INVESTMENT SECURITIES

9 Months Ended

Sep. 30, 2016

NOTE 4 – INVESTMENT SECURITIES

Investment Securities Available for Sale

The amortized cost, non-credit loss component of other-than-temporary impairment (“OTTI”) recorded in other comprehensive income (“OCI”), gross unrealized gains and losses recorded in OCI, approximate fair value, and weighted average yield of investment securities available for sale by contractual maturities as of September 30, 2016 and December 31, 2015 were as follows:

		September 30, 2016
		Amortized cost		Noncredit Loss Component of OTTI Recorded in OCI						Fair value		Weighted average yield%
						Gross Unrealized
						gains		losses

		(Dollars in thousands)
U.S. Treasury securities:
	Due within one year	$	7,513	$	-	$	1	$	-	$	7,514	0.57

Obligations of U.S.
government-sponsored
agencies:
Due within one year			9,629		-		4		-		9,633	0.70
After 1 to 5 years			496,782		-		3,215		53		499,944	1.32
After 10 years			44,724		-		7		133		44,598	0.87

Puerto Rico government
obligations:
After 1 to 5 years			21,423		12,023		-		-		9,400	4.38
After 5 to 10 years			845		-		6		-		851	5.20
After 10 years			21,205		3,196		116		1,556		16,569	5.39

United States and Puerto Rico
government obligations			602,121		15,219		3,349		1,742		588,509	1.53

Mortgage-backed securities:
FHLMC certificates:
After 5 to 10 years			6,314		-		145		-		6,459	2.31
After 10 years			251,516		-		3,504		62		254,958	2.10
			257,830		-		3,649		62		261,417	2.10

GNMA certificates:
Due within one year			1		-		-		-		1	1.69
After 1 to 5 years			93		-		3		-		96	3.85
After 5 to 10 years			98,314		-		2,557		-		100,871	3.05
After 10 years			131,216		-		12,532		-		143,748	4.37
			229,624		-		15,092		-		244,716	3.81
FNMA certificates:
After 1 to 5 years			22,594		-		452		-		23,046	1.99
After 5 to 10 years			26,448		-		577		19		27,006	2.06
After 10 years			602,540		-		14,534		20		617,054	2.31
			651,582		-		15,563		39		667,106	2.29
Collateralized mortgage
obligations issued or guaranteed by
the FHLMC and GNMA:
After 5 to 10 years			19,853		-		7		33		19,827	1.18
After 10 years			39,530		-		25		7		39,548	1.21
			59,383		-		32		40		59,375	1.20
Other mortgage pass-through
trust certificates:
After 5 to 10 years			81		-		-		-		81	7.20
After 10 years			30,606		8,476		-		-		22,130	2.37
			30,687		8,476		-		-		22,211	2.37
Total mortgage-backed
securities			1,229,106		8,476		34,336		141		1,254,825	2.48

Other
After 1 to 5 years			100		-		-		-		100	1.50

Equity Securities ⁽¹⁾			413		-		6		-		419	2.15

Total investment securities
available for sale		$	1,831,740	$	23,695	$	37,691	$	1,883	$	1,843,853	2.17

⁽¹⁾	Equity securities consisted of investment in a Community Reinvestment Act Qualified Investment Fund.

		December 31, 2015
		Amortized cost		Noncredit Loss Component of OTTI Recorded in OCI						Fair value		Weighted average yield%
						Gross Unrealized
						gains		losses

(Dollars in thousands)

U.S. Treasury securities:
	After 1 to 5 years	$	7,530	$	-	$	-	$	33	$	7,497	0.57

Obligations of U.S.
government-sponsored
agencies:
	Due within one year		14,624		-		4		10		14,618	0.68
	After 1 to 5 years		384,323		-		174		4,305		380,192	1.32
	After 5 to 10 years		58,150		-		343		242		58,251	2.34

Puerto Rico Government
obligations:
	After 1 to 5 years		25,663		14,662		-		-		11,001	4.38
	After 5 to 10 years		855		-		-		-		855	5.20
	After 10 years		23,162		5,255		134		1,680		16,361	5.40

United States and Puerto Rico
Government obligations			514,307		19,917		655		6,270		488,775	1.75

Mortgage-backed securities:

FHLMC certificates:
	After 5 to 10 years		336		-		31		-		367	4.95
	After 10 years		287,711		-		1,073		1,706		287,078	2.14
			288,047		-		1,104		1,706		287,445	2.15
GNMA certificates:
	Due within one year		2		-		-		-		2	1.70
	After 1 to 5 years		109		-		5		-		114	4.26
	After 5 to 10 years		120,298		-		3,182		-		123,480	3.07
	After 10 years		165,175		-		12,822		20		177,977	4.38
			285,584		-		16,009		20		301,573	3.83
FNMA certificates:
	After 1 to 5 years		2,552		-		74		-		2,626	3.32
	After 5 to 10 years		21,557		-		433		233		21,757	2.73
	After 10 years		759,247		-		5,628		6,063		758,812	2.34
			783,356		-		6,135		6,296		783,195	2.35

Other mortgage pass-through
trust certificates:
	After 5 to 10 years		92		-		1		-		93	7.26
	After 10 years		34,905		9,691		-		-		25,214	2.26
			34,997		9,691		1		-		25,307	2.26
Total mortgage-backed
	securities		1,391,984		9,691		23,249		8,022		1,397,520	2.61

Other
	After 1 to 5 years		100		-		-		-		100	1.50

Total investment securities
	available for sale	$	1,906,391	$	29,608	$	23,904	$	14,292	$	1,886,395	2.38

Maturities of mortgage-backed securities are based on contractual terms assuming no prepayments. Expected maturities of investments might differ from contractual maturities because they may be subject to prepayments and/or call options. The weighted average yield on investment securities available for sale is based on amortized cost and, therefore, does not give effect to changes in fair value. The net unrealized gain or loss on securities available for sale and the non-credit loss component of OTTI are presented as part of OCI.

The following tables show the Corporation’s available-for-sale investments’ fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of September 30, 2016 and December 31, 2015. The tables also include debt securities for which an OTTI was recognized and only the amount related to a credit loss was recognized in earnings. For unrealized losses for which OTTI was recognized, the related credit loss was charged against the amortized cost basis of the debt security.

	As of September 30, 2016
	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
		(In thousands)
Debt securities:
Puerto Rico Government obligations	$	-	$	-	$	21,688	$	16,775	$	21,688	$	16,775
U.S. Treasury and U.S. government
agencies obligations		60,970		186		-		-		60,970		186
Mortgage-backed securities:
FNMA		18,245		39		-		-		18,245		39
FHLMC		54,269		62		-		-		54,269		62
Collateralized mortgage obligations
issued or guaranteed by FHLMC and GNMA		31,896		40		-		-		31,896		40
Other mortgage pass-through trust
certificates		-		-		22,130		8,476		22,130		8,476
Equity securities		2		-		-		-		2		-
	$	165,382	$	327	$	43,818	$	25,251	$	209,200	$	25,578


	As of December 31, 2015
	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
		(In thousands)
Debt securities:
Puerto Rico Government obligations	$	-	$	-	$	23,008	$	21,597	$	23,008	$	21,597
U.S. Treasury and U.S. government
agencies obligations		198,243		929		210,504		3,661		408,747		4,590
Mortgage-backed securities:
FNMA		437,305		4,516		88,013		1,780		525,318		6,296
FHLMC		141,890		1,338		19,306		368		161,196		1,706
GNMA		1,047		20		-		-		1,047		20
Other mortgage pass-through trust
certificates		-		-		25,214		9,691		25,214		9,691
	$	778,485	$	6,803	$	366,045	$	37,097	$	1,144,530	$	43,900

Assessment for OTTI on Available-For-Sale Securities

Debt securities issued by U.S. government agencies, U.S. government-sponsored entities and the U.S. Treasury accounted for approximately 97% of the total available-for-sale portfolio as of September 30, 2016 and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government. The Corporation’s OTTI assessment was concentrated mainly on available-for-sale Puerto Rico Government debt securities, with an amortized cost of $43.5million, and on private label mortgage-backed securities (“MBS”) with an amortized cost of $30.6 million, and for which credit losses are evaluated on a quarterly basis. The Corporation considered the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

The length of time and the extent to which the fair value has been less than the amortized cost basis;
Any adverse change to the credit conditions and liquidity of the issuer, taking into consideration the latest information available about the financial condition of the issuer, credit ratings, the failure of the issuer to make scheduled principal or interest payments, recent legislation and government actions affecting the issuer’s industry and actions taken by the issuer to deal with the present economic climate;
Changes in the near term prospects of the underlying collateral of a security, if any, such as changes in default rates, loss severity given default, and significant changes in prepayment assumptions; and
The level of cash flows generated from the underlying collateral, if any, supporting the principal and interest payments of the debt securities.

The Corporation recorded OTTI losses on available-for-sale debt securities as follows:


		Quarter Ended				Nine-Month Period Ended
		September 30,				September 30,
		2016		2015		2016		2015
(In thousands)
Total other-than-temporary impairment losses		$	-	$	-	$	(1,845)	$	(29,521)
Portion of other-than-temporary impairment recognized in OCI			-		(231)		(4,842)		16,037
Net impairment losses recognized in earnings (1)		$	-	$	(231)	$	(6,687)	$	(13,484)

(1)	For the nine-month periods ended September 30, 2016 and 2015, approximately $6.3 million and $12.9 million, respectively, of the credit impairment recognized in earnings consisted of credit losses on Puerto Rico Government debt securities and $0.4 million and $0.6 million, respectively, was associated with credit losses on private label MBS.

The following tables summarize the roll-forward of credit losses on debt securities held by the Corporation for which a portion of an OTTI is recognized in OCI:

	Cumulative OTTI credit losses recognized in earnings on securities still held
			Credit impairments		Credit impairments
	June 30,		recognized in earnings		recognized in earnings on		September 30,
	2016		on securities not		securities that have been		2016
	Balance		previously impaired		previously impaired		Balance
(In thousands)
Available-for-sale securities
Puerto Rico Government obligations	$	22,189	$	-	$	-	$	22,189
Private label MBS		6,792		-		-		6,792
Total OTTI credit losses for available-for-sale
debt securities	$	28,981	$	-	$	-	$	28,981


	Cumulative OTTI credit losses recognized in earnings on securities still held
			Credit impairments		Credit impairments
	December 31,		recognized in earnings		recognized in earnings on		September 30,
	2015		on securities not		securities that have been		2016
	Balance		previously impaired		previously impaired		Balance
(In thousands)
Available-for-sale securities
Puerto Rico Government obligations	$	15,889	$	-	$	6,300	$	22,189
Private label MBS		6,405		-		387		6,792
Total OTTI credit losses for available-for-sale
debt securities	$	22,294	$	-	$	6,687	$	28,981


	Cumulative OTTI credit losses recognized in earnings on securities still held
			Credit impairments		Credit impairments
	June 30,		recognized in earnings		recognized in earnings on		September 30,
	2015		on securities not		securities that have been		2015
	Balance		previously impaired		previously impaired		Balance
(In thousands)
Available-for-sale securities
Puerto Rico Government obligations	$	12,856	$	-	$	-	$	12,856
Private label MBS		6,174		-		231		6,405
Total OTTI credit losses for available-for-sale
debt securities	$	19,030	$	-	$	231	$	19,261


	Cumulative OTTI credit losses recognized in earnings on securities still held
			Credit impairments		Credit impairments
	December 31,		recognized in earnings		recognized in earnings on		September 30,
	2014		on securities not		securities that have been		2015
	Balance		previously impaired		previously impaired		Balance
(In thousands)
Available-for-sale securities
Puerto Rico Government obligations	$	-	$	12,856	$	-	$	12,856
Private label MBS		5,777		-		628		6,405
Total OTTI credit losses for available-for-sale
debt securities	$	5,777	$	12,856	$	628	$	19,261

In the first quarter of 2016, the Corporation recorded a $6.3million OTTI charge on three Puerto Rico Government debt securities held by the Corporation as part of its available-for-sale securities portfolio, specifically bonds of the GDB maturing on February 1, 2019 and the Puerto Rico Public Buildings Authority maturing on July 1, 2028. This was the third OTTI charge on these securities recorded since June 30, 2015, as OTTI charges of $12.9 million and $3.0 million were booked in the second and fourth quarters of 2015, respectively, and reduced the amortized cost basis of these three Puerto Rico Government debt securities to $35.6million as of September 30, 2016, including accrued interest of $0.9 million.

During the first nine months of 2016, in consideration of the latest available information about the Puerto Rico Government’s financial condition, including the enactment of a debt moratorium law and the declaration of a state of emergency at the GDB, the issuance of the GDB and the Commonwealth’s audited financial statements for the fiscal year ended June 30, 2014, as well as the issuance of exchange proposals with the Commonwealth’s creditors related to its outstanding bond obligations, the Corporation applied a discounted cash flow analysis to its Puerto Rico Government debt securities in order to calculate the cash flows expected to be collected and to determine if any portion of the decline in market value of these securities was considered a credit-related other-than-temporary impairment. The analysis derives an estimate of value based on the present value of risk-adjusted cash flows of the underlying securities and included the following components:

The contractual future cash flows of the bonds are projected based on the key terms as set forth in the official statements for each security. Such key terms include, among others, the interest rate, amortization schedule, if any, and maturity date.

The risk-adjusted cash flows are calculated based on a probability of default analysis and recovery rate assumptions, including the weighting of different scenarios of ultimate recovery, considering the credit rating of each security. Constant monthly default rates are assumed throughout the life of the bonds, which considers the respective security's credit rating as of the date of the analysis.

The adjusted future cash flows are then discounted at the original effective yield of each investment based on the purchase price and expected risk-adjusted future cash flows as of the purchase date of each investment.

The discounted risk-adjusted cash flow analysis for the three Puerto Rico Government bonds mentioned above assumed a default probability of 100%, thus reflecting that it is more likely than not that these three bonds will default during their remaining terms. Based on this analysis, the Corporation determined that it is unlikely to receive all of the remaining contractual interest and principal amounts when due on these bonds and recorded, in the first quarter of 2016, other-than-temporary credit-related impairment charges amounting to $6.3 million, assuming recovery rates ranging from 35% to 80% (with a weighted average of 61%). On August 1, 2016, the GDB defaulted on a $28 million payment of interest due to its creditors, including interest due on bonds held by the Corporation. Similarly, the Puerto Rico Public Building Authority made only a partial payment on its interest payment due on October 1, 2016. In the third quarter of 2016, as a result of the recent defaults, the Corporation discontinued income recognition related to, and placed in non-performing status, the bonds of the GDB and the Puerto Rico Public Building Authority. As of September 30, 2016, the amortized cost of these bonds, including accrued interest of $0.9 million, was $35.6 million ($22.3 million of GDB bonds and $13.3 million of Puerto Rico Public Buildings Authority bonds), recorded at their aggregate fair value of $19.5 million ($9.4 million of GDB bonds and $10.1 million of Puerto Rico Public Buildings Authority bonds).

The Corporation does not have the intention to sell these securities and has sufficient capital and liquidity to hold these securities until a recovery of the fair value occurs; as such, only the credit loss component was reflected in earnings. Given the significant and prolonged uncertainty of a debt restructuring process, the Corporation cannot be certain that future impairment charges will not be required against these securities.

In addition, during the first nine months of 2016, the Corporation recorded a $0.4 million credit-related impairment loss associated with private label MBS, which are collateralized by fixed-rate mortgages on single-family residential properties in the United States. The interest rates on these private-label MBS is variable, tied to 3-month LIBOR and limited to the weighted-average coupon of the underlying collateral. The underlying mortgages are fixed-rate, single-family loans with original high FICO scores (over 700) and moderate original loan-to-value ratios (under 80%), as well as moderate delinquency levels.

Based on the expected cash flows, and since the Corporation does not have the intention to sell the securities and has sufficient capital and liquidity to hold these securities until a recovery of the fair value occurs, only the credit loss component was reflected in earnings. Significant assumptions in the valuation of the private label MBS were as follows:

	September 30, 2016		December 31, 2015
	Weighted		Weighted
	Average	Range	Average	Range

Discount rate	13.3%	12.03% - 13.58%	14.5%	14.5%
Prepayment rate	13.7%	6.5% - 22.5%	25%	15.92% - 31.25%
Projected Cumulative Loss Rate	4%	0.2% - 9.1%	4%	0.18% - 6.66%

Investments Held to Maturity

The amortized cost, gross unrealized gains and losses, approximate fair value, weighted-average yield and contractual maturities of investment securities held to maturity as of September 30, 2016 and December 31, 2015 were as follows:

		September 30, 2016
		Amortized cost						Fair value		Weighted average yield%
				Gross Unrealized
				gains		losses

Puerto Rico Municipal Bonds:
	After 1 to 5 years	$	1,136	$	-	$	27	$	1,109	5.38
	After 5 to 10 years		10,741		-		782		9,959	4.41
	After 10 years		144,313		-		23,140		121,173	4.66
Total investment securities
	held to maturity	$	156,190	$	-	$	23,949	$	132,241	4.65

		December 31, 2015
		Amortized cost						Fair value		Weighted average yield%
				Gross Unrealized
				gains		losses

Puerto Rico Municipal Bonds:
	After 1 to 5 years	$	1,371	$	-	$	37	$	1,334	5.38
	After 5 to 10 years		11,523		-		1,041		10,482	4.25
	After 10 years		148,589		-		28,861		119,728	4.64
Total investment securities
	held to maturity	$	161,483	$	-	$	29,939	$	131,544	4.62

The following tables show the Corporation’s held-to-maturity investments’ fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of September 30, 2016 and December 31, 2015:

	As of September 30, 2016
	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
		(In thousands)
Debt securities:
Puerto Rico Municipal Bonds	$	-	$	-	$	132,241	$	23,949	$	132,241	$	23,949


	As of December 31, 2015
	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
		(In thousands)
Debt securities:
Puerto Rico Municipal Bonds	$	4,163	$	140	$	127,381	$	29,799	$	131,544	$	29,939

Approximately 87% of the held-to-maturity municipal bonds were issued by five of the largest municipalities in Puerto Rico (San Juan, Carolina, Bayamon, Mayaguez and Guaynabo). These obligations typically are not issued in bearer form, nor are they registered with the SEC and are not rated by external credit agencies. In most cases, these bonds have priority over the payment of operating costs and expenses of the municipality, which are required by law to levy special property taxes in such amounts as are required for the payment of all of their respective general obligation bonds and loans.

The Corporation determines the fair market value of Puerto Rico Municipal Bonds based on a discounted cash flow analysis using risk-adjusted discount rates. A security with similar characteristics traded in the open market is used as a proxy for each municipal bond. Then the cash flow is discounted at the average spread over the discount curve exhibited by the proxy security at the end of each quarter.

When evaluating if the decrease in fair value could be classified as other-than-temporary, management considered aspects such as the fact that all municipalities are current on their payments and the fact that the bonds are subject to periodic credit reviews and are supported by assigned property tax revenues.

Based on the quarterly analysis performed and the circumstances discussed above, management concluded that the unrealized loss is attributable to the time value of money and liquidity assumptions and no individual municipal bond was other-than-temporarily impaired as of September 30, 2016.