Doral’s ability to pursue and enforce any deficiency amount to be collected. The probability of a loan migrating to foreclosure whether a current loan or a past due loan, and the amount of loss given such foreclosure, is based upon the Company’s own experience, with more recent experience weighted more heavily in the calculated factors. With this practice management believes the factors used better represent existing economic conditions. In estimating the amount of loss given foreclosure factor, management considers the actual price at which recent sales have been executed compared to the unpaid principal balance at the time of foreclosure. Management differentiates the foreclosure factor based upon the loans’ loan-to-value ratio (calculated as current loan balance divided by the original or most recent appraisal value), duration in other real estate owned and size of original loan.

In accordance with current accounting guidance, loans determined to be TDRs are considered to be impaired for purposes of estimating the ALLL and when being evaluated for impairment. The Company pools residential mortgage loans and small CRE loans with similar characteristics, and performs an impairment analysis of discounted cash flows. Commercial loans (including commercial real estate, commercial and industrial and construction and land) that have been loss mitigated are evaluated individually for impairment. Doral measures impaired loans at their estimated realizable values determined by discounting the expected future cash flows at

 

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the loan’s effective interest rate, or as a practical expedient, at the estimated fair value of the collateral, if the loan is collateral dependent. For collateral dependent construction projects, Doral determines the fair value measurement dependent upon its exit strategy of the particular asset(s) acquired in foreclosure. The cash flow forecast of the TDR loans is based upon estimates as to the rate at which reduced interest rate loans will make the reset payments or be re-modified, or be foreclosed upon, the cumulative default rate of TDR loans, the prepayment speed (voluntary and involuntary) of the loans, the likelihood a defaulted loan will be foreclosed upon, collateral sale prices in future periods, the broader economic performance, the continued behavior of Doral and the markets in a manner similar to past behavior, and other less significant matters. If a loan or pool yields a present value (or the estimated fair value of the collateral, when the loan is collateral dependent) below the recorded investment, an 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. Actual future cash flows may deviate significantly from those estimated at this time and additional provisions may be required in the future to reflect deviations from the estimated cash flows.

In the determination of the Company’s ALLL, the discounted cash flow analysis of the pools of small balance homogenous consumer and commercial TDRs is updated to reflect historical performance of the pool. Assumptions of probability of default and loss given default are updated, giving consideration to the performance of the TDR portfolio. For large commercial loans that are evaluated individually for impairment, the performance of the loan is also considered in order to estimate the realizable value of the loans as part of the evaluation of the ALLL.

Doral charges loans off when it is determined that the likelihood of collecting the amount is reduced to a level that the continuation of their recognition as an asset is not warranted. For residential mortgage loans, the reported loan investment is reduced by a charge to the ALLL, to an updated appraised amount less estimated costs to sell the property when the loan is 180 days past due. For consumer loans, the reported loan balance is reduced by a charge to the ALLL when the loan is 120 days past due, except for revolving lines of credit (typically credit cards) which are charged off to the estimated value of the collateral (if any) at 180 days. For all commercial loans the determination of whether a loan should be fully or partially charged off is much more subjective, and considers the results of an operating business, the value of the collateral, the financial strength of the guarantors, the likelihood of different outcomes of pending litigation affecting the borrower, the potential effect of new laws or regulations, and other matters. Doral’s commercial loan charge-offs are determined by the Charge-off Committee, which is a subcommittee of the Allowance Committee.

For large commercial loans (including commercial real estate, commercial and industrial, construction and land loan portfolios), the Company uses workout agents, collection specialists, attorneys and third party service providers to supplement the management of the portfolio, including the credit quality and loss mitigation alternatives. In the case of residential construction projects, the workout function is executed by a third party servicer, under the direction of Doral management, that monitors the end-to-end process including, but not limited to, completion of construction, necessary restructuring, pricing, marketing and unit sales. For large commercial and construction loans the initial risk rating is driven by performance and delinquency. On an ongoing basis, the risk rating of large credits is managed by the portfolio management and collections function and reviewed and validated by the loan review function. While management’s assessment of the inherent credit risk in the commercial portfolio continues to be high, the Company will continue to evaluate on a quarterly basis 25% of all commercial loans over 90 days past due and between $50,000 and $250,000 so that in any one year period it would have individually evaluated for impairment 100% of all substandard commercial loans between $50,000 and $250,000. The Bank has increased its oversight of commercial loans larger than $250,000 such that all are evaluated for individual impairment each quarter, and all such criticized loans are reviewed by the Bank’s Special Assets Committee each quarter.

An allowance reserve is established for individually impaired loans. The impairment loss measurement, 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, the Company is required to measure impairment based on the fair value of the collateral. The fair value of the collateral is generally obtained from appraisals or is based on management’s estimates of future cash flows discounted at the contractual interest rate, or for loans probable of foreclosure,

 

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discounted at a rate reflecting the principal market participant cost of funding, required rate of return and risks associated with the cash flows forecast. In the event that appraisals show a deficiency, the Company includes the deficiency in its loss reserve estimate. Although accounting guidance for loan impairment excludes large groups of smaller balance homogeneous loans that are collectively evaluated for impairment (e.g., mortgage loans), it specifically requires that loan modifications considered to be TDRs be analyzed for impairment in the same manner described above.

The Company applies the following methodologies to estimate its ALLL for the various loan portfolios:

Residential mortgage loans

The general component of the ALLL for residential mortgage loans is calculated based on the probability that loans within different delinquency buckets will default (“Probability of Default”) and, in the case of default, the extent of losses that the Company would realize (“Loss Given Default”). In determining the Probability 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 utilizes a migration analysis which places a heavier weighting on the most recent experience.

Severity of loss is calculated based on historical gross realized losses pursuant to OREO sales. Historical losses are adjusted upwards in cases where a lack of observations produces distortions such as apparent net gains on sale of OREO in smaller segments. Where the loan impairment analysis requires life-of-loan cash flow estimates in determining impairment, long-term housing values are modesty adjusted upward. 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. The severity of loss on defaulted loans is adjusted to reflect the likelihood that a defaulted loan will be foreclosed upon, as a significant number of residential mortgage loans that default in Puerto Rico will subsequently cure by pay-off, becoming current or performing as a modified loan.

For all loans whose terms have been modified and are considered troubled debt restructured 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.

The Company’s policy is to charge-off all amounts in excess of the collateral value when the residential mortgage loan principal or interest is 180 days or more past due.

Construction, commercial real estate, commercial and industrial and land loans

The general component of 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 (“Probability of Default”) and the estimated loss incurred in the event of default (“Loss Given Default”) or the loan quality assigned to each loan and the estimated expected loss associated with that loan grade. The Probability of Default is based upon the Company’s experience in its current portfolio. The Loss Given Default is based upon the Company’s actual experience in resolving defaulted loans.

The Company evaluates impaired loans and estimates the specific component of the ALLL using discounted cash flows of the loan, or fair value of the collateral, as appropriate, based on current accounting guidance. If foreclosure is probable, current accounting guidance requires that the Company use the fair value of the collateral. Commercial and construction loans over $250,000 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 his obligation according to the contractual terms of the loan agreement.

Consumer loans

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

 

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Loans classified as TDRs

The Company also engages in the restructuring and/or modification of the loans which 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. In accordance with accounting guidance, loans determined to be TDRs are impaired and therefore are evaluated individually or, in the case of residential mortgage in pools with similar characteristics for purposes of estimating the ALLL.

For residential mortgage loans determined to be TDRs, the Company pools TDRs with similar characteristics and performs an impairment analysis using discounted cash flows. If a pool yields a present value below the recorded investment in the same pool of 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 using discounted cash flows considering the probability of default and loss given foreclosure, 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 fluctuate 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.

Appraisals and other valuations

Doral obtains updated valuations at the time loans default, and periodically thereafter, that are used in estimating losses and determining charge-offs. During 2012, the Company made a concerted effort to obtain updated valuations and, as a result, was able to eliminate use of the index previously utilized to estimate declines in Puerto Rico commercial real estate development and land values. The new valuations account for approximately $78.7 million of the 2012 provision for loan and lease losses.

FAIR VALUE

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.

Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). 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 Company’s consolidated statement of financial condition.

Fair Value Hierarchy

The fair value accounting guidance provides a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement of a financial asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The Company categorizes its financial instruments based on the priority of inputs to the valuation technique, into the three level hierarchy described below:

 

   

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

 

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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.

Significant judgment may be required to determine whether certain financial instruments measured at fair value are included in Level 2 or Level 3. In making this determination, the Company considers all available information that market participants use to measure the fair value of the financial instrument, including observable market data, indications of market liquidity and orderliness, and the Company’s understanding of the valuation techniques and significant inputs used. Based on the specific facts and circumstances of each instrument or instrument category, judgments are made regarding the significance of the Level 3 inputs to the instrument’s fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3. The process for determining fair value using unobservable inputs is generally more subjective and involves a high degree of management judgments and assumptions.

Determination of Fair Value

It is the Company’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. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value. If quoted prices in active markets are not available, fair value measurement is based upon models that use primarily market-based or independently sourced market parameters, including interest rate yield curves and prepayment speeds. However, in certain cases, when market observable inputs for model-based valuation techniques are not readily available, the Company is required to make an estimate based primarily on unobservable inputs, including judgments about assumptions that market participants would use to estimate the fair value.

The Company’s financial instruments recorded at fair value on a recurring basis represent approximately 5.07% of the Company’s total reported assets of $8.5 billion as of December 31, 2012, compared with 8.0% of the Company’s total reported assets of $8.0 billion as of December 31, 2011. Financial assets for which the fair value was determined using significant Level 3 inputs represented approximately 41.39% and 31.0% of these financial instruments as of December 31, 2012 and December 31, 2011, respectively. Refer to Note 33 of the accompanying consolidated financial statements for a complete discussion about the extent to which the Company uses fair value to measure assets and liabilities, the valuation methodologies used, and the impact on the Company’s consolidated financial statements.

Fair Value Option

Under the fair value accounting guidance, the Company has the irrevocable option to elect, on a contract-by-contract basis, to measure certain financial assets and liabilities at the fair value of the contract and thereafter, with changes in fair value recorded in current earnings. The Company did not make any fair value option elections as of and for the years ended December 31, 2012 and 2011.

Key Controls over Fair Value Measurement

The Company uses independent pricing services and brokers (collectively, “pricing vendors”) to obtain fair values (“vendor prices”) which are used to either record the price of an instrument or to corroborate internally developed prices.

 

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The Company has a governance framework and a number of key controls that are intended to ensure that our fair value measurements are appropriate and reliable. The Company’s governance framework provides for independent oversight and segregation of duties. The Company’s control process includes review and approval of new transaction types, price verification, and review of valuation judgments, methods, models, process controls and results.

Valuation of Trading Securities and Derivatives

The Company uses derivatives to manage its exposure to interest rate risk. Derivatives used as economic hedges, are included in Trading Securities, either because they did not qualify for, or were not designated as, an accounting hedge. Trading Securities include derivatives that are used as economic hedges of mortgage servicing rights and Pipeline of Loans Held-for-Sale (LHFS). In addition, trading assets also include Interest-only strips which are instruments that can be contractually prepaid or otherwise settled in a way that the holder would not recover substantially all of its recorded investment.

The Company’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 derivative financial instruments, such as forward contracts or “to be announced securities” (“TBAs”), that the Company uses to manage its interest rate risk. Securities held for trading and derivatives are carried at fair values with realized and unrealized gains and losses reflected in non-interest income, within Net Gain (loss) on Trading Activities.

The fair values of the Company’s trading securities (other than IOs) are generally based on market prices obtained from market data sources. For instruments not traded on a recognized market, such as Mortgage Backed Securities, the Company 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.

All derivatives are recorded on the consolidated statement of condition at fair value taking into consideration the effects of legally enforceable master netting agreements that allow the Company to settle positive and negative positions and offset cash collateral held with the same counterparty on a net basis. Derivatives in a net asset position are reported as part of securities held for trading, while derivatives in a net liability position are reported as part of accrued expenses and other liabilities.

MORTGAGE SERVICING RIGHTS AND RETAINED INTERESTS

Gain or Loss on Mortgage Loan Sales

The Company generally sells or securitizes a portion of the residential mortgage loans that it originates. Federal Housing Administration and Veterans Administration guaranteed loans are generally securitized into Government National Mortgage Association mortgage-backed securities and are classified as Loans Held for Sale. After holding these securities for a period of time, usually less than one month, the Company 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 the Company also sells for cash through broker-dealers.

As part of its mortgage loan sale and securitization activities, the Company generally retains the right to service the mortgage loans it sells. The Company determines the gain on sale of a mortgage-backed security or loan pool by subtracting the carrying value, also known as basis, of the underlying mortgage loans and any costs to sell the loans from the proceeds received from the sale. 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 value of the MSRs recorded at the time of sale.

If the Company maintains effective control over the transferred assets, in a transfer of financial assets in exchange for cash or other consideration (other than beneficial interests in transferred assets), the Company accounts for the transfer as a secured borrowing (loan payable) with a pledge of collateral, rather than a sale.

 

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Retained Interests

The Company routinely originates, securitizes and sells mortgage loans into the secondary market. The Company generally retains the mortgage servicing rights and, in the past, also retained Interest-Only Strips. The Company’s interests that continue to be held (“retained interests”) are subject to prepayment and interest rate risk.

Mortgage Servicing Rights

MSRs are assets that represent the right to service mortgage loans for others. The Company recognizes MSRs when it retains servicing rights in connection with the sale or securitization of loans. The Company initially measures and subsequently carries its MSRs at fair value. MSRs entitle the Company to a future stream of cash flows based on the outstanding principal balance of the loans serviced and the contractual servicing fee and 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. 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 the Company, 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.

MSRs are classified as Servicing Assets in the Company’s consolidated statements of financial condition. Any servicing liability recognized is included as part of Accrued Expenses and Other Liabilities in the Company’s consolidated statements of financial condition. Changes in fair value of MSRs are recorded in the consolidated statement of operations within net gain on loans securitized and sold and capitalization of mortgage servicing. Changes in the fair value of residential MSRs from period to period result from (1) changes in the valuation model inputs or assumptions (principally reflecting changes in discount rates and prepayment speed assumptions, mostly due to changes in interest rates and costs to service, including delinquency and foreclosure costs), and (2) other changes, representing changes due to collection/realization of expected cash flows over time.

The Company determines the fair value of MSRs using a valuation model which calculates the present value of estimated future net servicing income. The assumptions supporting the valuation of the Company’s MSRs include estimates of discount rates, prepayment rates, servicing costs (including delinquency and foreclosure costs), float and escrow account earnings, contractual servicing fee income, and ancillary income (including late charges, float income and prepayment penalties, net of the expenses incurred for performing the servicing functions).

The Company compares the results of its internal model to the results of a third party simple model software, to assess reasonability of the internal model results.

The prepayment rate is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of the future net servicing income is the required rate of return investors in the market would expect for an asset with similar risk. To determine the discount rate, the Company considers the risk premium for uncertainties from servicing operations (e.g., possible changes in future servicing costs, ancillary income, and earnings on escrow accounts) and an adjustment for liquidity. Changes to the unpaid principal balance are driven by loan sold-capitalization, amortization-payoffs, and repurchases of delinquent loans. These assumptions, which are reviewed by senior management on a quarterly basis, can, and generally will, change from quarter-to-quarter as market conditions and projected interest rates change.

For the year ended December 31, 2012, the fair value of the MSRs totaled to $100.0 million, which reflects a decline of $12.3 million when compared to December 31, 2011. The decline in the MSR is the result of a capitalization of servicing assets of $13.6 million offset by a decrease in fair value of $25.9 million. The fair value measurements of the MSRs use significant unobservable inputs and, accordingly, are classified as Level 3.

These assumptions are subjective in nature and changes in these assumptions could materially affect the Company’s operating results. This impact does not reflect any economic hedging strategies that may be undertaken to mitigate such risk.

 

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The Company manages potential changes in the fair value of MSRs through a comprehensive risk management program. The intent is to mitigate the effects of changes in the fair value of MSRs through the use of risk management instruments. To reduce the sensitivity of earnings to interest rate and market value fluctuations, securities as well as certain derivatives such as options and interest rate swaps may be used as economic hedges of the MSRs, but are not designated as accounting hedges. These economic hedging instruments are generally carried at fair value with changes in fair value recognized within net gain (loss) on trading activities, whereas the changes in fair value of the MSR are recognized within net gain on loans securitized and sold and capitalization of mortgage servicing, in the consolidated statements of operations.

Interest-Only Strips

The Company originated residential mortgage loans which were subsequently securitized and sold in the secondary market in the form of mortgage-backed securities and structured these transactions to create interest-only strips. IOs entitle the Company to a future stream of cash flows based on the difference between the weighted average coupon (“WAC”) of the loans sold and the pass-through interest rate payable to the investors plus a contractual servicing fee.

IOs are classified as securities held for trading in the Company’s consolidated statements of financial condition. The Company initially measured and subsequently carries its IOs at fair value. Specifically, IOs are estimated as the 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.

To determine the fair value of its portfolio of variable IOs, the Company uses an internal valuation model that incorporates the following assumptions: Discount Rate (using 3-month LIBOR), Unpaid Principal Balance (“UPB”), Constant Prepayment Rate (“CPR”), and the implied forward rate curve. The IO Fair Value is estimated based on the projected future cash flows for loans where the Company retained the interest earnings cash flow. 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 rates rise. The fair value measurements of the IOs use significant unobservable inputs and, accordingly, are classified as Level 3.

Through the life of the IO, the Company recognizes as interest income the excess of all estimated cash flows attributable to these IOs over their recorded balance using the effective yield method. The Company updates its estimates of expected cash flows quarterly and recognizes changes in calculated effective yield on a prospective basis. As of December 31, 2012, the carrying value of the IOs of $41.7 million is related to the $199.8 million of outstanding principal balance in mortgage loans sold to investors.

MORTGAGE LOAN REPURCHASE LOSSES AND REPURCHASE LIABILITIES

Estimated Recourse Obligation and Repurchase Liability

The Company sells mortgage loans to various parties, including (1) Government Sponsored Entities (“GSEs”), which include the mortgage loans in GSE-guaranteed mortgage securitizations, (2) special purpose entities that issue private label Mortgage-Backed Securities (“MBS”), and (3) other financial institutions that purchase mortgage loans for investment or private label securitization. In addition, the Company pools FHA-insured and VA-guaranteed mortgage loans, which back securities guaranteed by GNMA. The agreements under which the Company sells mortgage loans and the insurance or guaranty agreements with FHA and VA contain provisions that include various representations and warranties regarding origination and characteristics of the mortgage loans. Although the specific representations and warranties vary among different sales, insurance, or guarantee agreements, they typically cover ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, compliance with applicable origination laws, and other matters.

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 of time or up to a certain percentage of the total amount in loans sold. The Company

 

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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 the expectation of changes in portfolio behavior and market environment.

In connection with the Company’s sales of mortgage loans, the Company entered into agreements containing varying representations and warranties about, among other things, the ownership of the loan, the validity of the lien securing the loan, the loan’s compliance with any applicable loan criteria established by the purchaser, including underwriting guidelines and the ongoing existence of mortgage insurance, and the loan’s compliance with applicable federal, state, and local laws. The Company may be required to repurchase the mortgage loan, indemnify the securitization trust, investor or insurer, or reimburse the securitization trust, investor, or insurer for credit losses incurred on the loan in the event of a material breach of contractual representations or warranties that is not remedied within a specified period of time (usually 90 days) after the Company receives notice of the breach.

During 2012, the Company made significant refinements to its process for estimating its representation and warranty reserve, due primarily to increased counterparty activity and its ability to extend the timeframe, in most instances, over which it estimates the repurchase liability for mortgage loans sold by the Company to GSEs and those mortgage loans placed into insured securitizations for the full life of the mortgage loans. The Company has established representation and warranty reserves for losses that it considers to be both probable and reasonably estimable associated with mortgage loans sold by each subsidiary, including both litigation and non-litigation liabilities. The reserve setting process relies heavily on estimates, which are inherently uncertain, and requires the application of judgment. In establishing the representation and warranty reserves, the Company considers a variety of factors, depending on the category of purchaser, and relies on historical data. The Company evaluates these estimates on a quarterly basis.

The methodology used to estimate the liability for obligations under representations and warranties related to transfers of residential mortgage loans is a function of the representations and warranties given and considers a variety of factors. Depending on the counterparty, these factors include actual defaults, estimated future defaults, historical loss experience, estimated home prices, other economic conditions, estimated probability that the Company will receive a repurchase request, including consideration of whether presentation thresholds will be met, number of payments made by the borrower prior to default, estimated probability that the Company will be required to repurchase a loan and the experience with and behavior of the counterparty. It also considers bulk settlements, as appropriate. The estimate of the liability for obligations under representations and warranties is based upon currently available information, significant judgment, and a number of factors, including those set forth above, that are subject to change. Changes to any one of these factors could significantly impact the estimate of the Company’s liability.

The provision for representations and warranties may vary significantly each period as the methodology used to estimate the expense continues to be refined based on the level and type of repurchase requests presented, defects identified, the latest experience gained on repurchase requests and other relevant facts and circumstances. The estimated range of possible loss related to representations and warranties is $358 thousand to $1.0 million, for which the Company has established a liability of $1.0 million in the consolidated financial statements.

The mortgage loan repurchase liability at December 31, 2012 represents the Company’s best estimate of the probable loss that it may incur for various representations and warranties in the contractual provisions of its sales of mortgage loans. Because the level of mortgage loan repurchase losses are dependent on economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgement. The Company manages the risk associated with potential repurchases or other forms of settlement through its underwriting and quality assurance practices, and by servicing mortgage loans to meet investor and secondary market standards.

Litigation Reserve

In accordance with applicable accounting guidance, the Company establishes an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and reasonably estimable. In such cases, there may be an exposure to loss in excess of any amounts accrued. When a

 

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loss is not both probable and reasonably estimable, the Company does not establish an accrued liability. As a litigation matter develops, the Company, in conjunction with any outside counsel handling the matter, evaluates, on an ongoing basis, whether such matter presents a loss contingency that is both probable and reasonably estimable. If, at the time of evaluation, the loss contingency related to a litigation or regulatory matter is not both probable and reasonably estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and reasonably estimable. Once the loss contingency related to a legal or regulatory matter is deemed to be both probable and reasonably estimable, the Company will establish an accrued liability with respect to such loss contingency and record a corresponding amount of litigation-related expense. The Company will continue to monitor the matter and adjust the reserve for further developments which could affect the amount of the accrued liability previously established.

For a limited number of the matters disclosed in Note 30, Commitments and Contingencies, to the consolidated financial statements for which a loss is probable or reasonably possible in future periods, whether in excess of a related accrued liability or where there is no accrued liability, the Company is able to estimate a range of possible losses. In determining whether it is possible to provide an estimate of loss or range of possible losses, the Company reviews and evaluates its material litigation and regulatory matters on an ongoing basis, in conjunction with any outside counsel handling the matter, in light of potentially relevant factual and legal developments. These may include information learned through the discovery process, rulings on dispositive motions, settlement discussions, and other rulings by courts, arbitrators or others. In cases in which the Company possesses sufficient information to develop an estimate of loss or range of possible losses, that estimate is aggregated and disclosed in Note 30, Commitments and Contingencies, to the consolidated financial statements. For other disclosed matters for which a loss is probable or reasonably possible, such an estimate is not possible. Those matters for which an estimate is not possible are not included within this estimated range. Therefore, the estimated range of possible losses represents what the Company believes to be an estimate of possible losses only for certain matters meeting these criteria. It does not represent the Company’s maximum loss exposure. Information is provided in note 30, Commitments and Contingencies, to the consolidated financial statements regarding the nature of and, where specified, the amount of the claim associated with these loss contingencies.

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 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 the weight of all available evidence 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 asset or liability balance during the year plus any change in the valuation allowance, if any; (ii) current tax expense; and (iii) interest and penalties related to uncertain tax positions.

 

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RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2012, 2011 AND 2010

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 that 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 2012, 2011 and 2010, was $220.5 million, $188.9 million and $164.4 million, respectively.

2012 compared to 2011 — Total interest income for the years ended December 31, 2012 and 2011 was $368.5 million and $367.6 million, respectively. Interest income increased by $0.9 million, or 0.23%, for the year ended December 31, 2012 compared to the corresponding 2011 period. Significant variances impacting interest income for the year ended December 31, 2012, when compared to the corresponding 2011 period, are as follows:

 

   

An increase of $19.2 million in interest income on loans due to:

 

   

A positive variance in interest income on commercial and industrial loans of $24.3 million, primarily due to an increase in the average balance of commercial and industrial loans of $409.9 million during 2012 as a result of the growth in the U.S. syndicated loan portfolio, partially offset by a decrease of $14.6 million in interest income on residential loans primarily due to a reduction in the average balance of $295.6 million for the year ended December 31, 2012 compared to the same period in 2011 and the effect of new non-performing loans.

 

   

An increase of $10.0 million in interest income on commercial real estate loans as a result of an increase of in the average balance of $236.8 million during 2012.

Total interest expense for the years ended December 31, 2012 and 2011 was $148.0 million and $178.7 million, respectively. Interest expense decreased by approximately $30.7 million, or 17.2%, for the year ended December 31, 2012 compared to the corresponding 2011 period. Significant variances impacting interest expense for the year ended December 31, 2012 when compared to the corresponding 2011 period, are as follows:

 

   

A decrease of $24.9 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 $195.9 million during 2012, while the cost of interest bearing deposits decreased 63 basis points compared to the same period in 2011. The average balance of brokered deposits decreased $105.4 million during 2012, when compared to the corresponding 2011 period.

 

   

A reduction of $11.0 million in interest expense on securities sold under agreements to repurchase was driven by a decrease of $353.8 million in the average balance of securities sold under agreements to repurchase during 2012 and a reduction of 21 basis points in the average interest cost during 2012.

 

   

An increase of $4.1 million in interest expense on notes payable related to the net increase of $199.6 million in average balance of notes payable resulting from a $331.0 million debt issued to third parties by Doral CLO II, Ltd. in 2012 at a rate of 3-month LIBOR plus a spread that ranges from 1.47% to 2.50% and a $251.0 million of debt issued to third parties by Doral CLO III, Ltd. at a rate of 3-month LIBOR plus a spread that ranges of 1.45% to 3.25%.

 

   

An increase of $1.1 million in interest expense on advances from FHLB resulted from the increase in the average balance of advances from FHLB of $60.2 million and a decrease of 7 basis points in average cost during 2012 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.

 

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A minimal decrease in interest expense on loans payable directly related to a reduction of $18.5 million in the average balance of loans payable as a result of the normal repayment of borrowings, despite an increase of 11 basis points in the average cost on loans payable during 2012 when compared to the corresponding 2011 period. This can be traced to an uptick in LIBOR 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.

2011 compared to 2010 — Total interest income for the years ended December 31, 2011 and 2010 was $367.6 million and $405.3 million, respectively, a decrease of $37.7 million, or 9.3%. 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 $4.9 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 $65.8 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 $29.0 million primarily due to an increase in the average balance of commercial and industrial loans of $468.0 million during 2011 as a result of the growth in the U.S. syndicated loan portfolio partially offset by a decrease of $19.4 million in interest income on residential loans primarily due to a reduction in the average balance of $195.1 million for the year ended December 31, 2011 compared to the same period in 2010.

 

   

A decrease of $2.7 million in income on 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 $40.3 million in interest income on investment securities available for sale, primarily due to a reduction of $1.2 billion in the average balance of investment securities available for sale resulting from the sale of agency CMOs and other mortgage backed securities during 2011. Total available for sale investment securities’ sales amounted to $1.4 billion during 2011, partially offset 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 available for sale decreased 34 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 securities sold under agreements to repurchase 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.

 

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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%.

 

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The following table presents Doral Financial’s average balance sheet for the years indicated, the total 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 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

 

    2012     2011     2010  

(Dollars in thousands)

  Average
Balance
    Interest     Average
Yield/
Rate
    Average
Balance
    Interest     Average
Yield/
Rate
    Average
Balance
    Interest     Average
Yield/
Rate
 

ASSETS:

                 

Interest-earning assets:

                 

Held for trading securities

  $ 96,651     $ 7,843       8.12   $ 82,108     $ 7,864       9.58   $ 70,680     $ 7,478       10.58

Available for sale securities:

                 

US obligations

    45,112       50       0.11     89,070       151       0.17     8,172       126       1.55

CMO agencies

    18,582       256       1.38     146,338       4,720       3.23     716,845       23,146       3.23

Agency MBS

    432,981       8,619       1.99     729,242       20,670       2.83     1,257,415       37,387       2.97

Other and private securities

    33,766       1,424       4.22     26,960       2,681       9.94     162,501       7,834       4.82
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

    530,441       10,349       1.95     991,610       28,222       2.85     2,144,933       68,493       3.19

Total loans held for sale

    344,707       10,083       2.92     289,909       9,241       3.19     314,478       10,717       3.41

Loans receivable

                 

Consumer:

                 

Residential(1)

    3,299,792       186,379       5.65     3,595,373       200,961       5.59     3,790,458       220,358       5.81

Consumer

    30,615       6,278       20.51     48,855       7,135       14.61     70,467       9,159       13.00
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    3,330,407       192,657       5.78     3,644,228       208,096       5.71     3,860,925       229,517       5.94

Commercial:

                 

Commercial real estate

    983,612       51,193       5.20     746,833       41,179       5.51     747,058       39,772       5.32

Commercial and industrial

    1,404,414       82,627       5.88     994,528       58,316       5.86     526,540       29,294       5.56

Construction and land

    356,421       9,833       2.76     317,913       10,387       3.27     445,545       13,024       2.92
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    2,744,447       143,653       5.23     2,059,274       109,882       5.34     1,719,143       82,090       4.78
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans(2)

    6,419,561       346,393       5.40     5,993,411       327,219       5.46     5,894,546       322,324       5.47

Other interest-earning assets

    423,598       3,892       0.92     499,933       4,312       0.86     655,690       6,974       1.06
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets/interest income

    7,470,251     $ 368,477       4.93     7,567,062     $ 367,617       4.86     8,765,849     $ 405,269       4.62
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Total non-interest-earning assets

    788,063           693,881           718,797      
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 8,258,314         $ 8,260,943         $ 9,484,646      
 

 

 

       

 

 

       

 

 

     

LIABILITIES AND STOCKHOLDERS’ EQUITY:

                 

Interest-bearing liabilities:

                 

Deposits:

                 

Interest bearing deposits

  $ 2,116,038     $ 19,612       0.93   $ 1,920,111     $ 26,268       1.37   $ 1,809,298     $ 34,324       1.90

Brokered deposits

    2,121,389       43,774       2.06     2,226,827       62,018       2.79     2,646,557       76,514       2.89
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total deposits

    4,237,427       63,386       1.50     4,146,938       88,286       2.13     4,455,855       110,838       2.49

Securities sold under agreements to repurchase

    379,402       10,120       2.67     733,185       21,119       2.88     1,645,805       52,654       3.20

Advances from FHLB

    1,211,532       38,202       3.15     1,151,314       37,129       3.22     1,174,411       47,155       4.02

Other short-term borrowings

                                     5,027       15       0.30

Notes payable

    710,302       30,356       4.27     510,716       26,224       5.13     388,738       23,513       6.05

Loans payable

    276,950       5,888       2.13     295,490       5,964       2.02     320,313       6,742       2.10
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities/interest expense

    6,815,613     $ 147,952       2.17     6,837,643     $ 178,722       2.61     7,990,149     $ 240,917       3.02
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Non-interest bearing deposits

    324,274           296,029           267,189      

Other non-interest bearing liabilities

    298,036           269,820           308,555      
 

 

 

       

 

 

       

 

 

     

Total non-interest-bearing liabilities

    622,310           565,849           575,744      
 

 

 

       

 

 

       

 

 

     

Total liabilities

    7,437,923           7,403,492           8,565,893      

Stockholders’ equity

    820,391           857,451           918,753      
 

 

 

       

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 8,258,314         $ 8,260,943         $ 9,484,646      
 

 

 

       

 

 

       

 

 

     

Net interest-earning assets

  $ 654,638         $ 729,419         $ 775,700      
 

 

 

       

 

 

       

 

 

     

Net interest income on a non-taxable equivalent basis

    $ 220,525         $ 188,895         $ 164,352    
   

 

 

       

 

 

       

 

 

   

Interest rate spread(3)

        2.76         2.25         1.60

Interest rate margin(4)

        2.95         2.50         1.87

Net interest-earning assets ratio(5)

        109.60         110.67         109.71

 

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(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.

 

(2) 

Interest income on loans includes $0.2 million, $0.3 million and $0.6 million for 2012, 2011 and 2010, respectively, of income from prepayment penalties related to the Company’s loan portfolio.

 

(3) 

Interest rate spread is 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 is net interest income as a percentage of average interest-earning assets.

 

(5) 

Net interest-earning assets ratio is 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

 

     2012 Compared to 2011     2011 Compared to 2010  
     Increase (Decrease) Due To:     Increase (Decrease) Due To:  

(In thousands)

   Volume     Rate     Total     Volume     Rate     Total  

Interest Income Variance

            

Held for trading securities

   $ 1,277     $ (1,298   $ (21   $ 1,136     $ (750   $ 386  

Available for sale securities:

            

US obligations

     (59     (42     (101     230       (205     25  

CMO agencies

     (2,696     (1,768     (4,464     (18,426           (18,426

Agency MBS

     (6,963     (5,088     (12,051     (15,030     (1,687     (16,717

Other and private securities

     557       (1,814     (1,257     (9,586     4,433       (5,153
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

     (9,161     (8,712     (17,873     (42,812     2,541       (40,271

Total loans held for sale

     1,663       (821     842       (808     (668     (1,476

Loans receivable

            

Consumer:

            

Residential

     (16,714     2,132       (14,582     (11,175     (8,222     (19,397

Consumer

     (3,181     2,324       (857     (3,058     1,034       (2,024
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     (19,895     4,456       (15,439     (14,233     (7,188     (21,421

Commercial:

            

Commercial real estate

     12,437       (2,423     10,014       (12     1,419       1,407  

Commercial and industrial

     24,111       200       24,311       27,361       1,661       29,022  

Construction and land

     1,175       (1,729     (554     (4,058     1,421       (2,637
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     37,723       (3,952     33,771       23,291       4,501       27,792  

Total loans

     19,491       (317     19,174       8,250       (3,355     4,895  

Other interest-earning assets

     (700     280       (420     (1,484     (1,178     (2,662
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest Income Variance

   $ 10,907     $ (10,047   $ 860     $ (34,910   $ (2,742   $ (37,652
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest Expense Variance

            

Deposits:

            

Interest bearing deposits

   $ 2,469     $ (9,125   $ (6,656   $ 2,002     $ (10,058   $ (8,056

Brokered deposits

     (2,796     (15,448     (18,244     (11,900     (2,596     (14,496
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total deposits

     (327     (24,573     (24,900     (9,898     (12,654     (22,552

Repurchase agreements

     (9,555     (1,444     (10,999     (26,717     (4,818     (31,535

Advances from FHLB

     1,897       (824     1,073       (902     (9,124     (10,026

Other short-term borrowings

                       (8     (8     (16

Notes payable

     9,039       (4,907     4,132       6,644       (3,933     2,711  

Loans payable

     (389     313       (76     (522     (256     (778
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest Expense Variance

     665       (31,435     (30,770     (31,403     (30,793     (62,196
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income Variance

   $ 10,242     $ 21,388     $ 31,630     $ (3,507   $ 28,051     $ 24,544  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Average interest-earning assets decreased from $7.6 billion for the year ended December 31, 2011 to $7.5 billion for the corresponding 2012 period, while at both periods the average interest-bearing liabilities remained the same at $6.8 billion. The repositioning of the balance sheet during 2012 resulted in a 45 basis point improvement in net interest margin from 2.50% for the year ended December 31, 2011 to 2.95% for the corresponding 2012 period.

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 and other debt securities during the second and third quarters of 2011 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 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 resulted in a 63 basis point improvement in net interest margin from 1.87% for the year ended December 31, 2010 to 2.50% for the corresponding 2011 period.

Provision for Loan and Lease Losses

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 an appropriate level, future additions to the allowance may be necessary if economic conditions change or if credit losses increase substantially from those estimated by Doral Financial in determining the ALLL. Unanticipated increases in the allowance for loan and lease losses could materially affect Doral Financial’s net income in future periods.

2012 compared to 2011.    Doral Financial’s provision for loan and lease losses for the year ended December 31, 2012 totaled $176.1 million compared to $67.5 million for 2011, an increase of $108.6 million. During 2012, management undertook an effort to review the assumptions and modeling underlying its allowance for loan and lease loss valuation and align the Company’s estimate with a more conservative view of future loan performance reflective of the uncertain economic and regulatory environments within which Doral operates. The resulting changes in estimates are captured in the 2012 allowance for loan and lease losses and the corresponding provision. 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.

Significant provisions for loan losses were recorded for the residential mortgage portfolio, with $112.2 million, commercial real estate with $35.3 million, and construction and land with $23.8 million in 2012 while provision for loan losses of $31.6 million for residential mortgage loans, $5.7 million for commercial real estate, and $23.9 million for construction and land were recorded in 2011. The 2012 PLLL in general reflects the more conservative estimates adopted by Doral in the provision for loan and lease loss estimates, the receipt of new valuations on properties previously defaulted on their loans or defaulting on their loans during the year, and the increase in nonperforming loans, particularly in the residential mortgage loan portfolio. Substantially all the 2012 provision for loan and lease losses relates to loans extended to borrowers domiciled in Puerto Rico.

Provision for the residential, commercial real estate, and construction and land portfolios for the year ended December 31, 2012 are described below:

 

   

Residential mortgage loans — The provision for loan and lease losses for the year ended December 31, 2012 totaled $112.0 million compared to the $31.6 million recorded for 2011. The significant increase in the 2012 provision for loan and lease losses resulted from adopting a more conservative outlook reflective of the uncertain current economic and regulatory environments. Specifically, during the first quarter of 2012, the provision for loan and lease losses included $9.9 million from Doral increasing its estimate of delinquent residential mortgage loans moving through foreclosure to REO; $13.5 million related to adjusting factors considered in estimating expected loss; $7.7 million related to increasing the estimate of

 

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Index to Financial Statements
 

cumulative redefaults of modified loans; $2.7 million related to decreasing the estimated rate at which modified loans will be expected to perform in the future; $3.0 million related to increasing the probability of a performing loan defaulting; and $22.6 million to charge off the full principal balance of all loans that were 5 years or more past due. The 2012 provision for loan and lease losses also included $32.9 million resulting from new valuations of properties collateralizing loans 180 days or more past due reflecting deterioration in property values since the loan was originally made or, for those loans delinquent more than a year, since the most recent previously valuation was received. Troubled debt restructurings executed during the year accounted for $10.2 million of the 2012 provision for loan and lease losses and $5.7 million can be attributed to losses experienced as properties moved to REO. Finally, $9.4 million of the 2012 provision for loan and lease losses resulted from an increase in the level of non-performing loans during the year.

 

   

Commercial real estate — The provision for loan and lease losses for the year ended December 31, 2012 totaled $35.3 million compared to the $5.7 million recorded in 2011. Approximately $25.8 million of the 2012 provision for loan and lease losses resulted from new valuations of properties collateralizing delinquent loans and $4.4 million resulted from deterioration in the estimate of amounts Doral will collect on foreclosure and resolution of properties collateralizing loans estimated to default. Another $3.7 million of the 2012 provision for loan and lease losses resulted from deterioration in the borrowers’ ability to timely service their debt and $1.4 million stemmed from additional potential losses related to specifically identified impaired loans.

 

   

Construction and land — The provision for loan and lease losses remained steady for the years ended December 31, 2012 and 2011, totaling $23.8 million for both periods. Approximately $21.0 of the 2012 provision for loan and lease losses resulted from new valuations of properties collateralizing delinquent loans and $2.8 million resulted from a decrease in the loan portfolio’s performance.

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 $64.0 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 $25.5 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 $53.9 million; however, Doral recorded a provision of $23.8 million during 2011 largely resulting from updated valuations of existing impaired loans.

The provision for the other consumer loan portfolio and the commercial and industrial loan portfolio reflected decreases of $3.7 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 approximately $32,000 during 2011, and net charge-offs declined $2.7 million.

 

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Index to Financial Statements

Non-interest income (loss)

A summary of non-interest income (loss) for the years ended December 31, 2012, 2011 and 2010 is provided below.

Table C — Non-interest income (loss)

 

     Year Ended December 31,  
                       Variance  

(In thousands)

   2012     2011     2010     2012 vs. 2011     2011 vs. 2010  

Net other-than-temporary impairment losses

   $ (6,396   $ (4,290   $ (13,961   $ (2,106   $ 9,671  

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

     47,438       33,894       20,375       13,544       13,519  

Servicing income:

          

Servicing fees

     25,977       27,117       24,240       (1,140     2,877  

Late charges

     4,852       4,837       10,110       15       (5,273

Prepayment penalties and other servicing fees

     1,637       1,727       1,686       (90     41  

Interest loss on serial notes and others

     (5,846     (5,758     (6,764     (88     1,006  

Amortization and market valuation of servicing asset

     (25,924     (12,074     (12,087     (13,850     13  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total servicing income

     696       15,849       17,185       (15,153     (1,336

Trading activities:

          

Gain on IO valuation

     4,019       7,481       8,811       (3,462     (1,330

Gain on MSR economic hedge

     652       1,464       7,476       (812     (6,012

Loss on hedging derivatives

     (7,022     (4,938     (2,611     (2,084     (2,327
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) gain on trading activities

     (2,351     4,007