EX-13.1 5 g17700exv13w1.htm EX-13.1 EX-13.1
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POPULAR, INC.
Annual Report / Informe Anual
2008

 


 

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1 Letter to Shareholders 9 Carta a los Accionistas 3 Popular, Inc. At a Glance 11 Un Vistazo a Popular, Inc. 4 Institutional Values 12 Valores Institucionales 5 Year in Review and BPOP Stock Performance 13 Resumen de Año y Desempeño de Acción BPOP 6 25-Year Historical Financial Summary 14 Resumen Financiero Histórico – 25 Años 8 Our Creed / Our People / Board of Directors 16 Nuestro Credo / Nuestra Gente / Junta de Directores Executive Officers / Corporate Information Oficiales Ejecutivos / Información Corporativa 17 Financial Review and Supplementary Information Popular, Inc. is a full service financial services provider based in Puerto Popular Inc. es un proveedor de servicios financieros con sede en Puerto Rico with operations in Puerto Rico, the United States, the Caribbean and Rico y operaciones en Puerto Rico, los Estados Unidos, el Caribe y América Latin America. As the leading financial institution in Puerto Rico, with Latina. Como institución financiera líder en Puerto Rico, con 240 240 branches and offices, the Corporation offers retail and commercial sucursales y oficinas, la Corporación ofrece servicios bancarios comerciales banking services through its principal banking subsidiary, Banco Popular y a individuos a través de Banco Popular de Puerto Rico, así como de Puerto Rico, as well as auto and equipment leasing and financing, servicios de arrendamiento y financiamiento de vehículos y equipo, mortgage loans, investment banking, broker-dealer and insurance services préstamos hipotecarios, corretaje y banca de inversión y seguros, a través through specialized subsidiaries. de subsidiarias especializadas. In the United States, the Corporation operates Banco Popular North En los Estados Unidos, la Corporación opera Banco Popular North America, America (BPNA), including its wholly-owned subsidiary E-LOAN. BPNA (BPNA) que incluye su subsidiaria E-LOAN. BPNA es un banco comunitario is a community bank providing a broad range of financial services and que provee una amplia gama de servicios y productos financieros en products to the communities it serves. BPNA operates branches in New las comunidades que sirve. BPNA opera sucursales en Nueva York, York, California, Illinois, New Jersey, and Florida. E-LOAN markets deposit California, Illinois, Nueva Jersey y Florida. E-LOAN mercadea cuentas de accounts under its name for the benefit of BPNA and offers loan customers depósito bajo su nombre para el beneficio de BPNA y ofrece a los clientes the option of being referred to a trusted consumer lending partner. de préstamos la opción de ser referidos a algún socio confiable. The Corporation, through its transaction processing company, EVERTEC, La Corporación, a través de su compañía de procesamiento de continues to use its expertise in technology as a competitive advantage transacciones financieras EVERTEC, utiliza su experiencia en tecnología in its expansion throughout the Caribbean and Latin America, as well como una ventaja competitiva para su expansión en el Caribe y América as internally servicing many of its subsidiaries’ system infrastructures and Latina, e internamente presta servicios a las infraestructuras de sistemas transactional processing businesses. The Corporation is exporting its así como procesamiento a las subsidiarias de la Corporación. La 115 years of experience through these regions while continuing its Corporación exporta sus 115 años de experiencia a estas regiones al commitment to meeting the needs of retail and business clients through tiempo que cumple su compromiso de satisfacer las necesidades de innovation, and to fostering growth in the communities it serves. clientes individuales y comerciales mediante la innovación, y fomenta el crecimiento de las comunidades a las que sirve.

 


 

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Dear Shareholders Popular reported a net loss of In August, we announced a 50% reduction in the quarterly $1.2 billion in 2008, compared dividend from $0.16 to $0.08 per common share, effective in to a net loss of $64.5 million in October 2008. This was an extremely difficult decision, given the previous year. These results its impact on our shareholders, but in light of the deteriorating represent a negative return on financial and economic scenario, it was the prudent action to assets (ROA) of 3.04% and a take. This reduction helps preserve approximately $90 million negative return on common of capital annually. equity (ROE) of 44.47%. Our In September, we sold PFH’s manufactured housing loan assets results were significantly to 21st Mortgage Corporation and Vanderbilt Mortgage and impacted by losses from the Finance, Inc. for a purchase price of $198 million in cash. sale and discontinuance of During the months of September and October, we issued $350 Popular Financial Holding’s million of fixed and floating rate notes in a private offering. (PFH) operations, an increase In November, PFH sold approximately $1.1 billion in loans of 191% in the provision for loan losses and a valuation and servicing-related assets to Goldman Sachs affiliates for allowance of the entire deferred tax asset related to our a purchase price of $731 million in cash. operation in the United States. Our stock price closed at $5.16 Finally, in December, Popular received $935 million as part of on December 31, 2008, 51% below the 2007 closing price, and the Capital Purchase Program of the U.S. Treasury Department’s it has declined sharply in the first months of 2009. Troubled Asset Relief Program (TARP), in exchange for senior Clearly, these results are extremely disappointing. While we preferred stock and a warrant. anticipated challenging conditions for the year, the crisis in the These actions helped us weather the economic storm with financial industry worsened beyond anyone’s expectations and greater financial flexibility and allowed us to meet all obligations spread throughout the U.S. economy. Meanwhile, Puerto Rico’s and other operational needs. We also closed the year 2008 with economy continued mired in a recession, which is now entering solid regulatory capital ratios. However, foreseeing another its fourth year. extremely challenging year, in February we announced another Against this backdrop of a deteriorating financial and reduction in the quarterly dividend, from $0.08 to $0.02 per economic environment, we executed a series of actions common share, which will preserve an additional $68 million throughout the year designed to improve capital, enhance in capital annually. We are also implementing additional cost-liquidity and reduce risk exposures. reduction measures. In March, we sold the assets of Equity One (a subsidiary Our organizational structure has also undergone important of PFH) to American General for a purchase price of changes. David H. Chafey, President of Banco Popular de Puerto $1.47 billion in cash. Rico (BPPR), also assumed the position of President of Banco In May, we issued $400 million of 8.25% Non-Cumulative Popular North America (BPNA) after the retirement of Roberto Monthly Income Preferred Stock, Series B at a price of $25 per R. Herencia. More recently, David was also named President share. The issue was oversubscribed and sold entirely in the and Chief Operating Officer of Popular, Inc. He is spearheading Puerto Rico market. the execution of the integration of both banks under one management group, creating efficiencies to better face current challenges and laying the groundwork for future growth. Against a backdrop of a deteriorating financial and economic environment, we executed a series of actions throughout the year designed to IMPROVE CAPITAL, ENHANCE LIQUIDITY AND REDUCE RISK EXPOSURES. P O P U L A R , I N C . 2 0 0 8 A N N U A L R E P O RT 1

 


 

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Dear Shareholders UNITED STATES for the benefit of BPNA. As part of the plan, all operational and The year 2008 was one of dramatic changes in our operations in support functions will be transferred to BPNA and EVERTEC, the United States. Our U.S. operations suffered substantial losses entailing a reduction of 100% of E-LOAN’s employees. Total due primarily to the sale of assets and a significantly higher annualized savings are expected to reach $37 million. Restructuring provision for loan losses as a result of deteriorating credit quality.charges, including impairments, will amount to approximately In addition, reflecting the negative income results for the last $24 million. three years, during 2008 we recorded a full valuation allowance Management is currently evaluating additional alternatives to of $861 million on the deferred tax assets related to our U.S. improve the financial performance of these operations. The strategic operations. This valuation allowance could be reduced once these direction is clear – we are focusing on core banking activities in operations begin to show positive results. regions where we believe we have a distinct competitive advantage, and we will leverage the infrastructure in Puerto Rico to reduce BANCO POPULAR NORTH AMERICA operational costs in the U.S. We are confident that a leaner, more Banco Popular North America (BPNA), which includes E-LOAN, agile organization will contribute positively to the results and reported a net loss of $524.8 million, $233.9 million of which are growth prospects of Popular. related to E-LOAN. The performance of BPNA’s banking operations was severely POPULAR FINANCIAL HOLDINGS impacted by an increase in the provision for loan losses from During 2008, we discontinued all Popular Financial Holdings (PFH) $77.8 million in 2007 to $346 million in 2008. The 345% increase operations. The discontinued operations of PFH reflected a net loss was driven by higher delinquencies in the commercial, residential of $563.4 million. mortgage and consumer portfolios, reflecting the continuing PFH started the year with a significantly reduced balance sheet downturn of the real estate market and the economy in general. due to the recharacterization completed in December 2007 of certain E-LOAN faced similar credit quality issues, particularly in its on-balance sheet securitizations – amounting to approximately HELOC and closed-end second mortgage portfolios, with its $3.2 billion – that allowed us to recognize these transactions as sales. provision increasing from $17.7 million in 2007 to $126.3 million In March, we completed the sale of approximately $1.42 billion in 2008. The rapid deterioration of this portfolio reflects a of Equity One’s assets for $1.47 billion, thus exiting PFH’s consumer substantial number of debtors falling behind in their first and finance business. second mortgages with little or no equity remaining to cover Most of PFH’s $1.5 billion portfolio, which was accounted for the principal of the junior lien, due principally to the significant at fair value based on Statement of Financial Accounting Standards decline in housing prices. (SFAS) No. 159 beginning on January 1st, 2008, was subsequently In response to these difficult conditions, we embarked on sold during the year in a series of transactions. In November, we a major restructuring plan for BPNA’s banking operations and completed the sale of approximately $1.1 billion of PFH’s loans E-LOAN. In the case of the banking operations, we will close, and mortgage servicing assets to several Goldman Sachs affiliates. consolidate or sell approximately 40 underperforming branches, In addition, we completed the sale of PFH’s manufactured exit lending businesses that do not generate deposits or fee housing loan assets to 21st Mortgage Corp. and Vanderbilt income, and reduce expenses. This plan entails a 30% headcou nt Mortgage and Finance, Inc. These transactions generated reduction and approximately $33 million in restructuring charges combined losses of $440 million, but generated $929 million in and impairments, and is expected to generate $50 million in additional liquidity and substantially reduced Popular’s exposure annual savings. to subprime assets in the U.S. As of December, E-LOAN ceased the origination of mortgages to focus exclusively on marketing deposit accounts under its name THE STRATEGIC DIRECTION IS CLEAR – we are focusing on core banking activities in regions where we believe we have a distinct competitive advantage, and we will leverage the infrastructure in Puerto Rico to reduce operational costs in the U.S. 2P O P U L A R , I N C . 2 0 0 8 A N N U A L R E P O RT

 


 

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POPULAR, INC. At a Glance PUERTO RICO BANCO POPULAR DE PUERTO RICO Our banking operations in Puerto Rico continued feeling the pressure Approximately 1.4 million clients of the island’s prolonged economic recession. Banco Popular de 187 branches and 62 offices throughout Puerto Rico (BPPR) reported a net income of $239.1 million in 2008, Puerto Rico and the Virgin Islands compared to $327.3 million in 2007. 6,244 FTEs as of 12/31/08 Despite the challenging economic conditions, BPPR was able to 605 ATMs and 27,162 POS throughout grow its revenues by 9% when compared to the previous year, due Puerto Rico and the Virgin Islands to an expansion in the net interest margin and higher non-interest #1 market share in total deposits (36.3% –income, a testament to the bank’s revenue-generating capacity. 9/30/08) and total loans (22.8% – 9/30/08) However, the provision for loan losses more than doubled from $25.9 billion in assets, $16.0 billion in loans the previous year, totaling $519 million in 2008. This dramatic and $18.4 billion in deposits as of 12/31/08 increase responded to a deterioration of credit quality, particularly in the commercial and construction portfolios. Delinquencies and BANCO POPULAR NORTH AMERICA losses in consumer portfolios, though higher than the year before, 139 branches throughout five states (Florida, remained substantially in line with our expectations. Without any California, New York, New Jersey and Illinois) doubt, the proactive and intensive management of credit quality 2,100 FTEs as of 12/31/08 was the key focus during the year. The commercial banking group restructured and strengthened $1.5 billion in deposits captured by E-LOAN as of 12/31/08 several areas to ensure the quality of incoming loans as well as to detect and manage potentially problematic loans early on by $12.4 billion in assets, $10.2 billion in loans and $9.7 billion in total deposits as of 12/31/08 focusing efforts on portfolio management and loan modification. The consumer lending area also invested in analytical tools to EVERTEC enhance collection practices, redesigned operational processes and 12 offices throughout Puerto Rico and Latin improved workforce productivity through training and revision of America serving 16 countries incentive programs. 1,766 FTEs as of 12/31/08 The changes, both in the commercial and individual credit areas, have placed us in a stronger position to manage what looks to be Processed over 1.1 billion transactions in 2008, another difficult year in terms of credit quality. of which more than 557 million corresponded to the ATH® Network Expenses grew by approximately 6% due to several factors such as the absorption of Citibank’s retail banking operations and higher FDIC 5,096 ATMs and 95,617 POS throughout Puerto Rico, United States and Latin America insurance premiums. The increase was partially offset by a series of cost-control initiatives like headcount reduction, lower advertising spending and disciplined spending on technology projects. We continuously analyze the performance and long-term prospects of the lines of business in which we compete, and take actions to either scale back or strengthen activities. An important decision this year involved the closing of Popular Finance, our consumer finance subsidiary on the island. The continued contraction of this market, the industry’s lack of profitability and our financial results led us to conclude that it was prudent to exit this line of business. Another 2008 3

 


 

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Dear Shareholders important action was the acquisition of the mortgage servicing strong revenue and net income growth from their activities in the rights to a $5 billion mortgage loan portfolio owned by Freddieregion. We strengthened business relationships in markets where Mac and Ginnie Mae and previously serviced by R&G Mortgage. we already had a presence and entered new ones, such as Mexico, The benefits of this acquisition include the opportunity to where we are targeting smaller players that are often overlooked create cost synergies by adding more volume to our servicing by larger processors. infrastructure, service an attractive client base and fortify BPPR’s EVERTEC has proven that by identifying niches and delivering leading position in the mortgage industry. superior service, it can successfully compete in the transaction-Our acquisition of Citibank’s local retail banking operations and processing business and provide a more diverse source of revenues Smith Barney in 2007 proved to be a great addition to BPPR’s for Popular. operations. In the case of the retail banking operations, we have retained most of the clients and deposits acquired and have been ADDRESSING CHALLENGES able to sell additional products to these clients. The Smith Barney The outlook for 2009 points to another difficult year. We are living transaction was well received by the local market, repositioned through unprecedented times, and we are making the necessary Popular Securities as an important player in the brokerage business, adjustments to weather this difficult period. While we believe and has produced financial results that exceeded our projections. actions by both the U.S. and Puerto Rican governments could help It is difficult to predict how long or deep the economic stabilize the financial system and stimulate the economy, we have recession in Puerto Rico is going to be. We will continue to put comprehensive plans in place to navigate the difficult waters manage our business to ensure that, notwithstanding the that lie ahead. challenging environment, BPPR continues solidifying its position Looking back, we deployed too much of our capital and as the leading financial institution in Puerto Rico and delivering resources in our U.S. operations without reaching appropriate strong financial results. profitability levels, and that has impacted our performance in recent years. We are determined to improve the profitability of EVERTEC these operations by focusing on our core banking business while EVERTEC had a strong year, delivering a net income of $43.6 we continue to build the formidable franchise we have in Puerto million in 2008, 40% higher than 2007. These results were Rico. Our Board of Directors continues to provide invaluable primarily driven by business-process outsourcing services, ATH® guidance, our management team is focused and our people are Network and point-of-sale (POS) transactions, and the sale of highly committed to the success of this organization. We thank VISA shares. These results were achieved in spite of the fact that you, our shareholders, and we will continue to work tirelessly to EVERTEC’s main clients, which include financial institutions, reward your continued support. government and businesses from other economic sectors, have also been impacted by the financial and economic crises. To mitigate the impact of lower business volume from these sources, during 2008 EVERTEC focused on pursuing new sources of revenues, expanding into new geographical markets, attracting new clients and controlling expenses. In Puerto Rico, EVERTEC continued initiatives to enhance the competitiveness of the ATH® Network, which remains the Richard L. Carrión most secure and cost effective payment method in Puerto Rico, Chairman and Chief Executive Officer and attracted new clients to its hosting and outsourcing services. EVERTEC’s expansion in Latin America continued in 2008, showing INSTITUTIONAL SOCIAL COMMITMENT C U S T O M E R INTEGRITY We are committed to work We achieve satisfaction for our We are guided by the highest Values actively in promoting the social customers and earn their loyalty by standards of ethics, integrity and economic well-being of the adding value to each interaction. and morality. Our customers’ communities we serve. Our relationship with the trust is of utmost importance customer takes precedence over to our institution. any particular transaction. 4P O P U L A R , I N C . 2 0 0 8 A N N U A L R E P O RT

 


 

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Year in Review and BPOP Stock Performance
The KBW Bank Index is a modified cap-weighted index consisting of 24 exchange-listed and National Market System stocks,representing national money center banks and leading regional institutions.
Market Events*
A Bank of America acquires Countrywide Financial. B British government temporarily nationalizes Northern Rock. C J.P.Morgan Chase acquires Bear Stearns in government-assisted deal. D Government places Fannie Mae,Freddie Mac in conservatorship.
E Lehman Brothers files for bankruptcy.Bank of America agrees to acquire Merrill Lynch.
F U.S.government approves $85 billion loan to American International Group.
G J.P.Morgan Chase acquires operations of Washington Mutual.
H U.S.government says it will provide $700 billion to stabilize U.S. financial markets.FDIC increases deposit insurance to $250,000 per depositor.
I Wells Fargo receives regulatory approval to acquire Wachovia Co.
*Information and dates compiled from related official web sites.
BPOP Actions
1 Popular restructures Popular Financial Holdings (PFH) and E-LOAN;exits wholesale subprime mortgage origination;consolidates BPNA functions. 2 Popular acquires Citibank’s retail banking and broker-dealer operations in Puerto Rico. 3 Recharacterization of PFH securitizations results in removal of $3.2 billion in loans from PFH’s balance sheet. 4 E-LOAN restructures business model,focuses on conforming first mortgages. 5 Popular adopts fair-value option (SFAS 159) for $1.5 billion in loans held by PFH. 6 Banco Popular North America (BPNA) sells six branches, $125 million in deposits in Texas for $12.8 million. 7 Popular sells approximately $1.42 billion of Equity One’s assets for $1.47 billion, exits consumer-finance business. 8 Popular issues $400 million of preferred shares in Puerto Rico priced at 8.25%. 9 Popular reduces quarterly dividend per common share by 50% to $0.08.The dividend reduction will help preserve approximately $90 million of capital annually. 10 Popular issues approximately $350 million of fixed and floating rate notes in a private offering. 11 Popular sells $260 million in manufactured housing loan assets of PFH for $198 million to enhance liquidity and reduce risk exposure. 12 Popular announces plan to reduce size of BPNA franchise; focus on branch-based banking.E-LOAN ceases loan originations. 13 Popular sells approximately $1.1 billion in loans and servicing-related assets to Goldman Sachs affiliates for $731 million to enhance liquidity and reduce risk exposure.
14 Popular acquires mortgage servicing rights to a $5 billion mortgage loan portfolio in Puerto Rico (owned by Ginnie Mae and Freddie Mac) for $38.2 million.
15 Popular issues $935 million in preferred stock and warrants to the U.S. Department of the Treasury under the TARP Capital Purchase Program.
EXCELLENCE
We believe there is only one way to do things:the right way.
INNOVATION
We foster a constant search
for new solutions as a strategy
to enhance our competitive
advantage.
OUR PEOPLE
We strive to attract,develop,compensate
and retain the most qualified people
in a work environment characterized by
discipline and affection.
SHAREHOLDER VALUE
Our goal is to produce high
and consistent financial returns
for our shareholders,based on a
long-term view.

 


 

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POPULAR, INC. 25-Year Historical Financial Summary (Dollars in millions, except per share data) 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 Selected Financial Information Net Income (Loss) $ 29.8 $ 32.9 $ 38.3 $ 38.3 $ 47.4 $ 56.3 $ 63.4 $ 64.6 $ 85.1 $ 109.4 $ 124.7 Assets 3,526.7 4,141.7 4,531.8 5,389.6 5,706.5 5,972.7 8,983.6 8,780.3 10,002.3 11,513.4 12,778.4 Net Loans1,373.9 1,715.7 2,271.0 2,768.5 3,096.3 3,320.6 5,373.3 5,195.6 5,252.1 6,346.9 7,781.3 Deposits 2,870.7 3,365.3 3,820.2 4,491.6 4,715.8 4,926.3 7,422.7 7,207.1 8,038.7 8,522.7 9,012.4 Stockholders’ Equity203.5 226.4 283.1 308.2 341.9 383.0 588.9 631.8 752.1 834.2 1,002.4 Market Capitalization $ 159.8 $ 216.0 $ 304.0 $ 260.0 $ 355.0 $ 430.1 $ 479.1 $ 579.0 $ 987.8 $ 1,014.7 $ 923.7 Return on Assets (ROA) 0.94% 0.89% 0.88% 0.76% 0.85% 0.99% 1.09% 0.72% 0.89% 1.02% 1.02% Return on Equity (ROE) 15.83% 15.59% 15.12% 13.09% 14.87% 15.87% 15.55% 10.57% 12.72% 13.80% 13.80% Per Common Share1 Net Income (Loss) – Basic $ 0.21 $ 0.23 $ 0.25 $ 0.24 $ 0.30 $ 0.35 $ 0.40 $ 0.27 $ 0.35 $ 0.42 $ 0.46 Net Income (Loss) – Diluted $ 0.21 $ 0.23 $ 0.25 $ 0.24 $ 0.30 $ 0.35 $ 0.40 $ 0.27 $ 0.35 $ 0.42 $ 0.46 Dividends (Declared) 0.06 0.07 0.08 0.09 0.09 0.10 0.10 0.10 0.10 0.12 0.13 Book Value 1.38 1.54 1.73 1.89 2.10 2.35 2.46 2.63 2.88 3.19 3.44 Market Price $ 1.11 $ 1.50 $ 2.00 $ 1.67 $ 2.22 $ 2.69 $ 2.00 $ 2.41 $ 3.78 $ 3.88 $ 3.52 Assets by Geographical Area Puerto Rico 91% 92% 92% 94% 93% 92% 89% 87% 87% 79% 76% United States 8% 7% 7% 5% 6% 6% 9% 11% 10% 16% 20% Caribbean and Latin America 1% 1% 1% 1% 1% 2% 2% 2% 3% 5% 4% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Traditional Delivery System Banking Branches Puerto Rico 113 115 124 126 126 128 173 161 162 165 166 Virgin Islands 33 33 33 33 38 8 United States 9 9 9 910 10 24 24 30 32 34 Subtotal 125 127 136 138 139 141 200 188 195 205 208 Non-Banking Offices Popular Financial Holdings 27 41 58 73 Popular Cash Express Popular Finance 14 17 18 26 26 26 26 28 Popular Auto 4 9 9 9 810 Popular Leasing, U.S.A. Popular Mortgage Popular Securities Popular Insurance Popular Insurance Agency U.S.A. Popular Insurance, V.I. E-LOAN EVERTEC Subtotal 14 17 22 35 62 76 92 111 Total125 127 136 152 156 163 235 250 271 297 319 Electronic Delivery System ATMs2 Owned and Driven Puerto Rico 78 94 113 136 153 151 211 206 211 234 262 Caribbean 3 3 3 33 38 8 United States 611 26 Subtotal 78 94 113 139 156 154 214 209 220 253 296 Driven Puerto Rico 6 36 51 55 68 65 54 73 81 86 88 Caribbean Subtotal 636 51 55 68 65 54 73 81 86 88 Total 84 130 164 194 224 219 268 282 301 339 384 Transactions (in millions) Electronic Transactions3 4.4 7.0 8.3 12.7 14.9 16.1 18.0 23.9 28.6 33.2 43.0 Items Processed 110.3 123.8 134.0 139.1 159.8 161.9 164.0 166.1 170.4 171.8 174.5 Employees (full-time equivalent) 4,110 4,314 4,400 4,699 5,131 5,213 7,023 7,006 7,024 7,533 7,606 1 Per common share data adjusted for stock splits. 2 Does not include host-to-host ATMs (2,223 in 2008) which are neither owned nor driven, but are part of the ATH® Network. 3 From 1981 to 2003, electronic transactions include ACH, Direct Payment, TelePago, Internet Banking and ATH® Network transactions in Puerto Rico. Since 2004, these numbers were adjusted to include ATH® Network transactions in the Dominican Republic, Costa Rica, El Salvador and United States, health care transactions, wire transfers, and other electronic payment transactions in addition to those previously stated. 6P O P U L A R , I N C . 2 0 0 8 A N N U A L R E P O RT

 


 

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 $ 146.4 $ 185.2 $ 209.6 $ 232.3 $ 257.6 $ 276.1 $ 304.5 $ 351.9 $ 470.9 $ 489.9 $ 540.7 $ 357.7 $ (64.5) $ (1,243.9) 15,675.5 16,764.1 19,300.5 23,160.4 25,460.5 28,057.1 30,744.7 33,660.4 36,434.7 44,401.6 48,623.7 47,404.0 44,411.4 38,882.8 8,677.5 9,779.0 11,376.6 13,078.8 14,907.8 16,057.1 18,168.6 19,582.1 22,602.2 28,742.3 31,710.2 32,736.9 29,911.0 26,276.1 9,876.7 10,763.3 11,749.6 13,672.2 14,173.7 14,804.9 16,370.0 17,614.7 18,097.8 20,593.2 22,638.0 24,438.3 28,334.4 27,550.2 1,141.7 1,262.5 1,503.1 1,709.1 1,661.0 1,993.6 2,272.8 2,410.9 2,754.4 3,104.6 3,449.2 3,620.3 3,581.9 3,268.4 $1,276.8 $ 2,230.5 $ 3,350.3 $ 4,611.7 $ 3,790.2 $ 3,578.1 $ 3,965.4 $ 4,476.4 $ 5,960.2 $ 7,685.6 $ 5,836.5 $ 5,003.4 $ 2,968.3 $ 1,455.1 1.04% 1.14% 1.14% 1.14% 1.08% 1.04% 1.09% 1.11% 1.36% 1.23% 1.17% 0.74% -0.14% -3.04% 14.22% 16.17% 15.83% 15.41% 15.45% 15.00% 14.84% 16.29% 19.30% 17.60% 17.12% 9.73% -2.08% -44.47% $ 0.53 $ 0.67 $ 0.75 $ 0.83 $ 0.92 $ 0.99 $ 1.09 $ 1.31 $ 1.74 $ 1.79 $ 1.98 $ 1.24 $ (0.27) $ (4.55) $ 0.53 $ 0.67 $ 0.75 $ 0.83 $ 0.92 $ 0.99 $ 1.09 $ 1.31 $ 1.74 $ 1.79 $ 1.97 $ 1.24 $ (0.27) $ (4.55) 0.15 0.18 0.20 0.25 0.30 0.32 0.38 0.40 0.51 0.62 0.64 0.64 0.64 0.48 3.96 4.40 5.19 5.93 5.76 6.96 7.97 9.10 9.66 10.95 11.82 12.32 12.12 6.33 $ 4.85 $ 8.44 $ 12.38 $ 17.00 $ 13.97 $ 13.16 $ 14.54 $ 16.90 $ 22.43 $ 28.83 $ 21.15 $ 17.95 $ 10.60 $ 5.16 75% 74% 74% 71% 71% 72% 68% 66% 62% 55% 53% 52% 59% 65% 21% 22% 23% 25% 25% 26% 30% 32% 36% 43% 45% 45% 38% 32% 4% 4% 3% 4% 4% 2% 2% 2% 2% 2% 2% 3% 3% 3% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 166 178 201 198 199 199 196 195 193 192 194 191 196 179 8 8 8 8 8 8 8 8 8 8 8 8 8 8 40 44 63 89 91 95 96 96 97 128 136 142 147 139 214 230 272 295 298 302 300 299 298 328 338 341 351 326 91 102 117 128 137 136 149 153 181 183 212 158 134 2 51 102 132 154 195 129 114 4 31 39 44 48 47 61 55 36 43 43 49 52 51 9 9 8 10 10 12 12 20 18 18 18 17 15 12 12 7 8 10 11 13 13 11 15 14 11 24 22 3 3 3 11 13 21 25 29 32 30 33 32 32 32 1 2 2 2 3 4 7 8 9 12 12 13 7 2 2 2 2 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 4 4 4 5 5 7 8 12 11 12 134 153 183 258 327 382 427 460 431 423 354 297 282 100 348 383 455 553 625 684 727 759 729 751 692 638 633 426 281 327 391 421 442 478 524 539 557 568 583 605 615 605 8 9 17 59 68 37 39 53 57 59 61 65 69 74 38 53 71 94 99 109 118 131 129 163 181 192 187 176 327 389 479 574 609 624 681 723 743 790 825 862 871 855 120 162 170 187 102 118 155 174 176 167 212 226 433 462 97 192 265 851 920 823 926 1,110 1,216 1,726 1,360 1,454 1,560 120 259 362 452 953 1,038 978 1,100 1,286 1,383 1,938 1,586 1,887 2,022 447 648 841 1,026 1,562 1,662 1,659 1,823 2,029 2,173 2,763 2,448 2,758 2,877 56.6 78.0 111.2 130.5 159.4 199.5 206.0 236.6 255.7 568.5 625.9 690.2 772.7 849.4 175.0 173.7 171.9 170.9 171.0 160.2 149.9 145.3 138.5 133.9 140.3 150.0 175.2 202.2 7,815 7,996 8,854 10,549 11,501 10,651 11,334 11,037 11,474 12,139 13,210 12,508 12,303 10,587 7
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 $ 146.4 $ 185.2 $ 209.6 $ 232.3 $ 257.6 $ 276.1 $ 304.5 $ 351.9 $ 470.9 $ 489.9 $ 540.7 $ 357.7 $ (64.5) $ (1,243.9) 15,675.5 16,764.1 19,300.5 23,160.4 25,460.5 28,057.1 30,744.7 33,660.4 36,434.7 44,401.6 48,623.7 47,404.0 44,411.4 38,882.8 8,677.5 9,779.0 11,376.6 13,078.8 14,907.8 16,057.1 18,168.6 19,582.1 22,602.2 28,742.3 31,710.2 32,736.9 29,911.0 26,276.1 9,876.7 10,763.3 11,749.6 13,672.2 14,173.7 14,804.9 16,370.0 17,614.7 18,097.8 20,593.2 22,638.0 24,438.3 28,334.4 27,550.2 1,141.7 1,262.5 1,503.1 1,709.1 1,661.0 1,993.6 2,272.8 2,410.9 2,754.4 3,104.6 3,449.2 3,620.3 3,581.9 3,268.4 $1,276.8 $ 2,230.5 $ 3,350.3 $ 4,611.7 $ 3,790.2 $ 3,578.1 $ 3,965.4 $ 4,476.4 $ 5,960.2 $ 7,685.6 $ 5,836.5 $ 5,003.4 $ 2,968.3 $ 1,455.1 1.04% 1.14% 1.14% 1.14% 1.08% 1.04% 1.09% 1.11% 1.36% 1.23% 1.17% 0.74% -0.14% -3.04% 14.22% 16.17% 15.83% 15.41% 15.45% 15.00% 14.84% 16.29% 19.30% 17.60% 17.12% 9.73% -2.08% -44.47% $ 0.53 $ 0.67 $ 0.75 $ 0.83 $ 0.92 $ 0.99 $ 1.09 $ 1.31 $ 1.74 $ 1.79 $ 1.98 $ 1.24 $ (0.27) $ (4.55) $ 0.53 $ 0.67 $ 0.75 $ 0.83 $ 0.92 $ 0.99 $ 1.09 $ 1.31 $ 1.74 $ 1.79 $ 1.97 $ 1.24 $ (0.27) $ (4.55) 0.15 0.18 0.20 0.25 0.30 0.32 0.38 0.40 0.51 0.62 0.64 0.64 0.64 0.48 3.96 4.40 5.19 5.93 5.76 6.96 7.97 9.10 9.66 10.95 11.82 12.32 12.12 6.33 $ 4.85 $ 8.44 $ 12.38 $ 17.00 $ 13.97 $ 13.16 $ 14.54 $ 16.90 $ 22.43 $ 28.83 $ 21.15 $ 17.95 $ 10.60 $ 5.16 75% 74% 74% 71% 71% 72% 68% 66% 62% 55% 53% 52% 59% 65% 21% 22% 23% 25% 25% 26% 30% 32% 36% 43% 45% 45% 38% 32% 4% 4% 3% 4% 4% 2% 2% 2% 2% 2% 2% 3% 3% 3% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 166 178 201 198 199 199 196 195 193 192 194 191 196 179 8 8 8 8 8 8 8 8 8 8 8 8 8 8 40 44 63 89 91 95 96 96 97 128 136 142 147 139 214 230 272 295 298 302 300 299 298 328 338 341 351 326 91 102 117 128 137 136 149 153 181 183 212 158 134 2 51 102 132 154 195 129 114 4 31 39 44 48 47 61 55 36 43 43 49 52 51 9 9 8 10 10 12 12 20 18 18 18 17 15 12 12 7 8 10 11 13 13 11 15 14 11 24 22 3 3 3 11 13 21 25 29 32 30 33 32 32 32 1 2 2 2 3 4 7 8 9 12 12 13 7 2 2 2 2 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 4 4 4 5 5 7 8 12 11 12 134 153 183 258 327 382 427 460 431 423 354 297 282 100 348 383 455 553 625 684 727 759 729 751 692 638 633 426 281 327 391 421 442 478 524 539 557 568 583 605 615 605 8 9 17 59 68 37 39 53 57 59 61 65 69 74 38 53 71 94 99 109 118 131 129 163 181 192 187 176 327 389 479 574 609 624 681 723 743 790 825 862 871 855 120 162 170 187 102 118 155 174 176 167 212 226 433 462 97 192 265 851 920 823 926 1,110 1,216 1,726 1,360 1,454 1,560 120 259 362 452 953 1,038 978 1,100 1,286 1,383 1,938 1,586 1,887 2,022 447 648 841 1,026 1,562 1,662 1,659 1,823 2,029 2,173 2,763 2,448 2,758 2,877 56.6 78.0 111.2 130.5 159.4 199.5 206.0 236.6 255.7 568.5 625.9 690.2 772.7 849.4 175.0 173.7 171.9 170.9 171.0 160.2 149.9 145.3 138.5 133.9 140.3 150.0 175.2 202.2 7,815 7,996 8,854 10,549 11,501 10,651 11,334 11,037 11,474 12,139 13,210 12,508 12,303 10,587 7

 


 

(GRAPHIC)
Our Creed Our People OUR CREED BOARD OF DIRECTORS EXECUTIVE OFFICERS Banco Popular is a local institution dedicating Richard L. Carrión Richard L. Carrión Chairman, Chairman, its efforts exclusively to the enhancement of the Chief Executive Officer, Chief Executive Officer, social and economic conditions in Puerto Rico Popular, Inc. Popular, Inc. and inspired by the most sound principles and Juan J. Bermúdez David H. Chafey Jr. fundamental practices of good banking. Retired Partner, Bermúdez & Longo, S.E. President, Chief Operating Officer, María Luisa Ferré Banco Popular pledges its efforts and resources Popular, Inc. President and Chief Executive Officer, to the development of a banking service Grupo Ferré Rangel Jorge A. Junquera Senior Executive Vice President, for Puerto Rico within strict commercial Michael Masin Chief Financial Officer, Popular, Inc. practices and so efficient that it could meet Private Investor Brunilda Santos de Álvarez, Esq. the requirements of the most progressive Manuel Morales Jr. Executive Vice President, President, Parkview Realty, Inc. community of the world. Chief Legal Officer, Popular, Inc. Francisco M. Rexach Jr. These words, written in 1928 by Don Rafael President, Capital Assets, Inc. Carrión Pacheco, Executive Vice President and Frederic V. Salerno President (1927–1956), embody the philosophy Private Investor of Popular, Inc. in all its markets. William J. Teuber Jr. Vice Chairman, EMC Corporation José R. Vizcarrondo President and Chief Executive Officer, OUR PEOPLE Desarrollos Metropolitanos, S.E. The men and women who work for our institution, Samuel T. Céspedes, Esq. from the highest executive to the employees Secretary of the Board of Directors, who handle the most routine tasks, feel a special Popular, Inc. pride in serving our customers with care and dedication. All of them feel the personal satisfaction of belonging to the “Banco Popular CORPORATE INFORMATION Family,” which fosters affection and understanding Independent Registered Public among its members, and which at the same time Accounting Firm PricewaterhouseCoopers LLP firmly complies with the highest ethical and moral standards of behavior. Annual Meeting The 2009 Annual Stockholders’ Meeting These words by Don Rafael Carrión Jr., President of Popular, Inc. will be held on Friday, May 1, at 9:00 a.m. at Centro Europa and Chairman of the Board (1956–1991), Building in San Juan, Puerto Rico. were written in 1988 to commemorate the 95th Additional Information anniversary of Banco Popular de Puerto Rico, and The Annual Report to the Securities and reflect our commitment to human resources. Exchange Commission on Form 10-K and any other financial information may also be viewed by visiting our website: www.popular.com 8P O P U L A R , I N C . 2 0 0 8 A N N U A L R E P O RT

 


 

Exhibit 13
Financial Review and
Supplementary Information
         
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    3  
 
       
Statistical Summaries
    78  
 
       
Financial Statements
       
 
       
Management’s Report to Stockholders
    83  
 
       
Report of Independent Registered Public Accounting Firm
    84  
 
       
Consolidated Statements of Condition as of December 31, 2008 and 2007
    86  
 
       
Consolidated Statements of Operations for the years ended December 31, 2008, 2007 and 2006
    87  
 
       
Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006
    88  
 
       
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2008, 2007 and 2006
    89  
 
       
Consolidated Statements of Comprehensive (Loss) Income for the years ended December 31, 2008, 2007 and 2006
    90  
 
       
Notes to Consolidated Financial Statements
    91  

 


 

2     POPULAR, INC. 2008 ANNUAL REPORT
Management’s Discussion and Analysis of Financial Condition and Results of Operations
         
Forward-Looking Statements
    3  
 
       
Overview
    3  
Regulatory Initiatives
    6  
 
       
Critical Accounting Policies / Estimates
    8  
 
       
Fair Value Option
    17  
 
       
Statement of Operations Analysis
       
Net Interest Income
    20  
Provision for Loan Losses
    22  
Non-Interest Income
    23  
Operating Expenses
    25  
Income Taxes
    28  
Fourth Quarter Results
    29  
 
       
Reportable Segment Results
    30  
 
       
Discontinued Operations
    34  
 
       
Statement of Condition Analysis
       
Assets
    39  
Deposits, Borrowings and Other Liabilities
    42  
Stockholders’ Equity
    43  
 
       
Risk Management
    45  
Market Risk
    46  
Liquidity Risk
    53  
Credit Risk Management and Loan Quality
    61  
Operational Risk Management
    71  
 
       
Recently Issued Accounting Pronouncements and Interpretations
    71  
 
       
Glossary of Selected Financial Terms
    75  
 
       
Statistical Summaries
       
Statements of Condition
    78  
Statements of Operations
    79  
Average Balance Sheet and Summary of Net Interest Income
    80  
Quarterly Financial Data
    82  

 


 

3
Managements Discussion and Analysis of Financial
Condition and Results of Operations
The following management’s discussion and analysis (“MD&A”) provides information which management believes necessary for understanding the financial performance of Popular, Inc. and its subsidiaries (the “Corporation” or “Popular”). All accompanying tables, consolidated financial statements and corresponding notes included in this “Financial Review and Supplementary Information - 2008 Annual Report” (“the report”) should be considered an integral part of this MD&A.
FORWARD-LOOKING STATEMENTS
The information included in this report may contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include descriptions of products or services, plans or objectives for future operations, and forecast of revenues, earnings, cash flows, or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.
     Forward-looking statements are not guarantees of future performance and, by their nature, involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which are beyond the Corporation’s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to, the rate of growth in the economy, as well as general business and economic conditions; changes in interest rates, as well as the magnitude of such changes; the fiscal and monetary policies of the federal government and its agencies; the relative strength or weakness of the consumer and commercial credit sectors and of the real estate markets; the performance of the stock and bond markets; competition in the financial services industry; possible legislative, tax or regulatory changes; and difficulties in combining the operations of acquired entities. Other possible events or factors that could cause results or performance to differ materially from those expressed in these forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of nonperforming assets, charge-offs and provision expense; changes in interest rates and market liquidity which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets; adverse movements and volatility in debt and equity capital markets; changes in market rates and prices which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; changes in accounting standards, rules and interpretations; increased competition; the Corporation’s ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change the business mix of the Corporation; and management’s ability to identify and manage these and other risks.
     All forward-looking statements are based upon information available to the Corporation as of the date of this report. Management assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
     The description of the Corporation’s business and risk factors contained in Item 1 and 1A of its Form 10-K for the year ended December 31, 2008, while not all inclusive, discusses additional information about the business of the Corporation and the material risk factors that, in addition to the other information in this report, readers should consider.
OVERVIEW
The Corporation is a financial holding company, which is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System. The Corporation has operations in Puerto Rico, the United States, the Caribbean and Latin America. As the leading financial institution in Puerto Rico, the Corporation offers retail and commercial banking services through its principal banking subsidiary, Banco Popular de Puerto Rico (“BPPR”), as well as auto and equipment leasing and financing, mortgage loans, consumer lending, investment banking, broker-dealer and insurance services through specialized subsidiaries. In the United States, the Corporation operates Banco Popular North America (“BPNA”), including its wholly-owned subsidiary E-LOAN. BPNA is a community bank providing a broad range of financial services and products to the communities it serves. BPNA operates branches in New York, California, Illinois, New Jersey, Florida and Texas. E-LOAN markets deposit accounts under its name for the benefit of BPNA and offers loan customers the option of being referred to a trusted consumer lending partner for loan products. The Corporation, through its transaction processing company, EVERTEC, continues to use its expertise in technology as a competitive advantage in its expansion throughout the United States, the Caribbean and Latin America, as well as internally servicing many of its subsidiaries’ system infrastructures and transactional processing businesses. Note 35 to the consolidated financial statements, as well as the Reportable Segments section in this MD&A, presents further information about the Corporation’s business segments. PFH, the Corporation’s consumer and mortgage lending subsidiary in the U.S., carried a maturing loan portfolio and operated a mortgage loan servicing unit during 2008. The PFH operations were discontinued in the later part of 2008. Refer to Note 2 and the Discontinued Operations section of this MD&A for additional information.
     During 2008, concerns about future economic growth, oil prices, lower consumer confidence, tightening of credit

 


 

4     POPULAR, INC. 2008 ANNUAL REPORT
availability and lower corporate earnings continued to challenge the economy. In the United States, market and economic conditions were severely impacted when credit conditions rapidly deteriorated and financial markets experienced widespread illiquidity and volatility. As a result of these unprecedented market conditions, federal government agencies, including the U.S. Treasury Department (“U.S. Treasury”) and the Federal Reserve Board, initiated several actions to boost the outlook of the U.S. financial services industry and help institutions unfreeze lending and spur economic growth. Meanwhile, Puerto Rico’s economy continued mired in a recession, which is now entering its fourth year.
     Popular, Inc. suffered from this market turmoil. The Corporation reported a net loss of $1.2 billion for the year ended December 31, 2008, compared with a net loss of $64.5 million for the year ended December 31, 2007. These financial results represented a negative return on assets of 3.04% and a negative return on common equity of 44.47%. While management anticipated challenging conditions for the year, the crisis in the financial industry worsened beyond expectations. The Corporation’s financial results were significantly impacted by losses from the sale and discontinuance of Popular Financial Holding’s (“PFH”) operations, an increase of 191% in the provision for loan losses and a valuation allowance of the entire deferred tax asset related to the Corporation’s operations in the United States.
     During 2008, the Corporation executed a series of actions designed to improve its capital and liquidity positions, which included the following:
    Sale of six retail bank branches of BPNA in Texas in January 2008;
 
    Sale of certain assets of Equity One (a subsidiary of PFH) to American General Financial in March 2008;
 
    Issuance of $400 million in preferred stock, which was sold entirely in the Puerto Rico market in May 2008;
 
    Reduction of 50% in the quarterly dividend from $0.16 to $0.08 per common share, effective in October 2008. This will help preserve approximately $90 million of capital a year in light of the difficult financial scenario. In February 2009, the Board of Directors reduced again the common stock dividend to $0.02 per common share. This will conserve an additional $68 million in capital per year. The dividend payment is reviewed on a quarterly basis and may be adjusted as circumstances warrant;
 
    Issuance of $350 million of senior unsecured notes in a private offering during September and October 2008;
 
    Sale of the remaining PFH assets in September and November 2008. These transactions, despite entailing considerable losses, generated approximately $929 million in additional liquidity to the Corporation;
 
    Receipt of $935 million in December 2008 from the U.S. Treasury as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program in exchange for preferred stock and warrants on common stock. Refer to the subdivision of “Regulatory Initiatives” in this Overview section of the MD&A.
     Also, during 2008, management approved restructuring plans at its U.S. mainland operations, BPNA and E-LOAN, with the objective of establishing a leaner, more efficient U.S. business model better suited to present economic conditions, improving profitability in the short term, increasing liquidity, lowering credit costs, and over time achieving a greater integration with corporate functions in Puerto Rico. Refer to the Operating Expenses section in this MD&A for further information on these restructuring plans.
     The Corporation’s continuing operations reported a net loss of $680.5 million for the year ended December 31, 2008, compared with net income of $202.5 million for the year ended December 31, 2007. The following principal items impacted these financial results:
    Higher provision for loan losses by $650.2 million as a result of higher credit losses and increased specific reserves for impaired loans. The deteriorating economy continued to negatively impact the credit quality of the Corporation’s loan portfolios with more rapid deterioration occurring in the latter part of 2008;
 
    Higher income tax expense, principally due to a valuation allowance on the Corporation’s deferred tax assets related to the U.S. operations recorded during the second half of 2008. Refer to the Income Taxes section in this MD&A for further information;
 
    Lower goodwill and trademark impairment losses by $199.3 million due to $211.8 million in impairment losses related to E-LOAN’s goodwill and trademark recognized in the fourth quarter of 2007, compared to losses of $12.5 million in the fourth quarter of 2008, consisting principally of $10.9 million in losses related to E-LOAN’s trademark. The trademark impairment losses recorded in 2008 resulted from E-LOAN ceasing to operate as a direct lender in the fourth quarter of 2008.
     As announced during the third quarter of 2008, the Corporation discontinued the operations of its U.S.-based subsidiary, PFH, which was the result of a series of actions taken between 2007 and 2008 and included restructuring plans, exiting origination channels, closure of unprofitable business units, consolidation of support functions with BPNA and major loan portfolio sales. These discontinued operations showed a net loss of $563.4 million for

 


 

5
Table A
Components of Net (Loss) Income as a Percentage of Average Total Assets
                                         
    For the Year  
    2008     2007     2006     2005     2004  
 
Net interest income
    3.13 %     2.77 %     2.60 %     2.64 %     2.80 %
Provision for loan losses
    (2.42 )     (0.72 )     (0.39 )     (0.26 )     (0.33 )
Sales and valuation adjustments of investment securities
    0.17       0.21       0.04       0.14       0.04  
Gain on sale of loans and valuation adjustments on loans held-for-sale
    0.01       0.13       0.16       0.08       0.08  
Trading account profit
    0.11       0.08       0.08       0.07        
Other non-interest income
    1.74       1.43       1.32       1.29       1.35  
 
 
    2.74       3.90       3.81       3.96       3.94  
Operating expenses
    (3.27 )     (3.28 )     (2.65 )     (2.51 )     (2.58 )
 
(Loss) income from continuing operations before income tax and cumulative effect of accounting change
    (0.53 )     0.62       1.16       1.45       1.36  
Income tax
    (1.13 )     (0.19 )     (0.29 )     (0.31 )     (0.28 )
Cumulative effect of accounting change, net of tax
                      0.01        
 
(Loss) income from continuing operations
    (1.66 )     0.43       0.87       1.15       1.08  
(Loss) income from discontinued operations, net of tax
    (1.38 )     (0.57 )     (0.13 )     0.02       0.15  
 
Net (loss) income
    (3.04 %)     (0.14 %)     0.74 %     1.17 %     1.23 %
 
the year ended December 31, 2008, compared with a net loss of $267.0 million for the previous year. Refer to the Discontinued Operations section in this MD&A for details on the financial results and major events of PFH for the years 2008 and 2007, including restructuring plans, sale of assets, the impact of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” in January 2008 and the recharacterization of certain on-balance sheet securitizations as sales in 2007.
     Table A presents a five-year summary of the components of net (loss) income as a percentage of average total assets. Table B presents the changes in net (loss) income applicable to common stock and (losses) earnings per common share for the last three years. In addition, Table C provides selected financial data for the past five years. A glossary of selected financial terms has been included at the end of this MD&A.
     Total assets at December 31, 2008 amounted to $38.9 billion, a decrease of $5.5 billion, or 12%, compared with December 31, 2007. Total earning assets at December 31, 2008 decreased by $4.8 billion, or 12%, compared with December 31, 2007. As of December 31, 2008, loans, the primary interest-earning asset category for the Corporation, totaled $26.3 billion, reflecting a decline of $3.6 billion, or 12%, from December 31, 2007. The decline in earning assets was principally associated the reduction in the loan portfolio of the discontinued operations of PFH, which had total loans of $3.3 billion at December 31, 2007. For more detailed information on lending activities, refer to the Statement of Condition Analysis and Credit Risk Management and Loan Quality sections of this MD&A. Investment and trading securities, the second largest component of interest-earning assets, accounted for $0.9 billion of the decline in total assets from December 31, 2007.
     Assets at December 31, 2008 were funded principally through deposits, primarily time deposits. Deposits supported approximately 71% of the asset base at December 31, 2008, while borrowings, other liabilities and stockholders’ equity accounted for approximately 29%. This compares to 64% and 36% as of the end of 2007. For additional data on funding sources, refer to the Statement of Condition Analysis and Liquidity Risk sections of this MD&A.
     Stockholders’ equity totaled $3.3 billion at December 31, 2008, compared with $3.6 billion at December 31, 2007. The reduction in stockholders’ equity from the end of 2007 to December 31, 2008 was principally the result of the net loss of $1.2 billion recorded for 2008, dividends paid during the year and the $262 million negative after-tax adjustment to beginning retained earnings due to the transitional adjustment for electing the fair value option, partially offset by the $400 million preferred stock offering in May 2008 and the $935 million of preferred stock issued under the TARP in December 2008.
     The shares of the Corporation’s common and preferred stock are traded on the National Association of Securities Dealers Automated Quotations (“NASDAQ”) system under the symbols BPOP, BPOPO and BPOPP. Table J shows the Corporation’s

 


 

6     POPULAR, INC. 2008 ANNUAL REPORT
Table B
Changes in Net (Loss) Income Applicable to Common Stock and (Losses) Earnings per Common Share
                                                 
    2008   2007   2006
(In thousands, except per common share amounts)   Dollars   Per share   Dollars   Per share   Dollars   Per share
 
Net (loss) income applicable to common stock for prior year
    ($76,406 )     ($0.27 )   $ 345,763     $ 1.24     $ 528,789     $ 1.98  
Favorable (unfavorable) changes in:
                                               
Net interest income
    (26,454 )     (0.10 )     50,927       0.18       31,866       0.12  
Provision for loan losses
    (650,165 )     (2.33 )     (153,663 )     (0.55 )     (65,571 )     (0.25 )
Sales and valuation adjustments of investment securities
    (31,153 )     (0.11 )     78,749       0.28       (44,392 )     (0.17 )
Trading account profit
    6,448       0.02       939             6,207       0.02  
Sales of loans and valuation adjustments on loans held-for-sale
    (54,028 )     (0.19 )     (16,291 )     (0.06 )     38,995       0.15  
Other non-interest income
    35,012       0.13       39,789       0.14       37,087       0.14  
Impairment losses on long-lived assets
    (3,013 )     (0.01 )     (10,478 )     (0.04 )            
Goodwill and trademark impairment losses
    199,270       0.71       (211,750 )     (0.76 )            
Amortization of intangibles
    (1,064 )           1,576       0.01       (2,472 )     (0.01 )
All other operating expenses
    13,541       0.05       (46,579 )     (0.16 )     (111,591 )     (0.42 )
Income tax
    (371,370 )     (1.33 )     49,530       0.18       3,016       0.01  
Cumulative effect of accounting change
                            (3,607 )     (0.01 )
 
(Loss) income from continuing operations
    (959,382 )     (3.43 )     128,512       0.46       418,327       1.56  
Loss from discontinued operations, net of tax
    (296,434 )     (1.06 )     (204,918 )     (0.73 )     (72,564 )     (0.27 )
 
Net (loss) income before preferred stock dividends, TARP preferred discount amortization and change in average common shares
    (1,255,816 )     (4.49 )     (76,406 )     (0.27 )     345,763       1.29  
Change in preferred dividends and in TARP preferred discount amortization
    (23,384 )     (0.08 )                        
Change in average common shares**
          0.02                         (0.05 )
 
Net (loss) income applicable to common stock
    ($1,279,200 )     ($4.55 )     ($76,406 )     ($0.27 )   $ 345,763     $ 1.24  
 
**   Reflects the effect of the shares repurchased, plus the shares issued through the Dividend Reinvestment Plan and the subscription rights offering, and the effect of stock options exercised in the years presented.
 
common stock performance on a quarterly basis during the last five years, including market prices and cash dividends declared.
     The Corporation, like other financial institutions, is subject to a number of risks, many of which are outside of management’s control, though efforts are made to manage those risks while optimizing returns. Among the risks assumed are (1) market risk, which is the risk that changes in market rates and prices will adversely affect the Corporation’s financial condition or results of operations, (2) liquidity risk, which is the risk that the Corporation will have insufficient cash or access to cash to meet operating needs and financial obligations, (3) credit risk, which is the risk that loan customers or other counterparties will be unable to perform their contractual obligations, and (4) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. These four risks are covered in greater detail throughout this MD&A. In addition, the Corporation is subject to legal, compliance and reputational risks, among others.
     Further discussion of operating results, financial condition and business risks is presented in the narrative and tables included herein.
Regulatory Initiatives
On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”), which provides the U.S. Secretary of the United States Treasury Department (“Treasury”) with broad authority to deploy up to $700 billion into the financial system to help restore stability and liquidity to U.S. markets. On October 24, 2008, Treasury announced plans to direct $250 billion

 


 

7
Table C
Selected Financial Data
                                         
    Year ended December 31,  
(Dollars in thousands, except per share data)   2008     2007     2006     2005     2004  
 
CONDENSED STATEMENTS OF OPERATIONS
                                       
Interest income
  $ 2,274,123     $ 2,552,235     $ 2,455,239     $ 2,081,940     $ 1,662,101  
Interest expense
    994,919       1,246,577       1,200,508       859,075       543,267  
 
Net interest income
    1,279,204       1,305,658       1,254,731       1,222,865       1,118,834  
 
Provision for loan losses
    991,384       341,219       187,556       121,985       133,366  
Net gain on sale and valuation adjustment of investment securities
    69,716       100,869       22,120       66,512       15,254  
Trading account profit (loss)
    43,645       37,197       36,258       30,051       (159 )
Gain on sale of loans and valuation adjustments on loans held-for-sale
    6,018       60,046       76,337       37,342       30,097  
Other non-interest income
    710,595       675,583       635,794       598,707       539,945  
Operating expenses
    1,336,728       1,545,462       1,278,231       1,164,168       1,028,552  
Income tax expense
    461,534       90,164       139,694       142,710       110,343  
Cumulative effect of accounting change, net of tax
                      3,607        
 
(Loss) income from continuing operations
    (680,468 )     202,508       419,759       530,221       431,710  
(Loss) income from discontinued operations, net of tax
    (563,435 )     (267,001 )     (62,083 )     10,481       58,198  
 
Net (loss) income
    ($1,243,903 )     ($64,493 )   $ 357,676     $ 540,702     $ 489,908  
 
Net (loss) income applicable to common stock
    ($1,279,200 )     ($76,406 )   $ 345,763     $ 528,789     $ 477,995  
 
PER COMMON SHARE DATA*
                                       
Net (loss) income:
                                       
Basic before cumulative effect of accounting change:
                                       
From continuing operations
    ($2.55 )   $ 0.68     $ 1.46     $ 1.93     $ 1.57  
From discontinued operations
    (2.00 )     (0.95 )     (0.22 )     0.04       0.22  
 
Total
    ($4.55 )     ($0.27 )   $ 1.24     $ 1.97     $ 1.79  
 
Diluted before cumulative effect of accounting change:
                                       
From continuing operations
    ($2.55 )   $ 0.68     $ 1.46     $ 1.92     $ 1.57  
From discontinued operations
    (2.00 )     (0.95 )     (0.22 )     0.04       0.22  
 
Total
    ($4.55 )     ($0.27 )   $ 1.24     $ 1.96     $ 1.79  
 
Basic after cumulative effect of accounting change:
                                       
From continuing operations
    ($2.55 )   $ 0.68     $ 1.46     $ 1.94     $ 1.57  
From discontinued operations
    (2.00 )     (0.95 )     (0.22 )     0.04       0.22  
 
Total
    ($4.55 )     ($0.27 )   $ 1.24     $ 1.98     $ 1.79  
 
Diluted after cumulative effect of accounting change:
                                       
From continuing operations
    ($2.55 )   $ 0.68     $ 1.46     $ 1.93     $ 1.57  
From discontinued operations
    (2.00 )     (0.95 )     (0.22 )     0.04       0.22  
 
Total
    ($4.55 )     ($0.27 )   $ 1.24     $ 1.97     $ 1.79  
 
Dividends declared
  $ 0.48     $ 0.64     $ 0.64     $ 0.64     $ 0.62  
Book value
    6.33       12.12       12.32       11.82       10.95  
Market price
    5.16       10.60       17.95       21.15       28.83  
Outstanding shares:
                                       
Average — basic
    281,079,201       279,494,150       278,468,552       267,334,606       266,302,105  
Average — diluted
    281,079,201       279,494,150       278,703,924       267,839,018       266,674,856  
End of period
    282,004,713       280,029,215       278,741,547       275,955,391       266,582,103  
 
                                       
AVERAGE BALANCES
                                       
Net loans**
  $ 26,471,616     $ 25,380,548     $ 24,123,315     $ 21,533,294     $ 17,529,795  
Earning assets
    36,026,077       36,374,143       36,895,536       35,001,974       29,994,201  
Total assets
    40,924,017       47,104,935       48,294,566       46,362,329       39,898,775  
Deposits
    27,464,279       25,569,100       23,264,132       22,253,069       19,409,055  
Borrowings
    7,378,438       9,356,912       12,498,004       11,702,472       9,369,211  
Total stockholders’ equity
    3,358,295       3,861,426       3,741,273       3,274,808       2,903,137  
 
                                       
PERIOD END BALANCES
                                       
Net loans**
  $ 26,268,931     $ 29,911,002     $ 32,736,939     $ 31,710,207     $ 28,742,261  
Allowance for loan losses
    882,807       548,832       522,232       461,707       437,081  
Earning assets
    36,146,389       40,901,854       43,660,568       45,167,761       41,812,475  
Total assets
    38,882,769       44,411,437       47,403,987       48,623,668       44,401,576  
Deposits
    27,550,205       28,334,478       24,438,331       22,638,005       20,593,160  
Borrowings
    6,943,305       11,560,596       18,533,816       21,296,299       19,882,202  
Total stockholders’ equity
    3,268,364       3,581,882       3,620,306       3,449,247       3,104,621  
 
                                       
SELECTED RATIOS
                                       
Net interest margin (taxable equivalent basis)
    3.81 %     3.83 %     3.72 %     3.86 %     4.09 %
Return on average total assets
    (3.04 )     (0.14 )     0.74       1.17       1.23  
Return on average common stockholders’ equity
    (44.47 )     (2.08 )     9.73       17.12       17.60  
Tier I capital to risk-adjusted assets
    10.81       10.12       10.61       11.17       11.82  
Total capital to risk-adjusted assets
    12.08       11.38       11.86       12.44       13.21  
 
*   Per share data is based on the average number of shares outstanding during the periods, except for the book value and market price which are based on the information at the end of the periods.
 
**   Includes loans held-for-sale.

 


 

8     POPULAR, INC. 2008 ANNUAL REPORT
of this authority into preferred stock investments by Treasury in qualified financial institutions as part of the TARP.
     The TARP requires an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends. This program provides for a minimum investment of 1% of Risk-Weighted Assets, with a maximum investment equal to the lesser of 3% of Total Risk-Weighted Assets or $25 billion. The perpetual preferred stock investment will have a dividend rate of 5% per year, until the fifth anniversary of the Treasury investment, and a dividend rate of 9%, thereafter. This program also requires the Treasury to receive warrants for common stock equal to 15% of the capital invested by the Treasury. As indicated earlier, on December 5, 2008, the Corporation received $935 million as part of the TARP Capital Purchase Program.
     Furthermore, the EESA included a provision for an increase in the amount of deposits insured by the Federal Deposit Insurance Corporation (“FDIC”) to $250,000 until December 31, 2009. Also, as part of the regulatory initiatives, the FDIC implemented the Temporary Liquidity Guarantee Program (“TLGP”) to strengthen confidence and encourage liquidity in the banking system. The TLGP is comprised of the Debt Guarantee Program (“DGP”) and the Transaction Account Guarantee Program (“TAGP”). The DGP guarantees all newly issued senior unsecured debt (e.g., promissory notes, unsubordinated unsecured notes and commercial paper) up to prescribed limits issued by participating entities beginning on October 14, 2008 and continuing through October 31, 2009. For eligible debt issued by that date, the FDIC provides the guarantee coverage until the earlier of the maturity date of the debt or June 30, 2012. The TAGP offers full guarantee for non-interest bearing deposit accounts held at FDIC-insured depository institutions. The unlimited deposit coverage is voluntary for eligible institutions and is in addition to the $250,000 FDIC deposit insurance per account that was included as part of the EESA. The TAGP coverage became effective on October 14, 2008 and will continue for participating institutions until December 31, 2009. Popular, Inc. opted to become a participating entity on both of these programs and will pay applicable fees for participation. Participants in the DGP program have a fee structure based on a sliding scale, depending on length of maturity. Shorter-term debt has a lower fee structure and longer-term debt has a higher fee. The range will be 50 basis points on debt of 180 days or less, and a maximum of 100 basis points for debt with maturities of one year or longer on an annualized basis. Any eligible entity that has not chosen to opt out of the TAGP will be assessed, on a quarterly basis, an annualized 10 basis points fee on balances in non-interest bearing transaction accounts that exceed the existing deposit insurance limit of $250,000. Also, on February 27, 2009, the Board of Directors of the FDIC voted to adopt an interim final rule to impose an emergency special assessment of 20 cents per $100 of deposits on June 30, 2009, and to allow the FDIC to impose emergency special assessments after June 30, 2009 of 10 cents per $100 of deposits if the reserve ratio of the Deposit Insurance Fund is estimated to fall to a level that the FDIC believes would adversely affect public confidence or to a level that is close to zero or negative at the end of a calendar quarter.
CRITICAL ACCOUNTING POLICIES / ESTIMATES
The accounting and reporting policies followed by the Corporation and its subsidiaries conform with generally accepted accounting principles (“GAAP”) in the United States of America and general practices within the financial services industry. The Corporation’s significant accounting policies are described in detail in Note 1 to the consolidated financial statements and should be read in conjunction with this section.
     Critical accounting policies require management to make estimates and assumptions, which involve significant judgment about the effect of matters that are inherently uncertain and that involve a high degree of subjectivity. These estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that differ from those estimates. The following MD&A section is a summary of what management considers the Corporation’s critical accounting policies / estimates.
Fair Value Measurement of Financial Instruments
Effective January 1, 2008, the Corporation is required to determine the fair values of its financial instruments based on the fair value hierarchy established in SFAS No. 157. The SFAS No. 157 hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price).
     In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active.” This statement clarifies that determining fair value in an inactive or dislocated market depends on facts and circumstances and requires significant management judgment. This statement specifies that it is acceptable to use inputs based on management estimates or assumptions, or to make adjustments to observable inputs to determine fair value when markets are not active and relevant observable inputs are not available. The Corporation’s fair value measurements are consistent with the guidance in FSP No. FAS 157-3.
     Instruments that trade infrequently, such that the market has become illiquid with no reliable pricing information available, are classified within Level 3 of the fair value hierarchy. Instruments classified as Level 3 are determined based on the valuation inputs used and the results of the Corporation’s price verification process.
     The Corporation categorizes its assets and liabilities measured at fair value under the three-level hierarchy as required by SFAS

 


 

9
No. 157, and the level within the hierarchy is based on whether the inputs to the valuation methodology used for fair value measurement are observable or unobservable. Observable inputs reflect the assumptions market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs reflect the Corporation’s estimates about assumptions that market participants would use in pricing the asset or liability based on the best information available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
    Level 1 — Unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date. No significant degree of judgment for these valuations is needed, as they are based on quoted prices that are readily available in an active market.
 
    Level 2 — Quoted prices other than those included in Level 1 that are observable either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and other inputs that are observable or that can be corroborated by observable market data for substantially the full term of the financial instrument.
 
    Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value measurement of the financial asset or liability. Unobservable inputs reflect the Corporation’s own assumptions about what market participants would use to price the asset or liability. The inputs are developed based on the best available information, which might include the Corporation’s own data su as internally developed models and discounted cash flow analyses. Assessments with respect to assumptions that market participants would use are inherently difficult to determine and use of different assumptions could result in material changes to these fair value measurements.
     The Corporation currently measures at fair value on a recurring basis its trading assets, available-for-sale securities, derivatives and mortgage servicing rights. From time to time, the Corporation may be required to record at fair value other assets on a nonrecurring basis, such as loans held-for-sale, impaired loans held-for-investment that are collateral dependent and certain other assets. These nonrecurring fair value adjustments typically result from the application of lower-of-cost-or-fair value accounting or write-downs of individual assets. Also, during 2008, the Corporation carried a substantial amount of loans and borrowings at fair value upon the adoption of SFAS No. 159. These loans and borrowings pertained to the PFH operations, most of which were sold during 2008 and are not outstanding at December 31, 2008.
     Refer to Note 31 to the consolidated financial statements for information on the Corporation’s fair value measurement disclosures required by SFAS No. 157. At December 31, 2008, approximately $8.3 billion, or 94%, of the assets from continuing operations measured at fair value on a recurring basis, used market-based or market-derived valuation inputs in their valuation methodology and, therefore, were classified as Level 1 or Level 2. The remaining 6% were classified as Level 3 since their valuation methodology considered significant unobservable inputs. The assets from discontinued operations measured at fair value on a recurring basis, amounting to $5 million, were all classified as Level 3 in the hierarchy. Additionally, the Corporation’s continuing operations reported $887 million of financial assets that were measured at fair value on a nonrecurring basis as of December 31, 2008, all of which were classified as Level 3 in the hierarchy.
     The Corporation requires the use of observable inputs when available, in order to minimize the use of unobservable inputs to determine fair value.
     The estimate of fair value reflects the Corporation’s judgment regarding appropriate valuation methods and assumptions. The amount of judgment involved in estimating the fair value of a financial instrument depends on a number of factors, such as type of instrument, the liquidity of the market for the instrument, transparency around the inputs to the valuation, as well as the contractual characteristics of the instrument.
     If listed prices or quotes are not available, the Corporation employs valuation models that primarily use market-based inputs including yield curves, interest rate curves, volatilities, credit curves, and discount, prepayment and delinquency rates, among other considerations. When market observable data is not available, the valuation of financial instruments becomes more subjective and involves substantial judgment. The need to use unobservable inputs generally results from diminished observability of both actual trades and assumptions resulting from the lack of market liquidity for those types of loans or securities. When fair values are estimated based on modeling techniques, such as discounted cash flow models, the Corporation uses assumptions such as interest rates, prepayment speeds, default rates, loss severity rates and discount rates. Valuation adjustments are limited to those necessary to ensure that the financial instrument’s fair value is adequately representative of the price that would be received or paid in the marketplace.
     Fair values are volatile and are affected by factors such as interest rates, liquidity of the instrument and market sentiment. Notwithstanding the judgment required in determining the fair value of the Corporation’s assets and liabilities, management believes that fair values are reasonable based on the consistency of the processes followed, which include obtaining external prices

 


 

10     POPULAR, INC. 2008 ANNUAL REPORT
when possible and validating a substantial share of the portfolio against secondary pricing sources when available.
     Following is a description of the Corporation’s valuation methodologies used for the principal assets and liabilities measured at fair value at December 31, 2008.
Trading Account Securities and Investment Securities Available-for-Sale
At December 31, 2008, the Corporation’s portfolio of trading and investment securities available-for-sale amounted to $8.6 billion and represented 97% of the Corporation’s assets from continuing operations measured at fair value on a recurring basis. At December 31, 2008, net unrealized gains on the trading and securities available-for-sale portfolios approximated $9 million and $250 million, respectively. Fair values for most of the Corporation’s trading and investment securities are classified under the Level 2 category. Trading and investment securities classified as Level 3, which are the securities that involved the highest degree of judgment, represent only 4% of the Corporation’s total portfolio of trading and investment securities. Refer to Note 31 to the consolidated financial statements for information on the breakdown of assets by hierarchy levels. Note 6 to the consolidated financial statements provides a detail of the Corporation’s investment securities available-for-sale, which represent a significant share of the financial assets measured at fair value at December 31, 2008.
     Management assesses the fair value of its portfolio of investment securities at least on a quarterly basis, which includes analyzing changes in fair value that have resulted in losses that may be considered other-than-temporary. Factors considered include for example, the nature of the investment, severity and duration of possible impairments, industry reports, sector credit ratings, economic environment, creditworthiness of the issuers and any guarantees, and the ability to hold the security until maturity or recovery. Any impairment that is considered other-than-temporary is recorded directly in the statement of operations.
     A general description of the particular valuation methodologies for trading and investment securities follows:
  U.S. Treasury securities: The fair value of U.S. Treasury securities is based on yields that are interpolated from the constant maturity treasury curve. These securities are classified as Level 2.
 
  Obligations of U.S. Government sponsored entities: The Obligations of U.S. Government sponsored entities include U.S. agency securities. The fair value of U.S. agency securities is based on an active exchange market and is based on quoted market prices for similar securities. The U.S. agency securities are classified as Level 2.
 
  Obligations of Puerto Rico, States and political subdivisions: Obligations of Puerto Rico, States and political subdivisions include municipal bonds. The bonds are evaluated by aggregating them by sectors and other similar characteristics. Market inputs used in the evaluation process include all or some of the following: trades, bid price or spread, two sided markets, quotes, benchmark curves including but not limited to Treasury benchmarks, LIBOR and swap curves, market data feeds such as MSRB, discount and capital rates, and trustee reports. The municipal bonds are classified as Level 2.
 
  Mortgage-backed securities: Certain agency mortgage-backed securities (“MBS”) are priced based on a bond’s theoretical value from similar bonds defined by credit quality and market sector. Their fair value incorporates an option adjusted spread. The agency MBS are classified as Level 2. Other agency MBS such as GNMA Puerto Rico Serials are priced using an internally-prepared pricing matrix with quoted prices from local brokers dealers. These particular MBS are classified as Level 3.
 
  Collateralized mortgage obligations: Agency and private collateralized mortgage obligations (“CMOs”) are priced based on a bond’s theoretical value from similar bonds defined by credit quality and market sector and for which fair value incorporates an option adjusted spread. The option adjusted spread model includes prepayment and volatility assumptions, ratings (whole loans collateral) and spread adjustments. These investment securities are classified as Level 2.
 
  Equity securities: Equity securities with quoted market prices obtained from an active exchange market are classified as Level 1.
 
  Corporate securities and mutual funds: Quoted prices for these security types are obtained from broker dealers. Given that the quoted prices are for similar instruments or do not trade in highly liquid markets, the corporate securities and mutual funds are classified as Level 2. The important variables in determining the prices of Puerto Rico tax-exempt mutual fund shares are net asset value, dividend yield and type of assets wtthin the fund. All funds trade based on a relevant dividend yield taking into consideration the aforementioned variables. In addition, demand and

 


 

11
supply also affect the price. Corporate securities that trade less frequently or are in distress are classified as Level 3.
     Securities are classified in the fair value hierarchy according to product type, characteristics and market liquidity. At the end of each quarter, management assesses the valuation hierarchy for each asset or liability measured. SFAS No. 157 quarterly analysis performed by the Corporation includes validation procedures and review of market changes, pricing methodology, assumption and level hierarchy changes, and evaluation of distress transactions.
     Most of the Corporation’s investment securities available-for-sale are classified as Level 2 in the fair value hierarchy given that the general investment strategy at the Corporation is principally “buy and hold” with little trading activity. As such, the majority of the values is obtained from third-party pricing service providers, and, as indicated earlier, is validated with alternate pricing sources when available. Securities not priced by a secondary pricing source are documented and validated internally according to their significance to the Corporation’s financial statements. Management has established materiality thresholds according to the investment class to monitor and investigate material deviations in prices obtained from the primary pricing service provider and the secondary pricing source used as support to the valuation results.
     Primary pricing sources were thoroughly evaluated for their consideration of current market conditions, including the relative liquidity of the market, and if pricing methodology rely, to the extent possible, on observable market and trade data. When a market quote for a specific security is not available, the pricing service provider generally uses observable data to derive an exit price for the instrument, such as benchmark yield curves and trade data for similar products. To the extent trading data is not available, the pricing service provider relies on specific information, including dialogue with brokers, buy side clients, credit ratings, spreads to established benchmarks and transactions on similar securities, to draw correlations based on the characteristics of the evaluated instrument.
     The pricing methodology and approach of our primary pricing service providers are consistent with general market convention. When trade data is not available, pricing service providers rely on available market quotes and on their models. If for any reason, the pricing service provider cannot observe data required to feed its model, it discontinues pricing the instrument. During the year ended December 31, 2008, none of the Corporation’s investment securities were subject to pricing discontinuance by the pricing service providers. Substantially all investment securities available-for-sale are priced with primary pricing service providers and validated by an alternate pricing source with the exception of GNMA Puerto Rico Serials, which are priced using a local demand prices matrix prepared from local dealer quotes, and of local investments, such as corporate securities and mutual funds priced by local dealers. During 2008, the Corporation did not adjust any prices obtained from pricing services providers or broker dealers.
Mortgage Servicing Rights
Mortgage servicing rights (“MSRs”), which amounted to $176 million at December 31, 2008, do not trade in an active, open market with readily observable prices. Fair value is estimated based upon discounted net cash flows calculated from a combination of loan level data and market assumptions. The valuation model combines loans with common characteristics that impact servicing cash flows (e.g., investor, remittance cycle, interest rate, product type, etc.) in order to project net cash flows. Market valuation assumptions include prepayment speeds, discount rate, cost to service, escrow account earnings, and contractual servicing fee income, among other considerations. Prepayment speeds are derived from market data that is more relevant to U.S. mainland loan portfolios, and thus, are adjusted for the Corporation’s loan characteristics and portfolio behavior since prepayment rates in Puerto Rico have been historically lower. Other assumptions are, in the most part, directly obtained from third-party providers. Disclosure of two of the key economic assumptions used to measure MSRs, which are prepayment speed and discount rate, and a sensitivity analysis to adverse changes to these assumptions, is included in Note 22 to the consolidated financial statements.
Derivatives
Interest rate swaps, interest rate caps and index options are traded in over-the-counter active markets. These derivatives are indexed to an observable interest rate benchmark, such as LIBOR or equity indexes, and are priced using an income approach based on present value and option pricing models using observable inputs. Other derivatives are exchange-traded, such as futures and options, or are liquid and have quoted prices, such as forward contracts or “to be announced securities” (“TBAs”). All of these derivatives are classified as Level 2. Valuations of derivative assets and liabilities reflect the value of the instrument including the values associated with counterparty risk and the Corporation’s own credit standing. The non-performance risk is determined using internally-developed models that consider the collateral held, the remaining term, and the creditworthiness of the entity that bears the risk, and uses available public data or internally-developed data related to current spreads that denote their probability of default. To manage the level of credit risk, the Corporation deals with counterparties of good credit standing, enters into master netting agreements whenever possible and, when appropriate, obtains collateral. The credit risk of the counterparty resulted in a reduction of derivative assets by $7.1 million at December 31, 2008. In the other hand, the incorporation of the Corporation’s own credit risk resulted in

 


 

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a reduction of derivative liabilities by $8.9 million at December 31, 2008.
Loans held-in-portfolio considered impaired under SFAS No. 114 that are collateral dependent
The impairment is measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, size and supply and demand. Continued deterioration of the housing markets and the economy in general have adversely impacted and continue to affect the market activity related to real estate properties. These collateral dependent impaired loans are classified as Level 3 and are reported as a nonrecurring fair value measurement.
Loans and Allowance for Loan Losses
Interest on loans is accrued and recorded as interest income based upon the principal amount outstanding.
     Recognition of interest income on commercial and construction loans, lease financing, conventional mortgage loans and closed-end consumer loans is discontinued when loans are 90 days or more in arrears on payments of principal or interest, or when other factors indicate that the collection of principal and interest is doubtful. Unsecured commercial loans are charged-off at 180 days past due. The impaired portions on secured commercial and construction loans are charged-off at 365 days past due. Income is generally recognized on open-end (revolving credit) consumer loans until the loans are charged-off. Closed-end consumer loans and leases are charged-off when payments are 120 days in arrears. Open-end (revolving credit) consumer loans are charged-off when payments are 180 days in arrears.
     One of the most critical and complex accounting estimates is associated with the determination of the allowance for loan losses. The provision for loan losses charged to current operations is based on this determination. The methodology used to establish the allowance for loan losses is based on SFAS No. 114 “Accounting by Creditors for Impairment of a Loan” (as amended by SFAS No. 118) and SFAS No. 5 “Accounting for Contingencies.” Under SFAS No. 114, the Corporation has defined as impaired loans those commercial borrowers with outstanding debt of $250,000 or more and with interest and /or principal 90 days or more past due. Also, specific commercial borrowers with outstanding debt of over $500,000 and over are deemed impaired when, based on current information and events, management considers that it is probable that the debtor will be unable to pay all amounts due according to the contractual terms of the loan agreement. Although SFAS No. 114 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 trouble debt restructures be analyzed under its provisions. An allowance for loan impairment is recognized to the extent that the carrying value of an impaired loan exceeds the present value of the expected future cash flows discounted at the loan’s effective rate, the observable market price of the loan, if available, or the fair value of the collateral if the loan is collateral dependent. The allowance for impaired commercial loans is part of the Corporation’s overall allowance for loan losses. SFAS No. 5 provides for the recognition of a loss allowance for groups of homogeneous loans. To determine the allowance for loan losses under SFAS No. 5, the Corporation applies a historic loss and volatility factor to specific loan balances segregated by loan type and legal entity. For subprime mortgage loans, the allowance for loan losses is established to cover at least one year of projected losses which are inherent in these portfolios.
     The Corporation’s management evaluates the adequacy of the allowance for loan losses on a monthly basis following a systematic methodology in order to provide for known and inherent risks in the loan portfolio. In developing its assessment of the adequacy of the allowance for loan losses, the Corporation must rely on estimates and exercise judgment regarding matters where the ultimate outcome is unknown such as economic developments affecting specific customers, industries or markets. Other factors that can affect management’s estimates are the years of historical data to include when estimating losses, the level of volatility of losses in a specific portfolio, changes in underwriting standards, financial accounting standards and loan impairment measurement, among others. Changes in the financial condition of individual borrowers, in economic conditions, in historical loss experience and in the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses. Consequently, the business, financial condition, liquidity, capital and results of operations could also be affected.
     A discussion about the process used to estimate the allowance for loan losses is presented in the Credit Risk Management and Loan Quality section of this MD&A.
Income Taxes
The calculation of periodic income taxes is complex and requires the use of estimates and judgments. The Corporation has recorded two accruals for income taxes: (1) the net estimated amount currently due or to be received from taxing jurisdictions, including any reserve for potential examination issues, and (2) a deferred income tax that represents the estimated impact of temporary differences between how the Corporation recognizes assets and liabilities under GAAP, and how such assets and liabilities are recognized under the tax code. Differences in the actual outcome of these future tax consequences could impact the Corporation’s financial position or its results of operations. In estimating taxes, management assesses the relative merits and

 


 

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risks of the appropriate tax treatment of transactions taking into consideration statutory, judicial and regulatory guidance.
     Income taxes are accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). The Corporation records income taxes under the asset and liability method, whereby deferred tax assets and liabilities are recognized based on the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and attributable to operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which the temporary differences are expected to be recovered or paid. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period when the changes are enacted.
     SFAS No.109 states that a deferred tax asset should be reduced by a valuation allowance if based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. SFAS No. 109 provides that the realization of deferred tax assets, including carryforwards and deductible temporary differences, depends upon the existence of sufficient taxable income of the same character during the carryback or carryforward period. SFAS No.109 requires the consideration of all sources of taxable income available to realize the deferred tax asset, including the future reversal of existing temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, taxable income in carryback years and tax-planning strategies.
     The Corporation’s U.S. mainland operations are in a cumulative loss position for the three-year period ended December 31, 2008. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position is considered significant negative evidence and has caused us to conclude that the Corporation will not be able to realize the deferred tax assets in the future. As of December 31, 2008, the Corporation recorded a full valuation allowance of $861 million on the deferred tax assets of the Corporation’s U.S. operations. Management will reassess the realization of the deferred tax assets based on the criteria of SFAS No.109 each reporting period. To the extent that the financial results of the U.S. operations improve and the deferred tax asset becomes realizable, the Corporation will be able to reduce the valuation allowance through earnings. Refer to the Income Taxes section of this MD&A for additional disclosures on factors considered by management in the establishment of the valuation allowance on deferred tax assets during the last two quarters of 2008.
     Changes in the Corporation’s estimates can occur due to changes in tax rates, new business strategies, newly enacted guidance, and resolution of issues with taxing authorities regarding previously taken tax positions. Such changes could affect the amount of accrued taxes. The current income tax payable for 2008 has been paid during the year in accordance with estimated tax payments rules. Any remaining payment will not have any significant impact on liquidity and capital resources.
     The valuation of deferred tax assets requires judgment in assessing the likely future tax consequences of events that have been recognized in the financial statements or tax returns and future profitability. The accounting for deferred tax consequences represents management’s best estimate of those future events. Changes in management’s current estimates, due to unanticipated events, could have a material impact on the Corporation’s financial condition and results of operations.
     In accounting for income taxes, the Corporation also considers Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Under the accounting guidance, a tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. The amount of unrecognized tax benefits, including accrued interest, as of December 31, 2008 amounted to $45 million. Refer to Note 28 to the consolidated financial statements for further information on the impact of FIN 48. The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to the statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examinations, litigation and legislative activity and the addition or elimination of uncertain tax positions. Although the outcome of tax audits is uncertain, the Corporation believes that adequate amounts of tax, interest and penalties have been provided for any adjustments that are expected to result from open years. From time to time, the Corporation is audited by various federal, state and local authorities regarding income tax matters. The audits are in various stages of completion; however, no outcome for a particular audit can be determined with certainty prior to the conclusion of the audit, appeal and, in some cases, litigation process. Although management believes its approach to determining the appropriate

 


 

14   POPULAR, INC. 2008 ANNUAL REPORT    
tax treatment is supportable and in accordance with SFAS No. 109 and FIN 48, it is possible that the final tax authority will take a tax position that is different than that which is reflected in the Corporation’s income tax provision and other tax reserves. As each audit is conducted, adjustments, if any, are appropriately recorded in the consolidated financial statement in the period determined. Such differences could have an adverse effect on the Corporation’s income tax provision or benefit, or other tax reserves, in the reporting period in which such determination is made and, consequently, on the Corporation’s results of operations, financial position and / or cash flows for such period.
Goodwill and Trademark
The Corporation’s goodwill and other identifiable intangible assets having an indefinite useful life are tested for impairment based on the requirements of SFAS No. 142, “Goodwill and Other Intangible Assets.” Intangibles with indefinite lives are evaluated for impairment at least annually and on a more frequent basis if events or circumstances indicate impairment could have taken place. Such events could include, among others, a significant adverse change in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment and a decision to change the operations or dispose of a reporting unit.
     As of December 31, 2008, goodwill totaled $606 million, while other intangibles with indefinite useful lives, mostly associated with E-LOAN’s trademark, amounted to $6 million. Refer to Notes 1 and 12 to the consolidated financial statements for further information on goodwill and other intangible assets. Note 12 to the consolidated financial statements provides an allocation of goodwill by business segment.
     During 2008, the Corporation recorded $1.6 million in goodwill impairment losses related to one of its Puerto Rico subsidiaries, Popular Finance, which ceased originating loans and closed its retail branch network during the fourth quarter of 2008. The goodwill assigned to this subsidiary was fully written-off in 2008. The subsidiary, which is expected to be merged with BPPR, continues to hold a running-off loan portfolio. During 2007, the Corporation recorded $164.4 million in goodwill impairment losses associated with the operations of E-LOAN. This resulted from the decision during the fourth quarter of 2007 to restructure the operations of E-LOAN.
     The Corporation performed the annual goodwill impairment evaluation for the entire organization during the third quarter of 2008 using July 31, 2008 as the annual evaluation date. The reporting units utilized for this evaluation were those that are one level below the business segments identified in Note 12 to the consolidated financial statements, which basically are the legal entities that compose the reportable segment. The Corporation follows push-down accounting, as such all goodwill is assigned to the reporting units when carrying out a business combination.
     In accordance with SFAS No. 142, the impairment evaluation is performed in two steps. The first step of the goodwill evaluation process is to determine if potential impairment exists in any of the Corporation’s reporting units, and is performed by comparing the fair value of the reporting units with their carrying amount, including goodwill. If required from the results of this step, a second step measures the amount of any impairment loss. The second step process estimates the fair value of the unit’s individual assets and liabilities in the same manner as if a purchase of the reporting unit was taking place. If the implied fair value of goodwill calculated in step 2 is less than the carrying amount of goodwill for the reporting unit, an impairment is indicated and the carrying value of goodwill is written down to the calculated value.
     The first step of the goodwill impairment test performed during 2008 showed that the carrying amount of the following reporting units exceeded their respective fair values: BPNA, Popular Auto and Popular Mortgage. As a result, the second step of the goodwill impairment test was performed for those reporting units. At December 31, 2008, the goodwill of these reporting units amounted to $404 million for BPNA, $7 million for Popular Auto and $4 million for Popular Mortgage. Only BPNA pertains to the Corporation’s U.S. mainland operations.
     As previously indicated, the second step compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination is determined. That is, an entity shall allocate the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. The fair value of the assets and liabilities reflects market conditions, thus volatility in prices could have a material impact on the determination of the implied fair value of the reporting unit goodwill at the impairment test date. Based on the results of the second step, management concluded that there was no goodwill impairment to be recognized by those reporting units. The analysis of the results for the second step indicates that the reduction in the fair value of these reporting units was mainly attributed to the deterioration of the loan portfolios’ fair value and not to the fair value of the reporting units as going concern entities.
     In determining the fair value of a reporting unit, the Corporation generally uses a combination of methods, including market price multiples of comparable companies and transactions, as well as discounted cash flow analysis.

 


 

     
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     The computations require management to make estimates and assumptions. Critical assumptions that are used as part of these evaluations include:
    a selection of comparable publicly traded companies, based on nature of business, location and size;
 
    a selection of comparable acquisition and capital raising transactions;
 
    the discount rate applied to future earnings, based on an estimate of the cost of equity;
 
    the potential future earnings of the reporting unit; and
 
    the market growth and new business assumptions.
     For purposes of the market comparable approach, valuations were determined by calculating average price multiples of relevant value drivers from a group of companies that are comparable to the reporting unit being analyzed and applying those price multiples to the value drivers of the reporting unit. While the market price multiple is not an assumption, a presumption that it provides an indicator of the value of the reporting unit is inherent in the valuation. The determination of the market comparables also involves a degree of judgment.
     For purposes of the discounted cash flows approach, the valuation is based on estimated future cash flows. The Corporation uses its internal Asset Liability Management Committee (“ALCO”) forecasts to estimate future cash flows. The cost of equity used to discount the cash flows was calculated using the Ibbotson Build-Up Method and ranged from 11.24% to 25.54% for the 2008 analysis.
     For BPNA, the most significant of the subsidiaries that had failed the first step of SFAS No. 142, the Corporation determined the fair value of Step 1 utilizing a market value approach based on a combination of price multiples from comparable companies and multiples from capital raising transactions of comparable companies. Additionally, the Corporation determined the reporting unit fair value using a discounted cash flow analysis (“DCF”) based on BPNA’s financial projections. The Step 1 fair value for BPNA under both valuation approaches (market and DCF) was below the carrying amount of its equity book value as of the valuation date (July 31st), requiring the completion of the second step of SFAS No. 142. In accordance with SFAS No. 142, the Corporation performed a valuation of all assets and liabilities of BPNA, including any recognized and unrecognized intangible assets, to determine the fair value of BPNA’s net assets. To complete the second step of SFAS No. 142, the Corporation subtracted from BPNA’s Step 1 fair values (determined based on the market and DCF approaches) the determined fair value of the net assets to arrive at the implied fair value of goodwill. The results of the Step 2 indicated that the implied fair value of goodwill exceeded the goodwill carrying value of $404 million, resulting in no goodwill impairment.
     Furthermore, as part of the SFAS No. 142 analyses, management performed a reconciliation of the aggregate fair values determined for the reporting units to the market capitalization of Popular, Inc. concluding that the fair value results determined for the reporting units in the July 31, 2008 test were reasonable.
     Management monitors events or changes in circumstances between annual tests to determine if these events or changes in circumstances would more likely than not reduce the fair value of a reporting unit below its carrying amount. As previously indicated, the annual test was performed during the third quarter of 2008 using July 31, 2008 as the annual evaluation date. At that time, the economic situation in the United States and Puerto Rico continued its evolution into recessionary conditions, including deterioration in the housing market and credit market. These conditions have carried over to the end of the year. Accordingly, management is closely monitoring the fair value of the reporting units, particularly those units that failed the Step 1 test in the annual goodwill impairment evaluation. As part of the monitoring process, management performed an assessment for BPNA as of December 31, 2008. The Corporation determined BPNA’s fair value utilizing the same valuation approaches (market and DCF) used in the annual goodwill impairment test. The determined fair value for BPNA as of December 31, 2008 continued to be below its carrying amount under all valuation approaches. The fair value determination of BPNA’s assets and liabilities was updated as of December 31, 2008 utilizing valuation methodologies consistent with the July 31, 2008 test. The results of the assessment as of December 31, 2008, indicated that the implied fair value of goodwill exceeded the goodwill carrying amount, resulting in no goodwill impairment. The results obtained in the December 31, 2008 assessment were consistent with the results of the annual impairment test in that the reduction in the fair value of BPNA was mainly attributable to a significant reduction in the fair value of BPNA’s loan portfolio.
     The goodwill impairment evaluation process requires the Corporation to make estimates and assumptions with regard to the fair value of the reporting units. Actual values may differ significantly from these estimates. Such differences could result in future impairment of goodwill that would, in turn, negatively impact the Corporation’s results of operations and the reporting units where the goodwill is recorded. For the BPPR reporting unit, had the estimated fair value calculated in Step 1 using the market comparable companies approach been approximately 35% lower, there would still be no requirement to perform a Step 2 analysis, thus there would be no indication of impairment on the $138 million of goodwill recorded in BPPR. For the BPNA reporting unit, had the implied fair value of goodwill calculated in Step 2 (assuming the lowest determined Step 1 fair value) been 84% lower, there would still be no impairment of the $404 million of goodwill recorded in BPNA as of December 31, 2008. The goodwill balance of BPPR and BPNA represent approximately 89% of the Corporation’s total goodwill balance.
     It is possible that the assumptions and conclusions regarding the valuation of the Corporations’s reporting units could change adversely and could result in the recognition of goodwill impairment. Such impairment could have a material adverse effect on the Corporation’s financial condition and future results of operations. Declines in the Corporation’s market capitalization increase the risk of goodwill impairment in 2009.
     The valuation of the E-LOAN trademark in 2008 and 2007 was performed using a valuation approach called the “relief-from-royalty” method. The basis of the “relief-from-royalty” method is that, by virtue of having ownership of the trademarks and trade names, Popular is relieved from having to pay a royalty, usually

 


 

     
16   POPULAR, INC. 2008 ANNUAL REPORT    
expressed as a percentage of revenue, for the use of trademarks and trade names. The main estimates involved in the valuation of this intangible asset included the determination of:
    an appropriate royalty rate;
 
    the revenue projections that benefit from the use of this intangible;
 
    the after-tax royalty savings derived from the ownership of the intangible; and
 
    the discount rate to apply to the projected benefits to arrive at the present value of this intangible.
     Since estimates are an integral part of this trademark impairment analysis, changes in these estimates could have a significant impact on the calculated fair value.
     Based on the impairment evaluation tests completed as of December 31, 2008 and 2007, the Corporation recorded impairment losses of $10.9 million and $47.4 million, respectively, associated with E-LOAN’s trademark.
Pension and Postretirement Benefit Obligations
The Corporation provides pension and restoration benefit plans for certain employees of various subsidiaries. The Corporation also provides certain health care benefits for retired employees of BPPR. The benefit costs and obligations of these plans are impacted by the use of subjective assumptions, which can materially affect recorded amounts, including expected returns on plan assets, discount rates, rates of compensation increase and health care trend rates. Management applies judgment in the determination of these factors, which normally undergo evaluation against industry assumptions and the actual experience of the Corporation. The Corporation uses an independent actuarial firm for assistance in the determination of the pension and postretirement benefit costs and obligations. Detailed information on the plans and related valuation assumptions are included in Note 25 to the consolidated financial statements.
     The Corporation periodically reviews its assumption for long-term expected return on pension plan assets in the Banco Popular de Puerto Rico Retirement Plan, which is the Corporation’s largest pension plan with a market value of assets of $361.5 million at December 31, 2008. The expected return on plan assets is determined by considering a total fund return estimate based on a weighted average of estimated returns for each asset class in the plan. Asset class returns are estimated using current and projected economic and market factors such as real rates of return, inflation, credit spreads, equity risk premiums and excess return expectations.
     As part of the review, the Corporation’s independent consulting actuaries performed an analysis of expected returns based on the plan’s asset allocation at January 1, 2009. This analysis is validated by the Corporation and used to develop expected rates of return. This forecast reflects the actuarial firm’s view of expected long-term rates of return for each significant asset class or economic indicator; for example, 9.1% for large / mid-cap stocks, 4.5% for fixed income, 9.9% for small cap stocks and 1.8% inflation at January 1, 2009. A range of expected investment returns is developed, and this range relies both on forecasts and on broad-market historical benchmarks for expected returns, correlations, and volatilities for each asset class.
     As a consequence of recent reviews, the Corporation left unchanged its expected return on plan assets for year 2009 at 8.0%, similar to the expected rate assumed in 2008 and 2007. The Corporation uses a long-term inflation estimate of 2.8% to determine the pension benefit cost, which is higher than the 1.8% rate used in the actuary’s expected return forecast model. The pension plan experienced a negative return in 2008. Since the expected return assumption is on a long-term basis, it is not materially impacted by the yearly fluctuations (either positive or negative) in the actual return on assets. However, if the actual return on assets continue to perform below management expectations for a continued period of time, this could eventually result in the reduction of the expected return on assets percentage assumption.
     Pension expense for the Banco Popular de Puerto Rico Retirement Plan in 2008 amounted to $3.5 million. This included a credit of $39.9 million for the expected return on assets.
     Pension expense is sensitive to changes in the expected return on assets. For example, decreasing the expected rate of return for 2009 from 8.00% to 7.50% would increase the projected 2009 expense for the Banco Popular de Puerto Rico Retirement Plan by approximately $1.8 million.
     The Corporation accounts for the underfunded status of its pension and postretirement benefit plans as a liability, with an offset, net of tax, in accumulated other comprehensive income. The determination of the fair value of pension plan obligations involves judgment, and any changes in those estimates could impact the Corporation’s consolidated statement of financial condition. The valuation of pension plan obligations is discussed above. Management believes that the fair value estimates of the pension plan assets are reasonable given that the plan assets are managed, in the most part, by the fiduciary division of BPPR, which is subject to periodic audit verifications. Also, the composition of the plan assets, as disclosed in Note 25 of the consolidated financial statements, is primarily in equity and debt securities, which have readily determinable quoted market prices.
     The Corporation uses the Citigroup Yield Curve to discount the expected program cash flows of the plans as a guide in the selection of the discount rate, as well as the Citigroup Pension Liability Index. The Corporation decided to use a discount rate

 


 

17
of 6.10% to determine the benefit obligation at December 31, 2008, compared with 6.40% at December 31, 2007.
     A 50 basis point decrease in the assumed discount rate of 6.10% as of the beginning of 2009 would increase the projected 2009 expense for the Banco Popular de Puerto Rico Retirement Plan by approximately $3.9 million. The change would not affect the minimum required contribution to the Plan.
     In February 2009, BPPR’s non-contributory, defined benefit retirement plan (“Pension Plan”) was frozen with regards to all future benefit accruals after April 30, 2009. This action was taken by the Corporation to generate significant cost savings in light of the severe economic downturn and decline in the Corporation’s financial performance; this measure will be reviewed periodically as economic conditions and the Corporation’s financial situation improve. The Pension Plan had previously been closed to new hires and was frozen as of December 31, 2005 to employees who were under 30 years of age or were credited with less than 10 years of benefit service. The aforementioned Pension Plan freezes apply to the Benefit Restoration Plans as well.
     The Corporation also provides a postretirement health care benefit plan for certain employees of BPPR. This plan was unfunded (no assets were held by the plan) at December 31, 2008. The Corporation had an accrual for postretirement benefit costs of $135.9 million at December 31, 2008. Assumed health care trend rates may have significant effects on the amounts reported for the health care plan. Note 25 to the consolidated financial statements provides information on the assumed rates considered by the Corporation and on the sensitivity that a one-percentage point change in the assumed rate may have on specified cost components and postretirement benefit obligation of the Corporation. Assumed health care trend rates were updated at December 31, 2008 to lengthen the expected period of time it will take to ultimately achieve a constant level of health care inflation.
Fair Value Option
The Corporation adopted the provisions of SFAS No. 159 in January 2008. SFAS No. 159 provides entities the option to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period. SFAS No. 159 permits the fair value option election on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.
     The Corporation elected to measure at fair value certain loans and borrowings outstanding at January 1, 2008 pursuant to the fair value option provided by SFAS No. 159. All of these financial instruments pertained to the operations of PFH and, as of the SFAS No. 159 adoption date, included:
    Approximately $1.2 billion of whole loans held-in-portfolio outstanding as of December 31, 2007 at the PFH operations. These whole loans consisted principally of first lien residential mortgage loans and closed-end second lien loans that were originated through the exited origination channels of PFH (e.g. asset acquisition, broker and retail channels), and home equity lines of credit that had been originated by E-LOAN but sold to PFH. Also, to a lesser extent, the loan portfolio included mixed-used multi-family loans (small commercial category) and manufactured housing loans.
 
    Approximately $287 million of “owned-in-trust” loans and $287 million of bond certificates associated with PFH securitization activities that were outstanding as of December 31, 2007. The “owned-in-trust” loans were pledged as collateral for the bond certificates as a financing vehicle through on-balance sheet securitization transactions. The “owned-in-trust” loans included first lien residential mortgage loans, closed-end second lien loans, mixed-used / multi-family loans (small commercial category) and manufactured housing loans. The majority of the portfolio was comprised of first lien residential mortgage loans. Upon the adoption of SFAS No. 159, the securitized loans and related bonds were both measured at fair value, thus their net position better portrayed the credit risk that was born by the Corporation.
     Management believed upon adoption of the accounting standard that accounting for these loans at fair value provided a more relevant and transparent measurement of the realizable value of the assets and differentiated the PFH portfolio from the loan portfolios that the Corporation continued to originate through channels other than PFH.
     PFH, which held the SFAS No. 159 loan portfolio, was financed primarily by advances from its holding company, Popular North America (“PNA”). In turn, PNA depended completely on the capital markets to raise financing to meet its financial obligations. Given the mounting pressure to address PNA’s liquidity needs in the second half of 2008 and the continuing problems with accessing the U.S. capital markets given the current unprecedented market conditions, management decided that the only viable option available to permanently raise the liquidity required by PNA was to sell PFH’s assets, which included the SFAS No. 159 financial instruments.

 


 

18     POPULAR, INC. 2008 ANNUAL REPORT
Table D
Net Interest Income — Taxable Equivalent Basis
                                                                                     
Year ended December 31,
(Dollars in millions)       (In thousands)
                                                                        Variance
Average Volume   Average Yields / Costs       Interest           Attributable to
2008   2007   Variance   2008   2007   Variance       2008   2007   Variance   Rate   Volume
         
$700
  $ 514     $ 186       2.68 %     5.17 %     (2.49 %)  
Money market investments
  $ 18,790     $ 26,565       ($7,775 )     ($14,482 )   $ 6,707  
8,189
    9,827       (1,638 )     5.03       5.16       (0.13 )  
Investment securities
    412,165       507,047       (94,882 )     (12,538 )     (82,344 )
665
    653       12       7.21       6.19       1.02    
Trading securities
    47,909       40,408       7,501       6,729       772  
         
9,554
    10,994       (1,440 )     5.01       5.22       (0.21 )         478,864       574,020       (95,156 )     (20,291 )     (74,865 )
         
 
                                          Loans:                                        
15,775
    14,917       858       6.13       7.72       (1.59 )  
Commercial and construction
    967,019       1,151,602       (184,583 )     (245,680 )     61,097  
1,114
    1,178       (64 )     8.01       7.89       0.12    
Leasing
    89,155       92,940       (3,785 )     1,345       (5,130 )
4,722
    4,748       (26 )     7.18       7.32       (0.14 )  
Mortgage
    339,019       347,302       (8,283 )     (6,384 )     (1,899 )
4,861
    4,537       324       10.15       10.50       (0.35 )  
Consumer
    493,593       476,234       17,359       (20,645 )     38,004  
         
26,472
    25,380       1,092       7.14       8.15       (1.01 )         1,888,786       2,068,078       (179,292 )     (271,364 )     92,072  
         
$36,026
  $ 36,374       ($348 )     6.57 %     7.26 %     (0.69 %)  
Total earning assets
  $ 2,367,650     $ 2,642,098       ($274,448 )     ($291,655 )   $ 17,207  
         
 
                                         
Interest bearing deposits:
                                       
$4,948
  $ 4,429     $ 519       1.89 %     2.60 %     (0.71 %)  
NOW and money market*
  $ 93,523     $ 115,047       ($21,524 )     ($34,997 )     13,473  
5,600
    5,698       (98 )     1.50       1.96       (0.46 )  
Savings
    84,206       111,877       (27,671 )     (19,242 )     (8,429 )
12,796
    11,399       1,397       4.08       4.73       (0.65 )  
Time deposits
    522,394       538,869       (16,475 )     (83,055 )     66,580  
         
23,344
    21,526       1,818       3.00       3.56       (0.56 )         700,123       765,793       (65,670 )     (137,294 )     71,624  
         
5,115
    8,316       (3,201 )     3.29       5.11       (1.82 )  
Short-term borrowings
    168,070       424,530       (256,460 )     (131,385 )     (125,075 )
2,263
    1,041       1,222       5.60       5.40       0.20    
Medium and long-term debt
    126,726       56,254       70,472       2,130       68,342  
         
 
                                         
Total interest bearing
                                       
30,722
    30,883       (161 )     3.24       4.04       (0.80 )  
liabilities
    994,919       1,246,577       (251,658 )     (266,549 )     14,891  
 
                                         
Non-interest bearing
                                       
4,120
    4,043       77                            
demand deposits
                                       
1,184
    1,448       (264 )                          
Other sources of funds
                                       
         
$36,026
  $ 36,374       ($348 )     2.76 %     3.43 %     (0.67 %)                                            
         
 
                    3.81 %     3.83 %     (0.02 %)  
Net interest margin
                                       
 
                       
Net interest income on
                                       
 
                                         
a taxable equivalent basis
    1,372,731       1,395,521       (22,790 )     ($25,106 )   $ 2,316  
 
                    3.33 %     3.22 %     0.11 %   Net interest spread                                
 
                       
Taxable equivalent
                                       
 
                                         
adjustment
    93,527       89,863       3,664                  
 
                                         
Net interest income
  $ 1,279,204     $ 1,305,658       ($26,454 )                
 
                                         
                                       
 
Notes:   The changes that are not due solely to volume or rate are allocated to volume and rate based on the proportion of the change in each category.
 
*   Includes interest bearing demand deposits corresponding to certain government entities in Puerto Rico.
 
     As described further in the Discontinued Operations section in this MD&A, during the third and fourth quarter of 2008, the Corporation sold substantially all of PFH’s assets. The sale of assets included the sale of the implied residual interest on the on-balance sheet securitizations transferring all rights and obligations to the third party with no continuing involvement whatsoever of the Corporation with respect to the transferred assets. As such, the Corporation achieved sale accounting with respect to those securitizations and de-recognized the associated loans and the bond certificates which had been measured at fair value pursuant to the SFAS No. 159 election described before.
     At December 31, 2008, there were only $5 million in loans measured at fair value pursuant to SFAS No. 159, with unrealized losses of $37 million. Non-performing loans measured pursuant to SFAS No. 159 which are past due 90 days or more were fair

 


 

19
                                                                                     
 
(Dollars in millions)       (In thousands)
                                                                        Variance
Average Volume   Average Yields / Costs       Interest           Attributable to
2007   2006   Variance   2007   2006   Variance       2007   2006   Variance   Rate   Volume
         
$514
  $ 564       ($50 )     5.17 %     5.56 %     (0.39 %)  
Money market investments
  $ 26,565     $ 31,382       ($4,817 )     ($1,824 )     ($2,993 )
9,827
    11,717       (1,890 )     5.16       5.10       0.06    
Investment securities
    507,047       597,930       (90,883 )     5,106       (95,989 )
653
    491       162       6.19       6.23       (0.04 )  
Trading securities
    40,408       30,593       9,815       (186 )     10,001  
         
10,994
    12,772       (1,778 )     5.22       5.17       0.05           574,020       659,905       (85,885 )     3,096       (88,981 )
         
 
                                          Loans:                                        
14,917
    13,476       1,441       7.72       7.61       0.11    
Commercial and construction
    1,151,602       1,026,153       125,449       12,913       112,536  
1,178
    1,283       (105 )     7.89       7.57       0.32    
Leasing
    92,940       97,166       (4,226 )     3,951       (8,177 )
4,748
    4,726       22       7.32       6.85       0.47    
Mortgage
    347,302       323,557       23,745       22,223       1,522  
4,537
    4,639       (102 )     10.50       10.00       0.50    
Consumer
    476,234       463,861       12,373       10,287       2,086  
         
25,380
    24,124       1,256       8.15       7.92       0.23           2,068,078       1,910,737       157,341       49,374       107,967  
         
$36,374
  $ 36,896       ($522 )     7.26 %     6.97 %     0.29 %  
Total earning assets
  $ 2,642,098     $ 2,570,642     $ 71,456     $ 52,470     $ 18,986  
         
 
                                         
Interest bearing deposits:
                                       
$4,429
  $ 3,878     $ 551       2.60 %     2.06 %     0.54 %  
NOW and money market*
  $ 115,047     $ 79,820     $ 35,227     $ 17,963     $ 17,264  
5,698
    5,440       258       1.96       1.43       0.53    
Savings
    111,877       77,611       34,266       4,485       29,781  
11,399
    9,977       1,422       4.73       4.24       0.49    
Time deposits
    538,869       422,663       116,206       46,060       70,146  
         
21,526
    19,295       2,231       3.56       3.01       0.55           765,793       580,094       185,699       68,508       117,191  
         
8,316
    10,405       (2,089 )     5.11       4.88       0.23    
Short-term borrowings
    424,530       508,174       (83,644 )     22,613       (106,257 )
1,041
    2,093       (1,052 )     5.40       5.36       0.04    
Medium and long-term debt
    56,254       112,240       (55,986 )     829       (56,815 )
         
 
                                         
Total interest bearing
                                       
30,883
    31,793       (910 )     4.04       3.78       0.26    
liabilities
    1,246,577       1,200,508       46,069       91,950       (45,881 )
 
                                         
Non-interest bearing
                                       
4,043
    3,970       73                            
demand deposits
                                       
1,448
    1,133       315                            
Other sources of funds
                                       
         
$36,374
  $ 36,896       ($522 )     3.43 %     3.25 %     0.18 %                                            
         
 
                    3.83 %     3.72 %     0.11 %  
Net interest margin
                                       
 
                       
Net interest income on
                                       
 
                                         
a taxable equivalent basis
    1,395,521       1,370,134       25,387       ($39,480 )   $ 64,867  
 
                    3.22 %     3.19 %     0.03 %  
Net interest spread
                               
 
                       
Taxable equivalent
                                         
 
                                         
adjustment
    89,863       115,403       (25,540 )                
 
                                         
Net interest income
  $ 1,305,658     $ 1,254,731     $ 50,927                  
 
                                         
                                       
valued at $1 million at December 31, 2008, resulting in unrealized losses of approximately $10 million, compared to an unpaid principal balance of $11 million. As of December 31, 2008, there was no debt outstanding measured at fair value.
     During the year ended December 31, 2008, the Corporation recognized $198.9 million in losses attributable to changes in the fair value of loans and notes payable (bond certificates), including net losses attributable to changes in instrument-specific credit spreads. These losses were included in the caption “Loss from discontinued operations, net of tax” in the consolidated statement of operations.
     Upon adoption of SFAS No. 159, the Corporation recognized a negative after-tax adjustment to beginning retained earnings

 


 

20     POPULAR, INC. 2008 ANNUAL REPORT
due to the transitional adjustment for electing the fair value option, as detailed in the following table.
                         
            Cumulative effect    
            adjustment to   January 1, 2008
    January 1, 2008   January 1, 2008   fair value
    (Carrying value)   retained earnings —   (Carrying value
(In thousands)   prior to adoption)   Gain (Loss)   after adoption)
 
Loans
  $ 1,481,297       ($494,180 )   $ 987,117  
 
Notes payable
(bond certificates)
    ($286,611 )   $ 85,625       ($200,986 )
 
Pre-tax cumulative effect of adopting fair value option accounting
            ($408,555 )        
Net increase in deferred tax asset
            146,724          
 
After-tax cumulative effect of adopting fair value option accounting
            ($261,831 )        
 
     The fair value adjustments in the loan portfolios recorded upon adoption of SFAS No. 159 on January 1, 2008 were mainly the result of the following factors:
      The loan portfolio was, in the most part, considered subprime and due to market conditions, considered distressed assets in a very illiquid market.
 
      There was a significant deterioration in the delinquency profile of the second lien closed-end mortgage loan portfolio.
 
      Property values obtained on subprime loans in foreclosure were declining significantly. Since property values did not justify initiating a foreclosure action, the loan in essence behaved as an unsecured loan.
 
      A substantial share of PFH’s closed-end second lien portfolio had combined loan-to-values greater than 90%.
 
      The consumer loans measured at fair value also included home equity lines of credit that although were considered prime based on FICO scores, they had deteriorated. Similar to second lien closed-end loans, the home equity lines of credit (“HELOCs”) were also behaving as an unsecured loan as a result of falling home values.
 
      Certain of the loan portfolios were trading at distressed levels based on the small trading activity available for the products and the expected return by the investors rather than the actual performance and fundamentals of these loans.
     Similar factors and continuing disruptions in the capital markets and credit deterioration contributed to the further decline in value of the loan portfolio during 2008.
Statement Of Operations Analysis
Net Interest Income
Net interest income, the Corporation’s continuing operations primary source of earnings, represented 61% of top line income (defined as net interest income plus non-interest income) for 2008 and 60% for 2007. Several variables may cause the net interest income to fluctuate from period to period, including interest rate volatility, the shape of the yield curve, changes in volume and mix of earning assets and interest bearing liabilities, repricing characteristics of assets and liabilities, and derivative transactions, among others.
     Interest earning assets include investment securities and loans that are exempt from income tax, principally in Puerto Rico. The main sources of tax-exempt interest income are investments in obligations of some U.S. Government agencies and sponsored entities of the Puerto Rico Commonwealth and its agencies, and assets held by the Corporation’s international banking entities, which are tax-exempt under Puerto Rico laws. To facilitate the comparison of all interest data related to these assets, the interest income has been converted to a taxable equivalent basis, using the applicable statutory income tax rates. The marginal tax rate for the Puerto Rico subsidiaries in 2008 and 2007 was 39%, as compared to 43.5% for BPPR and 41.5% for all the other Puerto Rico subsidiaries in 2006. The taxable equivalent computation considers the interest expense disallowance required by the Puerto Rico tax law.
     Average outstanding securities balances are based on amortized cost excluding any unrealized gains or losses on securities available-for-sale. Non-accrual loans have been included in the respective average loans and leases categories. Loan fees collected and costs incurred in the origination of loans are deferred and amortized over the term of the loan as an adjustment to interest yield. Prepayment penalties, late fees collected and the amortization of premiums / discounts on purchased loans are also included as part of the loan yield. Interest income for the year ended December 31, 2008 included a favorable impact of $17.4 million related to these loan fees, primarily in the commercial loans portfolio. In addition, these amounts approximated favorable impacts of $25.3 million and $21.3 million, respectively, for the years ended December 31, 2007 and 2006.
     Table D presents the different components of the Corporation’s net interest income, on a taxable equivalent basis, for the year ended December 31, 2008, as compared with the same period in 2007, segregated by major categories of interest earning assets and interest bearing liabilities.
     The decrease in average earning assets was mainly due to the Corporation’s strategy of not reinvesting maturities of low yielding investments. Increases in both commercial loans and


 

21
consumer loans partially offset the reduction in the investments category. Construction loans accounted for 51% of the increase in the commercial loans category. This increase occurred mainly in the Puerto Rico market as the Corporation continues to make disbursements from prior commitments. The performance of these loans is being closely monitored since the current economic environment will continue to pressure this sector. The increase in the consumer loans category was mainly due to a higher balance of HELOCs and closed-end second mortgages from E-LOAN. The market disruptions that took place in the second half of 2007 forced the Corporation to retain a higher balance of these loans. As part of the E-LOAN Restructuring Plan, the origination of these loans was discontinued. The Corporation’s funding mix was also modified with a portion of borrowings being replaced by brokered certificates of deposit entered into as part of the strategies to address the liquidity crisis of the latter half of 2007.
     The decrease in net interest income was mainly the result of the following factors:
      The Federal Reserve (“FED”) lowered the federal funds target rate from 4.25% at the beginning of 2008 to between 0% and 0.25% at December 31, 2008. The reduction in market rates impacted the yield of several of the Corporation’s earning assets during that period. These assets included commercial and construction loans, of which 67% have floating or adjustable rates, floating rate collateralized mortgage obligations, and HELOCs, as well as the origination of loans in a low interest rate environment. In addition, a higher proportion of closed-end second mortgages from the U.S. mainland operations contributed to the decrease in the yield of consumer loans since these loans carry a lower rate than consumer loans generated in the Puerto Rico market. Furthermore, the increase in non-accruing loans, which is discussed in the Credit Risk and Loan Quality section of this MD&A, had an unfavorable impact in interest income.
 
      Liquidity concerns during the second half of 2007 prompted the Corporation to enter into certain financing agreements which limited the expected benefit of reduced market rates in the overall cost of funds. These include brokered certificates of deposit and certain long-term funding agreements entered into during 2008.
 
      Partially offsetting the negative impacts was a reduction in the cost of both short-term borrowings and interest bearing deposits. These reductions were a combination of lower market rates and management’s initiatives to reduce the cost of certain interest bearing deposits reflecting the prevailing low interest rate environment. The categories impacted by these decreases include the internet deposits generated through E-LOAN.
     The average key index rates for the years 2006 through 2008 were as follows:
                         
    2008   2007   2006
 
Prime rate
    5.08 %     8.05 %     7.96 %
Fed funds rate
    2.08       5.05       4.96  
3-month LIBOR
    2.93       5.30       5.20  
3-month Treasury Bill
    1.45       4.46       4.84  
10-year Treasury
    3.64       4.63       4.79  
FNMA 30-year
    5.79       6.24       6.32  
 
     The Corporation’s taxable equivalent adjustment presented an increase, when compared to 2007, even though the total balance of investments decreased as a result of the previously mentioned strategy of not reinvesting maturities of low yielding assets. This is in part the result of a lower cost of funds during 2008. Puerto Rico tax law requires that an interest expense be assigned to the exempt interest income in order to calculate a net benefit. The interest expense is determined by applying the ratio of exempt assets to total assets to the Corporation’s total interest expense in Puerto Rico. To the extent that the cost of funds decreases at a faster pace than the yield of earning assets, the net benefit will increase.
     Although the Corporation showed improvement in its net interest margin in 2007, when compared to 2006, the year 2007 presented various challenges such as the liquidity crisis, internet-based deposits with higher interest rates and the competitive pressures in the deposits and loan markets. As shown in Table D, the increase in the net interest margin from continued operations for the year ended December 31, 2007, compared with the previous year, was mainly attributed to a change in the funding mix between total borrowings and interest bearing deposits. In addition, the increase in the loan portfolio partially offset the decrease experienced in the investments category. The rate differential between loans and investments contributed to reduce the effect of a higher cost of interest bearing deposits. The increase in the cost of interest bearing deposits was mainly the result of a higher proportion of internet-based deposits raised through the E-LOAN platform and higher rates for money markets and time deposits. The decrease in the taxable equivalent adjustment for 2007, as compared to 2006, was the result of a lower income tax rate in Puerto Rico in 2007, thus reducing the benefit calculated on exempt assets.
     Average tax-exempt earning assets approximated $7.9 billion in 2008, of which 80% represented tax-exempt investment securities, compared with $8.9 billion and 83% in 2007, and $9.7 billion and 87% in 2006.


 

22     POPULAR, INC. 2008 ANNUAL REPORT
Table E
Non-Interest Income
                                         
    Year ended December 31,
(In thousands)   2008   2007   2006   2005   2004
 
Service charges on deposit accounts
  $ 206,957     $ 196,072     $ 190,079     $ 181,749     $ 165,241  
 
Other service fees:
                                       
Debit card fees
    108,274       76,573       61,643       52,675       51,256  
Credit card fees and discounts
    107,713       102,176       89,827       82,062       69,702  
Processing fees
    51,731       47,476       44,050       42,773       40,169  
Insurance fees
    50,417       53,097       52,045       49,021       36,679  
Sale and administration of investment products
    34,373       30,453       27,873       28,419       22,386  
Mortgage servicing fees, net of amortization and fair value adjustments
    25,987       17,981       5,215       4,115       5,848  
Trust fees
    12,099       11,157       9,316       8,290       8,872  
Check cashing fees
    512       387       737       17,122       21,680  
Other fees
    25,057       26,311       27,153       33,857       30,596  
 
Total other service fees
    416,163       365,611       317,859       318,334       287,188  
 
Net gain on sale and valuation adjustments of investment securities
    69,716       100,869       22,120       66,512       15,254  
Trading account profit (loss)
    43,645       37,197       36,258       30,051       (159 )
Gain on sale of loans and valuation adjustments on loans held-for-sale
    6,018       60,046       76,337       37,342       30,097  
Other operating income
    87,475       113,900       127,856       98,624       87,516  
 
Total non-interest income
  $ 829,974     $ 873,695     $ 770,509     $ 732,612     $ 585,137  
 
Provision for Loan Losses
The provision for loan losses in the continuing operations totaled $991.4 million, or 165% of net charge-offs, for the year ended December 31, 2008, compared with $341.2 million or 136%, respectively, for 2007, and $187.6 million or 122%, respectively, for 2006.
     The provision for loan losses for the year ended December 31, 2008, when compared with the previous year, reflects higher net charge-offs by $349.3 million mainly in construction loans by $122.0 million, consumer loans by $93.4 million, commercial loans by $92.7 million, and mortgage loans by $37.4 million. During the year ended December 31, 2008, the Corporation recorded $316.5 million in provision for loan losses for loans classified as impaired under SFAS No. 114. Provision and net charge-offs information for prior periods was retrospectively adjusted to exclude discontinued operations from continuing operations for comparative purposes.
     General economic pressures, housing value declines, a slowdown in consumer spending and the turmoil in the global financial markets impacted the Corporation’s commercial and construction loan portfolios, increasing charge-offs, non-performing assets and loans judgmentally classified as impaired. The stress consumers experienced from depreciating home prices, rising unemployment and tighter credit conditions resulted in higher levels of delinquencies and losses in the Corporation’s mortgage and consumer loan portfolios. During 2008, the Corporation increased the allowance for loan losses across all loan portfolios.
     The increase in the provision for loan losses for the year ended December 31, 2007 when compared to the previous year was mainly attributed to higher net charge-offs by $97.3 million mainly in the consumer, commercial and mortgage loan portfolios, which reflect higher delinquencies in the U.S. mainland and Puerto Rico principally due to the downturn in the economy. Also, the increase reflected probable losses inherent in the loan portfolio, as a result of deteriorated economic conditions and market trends primarily in the commercial and consumer loan sectors, which include home equity lines and second lien mortgage loans.


 

23

     Refer to the Credit Risk Management and Loan Quality section for a detailed analysis of non-performing assets, allowance for loan losses and selected loan losses statistics. Also, refer to Table G and Note 9 to the consolidated financial statements for the composition of the loan portfolio.
Non-Interest Income
Refer to Table E for a breakdown on non-interest income from continuing operations by major categories for the past five years. Non-interest income accounted for 39% of total revenues in 2008, while it represented 40% of total revenues in the year 2007 and 38% in 2006.
     Non-interest income for the year ended December 31, 2008, compared with the previous year, was mostly impacted by:
    Lower gain on sales of loans and unfavorable valuation adjustments on loans held-for-sale, which are broken down as follows:
                         
    Year ended December 31,
(In thousands)   2008   2007   $ Variance
 
Gain on sale of loans
  $ 24,961     $ 66,058       ($41,097 )
Lower of cost or fair value value adjustment on loans held-for-sale
    (18,943 )     (6,012 )     (12,931 )
 
Total
  $ 6,018     $ 60,046       ($54,028 )
 
     The decrease in this income statement category for the year ended December 31, 2008, when compared to 2007, was primarily related to E-LOAN, which experienced a reduction of $48.7 million. The reduction in the gain on sales of loans at E-LOAN was associated with lower origination volumes and lower yields due to the weakness in the U.S. mainland mortgage and housing market and to the exiting of the loan origination business at this subsidiary. Early in 2008, E-LOAN had ceased originating home equity lines of credit, closed-end second lien mortgage loans and auto loans. In late 2008, E-LOAN also ceased originating first-lien mortgage loans. The reduction caused by E-LOAN was partially offset by higher gains in the sale of lease financings by the Corporation’s U.S. banking subsidiary of approximately $5.4 million. The increase in lower of cost or fair value adjustments were mostly related to a lease financing portfolio fair valued at $328 million that was reclassified from held-in-portfolio to held-for-sale during December 2008, and which management plans to sell in 2009.
    Lower net gain on sale and valuation adjustments of investment securities, which consisted of the following:
                         
    Year ended December 31,
(In thousands)   2008   2007   $ Variance
 
Net gain on sale of investment securities
  $ 78,863     $ 120,328       ($41,465 )
Other-than-temporary valuation adjustments on investment securities available-for-sale
    (9,147 )     (19,459 )     10,312  
 
Total
  $ 69,716     $ 100,869       ($31,153 )
 
     The decrease in the net gain on sale of investment securities for the year ended December 31, 2008, compared with the same period in 2007, was mostly related to $118.7 million in realized gains on the sale of the Corporation’s interest in Telecomunicaciones de Puerto Rico, Inc. (“TELPRI”) during the first quarter of 2007. This was partially offset by $49.3 million in realized gains due to the redemption by Visa of shares of common stock held by the Corporation during the first quarter of 2008 and by $28.3 million in capital gains from the sale of $2.4 billion in U.S. agency securities during the second quarter of 2008 as a strategy to reduce the portfolio’s vulnerability to declining interest rates.
     The other-than-temporary valuation adjustments on investment securities available-for-sale recorded during 2008 and 2007 were principally related to equity investments in U.S. financial institutions.
  There was a decrease in other operating income by $26.4 million mostly associated with the Corporation’s Corporate group which recorded lower revenues from investments accounted under the equity method, as well higher other-than-temporary impairments on certain of these investments. The other-than-temporary impairment amounted to $26.9 million in 2008 and was principally associated with private funds. There were also lower revenues from escrow closing services by E-LOAN due to the exiting of the loan origination business, as well as lower referral income. This was partially offset by higher gains on the sale of real estate properties by $13.7 million mainly in the U.S. banking subsidiary, as well as the gain of $12.8 million recorded in January 2008 related to the sale of BPNA’s retail bank branches located in Texas.
     These unfavorable variances in non-interest income were partially offset by:
  Higher other service fees by $50.6 million mostly related to higher debit card fees as a result of higher revenues from merchants due to a change in the pricing structure for transactions processed from a fixed charge per transaction


 

24     POPULAR, INC. 2008 ANNUAL REPORT

                                         
Table F                                        
Operating Expenses                                        
Year ended December 31,
(Dollars in thousands)   2008   2007   2006   2005   2004
 
Salaries
  $ 485,720     $ 485,178     $ 458,977     $ 417,060     $ 380,216  
Pension, profit sharing and other benefits
    122,745       135,582       132,998       129,526       125,375  
 
Total personnel costs
    608,465       620,760       591,975       546,586       505,591  
 
Net occupancy expenses
    120,456       109,344       99,599       96,929       80,073  
Equipment expenses
    111,478       117,082       120,445       112,167       100,567  
Other taxes
    52,799       48,489       43,313       37,811       39,021  
Professional fees
    121,145       119,523       117,502       98,015       77,343  
Communications
    51,386       58,092       56,932       52,904       51,346  
Business promotion
    62,731       109,909       118,682       92,173       68,553  
Printing and supplies
    14,450       15,603       15,040       15,545       15,771  
Impairment losses on long-lived assets
    13,491       10,478                    
Other operating expenses:
                                       
Credit card processing, volume and interchange expenses
    43,326       39,811       30,141       28,113       25,654  
Transportation and travel
    12,751       14,239       13,600       14,925       11,677  
FDIC assessments
    15,037       2,858       2,843       3,026       2,747  
OREO expenses
    12,158       2,905       994       162       (307 )
All other*
    73,066       54,174       55,144       56,263       42,672  
Goodwill and trademark impairment losses
    12,480       211,750                    
Amortization of intangibles
    11,509       10,445       12,021       9,549       7,844  
 
Subtotal
    728,263       924,702       686,256       617,582       522,961  
 
Total
  $ 1,336,728     $ 1,545,462     $ 1,278,231     $ 1,164,168     $ 1,028,552  
 
Personnel costs to average assets
    1.54 %     1.57 %     1.49 %     1.45 %     1.58 %
Operating expenses to average assets
    3.39       3.92       3.21       3.08       3.21  
Employees (full-time equivalent)
    10,387       11,374       11,025       11,330       10,557  
Average assets per employee (in millions)
  $ 3.80     $ 3.47     $ 3.62     $ 3.33     $ 3.03  
 
*
 
  Includes insurance expenses and sundry losses, among others.
 
to a variable rate based on the amount of the transaction, as well as higher surcharging income from the use of Popular’s automated teller machine network. There were also higher mortgage servicing fees due to an increase in the portfolio of serviced loans. Refer to Note 22 to the consolidated financial statements for information on the Corporation’s servicing assets and serviced portfolio.
  Higher service charges on deposits by $10.9 million primarily in BPPR due to higher account analysis fees in commercial accounts which are impacted by transaction volume, compensating deposit balances and earnings credit given to the customer depending on the interest rates.
     For the year ended December 31, 2007, non-interest income from continuing operations increased by $103.2 million, or 13%, when compared with 2006. There were higher net gains on sale of investment securities mainly as a result of $118.7 million in gains from the sale of the Corporation’s interest in TELPRI during the first quarter of 2007, compared principally to $13.6 million in gains from the sale of marketable equity securities and FNMA securities in 2006. This favorable variance on securities available-for-sale was partially offset by $19.5 million in other-than-temporary impairments in certain equity securities during 2007. Additionally, there were higher other service fees by $47.8 million primarily as a result of higher debit card fees mostly due to the change in the automatic teller machines’ interchange fees from a fixed rate to a variable rate as well as higher transactional volume, and to higher surcharge revenues from non-BPPR users of the ATM terminals. Also included in other service fees were higher credit card fees due to higher merchant fees resulting from higher volume of purchases and late payment fees due to greater volume of credit card accounts billed at a higher average rate pursuant to a change in contract terms. There was also an increase in mortgage


 

25

servicing fees related to higher servicing fees due to the growth in the portfolio of loans serviced for others and to the adoption of SFAS No. 156, in which the Corporation elected fair value measurement and, as a result, the residential mortgage servicing rights were positively adjusted to fair value. Other operating income for 2007 decreased when compared to 2006 due to lower gains on the sale of real estate properties by $12.2 million mainly in the U.S. banking subsidiary. Also, there were lower gains on sales of loans as a result of lower origination volume at E-LOAN due to market conditions and the lack of liquidity in the private secondary markets and lower gains on sale of Small Business Administration (“SBA”) loans by the Corporation’s U.S. banking subsidiary. This decrease in gains on sale of loans was partially offset by the fact that during 2006, BPPR realized a $20.1 million loss on the bulk sale of mortgage loans, and there were no similar losses during 2007.
Operating Expenses
Refer to Table F for the detail of operating expenses by major categories along with various related ratios for the last five years. Operating expenses from continuing operations totaled $1.3 billion for the year ended December 31, 2008, a decrease of $208.7 million, or 14%, compared with the same period in 2007. The operating expenses for 2007 and 2008 were impacted by numerous restructuring charges and impairment losses. To facilitate the comparative analysis, below are details on the restructuring plans executed by the Corporation during 2008 and 2007 that pertained to the continuing operations. Additional restructuring plans were implemented by the Corporation in those years, but the corresponding disclosures are included in the Discontinued Operations section of this MD&A.
                                 
            For the year ended           For the year ended
      December 31, 2008     December 31, 2007
            E-LOAN   E-LOAN   E-LOAN
    BPNA   2008   2007   2007
    Restructuring   Restructuring   Restructuring   Restructuring
(In millions)   Plan   Plan   Plan   Plan
 
Personnel costs
  $ 5.3     $ 3.0       ($0.3 )   $ 4.6  
Net occupancy expenses
    8.9             0.1       4.2  
Equipment expenses
                      0.4  
Professional fees
                      0.4  
Other operating expenses
          0.1              
 
Total restructuring charges
  $ 14.2     $ 3.1       ($0.2 )   $ 9.6  
Impairment losses on long-lived assets
    5.5       8.0             10.5  
Goodwill and trademark impairment losses
          10.9             211.8  
 
Total
  $ 19.7     $ 22.0       ($0.2 )   $ 231.9  
 
     The accelerated downturn of the U.S. economy requires a leaner, more efficient U.S. business model. As such, the Corporation determined to reduce the size of its banking operations in the U.S. mainland to a level better suited to present economic conditions and focus on core banking activities. On October 17, 2008, the Board of Directors of Popular, Inc. approved two restructuring plans for the BPNA reportable segment. The objective of the restructuring plans is to improve profitability in the short term, increase liquidity and lower credit costs and, over time, achieve a greater integration with corporate functions in Puerto Rico.
BPNA Restructuring Plan
The BPNA Restructuring Plan consists mainly of a number of initiatives grouped into three work streams: (1) branch network actions, (2) balance sheet initiatives, and (3) general expense reductions.
     As part of the branch network actions, management expects that approximately 40 underperforming branches, out of a total of 139, will be sold, closed, or consolidated in 2009. These branches were selected based on the fact that they rank lowest within BPNA’s network in both current profitability and potential for growth. Branch actions are distributed across all regions, including California, New Jersey, New York, Florida, Illinois and Texas. The Corporation will close or consolidate those branches for which it is unable to reach an agreement with a potential buyer. The branches that were identified for divesture held approximately $720 million in deposits at December 31, 2008. BPNA’s deposits totaled $9.7 billion as of such date.
     The balance sheet initiatives aim to significantly downsize or exit asset-generating businesses that are not relationship-based and / or whose profitability is being severely impacted by the current credit and economic conditions. As part of this initiative, the Corporation exited certain businesses including, among the principal ones, those related to the origination of non-conventional mortgages, equipment lease financing, business loans to professionals, multifamily lending, mixed-used commercial loans and credit cards. These business lines held a loan portfolio of approximately $2.1 billion at December 31, 2008. At December 31, 2008, BPNA had already stopped originating loans in these portfolios. The Corporation holds the existing portfolios of the exited businesses in a runoff mode. The existing equipment lease financing portfolio was primarily held-for-sale at December 31, 2008 and a significant portion was sold in February 2009. Also, the BPNA Restructuring Plan contemplated downsizing the following businesses: business banking, SBA lending, and consumer / mortgage lending. These latter efforts were also completed. The downsizing in SBA lending contemplates a


 

26     POPULAR, INC. 2008 ANNUAL REPORT
migration from a nation-wide and broker-based business model to a significant smaller regional and branch-based model.
     The general expense reduction initiative looks to capture cost savings in the support functions directly related with the reductions in the branch network and lending businesses, as well as identifying additional opportunities to cut discretionary expenses such as professional fees, traveling and others. The BPNA Restructuring Plan also contemplates greater integration with corporate functions in Puerto Rico.
     All restructuring efforts at BPNA are expected to result in approximately $50 million in recurrent annual cost savings. The majority of the savings are related to personnel costs since the restructuring plan incorporates a headcount reduction of approximately 640 full-time equivalent employees (“FTEs”), or 30% of BPNA’s workforce. Management expects the headcount reduction to be achieved by the third quarter of 2009.
     At December 31, 2008, the accrual for restructuring costs associated with the BPNA Restructuring Plan amounted to $10.9 million. During 2008, restructuring charges and impairment losses associated to the BPNA Restructuring Plan amounted to $19.7 million. An additional $12.9 million in associated costs are expected to be incurred in 2009. FTEs at BPNA, excluding E-LOAN, were 1,831 at December 31, 2008, compared to 2,157 at the same date in the previous year.
E-LOAN 2007 and 2008 Restructuring Plan
As indicated in the 2007 Annual Report, in November 2007, the Corporation approved an initial restructuring plan for E-LOAN (the “E-LOAN 2007 Restructuring Plan”). This plan included a substantial reduction of marketing and personnel costs at E-LOAN and changes in E-LOAN’s business model. At that time, the changes included concentrating marketing investment toward the Internet and the origination of first mortgage loans that qualify for sale to government sponsored entities (“GSEs”). Also, as a result of escalating credit costs and lower liquidity in the secondary markets for mortgage related products, in the fourth quarter of 2007, the Corporation determined to hold back the origination by E-LOAN of home equity lines of credit, closed-end second lien mortgage loans and auto loans.
     The Corporation does not expect to incur additional restructuring charges related to the 2007 E-LOAN Restructuring Plan. At December 31, 2008, the accrual for restructuring costs associated with the E-LOAN 2007 Restructuring Plan amounted to $2.2 million. This reserve was related principally to lease terminations.
     These efforts implemented during early 2008 proved not to be sufficient given the unprecendented market conditions and disappointing financial results. As previously explained, the Corporation’s Board of Directors approved in October 2008 a new restructuring plan for E-LOAN (the “E-LOAN 2008 Restructuring Plan”). This plan involved E-LOAN ceasing to operate as a direct lender, an event that occurred in late 2008. E-LOAN will continue to market deposit accounts under its name for the benefit of BPNA and offer loan customers the option of being referred to a trusted consumer lending partner. As part of the 2008 plan, all operational and support functions will be transferred to BPNA and EVERTEC. Total annualized savings are expected to reach $37 million. It is anticipated that the E-LOAN 2008 Restructuring Plan will result in estimated combined charges, including restructuring costs and impairment losses, of approximately $24 million between 2008 and 2009. At December 31, 2008, the accrual for restructuring costs associated with the E-LOAN 2008 Restructuring Plan amounted to $3.0 million.
     At December 31, 2008, E-LOAN’s workforce totaled 270 FTEs, compared to 767 FTEs at December 31, 2007. Management expects the headcount reduction to be completed by the third quarter of 2009.
     Refer to Note 35 to the consolidated financial statements for further information on the results of operations of E-LOAN, which are part of BPNA’s reportable segment. At December 31, 2008, E-LOAN’s assets consisted primarily of a running-off portfolio of loans held-for-investment totaling $801 million with an allowance for loan losses of $76 million. This loan portfolio consisted primarily of $76 million in mortgage loans and $725 million in consumer loans, including approximately $457 million in home equity lines of credit. Also, E-LOAN had $6 million in loans classified as held-for-sale, which consisted primarily of first lien mortgage loans originated during 2008. The ratio of allowance for loan losses to loans for E-LOAN approximated 9.49% at December 31, 2008. The assets of E-LOAN are funded primarily through intercompany long-term borrowings. Deposits originated through E-LOAN’s internet platform for the benefit of BPNA approximated $1.5 billion at December 31, 2008.

 


 

27
Operating expenses, isolating restructuring charges and related impairments
Isolating the impact of these restructuring related costs described above, operating expenses totaled $1.3 billion for the year ended December 31, 2008 and 2007. The increases (decreases) by operating expense category, isolating the restructuring related charges, were as follows:
                         
    Operating Expenses
    2008, excluding   2007, excluding    
    charges related to   charges related to    
    restructuring   restructuring    
(In millions)   plans   plans   Variance
 
Personnel costs
  $ 600.5     $ 616.2       ($15.7 )
Net occupancy expenses
    111.5       105.1       6.4  
Equipment expenses
    111.5       116.7       (5.2 )
Other taxes
    52.8       48.5       4.3  
Professional fees
    121.1       119.5       1.6  
Communications
    51.4       57.7       (6.3 )
Business promotion
    62.7       109.9       (47.2 )
Printing and supplies
    14.5       15.6       (1.1 )
Other operating expenses
    156.2       114.0       42.2  
Goodwill and trademark impairment losses
    1.6             1.6  
Amortization of intangibles
    11.5       10.4       1.1  
 
Total
  $ 1,295.3     $ 1,313.6       ($18.3 )
 
     The decrease was principally due to lower business promotion expenses and personnel costs, including the impact of the downsizing of E-LOAN’s operations in early 2008 that contributed to a reduction in headcount, and lower compensation tied to financial performance.
     The decrease in personnel costs for 2008, compared to 2007, was principally due to lower headcount, principally at E-LOAN, due to a reduction in FTEs in early 2008 because of the downsizing associated to the E-LOAN 2007 Restructuring Plan. Also, the additional layoffs at E-LOAN and BPNA in the fourth quarter of 2008 contributed to the reduction in personnel costs. Furthermore, given the net loss for the year and not attaining performance measures required under certain employee benefit plans, there was lower compensation tied to financial performance, including incentives and profit sharing during 2008. These reductions were principally offset by lower deferred costs in 2008 given the reduction in loan originations. Also, these reductions were partially offset by the impact of the integration to BPPR of the employees from the retail branches of Citibank — Puerto Rico, an acquisition done in December 2007. Also, there were higher severance payments related to key executive officers and pension costs.
     Excluding PFH, the Corporation’s FTEs were 10,387 as of December 31, 2008, compared with 11,374 at December 31, 2007. The BPNA reportable segment contributed with a decrease of 823 FTEs.
     The decrease in business promotion for 2008, compared to 2007, was principally related to the BPNA reportable segment by $35.1 million, including $31.0 million of E-LOAN principally related to the downsizing of the operations. The BPPR reportable segment contributed with a reduction in business promotion of $10.9 million, which was the result of cost control initiatives.
     The increase in other operating expenses was mainly attributed to higher FDIC insurance assessments mainly in BPPR and BPNA by $12.2 million and higher other real estate expenses by $9.3 million. The latter was mainly due to losses on the sale, or write downs in the collateral value of repossessed real estate properties, as well as higher foreclosure costs in the U.S. mainland operations. Also, the increase in other operating expenses was due to the recording of $15.5 million in reserves for unfunded loan commitments during 2008, primarily related to commercial and consumer lines of credit. In addition, there were higher credit card interchange and processing costs and higher sundry losses.
     For the year ended December 31, 2007, operating expenses from continuing operations increased by $267.2 million, or 21%, compared with the same period in 2006. As indicated earlier, 2007 was impacted by $231.9 million in charges related to the E-LOAN 2007 Restructuring Plan. Isolating the impact of the restructuring related costs, operating expenses totaled $1.3 billion for the year ended December 31, 2007, representing an increase of only $35.4 million, or 3%, when compared to same period in 2006.
     The increases in personnel costs from 2006 to 2007 were principally the result of merit increases across the Corporation’s subsidiaries, increased headcount, higher commissions on certain businesses, medical insurance costs and savings plan expenses, among other factors, coupled with lower cost deferrals due to a lower volume of loan originations. Net occupancy expenses increased mainly as a result of additional leased locations, tax escalations, and new leases on leased back properties in the U.S. banking subsidiary. Other taxes increased as a result of higher municipal license taxes, personal property taxes, examination banking fees and the new sales tax implemented in Puerto Rico during the later part of 2006. There were also increased other operating expenses due to higher credit card processing and interchange costs primarily due to higher credit card processing and interchange expenses. Also, the results for 2007 included the impairment losses related to E-LOAN’s goodwill, trademark and long-lived assets. Partially offsetting these increases were decreases in business promotion as a result of cost control measures on

 


 

28     POPULAR, INC. 2008 ANNUAL REPORT
marketing expenditures on the U.S. mainland operations, primarily at E-LOAN, partially offset by higher costs related to the loyalty reward program in the Puerto Rico operations.
Income Taxes
Income tax expense from continuing operations amounted to $461.5 million for the year December 31, 2008, compared with $90.2 million for previous year. During the year ended December 31, 2008, the Corporation recorded a valuation allowance on deferred tax assets of its U.S. mainland operations of $861 million. The recording of this valuation increased income tax expense by $643.0 million on the continuing operations and $209.0 million on the discontinued operations for the year ended December 31, 2008. The income tax impact of the discontinued operations is reflected as part of “Net loss from discontinued operations, net of tax” in the consolidated statement of income as of December 31, 2008. The deferred tax assets and full valuation allowance pertains to the continuing operations for statement of condition purposes.
     The increase in income tax expense for 2008, when compared to 2007, was primarily due to the impact on the recording of the valuation allowance previously indicated, partially offset by pre-tax losses in 2008, when compared to pre-tax earnings in the previous year. The components of the income tax expense for the continuing operations for the year ended December 31, 2008 and 2007 were as follows:
                                 
    2008   2007
            % of pre-tax           % of pre-tax
(In thousands)   Amount   loss   Amount   loss
 
Computed income tax at statutory rates
    ($85,384 )     39 %   $ 114,142       39 %
Benefits of net tax exempt interest income
    (62,600 )     29       (60,304 )     (21 )
Effect of income subject to preferential tax rate
    (17,905 )     8       (24,555 )     (9 )
Non-deductible goodwill impairment
                57,544       20  
Difference in tax rates due to multiple jurisdictions
    16,398       (8 )     10,391       4  
Deferred tax valuation allowance
    643,011       (294         
State taxes and others
    (31,986 )     15       (7,054 )     (2 )
 
Income tax expense
  $ 461,534       (211 %)   $ 90,164       31 %
 
     Income tax expense for the continuing operations for the year ended December 31, 2007 was $90.2 million, compared with an income tax expense of $139.7 million for 2006. This variance was primarily due to lower pre-tax earnings, a reduction in the income tax expense in the Puerto Rico operations due to a reduction in the statutory tax rate for Puerto Rico corporations as described in the Net Interest Income section of this MD&A and higher income subject to a preferential tax rate on capital gains in Puerto Rico when compared to 2006. This was partially offset by the fact that goodwill impairment losses taken in 2007 were non-deductible for taxes.
     The Corporation’s net deferred tax assets at December 31, 2008 amounted to $357 million (net of the valuation allowance of $861 million) compared to $520 million at December 31, 2007. Note 28 to the consolidated financial statements provides the composition of the net deferred tax assets as of such dates. All of the net deferred tax assets at December 31, 2008 pertain to the Puerto Rico operations and only carry a valuation allowance of $39 thousand. Of the amount related to the U.S. operations, without considering the valuation allowance, $666 million is attributable to net operating losses of such operations.
     This full valuation allowance in the Corporation’s U.S. operations was recorded in consideration of the requirements of SFAS No.109. Refer to the Critical Accounting Policies / Estimates section of this MD&A for information on the requirements of SFAS No. 109. As previously indicated, the Corporation’s U.S. mainland operations are in a cumulative loss position for the three-year period ended December 31, 2008. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position, along with the evaluation of all sources of taxable income available to realize the deferred tax asset, has caused management to conclude that the Corporation will not be able to fully realize the deferred tax assets in the future, considering solely the criteria of SFAS No. 109.
     At September 30, 2008, the Corporation’s U.S. mainland operations’ deferred tax assets amounted to $683 million with a valuation allowance of $360 million. At that time, the Corporation assessed the realization of the deferred tax assets by weighting all available negative and positive evidence, including future profitability, taxable income on carryback years and tax planning strategies. The Corporation’s U.S. mainland operations were also in a cumulative loss position for the three-year period ended September 30, 2008. For purposes of assessing the realization of the deferred tax assets in the U.S. mainland, this cumulative taxable loss position was considered significant negative evidence and caused management to conclude that at September 30, 2008, the Corporation would not be able to fully realize the deferred tax assets in the future. However, at that time, management also concluded that $322 million of the U.S. deferred tax assets would be realized. In making this analysis, management evaluated the factors that contributed to these losses in order to assess whether these factors were temporary or indicative of a permanent decline in the earnings of the U.S. mainland operations. Based on the analysis performed, management determined that the cumulative loss position was caused primarily by a significant increase in credit losses in two of its main businesses due to the unprecedented current credit market conditions, losses related to the PFH discontinued business, and restructuring charges. In assessing the realization of the deferred tax assets, management considered

 


 

29
all four sources of taxable income mentioned in SFAS No. 109 and described in the Critical Accounting Policies / Estimates section of this MD&A, including its forecast of future taxable income, which included assumptions about the unprecedented deterioration in the economy and in credit quality. The forecast included cost reductions initiated in connection with the reorganization of the U.S. mainland operations, future earnings projections for BPNA and two tax-planning strategies. The two strategies considered in management’s analysis at September 30, 2008 included reducing the level of interest expense in the U.S. operations by transferring such debt to the Puerto Rico operations and the transfer of a profitable line of business from the Puerto Rico operations to the U.S. mainland operations. Also, management’s analyses considered the past earnings history of BPNA and the discontinuance of one of the subsidiaries causing significant operating losses. Furthermore, management considered the long carryforward period for use of the net operating losses, which extends up to 20 years. At September 30, 2008, management concluded that it was more likely than not that the Corporation would not be able to fully realize the benefit of these deferred tax assets and thus, a valuation allowance for $360 million was recorded during that period, which was supported by specific computations based on factors such as financial projections and expected benefits derived from tax planning strategies as described above.
     As indicated in the Critical Accounting Policies / Estimates section of this MD&A, the valuation of deferred tax assets requires judgment based on the weight of all available evidence. Certain events transpired in the fourth quarter of 2008 that led management to reassess its expectations of the realization of the deferred tax assets of the U.S. mainland operations and to conclude that a full valuation allowance was necessary. These circumstances included a significant increase in the provision for loan losses for the PNA operations. The provision for loans losses for PNA consolidated amounted to $208.9 million for the fourth quarter of 2008, compared with $133.8 million for the third quarter of 2008. Actual loan net charge-offs were $105.7 million for the fourth quarter of 2008, compared with $70.2 million in the third quarter. This sharp increase has triggered an increase in the estimated provision for loan losses for 2009. Management had also considered during the third quarter further actions expected from the U.S. Government with respect to the acquisition of troubled assets under the TARP, that did not materialize in the fourth quarter of 2008.
      Additional uncertainty in an expected rebound in the economy and banking industry, based on most recent economic outlooks, forced management to place no reliance on forecasted income. A tax strategy considered in the September 30, 2008 analysis included the transfer of borrowings from PNA holding company to the Puerto Rico operations, particularly the parent holding company Popular, Inc. This tax planning strategy continues to be prudent and feasible but its benefit has been reduced after the credit rating agencies downgraded Popular, Inc.’s debt, which was expected to occur since the end of 2008 and was confirmed in January 2009. The rating downgrade would increase the cost of making any debt transfer and, accordingly, reduce the benefit of such action. The other tax strategy was the transfer of a profitable line of business from BPPR to BPNA. Although that strategy is still feasible, given the reduced profitability levels in the BPPR operations, which were reduced in the fourth quarter due to significant increased credit losses, management is less certain as to whether it is prudent to transfer a profitable business to the U.S. operations at this time.
     Management will reassess the realization of the deferred tax assets based on the criteria of SFAS No. 109 each reporting period. To the extent that the financial results of the U.S. operations improve and the deferred tax asset becomes realizable, the Corporation will be able to reduce the valuation allowance through earnings.
     Refer to Note 28 to the consolidated financial statements for additional information on income taxes.
Fourth Quarter Results
The Corporation reported a net loss of $702.9 million for the quarter ended December 31, 2008, compared with a net loss of $294.1 million for the same quarter of 2007. The Corporation’s continuing operations reported a net loss of $627.7 million for the quarter ended December 31, 2008, compared with a net loss of $150.5 million for the same quarter of 2007.
     Net interest income in the continuing operations for the fourth quarter of 2008 was $288.9 million, compared with $337.3 million for the fourth quarter of 2007. The decrease was due to a decline of $1.3 billion in average earning assets, together with a reduction of 39 basis points in the net interest margin. The decline in average earning assets was due mostly to the runoff of investment securities as part of a strategy of delevering the balance sheet. The reduction in the average balance of investment securities was used to repay short-term borrowings, including repurchase agreements and other short-term borrowings. In the loan portfolio, an increase in average commercial loans outstanding was offset in part by declines in mortgage and auto loans. The decline in the net interest yield was driven by a reduction in the yield of earning assets. This was caused primarily by the decline in the yield of commercial loans, which have a significant amount of floating rate loans whose yield decreased as the FED cut the funds rate in 2008. The FED lowered the federal funds target rate between 400 and 425 basis points from December 31, 2007 to December 31, 2008. Also contributing to the reduction in the yield of commercial loans was the substantial increase in non-performing loans as

 


 

30  POPULAR, INC. 2008 ANNUAL REPORT
described in the Credit Risk Management and Loan Quality section in this MD&A. The Corporation’s average cost of funds decreased driven by a reduction in the cost of deposits and short-term borrowings. Offsetting partially the decline in the cost of deposits and short-term borrowings was an increase in the cost of long-term borrowings. During 2008, certain medium-term notes, which had been issued in previous years at relatively low rates, matured and some were replaced with more expensive term funds whose cost reflects the current distressed conditions of the credit markets. Also contributing to the reduction in the net interest yield was the net loss for the year, which reduced available funds obtained through capital.
     The provision for loan losses in the continuing operations totaled $388.8 million, or 174% of net charge-offs, for the quarter ended December 31, 2008, compared with $121.7 million or 157%, respectively, for the same quarter in 2007, and $252.2 million, or 148%, respectively, for the quarter ended September 30, 2008. The provision for loan losses for the quarter ended December 31, 2008, when compared with the same quarter in 2007, reflects higher net charge-offs by $146.2 million, mainly in construction loans by $63.0 million, consumer loans by $28.8 million, commercial loans by $37.0 million, and mortgage loans by $15.1 million. Provision and net charge-offs information for prior periods was retrospectively adjusted to exclude discontinued operations for comparative purposes. The higher level of provision for the quarter ended December 31, 2008 was mainly attributable to the continuing deterioration in the commercial and construction loan portfolios due to current economic conditions in Puerto Rico and the U.S. mainland. The allowance for loan losses for commercial and construction credits has increased, particularly the specific reserves for loans considered impaired. Also, deteriorating economic conditions in the U.S. mainland housing market have impacted the delinquency rates of the residential mortgage portfolios. In addition, the Corporation has recorded a higher provision for loan losses in the fourth quarter of 2008 to cover for inherent losses in the mortgage portfolio of the Corporation’s U.S. mainland operations as a result of higher delinquencies and net charge-offs, and consideration of troubled debt restructurings in the mortgage portfolio, principally from the non-conventional business of BPNA. Furthermore, consumer loans net charge-offs rose principally due to higher losses on home equity lines of credit and second lien mortgage loans of the Corporation’s U.S. mainland operations, which are categorized by the Corporation as consumer loans. The deterioration in the delinquency profile and the declines in property values have negatively impacted charge-offs.
     Non-interest income from continuing operations totaled $141.5 million for the quarter ended December 31, 2008, compared with $190.6 million for the same quarter in 2007. The unfavorable variance in non-interest income was principally the result of an increase in lower of cost or fair value adjustments in loans reclassified to held-for-sale, primarily related to a lease portfolio from the U.S. mainland operations, lower gains on the sale of SBA commercial loans due to lower volume sold, and higher impairments on investments accounted under the equity method.
     Operating expenses for the continuing operations totaled $360.2 million for the quarter ended December 31, 2008, a decrease of $211.9 million, or 37%, compared with $572.1 million for the same quarter of 2007. As indicated earlier, E-LOAN and BPNA commenced further restructuring of its operations during the fourth quarter of 2008. For the quarter ended December 31, 2008, operating expenses for the continuing operations included approximately $42.8 million in costs associated with the restructuring plans in place at the subsidiaries, including impairments on E-LOAN’s trademark and other long-lived assets, compared to approximately $231.9 million in 2007, which also included impairment losses associated to E-LOAN’s goodwill. Isolating the impact of these restructuring related costs, operating expenses totaled $317.4 million for the quarter ended December 31, 2008, compared to $340.2 million for the quarter ended December 31, 2007. The decrease was principally due to lower business promotion expenses and personnel costs, including the impact of the downsizing of E-LOAN’s operations in early 2008 as well as lower compensation tied to financial performance.
     Income tax expense from continuing operations amounted to $309.1 million for the quarter ended December 31, 2008, compared with an income tax benefit of $15.4 million for the same quarter of 2007. The variance was primarily due to the establishment of a full valuation allowance on the deferred tax assets of the U.S. mainland operations, as well as the impact of higher operating losses.
Reportable Segment Results
The Corporation’s reportable segments for managerial reporting purposes consist of Banco Popular de Puerto Rico, EVERTEC and Banco Popular North America. These reportable segments pertain only to the continuing operations of Popular, Inc. As previously indicated, the operations of PFH, which were previously considered a reportable segment, were discontinued in the third quarter of 2008. Also, a Corporate group has been defined to support the reportable segments. For managerial reporting purposes, the costs incurred by the Corporate group are not allocated to the reportable segments. For a description of the Corporation’s reportable segments, including additional financial information and the underlying management accounting process, refer to Note 35 to the consolidated financial statements. Financial information for periods prior to 2008 was restated to conform to the 2008 presentation.
     The Corporate group had a net loss of $435.4 million in 2008, compared with net income of $41.8 million in 2007 and a net loss

 


 

31
of $28.4 million in 2006. The Corporate group’s financial results for the year ended December 31, 2008 included an unfavorable impact to income taxes due to an allocation (for segment reporting purposes) of $357.4 million of the $861 million valuation allowance on the deferred tax assets of the U.S. mainland operations to Popular North America (“PNA”), holding company of the U.S. operations. PNA files a consolidated tax return for its operations. The Corporate group recorded non-interest losses amounting to $32.6 million for the year ended December 31, 2008, compared to non-interest income of $118.0 million in the previous year. In 2008, the Corporation’s holding companies within the Corporate group realized other-than-temporary impairment losses on investment securities available-for-sale and investments accounted under the equity method of $36.0 million, which was previously explained in the Non-Interest Income section of this MD&A. In 2007, the Corporate group realized a gain of $118.7 million on the sale of its TELPRI shares in the first quarter of 2007.
      For segment reporting purposes, the impact of recording the valuation allowance on deferred tax assets of the U.S. operations was assigned to each legal entity within PNA (including PNA holding company as an entity) based on each entity’s net deferred tax asset at December 31, 2008, except for PFH. The impact of recording the valuation allowance at PFH was allocated among continuing and discontinued operations. The portion attributed to the continuing operations was based on PFH’s net deferred tax asset balance at January 1, 2008. The valuation allowance on deferred taxes as it relates to the operating losses of PFH for the year 2008 was assigned to the discontinued operations.
    The tax impact in results of operations for PFH attributed to the recording of the valuation allowance assigned to continuing operations was included as part of the Corporate Group for segment reporting purposes since it does not relate to any of the legal entities of the BPNA reportable segment. PFH is no longer considered a reportable segment.
     Highlights on the earnings results for the reportable segments are discussed below.
Banco Popular de Puerto Rico
The Corporation’s banking operations in Puerto Rico were adversely impacted by the prolonged economic recession being experienced by the Puerto Rico economy. The provision for loan losses significantly increased during 2008 as a response to deteriorating credit quality, particularly in the commercial and construction loan portfolios. Delinquencies and losses in consumer portfolios, though higher than the year before, remained substantially in line with management’s expectations. Despite the challenging economic conditions, during 2008, the BPPR reportable segment was able to grow its top line income by over 9%, when compared to the previous year. Despite the impact of the unprecedented market conditions, this reportable segment was able to maintain a healthy net interest margin and increase other service fees and service charges on deposits accounts by 16%. Although operating expenses grew by approximately 6%, the increase was offset by a series of cost control initiatives such as limiting new recruitment to achieve headcount reduction through attrition, lower advertising spending and more disciplined spending on technology projects.
     During the later part of 2008, the Corporation closed Popular Finance, one of its subsidiaries in Puerto Rico, which provided lending in the form of small consumer loans, primarily unsecured loans and mortgage loans to a subprime sector. The continued contraction of this small consumer loan market, the industry’s lack of profitability and the Corporation’s financial results led management to conclude that it was prudent to exit this line of business. The company ceased originating loans but continues to hold a $222 million loan portfolio at December 31, 2008. Popular Finance reported a net loss of $3.4 million in 2008, including the impact of goodwill impairment losses of $1.6 million. An important accomplishment for the BPPR reportable segment during 2008 was the acquisition of the mortgage servicing rights to a $5.1 billion mortgage loan portfolio. The benefits of this acquisition include the opportunity to create cost synergies, service an attractive client base and fortify BPPR’s position in the mortgage industry.
     The Banco Popular de Puerto Rico reportable segment reported net income of $239.1 million in 2008, a decrease of $88.2 million, or 27%, when compared with the previous year, primarily due to the significant increase in the provision for loan losses. Net income for the BPPR reportable segment amounted to $355.9 million for 2006.
     The main factors that contributed to the variance in the financial results for the year ended December 31, 2008, when compared to 2007, included:
    Higher net interest income by $1.4 million, or less than 1%. The increase in net interest income was primarily due to a change in the mix of earning assets with a greater proportion of loans that had yields higher than those of investment securities which had matured and were not replaced due to deleveraging of the balance sheet. The favorable variance in net interest income was also associated with lower cost of funds in short-term debt, certificates of deposit and non-maturity deposits. This was partially offset by lower interest income derived from loans and investment securities mainly due to lower interest rates in the current

 


 

32     POPULAR, INC. 2008 ANNUAL REPORT
environment and an increase in non-accruing loans. The lower market rates had a negative impact in the average yield of commercial and construction loans, as well as on the yield of floating rate collateralized mortgage obligations. Furthermore, the acquisition of brokered certificates of deposit during the latter part of 2007 prevented the Corporation’s cost of funds from fully benefiting from the decreases in market rates. The net interest margin for the BPPR reportable segment was 3.94% for the year ended December 31, 2008, compared with 3.89% for the previous year;
    Higher provision for loan losses by $275.3 million, or 113%, primarily related to the commercial, construction and consumer loan portfolios. These three portfolios experienced higher net charge-offs in 2008 compared to 2007 by $68.6 million, $65.6 million and $22.5 million, respectively. Also, during 2008, the Corporation increased its specific reserves for loans classified as impaired under SFAS No. 114. At December 31, 2008, there were $639 million of SFAS No. 114 impaired loans in the BPPR reportable segment with a related specific allowance for loan losses of $137 million, compared to $232 million and $46 million, respectively, at December 31, 2007. The ratio of allowance for loan losses to loans held-in-portfolio for the Banco Popular de Puerto Rico reportable segment was 3.44% at December 31, 2008, compared with 2.31% at December 31, 2007. The provision for loan losses represented 148% of net charge-offs for 2008, compared with 127% of net charge-offs for 2007. The net charge-offs to average loans held-in-portfolio for the Banco Popular de Puerto Rico reportable segment was 2.18% for the year ended December 31, 2008, compared with 1.22% in the previous year;
 
    Higher non-interest income by $135.1 million, or 28%, mainly due to a favorable variance in the caption of gain on sale of investment securities as a result of the gain on redemption of Visa stock in the first quarter of 2008 amounting to approximately $40.9 million and a gain of $28.3 million on the sale of $2.4 billion in U.S. agency securities during the second quarter of 2008. Another major contributor to this variance were higher other service fees by $52.8 million, principally related to an increase in fee income from debit and credit cards and higher mortgage servicing fees. Also, there were higher service charges on deposit accounts by $11.1 million and higher trading account profit by $6.4 million. The latter was related to higher gains on the sale of mortgage-backed securities;
 
    Higher operating expenses by $42.3 million, or 6%, primarily associated with the provision for unused credit line commitments, FDIC insurance premiums, other real estate expenses, credit card interchange expenses, collection services, other professional fees, personnel costs, net occupancy expenses, among others. These expenses were partially offset by lower business promotion expenses; and
    Lower income taxes by $92.9 million, or 81%, primarily due to lower taxable income, an increase in net exempt interest income due to a lower disallowance of expenses related to exempt income, higher income subject to a preferential tax rate on capital gains, and tax benefits from the purchase of tax credits during 2008.
     The principal factors that contributed to the variance in financial results for the year ended December 31, 2007, when compared 2006, included:
    Higher net interest income by $42.9 million, or 5%, primarily related to the commercial banking business;
 
    Higher provision for loan losses by $102.6 million, or 73%, primarily associated with higher net charge-offs mainly in the consumer and commercial loan portfolios due to higher delinquencies resulting from the slowdown in the economy. The provision for loan losses represented 127% of net charge-offs for 2007, compared with 124% in 2006. The ratio of allowance for loan losses to loans held-in-portfolio for the Banco Popular de Puerto Rico reportable segment was 2.31% at December 31, 2007, compared with 2.09% at December 31, 2006;
 
    Higher non-interest income by $53.6 million, or 12%, mainly due to higher other service fees by $42.0 million, primarily in debit and credit card fees and mortgage servicing fees. Also, there was a favorable variance in the caption of gains on sale of loans by $16.4 million because of a $20.1 million loss on the bulk sale of mortgage loans in the third quarter of 2006;
 
    Higher operating expenses by $34.1 million, or 5%, primarily associated with higher professional fees, personnel costs, business promotion, other operating taxes and other operating expenses, which include credit card processing and interchange expenses; and
 
    Lower income tax expense by $11.7 million, or 9%, primarily due to lower taxable income in 2007 than in the previous year.
EVERTEC
EVERTEC is the Corporation’s reportable segment dedicated to processing and technology outsourcing services, servicing customers in Puerto Rico, the Caribbean, Central America and the U.S. mainland. EVERTEC provides support internally to the Corporation’s subsidiaries, as well as to third parties. EVERTEC’s main clients include financial institutions, businesses and various levels of government. During 2008, EVERTEC continued

 


 

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initiatives to enhance the competitiveness of the ATH® debit payment method and attracted new clients to its hosting and outsourcing services. EVERTEC’s operations in Latin America showed revenue and net income growth during 2008.
     For the year ended December 31, 2008, net income for the reportable segment of EVERTEC totaled $43.6 million, an increase of $12.3 million, or 40%, compared with $31.3 million for 2007. Net income amounted to $26.0 million for 2006.
     Factors that contributed to the variance in results for 2008, when compared to 2007, included:
    Higher non-interest income by $21.6 million, or 9%, primarily due to higher transaction processing fees mainly related to the automated teller machine (“ATM”) network and point-of-sale (“POS”) terminals, and higher business process outsourcing. Also, there were higher payment, cash and item processing fees and information technology (“IT”) consulting services, among others. Furthermore, there were gains on sale of securities mostly as a result of a $7.6 million gain on the redemption of Visa stock held by ATH Costa Rica during the first quarter of 2008;
 
    Higher operating expenses by $7.5 million, or 4%, primarily due to higher other operating expenses, professional fees, personnel costs, and net occupancy expenses. These variances were offset by lower equipment and communication expenses; and
 
    Higher income tax expense by $1.9 million, or 11%, primarily due to higher taxable income.
     Variances by major categories, when comparing the financial results for 2007 versus 2006, included:
    Lower net interest loss by $1.1 million, or 57%, primarily due to increased revenues from funds invested in securities;
 
    Higher non-interest income by $12.4 million, or 5%, mostly as a result of higher electronic transactions processing fees related to point of sale and the automated teller machine network, other item processing fees associated with cash depot services and payment processing, and an increase in IT consulting services, among others;
 
    Higher operating expenses by $5.7 million, or 3%, primarily due to higher personnel costs, including the impact of merit increases, higher headcount, commissions and medical costs, among other factors, and professional services primarily in programming services. These variances were partially offset by lower equipment expenses due to lower software package expenses and lower depreciation of electronic equipment; and
 
    Higher income tax expense by $2.5 million, or 17%, primarily due to higher taxable income in 2007 compared to the previous year.
Banco Popular North America
As previously indicated, in response to difficult economic conditions and a business structure that was not delivering profitable results or an adequate return on capital, management executed a series of major actions to reduce the size of the BPNA reportable segment to achieve a learner, more efficient business model and to focus on core banking operations. Refer to the Operating Expenses section of this MD&A for a description of the restructuring plans implemented for the BPNA banking operations and E-LOAN during 2008. Both restructuring plans are expected to be completed in 2009. Besides those measures being taken, which were described in the Operating Expenses section, management is currently evaluating additional alternatives to improve the financial performance of the BPNA operations, which may include exiting other business lines in the U.S. operations to focus on core banking activities and selling loan portfolios. Management is also committed to leverage the infrastructure in Puerto Rico to reduce operational costs in the U.S. mainland operations. A new senior management team has been appointed to lead these efforts.
     For the year ended December 31, 2008, the reportable segment of Banco Popular North America, which includes the operations of E-LOAN, had a net loss of $524.8 million, compared to a net loss of $195.4 million for 2007 and a net income of $67.5 million for 2006. E-LOAN’s net loss for the year ended December 31, 2008 amounted to $233.9 million, compared to net losses of $245.7 million in 2007 and $33.0 million in 2006.
     The main factors that contributed to the variance in financial results for 2008 when compared to 2007 for the Banco Popular North America reportable segment included:
    Lower net interest income by $19.1 million, or 5%. The unfavorable variances were mainly due to lower loan yields, offset in part by a reduction in the cost of interest bearing deposits, mainly time deposits and internet-based deposits gathered through the E-LOAN deposit platform. Furthermore, BPNA incurred a penalty of $6.9 million on the cancellation of FHLB advances in December 2008. The variance due to a lower net interest yield was partially offset by an increase in the average volume of loans, which was funded through borrowings;
 
    Higher provision for loan losses by $376.8 million, or 395%, primarily due to higher net charge-offs, specific reserves for commercial, construction and mortgage loans, as well as the impact of the continuing deterioration of the U.S. residential housing market and the economy in general. The ratio of allowance for loan losses to loans held-in-portfolio for the Banco Popular North America reportable segment was 3.42% at December 31, 2008, compared with

 


 

34    POPULAR, INC. 2008 ANNUAL REPORT
1.26% at December 31, 2007. The provision for loan losses represented 190% of net charge-offs for 2008, compared with 168% in 2007. The net charge-offs to average loans held-in-portfolio for the Banco Popular North America reportable segment was 2.45% for the year ended December 31, 2008, compared with 0.61% in the previous year;
    Lower non-interest income by $45.0 million, or 24%, mainly due to lower gains on sale of loans by $62.0 million, as well as lower revenues derived from escrow closing services and referral income, all of which were primarily associated to E-LOAN’s downsizing. This was partially offset by higher gains on the sale of real estate properties by the U.S. banking subsidiary, as well as the gain recorded in early 2008 related to the sale of BPNA’s retail bank branches located in Texas;
 
    Lower operating expenses by $255.6 million, or 37%, mainly due to the goodwill impairment losses recorded in 2007 by E-LOAN, as well as a reduction in personnel and business promotion expenses for 2008 due to the downsizing of E-LOAN early that year. Also, refer to the Operating Expenses section of this MD&A for information on BPNA and E-LOAN’s restructuring plans; and
 
    Income tax expense of $114.7 million in 2008, compared with income tax benefit of $29.5 million in 2007. This variance was mainly due to the establishment of the valuation allowance on the deferred tax assets of the U.S. mainland continuing operations. The valuation allowance on deferred tax assets corresponding to the BPNA reportable segment amounted to $294.5 million at December 31, 2008.
     The principal factors that contributed to the variance in financial results for the BPNA reportable segment for the year ended December 31, 2007, when compared 2006, included:
    Lower net interest income by $9.4 million, or less than 3%;
 
    Higher provision for loan losses by $49.0 million, or 105%, primarily due to higher net charge-offs in the mortgage and commercial loan portfolios. The provision for loan losses represented 168% of net charge-offs for 2007, compared with 117% of net charge-offs in 2006;
 
    Lower non-interest income by $32.6 million, or 15%, mainly due to an unfavorable variance in the caption of gain on sale of loans and valuation adjustments on loans held-for-sale by $25.7 million mostly due to lower loan volume originated and sold by E-LOAN, lower price margins due to market conditions, reduced gains on sale of SBA loans by BPNA due to lower volume, and unfavorable lower of cost or market adjustments on mortgage loans held-for-sale due to less liquidity in the secondary markets. Also contributing to the unfavorable variance in non-interest income for this reportable segment were lower gains on the sale of real estate properties by $10.4 million. These unfavorable variances were partially offset by higher service charges on deposits by $5.3 million;
    Higher operating expenses by $238.7 million, or 53%, mainly due to the $211.8 million impairment losses related to E-LOAN’s goodwill and trademark. Also included in the increase for 2007 are the $9.6 million of restructuring charges and $10.5 million in impairment losses on long-lived assets as a result of the E-LOAN Restructuring Plan. Other increases in personnel costs, net occupancy and equipment expenses were partially offset by lower business promotion expenses; and
 
    Income tax benefit of $29.5 million in 2007, compared to income tax expense of $37.3 million in 2006. The variance is mainly attributed to higher losses in the operations of E-LOAN, as well as lower taxable income at BPNA.
Discontinued Operations
During the third and fourth quarters of 2008, the Corporation executed a series of asset sale transactions and a restructuring plan that led to the discontinuance of the Corporation’s PFH operations (including Popular, FS), which prior to September 30, 2008, was defined as a reportable segment for managerial reporting purposes. The discontinuance included the sale of a substantial portion of PFH’s assets and exiting all business activities conducted at PFH, including loan servicing functions to non-affiliated parties. For financial reporting purposes, the results of the discontinued operations of PFH are presented as “Assets / Liabilities from discontinued operations” in the consolidated statement of condition and “Loss from discontinued operations, net of tax” in the consolidated statement of operations. Prior periods presented in the consolidated statement of operations, as well as certain disclosures included in this MD&A and notes to the financial statements, were retrospectively adjusted to present in a separate line item the results of discontinued operations for comparative purposes. The consolidated statement of condition for periods prior to 2008 does not reflect the reclassification to discontinued operations.
     Total assets from PFH’s discontinued operations amounted to $13 million at December 31, 2008 and are classified as “Assets from discontinued operations” in the consolidated statement of condition. PFH’s assets approximated $3.9 billion at December 31, 2007 and $8.4 billion at December 31, 2006.

 


 

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     Assets and liabilities of the PFH discontinued operations at December 31, 2008 are detailed in the table below. These assets are mostly held-for-sale.
         
(In millions)   2008
 
Loans held-for-sale at lower of cost or fair value
  $ 2.3  
Loans measured pursuant to SFAS No. 159
    4.9  
Other assets
    4.2  
Other
    1.2  
 
Total assets
  $ 12.6  
 
 
       
Other liabilities
  $ 24.6  
 
Total liabilities
  $ 24.6  
 
Net liabilities
  $ 12.0  
 
     The Corporation reported a net loss for the discontinued operations of $563.4 million for the year ended December 31, 2008, compared with a net loss of $267.0 million for the previous year. The loss included write-downs of assets held-for-sale to fair value, net losses on the sale of loans, restructuring charges and the recording of a valuation allowance on deferred tax assets of $209.0 million.
     The following table provides financial information for the discontinued operations for the year ended December 31, 2008 and 2007.
                 
(In millions)   2008   2007
 
Net interest income
  $ 30.8     $ 143.7  
Provision for loan losses
    19.0       221.4  
Non-interest loss, including fair value adjustments on loans and MSRs
    (266.9 )     (89.3 )
Lower of cost or market adjustments on reclassification of loans to held-for-sale prior to recharacterization
          (506.2 )
Gain upon completion of recharacterization
          416.1
Operating expenses, including reductions in value of servicing advances and other real estate, and restructuring costs
    213.5       159.1  
Loss on disposition during the period (1)
    (79.9 )      
 
Pre-tax loss from discontinued operations
    ($548.5 )     ($416.2 )
Income tax expense (benefit)
    14.9       (149.2 )
 
Loss from discontinued operations, net of tax
    ($563.4 )     ($267.0 )
 
(1)   Loss on disposition was associated to the sale of manufactured housing loans in September 2008, including lower of cost or market adjustments at reclassification from loans held-in-portfolio to loans held-for-sale, and to the loss on the sale of assets in November 2008.
 
     In 2007, PFH began downsizing its operations and shutting down certain loan origination channels, which included, among others, the wholesale subprime mortgage origination business, wholesale broker, retail and call center business units. PFH began 2008 with a significantly reduced asset base due to the shutting down of those origination channels and the recharacterization, in December 2007, of certain on-balance sheet securitizations as sales, which involved approximately $3.2 billion in unpaid principal balance (“UPB”) of loans. This recharacterization transaction is discussed in a subdivision included in this section of the MD&A.
     In March 2008, the Corporation sold approximately $1.4 billion of consumer and mortgage loans that were originated through Equity One’s (a subsidiary of PFH) consumer branch network and recognized a gain upon sale of approximately $54.5 million. The loan portfolio buyer retained certain branch locations. Equity One closed all consumer service branches not assumed by the buyer, thus exiting PFH’s consumer finance business in early 2008.
      In September 2008, the Corporation sold PFH’s portfolio of manufactured housing loans with a UPB of approximately $309 million for cash proceeds of $198 million. The Corporation recognized a loss on disposition of $53.5 million.
     During the third quarter of 2008, the Corporation also entered into an agreement to sell substantially all of PFH’s outstanding loan portfolio, residual interests and servicing related assets. This transaction, which consummated in November 2008, involved the sale of approximately $748 million in assets, which for the most part were measured at fair value. The Corporation recognized a loss of approximately $26.4 million in the fourth quarter of 2008 related to this disposition. Proceeds from this sale amounted to $731 million. During the third quarter of 2008, the Corporation recognized fair value adjustments on these assets held-for-sale of approximately $360 million.
     Also, in conjunction with the November 2008 sale, the Corporation sold the implied residual interests associated to certain on-balance sheet securitizations, thus transfering all rights and obligations to the third party with no continuing involvement whatsoever of Popular with the transferred assets. The Corporation reduced the secured debt related to these securitizations of approximately $164 million, as well as the loans that served as collateral for approximately $158 million. The on-balance sheet secured debt as well as the related loans were measured at fair value pursuant to SFAS No. 159.
     As part of the actions to exit PFH’s business, the Corporation executed two restructuring plans during 2008 related to the PFH operations: the “PFH Branch Network Restructuring Plan” and the “PFH Discontinuance Restructuring Plan”. Also, in 2007 the Corporation implemented the “PFH Restructuring and Integration Plan”. The following section provides information on these restructuring plans. The restructuring costs are included in the line item “Loss from discontinued operations, net of tax” in the consolidated statements of operations for 2008 and 2007.
PFH Restructuring and Integration Plan
In January 2007, the Corporation adopted a Restructuring and Integration Plan at PFH, the holding company of Equity One (the “PFH Restructuring and Integration Plan”). This particular plan called for PFH to exit the wholesale subprime mortgage loan

 


 

36     POPULAR, INC. 2008 ANNUAL REPORT
origination business early in the first quarter of 2007 and to shut down the wholesale broker, retail and call center business divisions. Also, the plan included consolidating PFH support functions with its sister U.S. banking entity, Banco Popular North America, creating a single integrated North American financial services unit. At that time, Popular decided to continue the operations of Equity One and its subsidiaries (“Equity One”), with over 130 consumer services branches principally dedicated to direct subprime loan origination, consumer finance and mortgage servicing.
     The following table details the expenses recorded by the Corporation that were associated with this particular restructuring plan.
                 
    December 31,
(In millions)   2007   2006
 
Personnel costs
  $ 7.8 (a)      
Net occupancy expenses
    4.5 (b)      
Equipment expenses
    0.3        
Professional fees
    1.8 (c)      
Other operating expenses
    0.3        
 
Total restructuring costs
  $ 14.7        
Impairment losses on long-lived assets
        $ 7.2 (d)
Goodwill impairment losses
          14.2 (e)
 
Total
  $ 14.7     $ 21.4  
 
(a)   Severance, retention bonuses and other benefits
 
(b)   Lease terminations
 
(c)   Outplacement and service contract terminations
 
(d)   Software and leasehold improvements
 
(e)   Attributable to business exited at PFH
 
     At December 31, 2007, the accrual for restructuring costs associated with the PFH Restructuring and Integration Plan amounted to $3.2 million. There was no accrual outstanding at December 31, 2008 associated with this plan.
PFH Branch Network Restructuring Plan
Given the disruption in the capital markets since the summer of 2007 and its impact on funding, management of the Corporation concluded during the fourth quarter of 2007 that it was difficult to generate an adequate return on the capital invested at Equity One’s consumer service branches. As indicated earlier, the Corporation closed Equity One’s consumer service branches during the first quarter of 2008 as part of the initiatives to exit the subprime loan origination operations at PFH. Restructuring charges and impairment losses on long-lived assets, which resulted from the PFH Branch Network Restructuring Plan, are detailed in the table below.
                 
    December 31,
(In millions)   2008   2007
 
Personnel costs
  $ 8.9 (a)      
Net occupancy expenses
    6.7 (b)      
Equipment expenses
    0.7        
Communications
    0.2        
Other operating expenses
    0.9        
 
Total restructuring costs
  $ 17.4        
Impairment losses on long-lived assets
        $ 1.9 (c)
 
 
  $ 17.4     $ 1.9  
 
(a)   Severance, retention bonuses and other benefits
 
(b)   Lease terminations
 
(c)   Leasehold improvements, furniture and equipment
 
     At December 31, 2008, the accrual for restructuring costs associated with the PFH Branch Network Restructuring Plan amounted to $1.9 million. The Corporation does not expect to incur additional restructuring costs related to the PFH Branch Network Restructuring Plan.
     The PFH Branch Network Restructuring Plan charges are included in the line item “Loss from discontinued operations, net of tax” in the consolidated statements of operations for 2008 and 2007.
PFH Discontinuance Restructuring Plan
In August 2008, the Corporation entered into an additional restructuring plan for its PFH operations to eliminate employment positions, terminate contracts and incur other costs associated with the discontinuance of PFH’s operations.

 


 

37
     Restructuring charges and impairment losses on long-lived assets, which resulted from the PFH Discontinuance Restructuring Plan, are detailed in the table below.
         
    December 31,
(In millions)   2008
 
Personnel costs
  $ 4.1 (a)
 
Total restructuring costs
  $ 4.1  
Impairment losses on long-lived assets
    3.9 (b)
 
 
  $ 8.0  
 
(a)   Severance, retention bonuses and other benefits
 
(b)   Leasehold improvements, furniture, equipment and prepaid expenses
 
     At December 31, 2008, the accrual for restructuring costs associated with the PFH Discontinuance Restructuring Plan amounted to $3.4 million.
     Restructuring costs and impairment losses on long-lived assets for both plans described above are included in the line item “Loss from discontinued operations, net of tax” in the consolidated statements of operations for 2008 and 2007.
     Full-time equivalent employees at the PFH discontinued operations decreased from 930 at December 31, 2007 to 200 at December 31, 2008. The employees that remain at PFH are expected to depart by mid-2009 or transferred to other of the Corporation’s U.S. mainland subsidiaries for support functions.
Recharacterization of Certain On-Balance Sheet Securitizations as Sales under FASB Statement No. 140
From 2001 through 2006, the Corporation, particularly PFH or its subsidiary Equity One, conducted 21 mortgage loan securitizations that were sales for legal purposes but did not qualify for sale accounting treatment at the time of inception because the securitization trusts did not meet the criteria for qualifying special purpose entities (“QSPEs”) contained in SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”. As a result, the transfers of the mortgage loans pursuant to these securitizations were initially accounted for as secured borrowings with the mortgage loans continuing to be reflected as assets on the Corporation’s consolidated statements of condition with appropriate footnote disclosure indicating that the mortgage loans were, for legal purposes, sold to the securitization trusts.
     As part of the Corporation’s strategy of exiting the subprime business at PFH, on December 19, 2007, PFH and the trustee for each of the related securitization trusts amended the provisions of the related pooling and servicing agreements to delete the discretionary provisions that prevented the transactions from qualifying for sale treatment. These changes in the primary discretionary provisions included:
  deleting the provision that grants the servicer (PFH) “sole discretion” to have the right to purchase for its own account or for resale from the trust fund any loan which is 91 days or more delinquent;
 
  deleting the provision that grants the servicer “sole discretion” to sell loans with respect to which it believes default is imminent;
 
  deleting the provision that grants the servicer “sole discretion” to determine whether an immediate sale of a real estate owned (“REO”) property or continued management of such REO property is in the best interest of the certificateholders; and
 
  deleting the provision that grants the residual holder (PFH) to direct the trustee to acquire derivatives post closing.
     The Corporation obtained a legal opinion, which among other considerations, indicated that each amendment (a) was authorized or permitted under the pooling and servicing agreement related to such amendment, and (b) will not adversely affect in any material respect the interests of any certificateholders covered by the related pooling and servicing agreement.
     The amendments to the pooling and servicing agreement allowed the Corporation to recognize 16 out of the 21 transactions as sales under SFAS No. 140.
      The net impact of the recharacterization transaction was a pre-tax loss of $90.1 million, which was included in the caption “(Loss) gain on sale of loans and valuation adjustments on loans held-for-sale” in the consolidated statement of operations of the 2007 Annual Report. This amount is included as part of “Net loss from discontinued operations, net of tax” in the 2007 comparative financial information of this 2008 Annual Report. The net loss on the recharacterization included the following:
         
    For the year ended
(In millions)   December 31, 2007
 
Lower of cost or market adjustment at reclassification from loans held-in- portfolio to loans held-for-sale
    ($506.2 )
Gain upon completion of recharacterization
    416.1  
 
Total impact, pre-tax
    ($90.1 )
 
     The recharacterization involved a series of steps, which included the following:
(i)   reclassifying the loans as held-for-sale with the corresponding lower of cost or market adjustment as of the date of the transfer;
 
(ii)   removing from the Corporation’s books approximately $2.6 billion in mortgage loans recognized at fair value after reclassification to the held-for-sale category (UPB of $3.2 billion) and $3.1 billion in related liabilities representing secured borrowings;

 


 

38     POPULAR, INC. 2008 ANNUAL REPORT
  (iii)   recognizing assets referred to as residual interests, which represent the fair value of residual interest certificates that were issued by the securitization trusts and retained by PFH, and
 
  (iv)   recognizing mortgage servicing rights, which represent the fair value of PFH’s right to continue to service the mortgage loans transferred to the securitization trusts.
     At the date of reclassification of the loans as held-for-sale, which was simultaneous with the date in which the pooling and servicing agreements were amended, management assessed the adequacy of the allowance for loan losses related to the loan portfolio at hand, which amounted to $74 million and represented approximately 2.3% of the subprime mortgage loan portfolio. The allowance for loan losses was based on expectations of the inherent losses in the loan portfolio for a 12-month period. Furthermore, management determined the fair value of the loans at the date of reclassification using a new securitization capital structure methodology. Given that historically PFH relied on securitization transactions to dispose of assets originated, management believed that the securitization market was PFH’s principal market for purposes of determining fair value. The classes of securities created under the capital structure were valued based on expected yields required by investors for each bond and residual class created. In order to value each class of securities, the valuation considered estimated credit spreads required by investors to purchase the different classes of bonds created in the securitization and prepayment curves, loss estimates, and loss timing curves to derive bond cash flows.
     The fair value analysis indicated an estimated fair value of the loan portfolio of $2.6 billion which, compared to the carrying value of the loans after considering the allowance for loan losses, resulted in the $506.2 million loss. The significant unfavorable fair value adjustment in the loan portfolio was in part associated to adverse market and liquidity conditions in the subprime market at the time and the weakness in the housing sector. These factors resulted in a higher discount rate; that is, a higher rate of return expected by an investor in a securitization’s market. Market liquidity for subprime assets declined considerably during 2007. During 2007, the subprime sector in general was experiencing (1) deteriorating credit performance trends, (2) continued turmoil with subprime lenders (increases in losses, bankruptcies, downgrades), (3) lower levels of home price appreciation, and (4) a general tightening of credit standards that may had adversely affected the ability of borrowers to refinance their existing mortgages. Given the very uncertain conditions in the subprime market and lack of trading activity, price level indications were reflective of relatively low values with high internal rates of return. The fair value measurement also considers cumulative losses expected throughout the life of the loans, which exceeded the inherent losses in the portfolio considered for the allowance for loan losses determination. Lower levels of home price appreciation, declining demand for housing units leading to rising inventories, housing affordability challenges and general tightening of underwriting standards were expected to lead to higher cumulative credit losses.
     After reclassifying the loans to held-for-sale at fair value, the Corporation proceeded to simultaneously account for the transfers as sales upon recharacterization. The accounting entries at recharacterization entailed the removal from the Corporation’s books of the $2.6 billion in mortgage loans measured at fair value, the $3.1 billion in secured borrowings (which represent the bond certificates due to investors in the securitizations that are collateralized by the mortgage loans), and other assets and liabilities related to the securitization including, for example, accrued interest. Upon sale accounting, the Corporation also recognized residual interests of $38 million and MSRs of $18 million, which represented the Corporation’s retained interests. The residual interests represented the fair value at recharacterization date of residual interest certificates that were issued by the securitization trusts and retained by PFH, and the MSRs represented the fair value of PFH’s right to continue to service the mortgage loans transferred to the securitization trusts.
     At the recharacterization date, the secured borrowings carrying amount was in excess of the mortgage loans de-recognized principally due to the fact that the accounting basis for the secured borrowings was amortized cost and the mortgage loans de-recognized were accounted at the lower of cost or market as described above. This fact and the recognition of the residual interests and MSRs led to the $416.1 million gain upon recharacterization. Under generally accepted accounting principles, the secured borrowings related to the on-balance sheet securitizations were recognized as a liability measured at “amortized cost”. The balance of these “secured borrowings” was reduced monthly only by the amounts remitted by the servicer to the trustee for distribution to the certificateholders. These amounts consisted principally of collections on the securitized mortgage loans, proceeds from the sale of other real estate properties and servicing advances.
     On the closing date for each of the subject securitizations, the Corporation, through its subsidiaries, received cash for the sold loans (legally the securitization qualified as a sale since inception). Upon the recharacterization, the Corporation retained the residual beneficial interests, de-recognized the loans and was not obligated to return to the related trust funds any of the cash proceeds previously received at the related closings. In addition, from an accounting perspective, the recharacterization had the effect of releasing the Corporation from its securitization related liabilities to the related trust funds.
     As indicated earlier, before the recharacterization, the underlying loans and secured borrowings were included as assets

 


 

39
Table G
Loans Ending Balances (including Loans Held-for-Sale)
                                                 
As of December 31,
                                            Five-Year
(Dollars in thousands)   2008   2007   2006   2005   2004   C.G.R.
 
Commercial
  $ 13,687,060     $ 13,685,791     $ 13,115,442     $ 11,921,908     $ 10,396,732       10.69 %
Construction
    2,212,813       1,941,372       1,421,395       835,978       501,015       45.83  
Lease financing
    1,080,810       1,164,439       1,226,490       1,308,091       1,164,606       0.51  
Mortgage*
    4,639,464       7,434,800       11,695,156       12,872,452       12,641,329       (13.73 )
Consumer
    4,648,784       5,684,600       5,278,456       4,771,778       4,038,579       7.30  
 
Total
  $ 26,268,931     $ 29,911,002     $ 32,736,939     $ 31,710,207     $ 28,742,261       3.05 %
 
*   Includes residential construction.
 
and liabilities of the Corporation. However, the maximum risk to the Corporation was limited to the amount of overcollateralization in each subject transaction (effectively, the value of the residual beneficial interest retained by the Corporation). After a subject transaction’s overcollaterization reduces to zero, the risk of loss on the securitized mortgage loans is entirely borne by the non-residual certificateholders. However, by reflecting the loans as “owned” by the Corporation, investors could have viewed the Corporation’s credit exposure to this portfolio as significantly larger than it actually was. Recharacterization of these transactions as sales eliminated the loans from the Corporation’s books and, therefore, better portrayed the Corporation’s legal rights and obligations in these transactions. Besides the servicing rights and related assets associated with servicing the trust assets, such as servicing and escrow advances, after the recharacterization transaction, the Corporation only retained in its accounting records the residual interests that were accounted at fair value and which represented the maximum risk of loss to the Corporation.
     The removal of the mortgage assets from Popular’s books had a favorable impact on its capital ratios and reduced the amount of subprime mortgages in the Corporation’s books. The loan recharacterization transaction contributed with a reduction in non-performing mortgage loans of approximately $316 million, when compared to December 31, 2006.
     In November 2008, the Corporation sold all residual interests and mortgage servicing rights related to all securitization transactions completed by PFH. Therefore, the Corporation does not retain any interest on the securitization’s trust assets from a legal or accounting standpoint as of December 31, 2008.
Statement of Condition Analysis
Assets
Refer to the consolidated financial statements included in this 2008 Annual Report for the Corporation’s consolidated statements of condition as of December 31, 2008 and 2007. Also, refer to the Statistical Summary 2004-2008 in this MD&A for condensed statements of condition for the past five years. At December 31, 2008, total assets were $38.9 billion, which included $12.6 million from the discontinued operations. Total assets at December 31, 2007 were $44.4 billion. The decline of $5.5 billion, or 12%, was primarily due to the sale during 2008 of substantially all assets of PFH, as described in the Discontinued Operations section in this MD&A, and to a reduction in the volume of investment securities, mainly due to maturities.
Investment securities
The Corporation holds investment securities primarily for liquidity, yield enhancement and interest rate risk management. The portfolio mainly includes very liquid, high quality debt securities. The following table provides a breakdown of the Corporation’s investment securities available-for-sale and held-to-maturity on a combined basis at December 31, 2008 and 2007.
                 
(In millions)   2008   2007
 
U.S. Treasury securities
  $ 502.1     $ 471.1  
Obligations of U.S. government sponsored entities
    4,808.5       5,893.1  
Obligations of Puerto Rico, States and political subdivisions
    385.7       178.0  
Collateralized mortgage obligations
    1,656.0       1,396.8  
Mortgage-backed securities
    848.5       1,010.1  
Equity securities
    10.1       34.0  
Other
    8.3       16.5  
 
Total
  $ 8,219.2     $ 8,999.6  
 

 


 

40     POPULAR, INC. 2008 ANNUAL REPORT
     Notes 6 and 7 to the consolidated financial statements provide additional information by contractual maturity categories and gross unrealized gains / losses with respect to the Corporation’s available-for-sale and held-to-maturity investment securities portfolio.
     The vast majority of these investment securities, or approximately 97%, are rated the equivalent of AAA by the major rating agencies. The mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) are investment grade securities, all of which are rated AAA by at least one of the three major rating agencies as of December 31, 2008. All MBS held by the Corporation and approximately 91% of the CMOs held as of December 31, 2008 are guaranteed by government sponsored entities.
     At December 31, 2008, there were investment securities available-for-sale with a market value of $1.4 billion in an unrealized loss position. The unrealized losses on this particular portfolio approximated $88.0 million at December 31, 2008 and corresponded principally to CMOs. Management believes that the unrealized losses in the Corporation’s portfolio of securities available-for-sale at December 31, 2008 were temporary and were substantially related to widening credit spreads and general lack of liquidity in the marketplace.
     The CMOs accounted for approximately $71 million, or 81%, of the total unrealized losses in the portfolio of securities available-for-sale at year-end 2008. Federal agency CMOs and private label CMOs represented 91% and 9%, respectively, of the CMOs portfolio available-for-sale at December 31, 2008.
     The securities that made up the private label component of the CMO portfolio available-for-sale are each rated AAA by either Moody’s and / or Standard & Poor’s rating agencies. None of the securities are on negative watch or outlook or have their ratings changed from their respective issuance dates. Their carrying value at December 31, 2008 was about $149 million, net of unrealized losses of $41 million and are primarily from adjustable rate mortgages with lower coupons. In addition to verifying the credit ratings for the private label CMOs, management analyzed the underlying mortgage loan collateral for these securities. Various statistics or metrics were reviewed for each private label CMO, including among others the weighted average loan-to-value, FICO score, and delinquency and foreclosure rates. All of these CMOs securities were found to be in good credit condition.
     Since no observable credit quality issues were present in the Corporation’s CMOs at December 31, 2008, and management has the intent and ability to hold the CMOs for a reasonable period of time for a forecasted recovery of fair value up to (or beyond) the cost of these investments, management considered the unrealized losses to be temporary.
Loan portfolio
A breakdown of the loan portfolio, the principal category of earning assets, is presented in Table G. In general terms, the decline in the Corporation’s loan portfolio was mostly reflected in mortgage and consumer loans, and relates principally to the sale of PFH’s loan portfolio as described in the Discontinued Operations section of this MD&A. Included in Table G are $536 million of loans held-for-sale at December 31, 2008, compared to $1.9 billion at December 31, 2007. The discontinued operations of PFH accounted for $1.4 billion of the loans held-for-sale at December 31, 2007.
     The commercial loan portfolio remained stable at December 31, 2008, when compared to December 31, 2007. The discontinued operations had a commercial loan portfolio of $186 million at December 31, 2007. This portfolio was substantially sold during 2008. Excluding the impact of the commercial loan portfolio of PFH, the continuing operations experienced an increase of $187 million from December 31, 2007, primarily at the U.S. banking operations, principally in commercial loans in the areas of income producing property and mixed use real estate. The commercial loan portfolio did not attain the growth levels experienced in prior years in part due to the impact of tightened underwriting standards, deteriorated general economic conditions which have caused business stagnation and closures, and the impact to the Corporation of the increase in commercial loan net charge-offs of $93 million.
     The growth in the construction loan portfolio from December 31, 2007 to the same date in 2008 of 14% corresponded principally to the BPPR reportable segment and was mainly on loans to builders and developers of multi-unit construction projects serving both the residential and business sectors. The increase in the construction loan portfolio was offset by an increase in construction loan net charge-offs of $122 million.
     The decrease in the lease financing portfolio of 7% from the end of 2007 to 2008 was principally related to the BPPR reportable segment, which experienced a decline in the portfolio of approximately $100 million. This decline was primarily due to the recessionary economy which has led to lower origination volume. The lease financing portfolio of the BPNA reportable segment remained relatively stable. As of December 31, 2008, the BPNA reportable segment included $328 million in lease financing held-for-sale, compared to $67 million at the same date in the previous year.
     The main factor contributing to the decrease of $2.8 billion in mortgage loans from December 31, 2007 to December 31, 2008 was due to the loan sales by PFH during 2008. The discontinued operations of PFH had a mortgage loan portfolio of $2.4 billion at December 31, 2007. The decline from December 31, 2007 was also related to the banking operations of BPPR, which completed

 


 

41
Table H
Deposits Ending Balances
                                                 
    As of December 31,
                                            Five-Year
(Dollars in thousands)   2008   2007   2006   2005   2004   C.G.R.
 
Demand deposits*
  $ 4,849,387     $ 5,115,875     $ 4,910,848     $ 4,415,972     $ 4,173,268       5.41 %
Savings, NOW and money market deposits
    9,554,866       9,804,605       9,200,732       8,800,047       8,865,831       4.04  
Time deposits
    13,145,952       13,413,998       10,326,751       9,421,986       7,554,061       15.01  
 
Total
  $ 27,550,205     $ 28,334,478     $ 24,438,331     $ 22,638,005     $ 20,593,160       8.77 %
 
*   Includes interest and non-interest bearing demand deposits.
 
a residential mortgage loans securitization into FNMA mortgage-backed securities of approximately $307 million unpaid principal balance of mortgage loans during 2008. Most of these mortgage-backed securities were sold in the secondary markets during the second quarter of 2008. The sale proceeds were reinvested in U.S. agency securities. The objective of the sale was to reduce the Corporation’s level of mortgage loans retained in portfolio and enhance its return on risk-weighted capital.
     The decrease in consumer loans from December 31, 2007 to December 31, 2008 of approximately $1.0 billion was mainly due to sales during 2008 of the consumer loan portfolio of PFH, particularly personal loans. These operations had a consumer loan portfolio of $678 million at the end of 2007. The decline from December 31, 2007 to the same date in 2008 was also related to sales of auto loans by E-LOAN during 2008, and reductions in the consumer loan portfolio of BPNA’s banking operations, primarily due to the runoff mode of its auto loan portfolios without any concentrated lending efforts in these products. The U.S. operations ceased originating auto loans as part of the E-LOAN 2007 Restructuring Plan. Furthermore, there was lower volume of personal and auto loans in the Banco Popular de Puerto Rico reportable segment due to current economic conditions. Auto loan originations have reduced, but the Puerto Rico operations have maintained their market share, ranking first in the Island.
     A breakdown of the Corporation’s consumer loan portfolio at December 31, 2008 and 2007 follows:
                                 
(In thousands)   2008 (1)   2007   Change   % Change
 
Personal
  $ 1,911,958     $ 2,525,458       ($613,500 )     (24 %)
Credit cards
    1,148,631       1,128,137       20,494       2  
Auto
    766,999       1,040,661       (273,662 )     (26 )
Home equity lines of credit
    572,917       751,299       (178,382 )     (24 )
Other
    248,279       239,045       9,234       4  
 
Total
  $ 4,648,784     $ 5,684,600       ($1,035,816 )     (18 %)
 
(1)   Consumer loans from discontinued operations at December 31, 2008 are presented as part of “Assets from discontinued operations” in the consolidated statement of condition. Refer to Note 2 to the consolidated financial statements for further information on the discontinued operations.
 
     The home equity lines of credit at December 31, 2008 pertain principally to E-LOAN with a portfolio of approximately $457 million and BPNA banking operations with a home equity lines of credit portfolio of close to $79 million. These loans are classified as held-in-portfolio, thus are not measured at fair value or lower of cost or fair value at December 31, 2008. The “other” category in consumer loans includes marine loans and revolving lines of credit.
Servicing assets
Servicing assets totaled $180 million at December 31, 2008, compared to $197 million at December 31, 2007. The Corporation accounts for mortgage servicing rights at fair value, and represented 98% of the total servicing assets at the end of 2008. The remainder of the servicing rights is related to SBA loans.
     The PFH discontinued operations had $81 million in mortgage servicing rights at December 31, 2007, all of which were sold during 2008. The decline in servicing rights caused by the PFH sale was offset in part by increases in the BPPR reportable segment. This reportable segment originates servicing rights principally as part of the pooling of mortgage loans into agency securities and, from time to time, purchases the right to service other mortgage portfolios. During 2008, the Corporation acquired the servicing rights to a $5.1 billion mortgage loan portfolio owned by Freddie Mac and GNMA, and previously serviced by R&G Mortgage Corporation. Refer to Note 22 to the consolidated financial statements for detailed information related to the Corporation’s servicing assets.

 


 

42     POPULAR, INC. 2008 ANNUAL REPORT
Other assets
The following table provides a breakdown of the principal categories that comprise the caption of “Other assets” in the consolidated statements of condition at December 31, 2008 and 2007.
                         
(In thousands)   2008 (1)   2007   Change
 
Net deferred tax assets (net of valuation allowance)
  $ 357,507     $ 525,369       ($167,862 )
Bank-owned life insurance program
    224,634       215,171       9,463  
Prepaid expenses
    136,236       188,237       (52,001 )
Derivative assets
    109,656       76,958       32,698  
Investments under the equity method
    92,412       89,870       2,542  
Trade receivables from brokers and counterparties
    1,686       1,160       526  
Securitization advances and related assets
          168,599       (168,599 )
Others
    193,466       191,630       1,836  
 
Total
  $ 1,115,597     $ 1,456,994       ($341,397 )
 
(1)   Other assets from discontinued operations at December 31, 2008 are presented as part of “Assets from discontinued operations” in the consolidated statement of condition. Refer to Note 2 to the consolidated financial statements for further information on the discontinued operations.
 
     Explanations for the principal variances from December 31, 2007 to December 31, 2008 include:
    A decrease in net deferred tax assets, which was impacted by the establishment of a full valuation allowance on the deferred tax assets of the U.S mainland operations. At December 31, 2007, the U.S. operations had net deferred tax assets of $289 million.
 
    A decrease in securitization advances and related assets, which was due to the sale of these assets by PFH in the fourth quarter of 2008.
Goodwill and other intangibles
Goodwill and other intangible assets totaled $659 million at December 31, 2008, a decrease of $41 million, compared to December 31, 2007. The decrease was principally associated with purchase accounting adjustments related to the Citibank’s retail branches acquisition completed in December 2007, and impairment losses on E-LOAN’s trademark of $10.9 million in the fourth quarter of 2008. Refer to Note 12 to the consolidated financial statements for further information on goodwill and the composition of other intangible assets.
Deposits, Borrowings and Other Liabilities
The composition of the Corporation’s financing to total assets at December 31, 2008 and 2007 was as follows:
                                         
                    % increase (decrease)   % of total assets
(Dollars in millions)   2008   2007   from 2007 to 2008   2008   2007
 
Non-interest bearing deposits
  $ 4,294     $ 4,511       (4.8 %)     11.1 %     10.2 %
Interest bearing core deposits
    15,647       15,553       0.6       40.2       35.0  
Other interest bearing deposits
    7,609       8,271       (8.0 )     19.6       18.6  
Federal funds and repurchase agreements
    3,552       5,437       (34.7 )     9.1       12.2  
Other short-term borrowings
    5       1,502       (99.7 )           3.4  
Notes payable
    3,387       4,621       (26.7 )     8.7       10.4  
Others
    1,121       934       20.0       2.9       2.1  
Stockholders’ equity
    3,268       3,582       (8.8 )     8.4       8.1  
 
Deposits
The Corporation’s deposits by categories for 2008 and previous years are presented in Table H. Total deposits amounted to $27.6 billion at December 31, 2008, a decrease of $784 million, or 3%, from the end of 2007. Brokered deposits totaled $3.1 billion at December 31, 2008 and 2007. The Corporation has maintained the level of brokered deposits to increase its level of on-hand liquidity.
Borrowings
At December 31, 2008, borrowed funds amounted to $6.9 billion, compared to $11.6 billion at December 31, 2007. Refer to Notes 14, 15 and 16 to the consolidated financial statements for detailed information on the Corporation’s borrowings as of such dates. Also, refer to the Liquidity Risk section in this MD&A for additional information on the Corporation’s funding sources at December 31, 2008.
     The decline in borrowings from December 31, 2007 to December 31, 2008 was principally impacted by the reduction in financing requirements due to the sale of the PFH assets during 2008. Also, the decrease was influenced by a general reduction in asset size given the maturities of investment securities, which proceeds were not reinvested in securities, and other sales of loan portfolios, such as the sales of auto loans by E-LOAN during 2008.
     During 2008, the Corporation placed less reliance on short-term borrowings, which declined from $1.5 billion at December 31, 2007 to $5 million at December 31, 2008. The reduction included less reliance on advances with the Federal Home Loan Banks and on advances under credit facilities with other financial institutions. There were also lower balances of repurchase agreements, which amounted to $3.4 billion at December 31,

 


 

43
Table I
Capital Adequacy Data
                                         
    As of December 31,
(Dollars in thousands)   2008   2007   2006   2005   2004
 
Risk-based capital:
                                       
Tier I capital
  $ 3,272,375     $ 3,361,132     $ 3,727,860     $ 3,540,270     $ 3,316,009  
Supplementary (Tier II) capital
    384,975       417,132       441,591       403,355       389,638  
 
Total capital
  $ 3,657,350     $ 3,778,264     $ 4,169,451     $ 3,943,625     $ 3,705,647  
 
Risk-weighted assets:
                                       
Balance sheet items
  $ 26,838,542     $ 30,294,418     $ 32,519,457     $ 29,557,342     $ 26,561,212  
Off-balance sheet items
    3,431,217       2,915,345       2,623,264       2,141,922       1,495,948  
 
Total risk-weighted assets
  $ 30,269,759     $ 33,209,763     $ 35,142,721     $ 31,699,264     $ 28,057,160  
 
Ratios:
                                       
Tier I capital (minimum required — 4.00%)
    10.81 %     10.12 %     10.61 %     11.17 %     11.82 %
Total capital (minimum required — 8.00%)
    12.08       11.38       11.86       12.44       13.21  
Leverage ratio*
    8.46       7.33       8.05       7.47       7.78  
Equity to assets
    8.21       8.20       7.75       7.06       7.28  
Tangible equity to assets
    6.64       6.64       6.25       5.86       6.59  
Equity to loans
    12.14       11.79       11.66       11.01       11.55  
Internal capital generation rate
    (42.11 )     (6.61 )     4.48       10.93       10.82  
 
*   All banks are required to have a minimum Tier I leverage ratio of 3% or 4% of adjusted quarterly average assets, depending on the bank’s classification.
 
2008, compared with $5.1 billion at December 31, 2007. This decline was due in part to lower volume of investment securities available as collateral due to the Corporation’s deleverage strategy. Notes payable also declined from $4.6 billion at December 31, 2007 to $3.4 billion at December 31, 2008. The decline was principally in medium-term notes, despite an issuance of $350 million of notes in private offerings to certain institutional investors during 2008.
     Other liabilities amounted to $1.1 billion at December 31, 2008, compared with $934 million at December 31, 2007, an increase of $162 million, or 17%. The increase in other liabilities was principally due to an increase in the liability for pension and restoration benefit plans of $200 million, which was primarily the result of a decline in the fair value of the plan assets due to the volatility in fair values in the current distressed market. Refer to Note 25 to the consolidated financial statements for information on the pension and restoration benefit plans, as well as the Critical Accounting Policies / Estimates section of this MD&A.
Stockholders’ Equity
Stockholders’ equity totaled $3.3 billion at December 31, 2008, compared with $3.6 billion at December 31, 2007. Refer to the consolidated statements of condition and of stockholders’ equity included in this Form 10-K for information on the composition of stockholders’ equity at December 31, 2008 and 2007. Also, the disclosures of accumulated other comprehensive loss, an integral component of stockholders’ equity, are included in the consolidated statements of comprehensive (loss) income.
     Stockholders’ equity decreased $314 million from the end of 2007 to December 31, 2008 as a result of the reduction in retained earnings due to the net loss of $1.2 billion recorded for the year ended December 31, 2008, dividends paid during the year and the $262 million negative after-tax adjustment to beginning retained earnings due to the transitional adjustment for electing the fair value option. These unfavorable variances were partially offset by the $400 million preferred stock offering in May 2008 and the $935 million of proceeds from the issuance of preferred stock under the TARP in December 2008. Accumulated other comprehensive loss reflected the impact of the increase in the underfunding of the pension and postretirement benefit plans and higher unrealized gains on securities available-for-sale.
     In May 2008, the Corporation issued $400 million of its 8.25% Non-cumulative Monthly Income Preferred Stock, 2008 Series B. These shares of preferred stock are perpetual, nonconvertible and are redeemable, in whole or in part, solely at the option of the Corporation with the consent of the Board of Governors of the Federal Reserve System beginning on May 28, 2013. The redemption price per share is $25.50 from May 28, 2013 through May 28, 2014, $25.25 from May 28, 2014 through May 28, 2015 and $25.00 from May 28, 2015 and thereafter. The Series B Preferred Stock was issued on May 28, 2008 at a purchase price of $25.00 per share.

 


 

44     POPULAR, INC. 2008 ANNUAL REPORT
Table J
Common Stock Performance
                                                                 
                    Cash
Dividends
  Book
Value
  Dividend           Price/   Market/
    Market Price   Declared   Per   Payout   Dividend   Earnings   Book
    High   Low   Per Share   Share   Ratio   Yield *   Ratio   Ratio
 
 
                                                               
2008
                          $ 6.33       N.M.       6.17 %     N.M.       81.52 %
4th quarter
  $ 8 3/5   $ 5     $ 0.08                                          
3rd quarter
    11 1/6     5 1/8     0.08                                          
2nd quarter
    13       6 3/5     0.16                                          
1st quarter
    14       9       0.16                                          
 
                                                               
2007
                            12.12       N.M.       4.38       (39.26x )     87.46  
4th quarter
  $ 12 1/2   $ 8 2/3   $ 0.16                                          
3rd quarter
    16 1/6     11 3/8     0.16                                          
2nd quarter
    17 1/2     15 5/6     0.16                                          
1st quarter
    19       15 5/6     0.16                                          
 
                                                               
2006
                            12.32       51.02 %     3.26       14.48       145.70  
4th quarter
  $ 19 2/3   $ 17 2/9   $ 0.16                                          
3rd quarter
    20 1/8     17 2/5     0.16                                          
2nd quarter
    22       18 1/2     0.16                                          
1st quarter
    21 1/5     19 1/2     0.16                                          
 
                                                               
2005
                            11.82       32.31       2.60       10.68       178.93  
4th quarter
  $ 24     $ 20 1/9   $ 0.16                                          
3rd quarter
    27 1/2     24 2/9     0.16                                          
2nd quarter
    25 2/3     23       0.16                                          
1st quarter
    28       23 4/5     0.16                                          
 
                                                               
2004
                            10.95       32.85       2.50       16.11       263.29  
4th quarter
  $ 28 7/8   $ 24 1/2   $ 0.16                                          
3rd quarter
    26 1/3     21 1/2     0.16                                          
2nd quarter**
    22       20       0.16                                          
1st quarter**
    24       21 1/2     0.14                                          
 
*   Based on the average high and low market price for the four quarters.
 
**   Per share data for these periods have been adjusted to reflect the two-for-one stock split effected in the form of a dividend on July 8, 2004.
N.M. refers to not meaningful value.
 
     On December 5, 2008, in connection with the TARP Capital Purchase Program, the Corporation issued and sold to the U.S. Treasury 935,000 shares of Popular, Inc.’s Fixed Rate Cumulative Perpetual Preferred Stock, Series C. The Preferred Stock Series C has a liquidation preference of $1,000 per share, and a warrant to purchase 20,932,836 shares of Popular’s common stock at an exercise price of $6.70 per share. Proceeds from the issuance amounted to $935 million. The allocated carrying values of the Series C Preferred Stock and the warrant on the date of issuance (based on the relative fair values) were $896 million and $39 million, respectively.
     The shares of Series C Preferred Stock qualify as Tier 1 regulatory capital and pay cumulative dividends quarterly at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series C Preferred Stock will accrete to the redemption price of $935 million over five years. The Series C Preferred Stock is non-voting, other than class voting rights on certain matters that could adversely affect the preferred shares. The Series C Preferred Stock may be redeemed by Popular at par after December 5, 2011. Prior to that date, the preferred shares may only be redeemed by Popular at par in an amount up to the cash proceeds received by Popular (minimum $233.75 million)

 


 

45
from qualifying equity offerings of any Tier 1 perpetual preferred or common stock. Any redemption is subject to the consent of the Board of Governors of the Federal Reserve System. Until December 5, 2011, or such earlier time as all preferred shares have been redeemed or transferred by Treasury, Popular will not, without Treasury’s consent, be able to increase its dividend rate per share of common stock or repurchase its common stock. The Series C Preferred Stock is not subject to any mandatory redemption, sinking fund or other similar provisions. Holders of Series C Preferred Stock will have no right to require redemption or repurchase of any shares of Series C Preferred Stock. The warrant is immediately exercisable and has a 10-year term. The Corporation’s common stock ranks junior to Series C Preferred Stock as to dividend rights and / or as to rights on liquidation, dissolution or winding up of the Corporation. Refer to Note 20 to the consolidated financial statements for further information with respect to the Series C preferred shares.
     The Corporation offers a dividend reinvestment and stock purchase plan for its stockholders that allows them to reinvest their quarterly dividends in shares of common stock at a 5% discount from the average market price at the time of the issuance, as well as purchase shares of common stock directly from the Corporation by making optional cash payments at prevailing market prices. No shares will be sold directly by the Corporation to participants in the dividend reinvestment and stock purchase plan at less than $6 per share, the par value of the Corporation’s common stock. During 2008, $17.7 million in additional capital was issued under the plan, compared to $20.2 million in 2007.
     The Corporation continues to exceed the well-capitalized guidelines under the federal banking regulations. At December 31, 2008 and 2007, BPPR and BPNA were all well-capitalized. Table I presents the Corporation’s capital adequacy information for the years 2004 to 2008. Note 21 to the consolidated financial statements presents further information on the Corporation’s regulatory capital requirements.
     Included within surplus in stockholders’ equity at December 31, 2008 was $392 million corresponding to a statutory reserve fund applicable exclusively to Puerto Rico banking institutions. This statutory reserve fund totaled $374 million at December 31, 2007. The Banking Act of the Commonwealth of Puerto Rico requires that a minimum of 10% of BPPR’s net income for the year be transferred to a statutory reserve account until such statutory reserve equals the total of paid-in capital on common and preferred stock. During 2008, $18 million was transferred to the statutory reserve. Any losses incurred by a bank must first be charged to retained earnings and then to the reserve fund. Amounts credited to the reserve fund may not be used to pay dividends without the prior consent of the Puerto Rico’s Commissioner of Financial Institutions. The failure to maintain sufficient statutory reserves would preclude BPPR from paying dividends. At December 31, 2008 and 2007, BPPR was in compliance with the statutory reserve requirement. The more relevant capital requirements applicable to the Corporation are the federal banking agencies’ capital requirements included in Table I.
     The average tangible equity amounted to $2.7 billion for the period ended December 31, 2008, compared to $3.1 billion at December 31, 2007. Total tangible equity was $2.6 billion at December 31, 2008, compared to $2.9 billion at December 31, 2007. The average tangible equity to average tangible assets ratio was 6.64% at December 31, 2008 and December 31, 2007. Tangible equity consists of total stockholders’ equity less goodwill and other intangibles.
Risk Management
Managing risk is an essential component of the Corporation’s business. The Corporation’s primary risk exposures are market, liquidity, credit and operational risks, all of which are discussed in the following sections. Risk identification and monitoring are key elements in overall risk management.
     The Corporation’s Board of Directors (the “Board”) has established a Risk Management Committee (“RMC”) to undertake the responsibilities of overseeing and approving the Corporation’s Risk Management Program. The RMC, management structure and established management committees jointly delineate the management of risks.
     The RMC will, as an oversight body, monitor and evaluate policies and procedures to identify, measure, monitor and control risks while maintaining the effectiveness and efficiency of the business and operational processes. As an approval body, the RMC reviews and approves or disapproves the Corporation’s risk management policies and risk management systems. It also reports periodically to the Board about its activities.
     The Board and RMC have delegated to the Corporation’s management the implementation of the risk management processes. This implementation is split into three separate but coordinated efforts that include business and / or operational units, a Corporate Risk Management Group (“CRMG”) and risk managers at the reportable segments. Moreover, management oversight of the Corporation’s risk-taking and risk management activities is conducted through management committees, some of which are as follows:
    CRESCO (Credit Risk Management Committee) — manages the Corporation’s overall credit exposure and approves credit policies, standards and guidelines that define, quantify, and monitor credit risk. Through this committee, management reviews asset quality ratios, trends and forecasts, problem loans, establishes the provision for loan losses and assesses the methodology

 


 

46     POPULAR, INC. 2008 ANNUAL REPORT
Table K
Interest Rate Sensitivity
                                                                 
    As of December 31, 2008
    By Repricing Dates
                    After   After   After                
            Within   three months   six months   nine months           Non-interest    
    0-30   31-90   but within   but within   but within   After one   bearing    
(Dollars in thousands)   days   days   six months   nine months   one year   year   funds   Total
 
Assets:
                                                               
Money market investments
  $ 763,809     $ 30,346     $ 200     $ 199             $ 100             $ 794,654  
Investment and trading securities
    1,271,221       178,259       128,646       301,626     $ 100,213       7,102,839               9,082,804  
Loans
    10,525,656       1,152,218       1,047,830       915,859       882,949       11,751,592               26,276,104  
Other assets
                                                  $ 2,729,207       2,729,207  
 
Total
    12,560,686       1,360,823       1,176,676       1,217,684       983,162       18,854,531       2,729,207       38,882,769  
 
Liabilities and stockholders’ equity:
                                                               
Savings, NOW, money market and other interest bearing demand accounts
    2,051,950       35       28,454               110       8,030,152               10,110,701  
Other time deposits
    1,635,902       2,020,242       3,083,801       1,916,237       1,177,544       3,312,225               13,145,951  
Federal funds purchased and assets sold under agreements to repurchase
    1,876,730       327,015       62,000                       1,285,863               3,551,608  
Other short-term borrowings
    2,711       1,400       823                                       4,934  
Notes payable
    215,244       251,609       608,926       813       819       2,309,352               3,386,763  
Non-interest bearing deposits
                                                    4,293,553       4,293,553  
Other non-interest bearing liabilities and minority interest
                                                    1,120,895       1,120,895  
Stockholders’ equity
                                                    3,268,364       3,268,364  
 
Total
  $ 5,782,537     $ 2,600,301     $ 3,784,004     $ 1,917,050     $ 1,178,473     $ 14,937,592     $ 8,682,812     $ 38,882,769  
 
Interest rate swaps
    200,000               (200,000 )                                        
Interest rate sensitive gap
    6,978,149       (1,239,478 )     (2,807,328 )     (699,366 )     (195,311 )     3,916,939       (5,953,605 )        
Cumulative interest rate sensitive gap
    6,978,149       5,738,671       2,931,343       2,231,977       2,036,666       5,953,605                  
Cumulative interest rate sensitive gap to earning assets
    19.30 %     15.87 %     8.11 %     6.17 %     5.63 %     16.47 %                
 
*   This table includes information from the discontinued operations.
 
      and adequacy of the allowance for loan losses on a monthly basis.
 
    ALCO (Asset / Liability Management Committee) — oversees and approves the policies and processes designed to ensure prudent market risk and balance sheet management including interest rate, liquidity, investment and trading policies.
 
    ORCO (Operational Risk Committee) — monitors operational risk management activities to ensure the development and consistent application of operational risk policies, processes and procedures that measure, limit and manage the Corporation’s operational risks while maintaining the effectiveness and efficiency of the operating and businesses processes. It also reviews and approves operational risk tolerance levels and positions across the Corporation.
Market Risk
Market risk represents the risk of loss due to adverse movements in market rates or prices, which include interest rates, foreign exchange rates and equity prices; the failure to meet financial obligations coming due because of the inability to liquidate assets or obtain adequate funding; and the inability to easily unwind or offset specific exposures without significantly lowering prices because of inadequate market depth or market disruptions.
     The ALCO and the Corporate Finance Group are responsible for planning and executing the Corporation’s market, interest rate risk, funding activities and strategy, and for implementing the policies and procedures approved by the RMC.
     The financial results and capital levels of Popular, Inc. are constantly exposed to market risk.
     Current levels of market volatility are unprecedented. The capital and credit markets have been experiencing volatility and disruption for more than 12 months. The markets have produced

 


 

47
downward pressure on stock prices and credit availability for certain issuers, often without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that the Corporation will not experience an adverse effect, which may be material, on its ability to access capital and on its business, financial condition and results of operations. The programs announced in the fourth quarter of 2008 by the federal government should help ensure that the Corporation obtain access to capital markets liquidity, if needed. The FDIC TLGP program permits the Corporation to issue senior debt with an FDIC guarantee.
     Significant declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks, and also in sales of those assets at significantly discounted prices. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with more strongly capitalized institutions and, in some cases, to fail. Concerned about the general stability of the financial markets and the strength of counterparties, many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers including other financial institutions. The resulting lack of available credit, lack of confidence in the financial sector, increased volatility in the financial markets and reduced business activity could also materially and adversely affect the Corporation’s ability to raise capital or longer-term financing.
     Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. The Corporation has exposure to many different industries and counterparties, and management routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients. Many of these transactions expose the Corporation to credit risk in the event of default of the Corporation’s counterparty or client. In addition, the Corporation’s credit risk may be exacerbated when the collateral held by it cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure. There is no assurance that any such losses would not materially and adversely affect the Corporation’s results of operations.
     Despite the varied nature of market risks, the primary source of this risk to the Corporation is the impact of changes in interest rates on net interest income. Net interest income is the difference between the revenue generated on earning assets and the interest cost of funding those assets. Depending on the duration and repricing characteristics of the assets, liabilities and off-balance sheet items, changes in interest rates could either increase or decrease the level of net interest income. For any given period, the pricing structure of the assets and liabilities is matched when an equal amount of such assets and liabilities mature or reprice in that period. Any mismatch of interest earning assets and interest bearing liabilities is known as a gap position. A positive gap denotes asset sensitivity, which means that an increase in interest rates could have a positive effect on net interest income, while a decrease in interest rates could have a negative effect on net interest income. At December 31, 2008, the Corporation had a positive gap position as shown on Table K of this MD&A.
     The Board of Governors of the Federal Reserve, which influences interest rates, lowered interbank borrowing rates during the year ended December 31, 2008 between 400 and 425 basis points. The Board of Governors of the Federal Reserve has also expressed concerns about a variety of economic conditions. Many of the Corporation’s commercial loans are variable-rate and, accordingly, rate decreases may result in lower interest income to Popular in the near term; however, depositors will continue to expect reasonable rates of interest on their accounts, potentially compressing net interest margins further. The future outlook on interest rates and their impact on Popular’s interest income, interest expense and net interest income is uncertain.
     Because of the current economic and market crisis, the governments of major world economic powers, including the United States, have taken extraordinary steps to stabilize the financial system. For example, the U.S. Government has passed the EESA, which provides the U.S. Treasury Department the ability to purchase or insure troubled assets held by financial institutions. In addition, the Treasury Department has the ability to purchase equity stakes in financial institutions. Other extraordinary measures taken by U.S. governmental agencies include increasing deposit insurance limits, providing financing to money market mutual funds, and purchasing commercial paper. It is not clear at this time what impacts these measures, as well as other extraordinary measures previously announced or that will be announced in the future, will have on the Corporation or the financial markets as a whole. Management will continue to monitor the effects of these programs as they relate to the Corporation and its future operations. Refer to the Overview of this MD&A for additional information on the regulatory initiatives and the impact to Popular as of the end of 2008.
Interest Rate Risk
Interest rate risk (“IRR”), a component of market risk, is the exposure to adverse changes in net interest income due to changes in interest rates. Management considers IRR a predominant market risk in terms of its potential impact on profitability or market value.

 


 

48     POPULAR, INC. 2008 ANNUAL REPORT
Table L

Maturity Distribution of Earning Assets
                                                 
    As of December 31, 2008
    Maturities
            After one year        
            through five years   After five years    
            Fixed   Variable   Fixed   Variable    
    One year   interest   interest   interest   interest    
(In thousands)   or less   rates   rates   rates   rates   Total
 
Money market securities
  $ 794,554     $ 100                       $ 794,654  
Investment and trading securities
    758,556       5,257,639     $ 213,224     $ 1,943,736     $ 681,831       8,854,986  
Loans:
                                               
Commercial
    5,051,467       2,438,344       2,586,886       1,288,481       2,321,881       13,687,059  
Construction
    1,715,013       40,092       433,017       5,981       18,710       2,212,813  
Lease financing
    618,139       460,340             2,331             1,080,810  
Consumer
    2,153,422       1,533,034       419,408       162,539       380,381       4,648,784  
Mortgage
    880,873       1,288,972       420,000       1,500,690       548,930       4,639,465  
 
Total
  $ 11,972,024     $ 11,018,521     $ 4,072,535     $ 4,903,758     $ 3,951,733     $ 35,918,571  
 
Notes:    Equity securities available-for-sale and other investment securities, including Federal Reserve Bank stock and Federal Home Loan Bank stock held by the Corporation, are not included in this table.
 
    Loans held-for-sale have been allocated according to the expected sale date.
 
     The Corporation is subject to various categories of interest rate risk, including:
    Repricing or Term Structure Risk — this risk arises due to mismatches in the timing of rate changes and cash flows from the Corporation’s assets and liabilities. For example, if assets reprice or mature at a faster pace than liabilities and interest rates are generally declining, earnings could initially decline.
 
    Basis Risk — this risk involves changes in the spread relationship of the different rates that impact the Corporation’s balance sheet. This type of risk is present when assets and liabilities have similar repricing frequencies but are tied to different market interest rate indexes.
 
    Yield Curve Risk — short-term and long-term market interest rates may change by different amounts; for example, the shape of the yield curve may affect new loan yields and funding costs differently.
 
    Options Risk — changes in interest rates may shorten or lengthen the maturities of assets and liabilities. For example, prepayments, which tend to increase when market rates decline, may accelerate maturities for mortgage related products. In addition, call options in the Corporation’s investment portfolios may be exercised in a declining rate. Conversely, the opposite would occur in a rising interest rate scenario.
     In addition to the risks detailed above, interest rates may have an indirect impact on loan demand, credit losses, loan origination volume, the value of the Corporation’s investment securities holdings, gains and losses on sales of securities and loans, the value of mortgage servicing rights, and other sources of earnings. In limiting interest rate risk to an acceptable level, management may alter the mix of floating and fixed rate assets and liabilities, change pricing schedules, adjust maturities through sales and purchases of investment securities, and enter into derivative contracts, among other alternatives.
     Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective management of interest rate risk begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate rate risk position given line of business forecasts, management objectives, market expectations and policy constraints.
     Designated management, as previously described, implements the market risk policies approved by the Board as well as the risk management strategies reviewed and adopted by the RMC on its meetings. The ALCO measures and monitors the level of short and long-term IRR assumed by the Corporation and its subsidiaries. It uses simulation analysis and static gap estimates for measuring short-term IRR. Economic value of equity (“EVE”) analysis is used to monitor the level of long-term IRR assumed. During 2008, management expanded the types of analyses used to measure interest rate risk. Simulations used to isolate and measure basis

 


 

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and yield curve risk exposures were developed as well as prepayment stress scenarios.
     Static gap analysis measures the volume of assets and liabilities maturing or repricing at a future point in time. The repricing volumes typically include adjustments for anticipated future asset prepayments and for differences in sensitivity to market rates. The volume of assets and liabilities repricing during future periods, particularly within one year, is used as one short-term indicator of IRR. Table K presents the static gap estimate for the Corporation as of December 31, 2008. These static measurements do not reflect the results of any projected activity and are best used as early indicators of potential interest rate exposures. They do not incorporate possible action that could be taken to manage the Corporation’s IRR.
     The interest rate sensitivity gap is defined as the difference between earning assets and interest bearing liabilities maturing or repricing within a given time period. At December 31, 2008, the Corporation’s one-year cumulative positive gap was $2.0 billion, or 5.63% of total earning assets.
     Net interest income simulation analysis performed by legal entity and on a consolidated basis is another tool used by the Corporation in estimating the potential change in future earnings resulting from hypothetical changes in interest rates. Sensitivity analysis is calculated on a monthly basis using a simulation model which incorporates actual balance sheet figures detailed by maturity and interest yields or costs. It also incorporates assumptions on balance sheet growth and expected changes in its composition, estimated prepayments in accordance with projected interest rates, pricing and maturity expectations on new volumes and other non-interest related data. Simulations are processed using various interest rate scenarios to determine potential changes to the future earnings of the Corporation. The types of rate scenarios processed during the year include economic most likely scenarios, flat rates, yield curve twists, +/- 200 basis points parallel ramps and +/- 200 basis points parallel shocks. The asset and liability management group also performs validation procedures on various assumptions used as part of the sensitivity analysis as well as validations of results on a monthly basis. Due to the importance of critical assumptions in measuring market risk, the risk models incorporate third-party developed data for critical assumptions such as prepayment speeds on mortgage loans, estimates on the duration of the Corporation’s deposits and interest rate scenarios.
     Simulation analyses are based on many assumptions, including relative levels of market interest rates, interest rate spreads, loan prepayments and deposit decay. Thus, they should not be relied upon as indicative of actual results. Further, the estimates do not contemplate actions that management could take to respond to changes in interest rates. By their nature, these forward-looking computations are only estimates and may be different from what may actually occur in the future.
     The Corporation usually runs its net interest income simulations under interest rate scenarios in which the yield curve is assumed to rise and decline gradually by the same amount, usually 200 basis points. Given the fact that as of year-end 2008, some short-term rates were close to zero and some term interest rates were below 2.0%, management has decided to focus measuring the risk of net interest income in rising rate scenarios. The rising rate scenarios used were gradual parallel changes of 200 and 400 basis points during the twelve-month period ending December 31, 2009. Projected net interest income under the 200 basis points rising rate scenario increased by $50.9 million while the 400 basis points simulation increased by $90.8 million. These scenarios were compared against the Corporation’s flat interest rates forecast.
     The Corporation’s loan and investment portfolios are subject to prepayment risk, which results from the ability of a third-party to repay debt obligations prior to maturity. At December 31, 2008, net discount associated with loans acquired represented less than 1% of the total loan portfolio, while net premiums associated with portfolios of AFS and HTM securities approximated 1% of these investment securities portfolios. Prepayment risk also could have a significant impact on the duration of mortgage-backed securities and collateralized mortgage obligations, since prepayments could shorten the weighted average life of these portfolios. Table L, which presents the maturity distribution of earning assets, takes into consideration prepayment assumptions, as determined by management, based on the expected interest rate scenario.
     The Corporation uses EVE analysis to attempt to measure the sensitivity of its assets and liabilities to changes in interest rates. EVE is equal to the estimated present value of the Corporation’s assets minus the estimated present value of the liabilities. It is a useful tool to measure long-term interest rate risk because it captures cash flows from all future periods.
     EVE is estimated on a monthly basis and shock scenarios are prepared on a quarterly basis. The shock scenarios consist of +/-200 basis points parallel shocks. As previously mentioned, given the low levels of current market rates, the Corporation will focus on measuring the risk in a rising rate scenario. Minimum EVE ratio limits, expressed as EVE as a percentage of total assets, have been established for base case and shock scenarios. In addition, management has also defined limits for the increases / decreases in EVE resulting from the shock scenarios. As of December 31, 2008, the Corporation was in compliance with these limits.
Trading
The Corporation’s trading activities are another source of market risk and are subject to policies and risk guidelines approved by the Board to manage such risks. Most of the Corporation’s trading activities are limited to mortgage banking activities and the

 


 

50     POPULAR, INC. 2008 ANNUAL REPORT
market-making activities of the Corporation’s broker-dealer business. Trading positions in the mortgage banking business, which are mostly agency mortgage-backed securities, are hedged in the agency TBA market. In anticipation of customer demand, the Corporation carries an inventory of capital market instruments and maintains market liquidity by quoting bid and offer prices and trading with other market makers and clients. Positions are also taken in interest rate sensitive instruments, based on expectations of future market conditions. These activities constitute the proprietary trading business and are conducted by the Corporation to provide customers with securities inventory and liquidity.
     Trading instruments are recognized at market value, with changes resulting from fluctuations in market prices, interest rates or exchange rates reported in current period income. Further information on the Corporation’s risk management and trading activities is included in Note 33 to the consolidated financial statements.
     In the opinion of management, the size and composition of the trading portfolio does not represent a potentially significant source of market risk for the Corporation.
     At December 31, 2008, the trading portfolio of the Corporation amounted to $646 million and represented 2% of total assets, compared with $768 million and 2% a year earlier. Mortgage-backed securities represented 92% of the trading portfolio at the end of 2008, compared with 90% in 2007. The mortgage-backed securities are investment grade securities, all of which are rated AAA by at least one of the three major rating agencies at December 31, 2008. A significant portion of the trading portfolio is hedged against market risk by positions that offset the risk assumed. This portfolio was composed of the following at December 31, 2008:
                 
            Weighted
(Dollars in thousands)   Amount   Average Yield*
 
Mortgage-backed securities
  $ 591,390       5.99 %
CMO
    4,776       5.91  
Commercial paper
    4,600       3.05  
U.S. Treasury and agencies
    275        
Puerto Rico and U.S. Government obligations
    27,808       5.99  
Interest-only strips
    1,803       26.32  
Other
    15,251       6.76  
 
 
  $ 645,903       6.04 %
 
*   Not on a taxable equivalent basis.
 
     At December 31, 2008, the trading portfolio of the Corporation had an estimated duration of 2.45 years and a one-month value at risk (VAR) of approximately $3 million, assuming a confidence level of 95%. VAR is a key measure of market risk for the Corporation. VAR represents the maximum amount that the Corporation can expect to lose within one month in the course of its risk taking activities with 95% confidence. Its purpose is to describe the amount of capital needed to absorb potential losses from adverse market volatility. There are numerous assumptions and estimates associated with VAR modeling, and actual results could differ from these assumptions and estimates.
     The Corporation enters into forward contracts to sell mortgage-backed securities with terms lasting less than a month which are accounted for as trading derivatives. These contracts are recognized at fair value with changes directly reported in current period income. Refer to the Derivatives section that follows in this MD&A for additional information. At December 31, 2008, the fair value of these forward contracts was not significant.
Derivatives
The Corporation utilizes derivatives as part of its overall interest rate risk management strategy to protect against changes in net interest income and cash flows. Derivative instruments that the Corporation may use include, among others, interest rate swaps and caps, index options, and forward contracts. The Corporation does not use highly leveraged derivative instruments in its interest rate risk management strategy. The Corporation also enters into interest rate swaps, interest rate caps and foreign exchange contracts for the benefit of commercial customers. The Corporation economically hedges its exposure related to these commercial customer derivatives by entering into offsetting third-party contracts with approved, reputable counterparties with substantially matching terms and currencies. Refer to Note 33 to the consolidated financial statements for further information on the Corporation’s involvement in derivative instruments and hedging activities.
     The Corporation’s derivative activities are entered primarily to offset the impact of market volatility on the economic value of assets or liabilities. The net effect on the market value of potential changes in interest rates of derivatives and other financial instruments is analyzed. The effectiveness of these hedges is monitored to ascertain that the Corporation is reducing market risk as expected. Derivative transactions are generally executed with instruments with a high correlation to the hedged asset or liability. The underlying index or instrument of the derivatives used by the Corporation is selected based on its similarity to the asset or liability being hedged. As a result of interest rate fluctuations, hedged fixed and variable interest rate assets and liabilities will appreciate or depreciate in fair value. The effect of this unrealized appreciation or depreciation is expected to be substantially offset by the Corporation’s gains or losses on the derivative instruments that are linked to these hedged assets and liabilities. Management will assess if circumstances warrant liquidating or replacing the derivatives position in the

 


 

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hypothetical event that high correlation is reduced. Based on the Corporation’s derivative instruments outstanding at December 31, 2008, it is not anticipated that such a scenario would have a material impact on the Corporation’s financial condition or results of operations.
     Certain derivative contracts also present credit risk because the counterparties may not meet the terms of the contract. The Corporation controls credit risk through approvals, limits and monitoring procedures. The Corporation deals exclusively with counterparties that have high quality credit ratings. Further, as applicable under the terms of the master arrangements, the Corporation may obtain collateral, where appropriate, to reduce credit risk. The credit risk attributed to the counterparty nonperformance risk is incorporated in the fair value of the derivatives. Additionally, as required by SFAS No. 157, the fair value of the Corporation’s own credit standing is considered in the fair value of the derivative liabilities. At December 31, 2008, inclusion of the credit risk in the fair value of the derivatives resulted in a net benefit of $1.8 million, which consisted of a loss of $7.1 million resulting from the assessment of the counterparties’ credit risk and a gain of $8.9 million from the Corporation’s credit standing adjustment.
Cash Flow Hedges
Utilizing a cash flow hedging strategy, the Corporation manages the variability of cash payments due to interest rate fluctuations by the effective use of derivatives linked to hedged assets and liabilities. The notional amount of derivatives designated as cash flow hedges as of December 31, 2008 amounted to $313 million. The cash flow hedges outstanding related to forward contracts or “to be announced” (“TBA”) mortgage-backed securities that are sold and bought for future settlement to hedge the sale of mortgage-backed securities and loans prior to securitization, had a notional amount of $113 million at December 31, 2008. The seller agrees to deliver on a specified future date, a specified instrument, at a specified price or yield. These securities are hedging a forecasted transaction and thus qualify for cash flow hedge accounting.
     In conjunction with the issuance of medium-term notes, the Corporation entered into interest rate swaps to convert floating rate debt to fixed rate debt with the objective of minimizing the exposure to changes in cash flows due to higher interest rates. These contracts are designated as cash flow hedges for accounting purposes in accordance with SFAS No. 133, and have a notional amount of $200 million at December 31, 2008. Refer to Note 33 to the consolidated financial statements for additional quantitative information on these derivative contracts.
Fair Value Hedges
The Corporation did not have any outstanding derivatives designated as fair value hedges at December 31, 2008 and 2007.
Trading and Non-Hedging Derivative Activities
The Corporation takes derivative positions based on market expectations or to benefit from price differentials between financial instruments and markets. However, these derivatives instruments are mostly utilized to economically hedge a related asset or liability. The Corporation also enters into various derivatives to provide these types of products to customers. These types of free-standing derivatives are carried at fair value with changes in fair value recorded as part of the results of operations for the period.
     Following is a description of the most significant of the Corporation’s derivative activities that do not qualify for hedge accounting as defined in SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (as amended). Refer to Note 33 to the consolidated financial statements for additional quantitative and qualitative information on these derivative instruments.
     At December 31, 2008, the Corporation had outstanding $2.1 billion in notional amount of interest rate swap agreements with a positive fair value (asset) of $2 million, which were not designated as accounting hedges. These swaps were entered in the Corporation’s capacity as an intermediary on behalf of its customers and their offsetting swap position.
      For the year ended December 31, 2008, the impact of the mark-to-market of interest rate swaps not designated as accounting hedges was a net decrease in earnings of approximately $2.5 million, primarily in the interest expense category of the statement of operations, compared with an earnings reduction of approximately $11.6 million in 2007 mainly in the interest expense category. Derivatives that the Corporation no longer utilized at December 31, 2008 included swaps to economically hedge changes in the fair value of loans prior to securitization, swaps that were economically hedging the cost of short-term borrowings, and swaps that were hedging the payments of bond certificates offered as part of on-balance sheet securitizations. Additionally, during 2007, the Corporation cancelled all swaps related to the auto loans because a substantial amount of that loan portfolio was sold.
     Another strategy that was discontinued in the latter part of 2008 was the issuing of interest rate lock commitments (“IRLCs”) in connection with E-LOAN’s activities to fund mortgage loans

 


 

52      POPULAR, INC. 2008 ANNUAL REPORT
at interest rates previously agreed (locked) by both the Corporation and the borrower for a specified period of time. These IRLCs were recognized as derivatives pursuant to SFAS No. 133. To account for the changes in IRLC’s market value, the Corporation entered into forward loan sales commitments to economically hedge the risk of potential changes in the value of the loans that would result from these commitments. This strategy was discontinued since E-LOAN ceased originating mortgage loans in 2008. At December 31, 2007, the Corporation had outstanding IRLCs with a notional amount of $149 million and a negative fair value (liability) of $128 thousand.
     At December 31, 2008, the Corporation had forward contracts with a notional amount of $272 million and a negative fair value (liability) of $5 million not designated as accounting hedges. These forward contracts are considered derivatives under SFAS No. 133 and are recorded at fair value. Subsequent changes in the value of these forward contracts are recorded in the statement of operations. These forward contracts are principally used to economically hedge the changes in fair value of mortgage loans held-for-sale and mortgage pipeline through both mandatory and best efforts forward sale agreements. These forward contracts are entered into in order to optimize the gain on sale of loans and / or mortgage-backed securities. For the year ended December 31, 2008, the impact of the mark-to-market of the forward contracts not designated as accounting hedges was a reduction to earnings of $15.3 million, which was included in the categories of trading account profit and gain on sale of loans in the consolidated statement of operations. In 2007, the unfavorable impact to earnings of $11.2 million was also included in the categories of trading account profit and gain on sale of loans.
     Furthermore, the Corporation has over-the-counter option contracts which are utilized in order to limit the Corporation’s exposure on customer deposits whose returns are tied to the S&P 500 or to certain other equity securities or commodity indexes. The Corporation, through its Puerto Rico banking subsidiary, BPPR, offers certificates of deposit with returns linked to these indexes to its retail customers, principally in connection with IRA accounts, and certificates of deposit sold through its broker-dealer subsidiary. At December 31, 2008, these deposits amounted to $179 million, or less than 1% of the Corporation’s total deposits. In these certificates, the customer’s principal is guaranteed by BPPR and insured by the FDIC to the maximum extent permitted by law. The instruments pay a return based on the increase of these indexes, as applicable, during the term of the instrument. Accordingly, this product gives customers the opportunity to invest in a product that protects the principal invested but allows the customer the potential to earn a return based on the performance of the indexes.
     The risk of issuing certificates of deposit with returns tied to the applicable indexes is hedged by BPPR. BPPR purchases index options from financial institutions with strong credit standings, whose return is designed to match the return payable on the certificates of deposit issued. By hedging the risk in this manner, the effective cost of the deposits raised by this product is fixed. The contracts have a maturity and an index equal to the terms of the pool of client’s deposits they are economically hedging.
     The purchased option contracts are initially accounted for at cost (i.e., amount of premium paid) and recorded as a derivative asset. The derivative asset is marked-to-market on a quarterly basis with changes in fair value charged to earnings. The deposits are hybrid instruments containing embedded options that must be bifurcated in accordance with SFAS No. 133. The initial value of the embedded option (component of the deposit contract that pays a return based on changes in the applicable indexes) is bifurcated from the related certificate of deposit and is initially recorded as a derivative liability and a corresponding discount on the certificate of deposit is recorded. Subsequently, the discount on the deposit is accreted and included as part of interest expense while the bifurcated option is marked-to-market with changes in fair value charged to earnings.
     The purchased index options are used to economically hedge the bifurcated embedded option. These option contracts do not qualify for hedge accounting in accordance with the provisions of SFAS No. 133 and therefore cannot be designated as accounting hedges. At December 31, 2008, the notional amount of the index options on deposits approximated $209 million with a fair value of $9 million (asset) while the embedded options had a notional value of $179 million with a fair value of $9 million (liability).
     Refer to Note 33 to the consolidated financial statements for a description of other non-hedging derivative activities utilized by the Corporation during 2008 and 2007.
Foreign Exchange
The Corporation conducts business in certain Latin American markets through several of its processing and information technology services and products subsidiaries. Also, it holds interests in Consorcio de Tarjetas Dominicanas, S.A. (“CONTADO”) and Centro Financiero BHD, S.A. (“BHD”) in the Dominican Republic. Although not significant, some of these businesses are conducted in the country’s foreign currency. The resulting foreign currency translation adjustment, from operations for which the functional currency is other than the U.S. dollar, is reported in accumulated other comprehensive loss in the consolidated statements of condition, except for highly-inflationary environments in which the effects are included in other operating income in the consolidated statements of operations.

 


 

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     At December 31, 2008, the Corporation had approximately $39 million in an unfavorable foreign currency translation adjustment as part of accumulated other comprehensive loss, compared to unfavorable adjustments of $35 million at December 31, 2007 and $37 million at December 31, 2006.
Liquidity Risk
Liquidity is the ongoing ability to meet liability maturities and deposit withdrawals, fund asset growth and business operations, and repay contractual obligations at reasonable cost and without incurring material losses. Liquidity management involves forecasting funding requirements and maintaining sufficient capacity to meet the needs and accommodate fluctuations in asset and liability levels due to changes in the Corporation’s business operations or unanticipated events.
     Cash requirements for a financial institution are primarily made up of deposit withdrawals, contractual loan funding, the repayment of borrowings as they mature and the ability to fund new and existing investments as opportunities arise. An institution’s liquidity may be pressured if, for example, its credit rating is downgraded, it experiences a sudden and unexpected substantial cash outflow, or some other event causes counterparties to avoid exposure to the institution. An institution is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. The objective of effective liquidity management is to ensure that the Corporation remains sufficiently liquid to meet all of its financial obligations, finance expected future growth and maintain a reasonable safety margin for cash commitments under both normal operating conditions and under unpredictable circumstances of industry or market stress.
     The Board is responsible for establishing Popular’s tolerance for liquidity risk including approving relevant risk limits and policies. The Board has delegated the monitoring of these risks to the RMC and the ALCO. The management of liquidity risk, on both a long-term and day-to-day basis, is the responsibility of the Corporate Treasury Division. The Corporation’s Corporate Treasurer is responsible for implementing the policies and procedures approved by the Board and for monitoring the liquidity position on an ongoing basis. Also, the Corporate Treasury Division coordinates corporate wide liquidity management strategies and activities with the reportable segments, oversees any policy breaches and manages the escalation process. The Corporate Treasurer reports to the ALCO and RMC the Corporation’s liquidity risk position, any critical risks or issues and proposed solutions.
     The Corporation has established policies and procedures to assist it in remaining sufficiently liquid to meet all of its financial obligations, finance expected future growth and maintain a reasonable safety margin for cash commitments under both normal operating conditions and unsettled market environments.
Liquidity, Funding and Capital Resources
The financial market disruptions that began in 2007 severely impacted the economy and financial services sector during 2008. The unsecured short-term funding markets remained stressed as investors reduced their exposures and were hesitant to lend cash on a long-term basis. The commercial paper markets essentially ceased to function efficiently. Also, the availability of overnight and term funds in the interbank market was substantially reduced.
     As indicated earlier, the U.S. credit markets have been marked by unprecedented instability and disruption since 2007, making most funding activities much more challenging for financial institutions. Credit spreads have widened significantly and rapidly as many investors allocated their funds to only the highest-quality financial assets such as U.S. government securities. The result of these actions taken by market participants made it more difficult for corporate borrowers to raise financing in the credit markets and reduced the value of most financial assets except the highest-quality obligations.
     Several sectors have been significantly impacted, including the money markets, the corporate debt market and more recently, the municipal securities markets. A primary catalyst of the market disruptions has been an abrupt shift by investors away from non-government securities into U.S. Government obligations, and the unwillingness to assume many types of risk.
     The Corporation has historically financed a portion of its business in the money and corporate bond markets, both of which have been adversely affected by financial market developments since the beginning of the third quarter of 2007. As it became more challenging to raise financing in the capital markets, the Corporation’s management took actions to reduce the use of borrowings to finance its businesses and thus ensure access to stable sources of liquidity. These actions, which are explained below, included, for example, replacing short-term unsecured borrowings with deposits and increasing secured lines of credit for contingency purposes.
     The Corporation’s liquidity position is closely monitored on an ongoing basis. Sources of liquidity include access to a stable base of core deposits and to brokered deposits available in the national markets. Other sources are available with other third-party providers, which may include primarily secured credit lines and on-balance sheet liquidity in the form of unpledged securities. In addition to these, asset sales could be a source of liquidity to the Corporation. Even if some of these alternatives may not be available temporarily, it is expected that in the normal course of business, the Corporation’s funding sources are adequate.

 


 

54     POPULAR, INC. 2008 ANNUAL REPORT
     Liquidity is managed at the level of the holding companies that own the banking and non-banking subsidiaries. Also, it is managed at the level of the banking and non-banking subsidiaries.
     The subsequent sections provide further information on the Corporation’s major funding activities and needs, as well as the risks involved in these activities. A more detailed description of the Corporation’s borrowings and available lines of credit, including its terms, is included in Notes 14 through 18 to the consolidated financial statements. Also, the consolidated statements of cash flows in the accompanying consolidated financial statements provide information on the Corporation’s cash inflows and outflows.
     While market conditions have been challenging, the Corporation was able to maintain a stable base of deposits. Also, the Corporation took a series of actions to enhance its liquidity and capital position during 2008. The following major events impacted the Corporation’s funding activities and capital position during 2008:
    The Corporation repaid $500 million in medium-term notes upon their maturity in April 2008.
 
    During the second quarter of 2008, the Corporation completed the public offering of $400 million of 8.25% Non-cumulative Monthly Income Preferred Stock, Series B, which qualifies in its entirety as “Tier I” capital for risk-based capital ratios. Net proceeds were used for general corporate purposes, including funding subsidiaries and increasing Popular’s liquidity and capital.
 
    As previously indicated in the Discontinued Operations section in this MD&A, during 2008, the Corporation sold substantially all assets of PFH. The proceeds from the transactions were used to cancel short-term debt and provided additional liquidity to the bank holding companies.
 
    During the third quarter and early fourth quarter of 2008, Popular, Inc. issued an aggregate principal amount of $350 million of senior notes in private offerings to certain institutional investors. The notes mature in 2011 subject to specific provisions under the note indentures. The proceeds from the issuances, coupled with the proceeds from the sale of the PFH assets, were used for general corporate purposes, including the upcoming repayment of medium-term notes due in 2009.
 
    There were reductions in short-term borrowings in the normal course of business related in part to lower volume of investment securities and loans, including reductions from the sales by PFH.
 
    Brokered deposits, which amounted to $3.1 billion at December 31, 2008, continued to be used as an important funding source of on-hand liquidity amidst the financial industry developments in the second half of 2008. The level of brokered deposits at year-end 2008 was at the same level as in the previous year. One of the strategies followed by management during 2007 in response to the unprecedented market disruptions was the utilization of brokered deposits to replace short-term uncommitted lines of credit.
 
    The Board of Directors reduced the quarterly dividend level from $0.16 per common share to $0.08 per common share commencing in the third quarter of 2008. The new dividend payment rate represents a reduction of 50 percent from its previous quarterly dividend payment rate. The reduction will help preserve $90 million of capital a year. In February 2009, the Board reduced again the common dividend to $0.02 per common share. This will conserve an additional $68 million in capital per year. The dividend payment is reviewed on a quarterly basis.
 
    As indicated earlier, in December 2008, the Corporation received $935 million as part of the TARP Capital Purchase Program in exchange for senior preferred stock and a warrant to purchase shares of common stock of the Corporation. The Corporation has made capital contributions to BPNA with the proceeds from the TARP to ensure the entity remained well-capitalized. The remaining proceeds have been temporarily deployed to purchase mortgage-backed securities, corporate bonds, and as a loan to the Corporation’s subsidiary BPPR. The funds provided to both banks will encourage creditworthy lending in our home markets.
     Holders of the Corporation’s common stock are only entitled to receive such dividends as the Board may declare out of funds legally available for such payments. Although the Corporation has historically declared cash dividends on its common stock, it is not required to do so, and it may have to reduce the amount of cash dividends payable on the common stock in future periods as circumstances warrant. Dividends on the Corporation’s preferred stock, 2003 Series A and 2008 Series B, are non-cumulative and is payable only if declared by the Board, and can only be declared out of funds legally available for such payments. Dividends on the Series C Preferred Stock are cumulative and can only be declared out of funds legally available for such payments. The Corporation’s

 


 

55
Table M
Average Total Deposits
                                                 
    For the Year
                                            Five-Year
(Dollars in thousands)   2008   2007   2006   2005   2004   C.G.R.
 
Non-interest bearing demand deposits
  $ 4,120,280     $ 4,043,427     $ 3,969,740     $ 4,068,397     $ 3,918,452       3.35 %
 
Savings accounts
    5,600,377       5,697,509       5,440,101       5,676,452       5,407,600       1.53  
NOW, money market and other interest bearing demand accounts
    4,948,186       4,429,448       3,877,678       3,731,905       2,965,941       14.17  
 
Certificates of deposit:
                                               
Under $100,000
    6,955,843       3,949,262       3,768,653       3,382,445       3,067,220       19.30  
$100,000 and over
    4,598,146       5,928,983       4,963,534       4,266,983       3,144,173       9.80  
 
Certificates of deposit
    11,553,989       9,878,245       8,732,187       7,649,428       6,211,393       14.94  
 
Other time deposits
    1,241,447       1,520,471       1,244,426       1,126,887       905,669       10.25  
 
Total interest bearing deposits
    23,343,999       21,525,673       19,294,392       18,184,672       15,490,603       10.36  
 
Total deposits
  $ 27,464,279     $ 25,569,100     $ 23,264,132     $ 22,253,069     $ 19,409,055       9.11 %
 
issuance of preferred shares to the U.S. Treasury under the TARP Capital Purchase Program also imposes restrictions on the Corporation’s ability to pay dividends under certain conditions. Refer to Note 20 to the consolidated financial statements for detailed information on the Series C preferred stock.
     The preferred stock issuances described above, including the participation in the TARP, the reduction in the common stock dividend payment, as well as the sales of PFH assets substantially improved the Corporation’s liquidity and capital position. Management believes that the measures that have been taken and the current sources of liquidity, some of which are described in the sections below, will provide sufficient liquidity for the Corporation to meet the repayment of debt maturities during 2009 and other operational needs.
Banking Subsidiaries
Primary sources of funding for the Corporation’s banking subsidiaries (BPPR, BPNA or “the banking subsidiaries”) include retail and commercial deposits, secured institutional borrowings, unpledged marketable securities and, to a lesser extent, loan sales. In addition, the Corporation’s banking subsidiaries maintain secured borrowing facilities with the Federal Home Loan Banks (“FHLB”) and at the discount window of the Federal Reserve Bank of New York (“FED”), and have a considerable amount of collateral that can be used to raise funds under these facilities. Borrowings from the FHLB or the FED discount window require the Corporation to post securities or whole loans as collateral. The banking subsidiaries must maintain their FHLB memberships to continue accessing this source of funding.
     The principal uses of funds for the banking subsidiaries include loan and investment portfolio growth, repayment of obligations as they become due, and operational needs. Also, the banking subsidiaries assume liquidity risk related to off-balance sheet activities mainly in connection with contractual commitments, recourse provisions, servicing advances, derivatives and support to several mutual funds administered by BPPR.
     The bank operating subsidiaries maintain sufficient funding capacity to address large increases in funding requirements such as deposit outflows. This capacity is comprised of available liquidity derived from secured funding sources and on-balance sheet liquidity in the form of liquid unpledged securities.
Deposits
Deposits are a key source of funding as they tend to be less volatile than institutional borrowings and their cost is less sensitive to changes in market rates. Core deposits are generated from a large base of consumer, corporate and institutional customers.
     The Corporation’s ability to compete successfully in the marketplace for deposits depends on various factors, including pricing, service, convenience and financial stability as reflected by operating results and credit ratings (by nationally recognized credit rating agencies). Although a downgrade in the credit rating of the Corporation may impact its ability to raise deposits or the rate it is required to pay on such deposits, management does not believe that the impact should be material. Deposits at all of the Corporation’s banking subsidiaries are federally insured and this is expected to mitigate the effect of a downgrade in credit ratings. As indicated in the Overview section of this MD&A, the TAGP, to which the Corporation elected to be a participant, offers a full guarantee for non-interest bearing deposit accounts held at FDIC-insured depository institutions. The unlimited deposit coverage will be voluntary for eligible institutions and would be in addition

 


 

56     POPULAR, INC. 2008 ANNUAL REPORT
to the $250,000 FDIC deposit insurance per account that was included as part of the EESA. The TAGP coverage will continue until December 31, 2009.
     Total deposits at the Corporation decreased from $28.3 billion at December 31, 2007 to $27.6 billion at December 31, 2008, a decrease of 3%. Refer to Table H for a breakdown of deposits by major types.
     Core deposits have historically provided the Corporation with a sizable source of relatively stable and low-cost funds. As indicated in the glossary, for purposes of defining core deposits, the Corporation excludes brokered certificates of deposit with denominations under $100,000.
     Core deposits totaled $19.9 billion, or 72% of total deposits, at December 31, 2008, compared to $20.1 billion and 71% at December 31, 2007. Core deposits financed 55% of the Corporation’s earning assets at December 31, 2008, compared to 49% at December 31, 2007.
     Certificates of deposit with denominations of $100,000 and over at December 31, 2008 totaled $4.7 billion, or 17% of total deposits, compared to $5.3 billion, or 19%, at December 31, 2007. Their distribution by maturity at December 31, 2008 was as follows:
         
(In thousands)        
 
3 months or less
  $ 1,654,941  
3 to 6 months
    1,153,939  
6 to 12 months
    1,156,210  
Over 12 months
    741,537  
 
 
  $ 4,706,627  
 
     The Corporation had $3.1 billion in brokered deposits at December 31, 2008 and 2007. Brokered certificates of deposit, which are typically sold through an intermediary to small retail investors, provide access to longer-term funds that are available in the market area and provide the ability to raise additional funds without pressuring retail deposit pricing. In the event that any of the Corporation’s banking subsidiaries fall under the regulatory capital ratios of a well-capitalized institution, that banking subsidiary faces the risk of not being able to raise brokered deposits. All of the Corporation’s banking subsidiaries were considered well-capitalized at December 31, 2008.
     Average deposits for the year ended December 31, 2008 represented 76% of average earning assets, compared with 70% and 63% for the years ended December 31, 2007 and 2006, respectively. Table M summarizes average deposits for the past five years.
Borrowings
To the extent that the banking subsidiaries are unable to obtain sufficient liquidity through core deposits, the Corporation may meet its liquidity needs through short-term borrowings by selling securities under repurchase agreements. These are subject to availability of collateral.
     The Corporation’s banking subsidiaries also have the ability to borrow funds from the FHLB at competitive prices. At December 31, 2008, the banking subsidiaries had short-term and long-term credit facilities authorized with the FHLB aggregating $2.2 billion based on assets pledged with the FHLB at that date, compared with $2.6 billion as of December 31, 2007. Outstanding borrowings under these credit facilities totaled $1.1 billion at December 31, 2008, compared with $1.7 billion as of December 31, 2007. Such advances are collateralized by securities, do not have restrictive covenants and, generally do not have any callable features. Refer to Note 17 to the consolidated financial statements for additional information.
     At December 31, 2008, the banking subsidiaries had a borrowing capacity at the FED discount window of approximately $3.4 billion, which remained unused as of that date. This compares to a borrowing capacity at the FED discount window of $3.0 billion at December 31, 2007, which was also unused at that date. This facility is a collateralized source of credit that is highly reliable even under difficult market conditions. The amount available under this line is dependent upon the balance of loans and securities pledged as collateral.
     As previously discussed in the Overview section of this MD&A, the Corporation has the option under the DGP to issue senior unsecured debt fully guaranteed by the FDIC on or before October 31, 2009 with a maturity of June 30, 2012 or sooner.
     At December 31, 2008, management believes that the banking subsidiaries had sufficient liquidity to meet its cash flow obligations for the foreseeable future.
Bank Holding Companies
The principal sources of funding for the holding companies have included dividends received from its banking and non-banking subsidiaries, asset sales and proceeds from the issuance of medium-term notes, junior subordinated debentures and equity. Banking laws place certain restrictions on the amount of dividends a bank may make to its parent company. Such restrictions have not had, and are not expected to have, any material effect on the Corporation’s ability to meet its cash obligations. The principal uses of these funds include the repayment of maturing debt, dividend payments to shareholders and subsidiary funding through capital or debt.
     The Corporation’s bank holding companies (“BHCs”, Popular, Inc., Popular North America and Popular International Bank, Inc.)


 

57
have in the past borrowed in the money markets and the corporate debt market primarily to finance their non-banking subsidiaries. These sources of funding have become difficult and costly due to disrupted marked conditions. The cash needs of non-banking subsidiaries is now minimal given that the PFH business has been discontinued.
     The BHCs have additional sources of liquidity available in the form of credit facilities available from affiliate banking subsidiaries and on-hand liquidity, as well as a limited amount of dividends that can be paid by the subsidiaries subject to regulatory and legal limitations, and assets that could be sold or financed. Other potential sources of funding include the issuance of FDIC-backed senior debt under the DGP.
     As members subject to the regulations of the Federal Reserve System, BPPR and BPNA must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared by each entity during the calendar year would exceed the total of its net income for that year, as defined by the Federal Reserve Board, combined with its retained net income for the preceding two years, less any required transfers to surplus or to a fund for the retirement of any preferred stock. The payment of dividends by BPPR may also be affected by other regulatory requirements and policies, such as the maintenance of certain minimum capital levels. At December 31, 2008, BPPR could have declared a dividend of approximately $31.6 million without the approval of the Federal Reserve Board. At December 31, 2008, BPNA was required to obtain the approval of the Federal Reserve Board to be able to declare a dividend. The Corporation has never received dividend payments from its U.S. subsidiaries. Refer to Popular, Inc.’s Form 10-K for the year ended December 31, 2008 for further information on dividend restrictions imposed by regulatory requirements and policies on the payment of dividends by BPPR and BPNA.
Non-banking subsidiaries
The principal sources of funding for the non-banking subsidiaries include internally generated cash flows from operations, borrowed funds from the holding companies or their direct parent companies, wholesale funding, loan sales repurchase agreements and warehousing lines of credit. The principal uses of funds for the non-banking subsidiaries include loan portfolio growth, repayment of maturing debt and operational needs. Given the discontinuance of the PFH operations, the liquidity needs of non-banking subsidiaries are minimal since most of them fund internally from operating cash flows or from intercompany borrowings from their holding companies, BPPR or BPNA.
Other Funding Sources
The Corporation may also raise limited amounts of funding through approved, but uncommitted lines of credit or federal funds lines with authorized counterparties. These lines are available at the option of the counterparty.
     The investment securities portfolio provides an additional source of liquidity, which may be created through either securities sales or repurchase agreements. The Corporation’s portfolio consists primarily of liquid government sponsored agency securities, government sponsored issued mortgage-backed securities, and collateralized mortgage obligations of excellent credit standing that can be used to raise funds in the repo markets. At December 31, 2008, the investment and trading securities portfolios, as shown in Table L, totaled $8.9 billion, of which $759 million, or 9%, had maturities of one year or less. Mortgage-related investments in Table L are presented based on expected maturities, which may differ from contractual maturities, since they could be subject to prepayments. The availability of the repurchase agreement would be subject to having sufficient available un-pledged collateral at the time the transactions are to be consummated. The Corporation’s un-pledged investment and trading securities, excluding other investment securities, amounted to $2.7 billion as of December 31, 2008. A substantial portion of these securities could be used to raise financing quickly in the U.S. money markets or from secured lending sources.
     Additional liquidity may be provided through loan maturities, prepayments and sales. The loan portfolio can also be used to obtain funding in the capital markets. In particular, mortgage loans and some types of consumer loans, have secondary markets which the Corporation may use. The maturity distribution of the loan portfolio as of December 31, 2008 is presented in Table L. As of that date, $10.4 billion, or 40% of the loan portfolio was expected to mature within one year. The contractual maturities of loans have been adjusted to include prepayments based on historical data and prepayment trends.
Risks to Liquidity
The importance of the Puerto Rico market for the Corporation is an additional risk factor that could affect its financing activities. In the case of an extended economic slowdown in Puerto Rico, the credit quality of the Corporation could be affected and, as a result of higher credit costs, profitability may decrease. The substantial integration of Puerto Rico with the U.S. economy may also complicate the impact of a recession in Puerto Rico, as the U.S. recession underway, concurrently with a slowdown in Puerto Rico, may make a recovery in the local economic cycle more challenging, which is what was experienced in 2008 and is expected for the foreseeable future. The economy in Puerto Rico is experiencing its fourth year of a recessionary cycle.
     Factors that the Corporation does not control, such as the economic outlook of its principal markets and regulatory changes, could affect its ability to obtain funding. In order to


 

58     POPULAR, INC. 2008 ANNUAL REPORT
prepare for the possibility of such a scenario, management has adopted contingency plans for raising financing under stress scenarios when important sources of funds that are usually fully available are temporarily unavailable. These plans call for using alternate funding mechanisms such as the pledging of certain asset classes and accessing secured credit lines and loan facilities put in place with the FHLB and the FED. The Corporation has a substantial amount of assets available for raising funds through these channels and is confident that it has adequate alternatives to rely on under a scenario where some primary funding sources are temporarily unavailable.
     Total lines of credit outstanding are not necessarily a measure of the total credit available on a continuing basis. Some of these lines could be subject to collateral requirements, standards of creditworthiness, leverage ratios and other regulatory requirements, among other factors.
     Maintaining adequate credit ratings on Popular’s debt obligations is an important factor for liquidity because the credit ratings impact the Corporation’s ability to borrow, the cost at which it can raise financing and access to funding sources. The credit ratings are based on the financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core retail and commercial deposits, and the Corporation’s ability to access a broad array of wholesale funding sources, among other factors. Changes in the credit rating of the Corporation or any of its subsidiaries to a level below “investment grade” may affect the Corporation’s ability to raise funds in the capital markets. The Corporation’s counterparties are sensitive to the risk of a rating downgrade. In the event of a downgrade, it may be expected that the cost of borrowing funds in the institutional market would increase. In addition, the ability of the Corporation to raise new funds or renew maturing debt may be more difficult.
     The Corporation’s ratings and outlook at December 31, 2008 are presented in the tables below. Also included are revised ratings announced by the rating agencies during January 2009.
                                 
    At December 31, 2009
Popular, Inc.
    Short-term   Long-term   Preferred    
    debt   debt   stock   Outlook
 
Fitch
    F-2       A-     BBB+   Negative
Moody’s
  P-2       A3     Baa2   Negative
S&P
    A-2     BBB+   BBB-   Negative
 
                                 
    January 2009
Popular, Inc.
    Short-term   Long-term   Preferred    
    debt   debt   stock   Outlook
 
Fitch
    F-2     BBB   BB+   Negative
Moody’s
    W/R *   Baa1   Baa3   Negative
S&P
    A-3     BBB-   BB   Stable
 
*   W/R — withdrawn
 
     In their January 2009 report, Fitch Ratings recognized numerous positive actions over 2008 to address the Corporation’s near-term challenges. However, they indicated the continued credit quality deterioration and the expectations for ongoing pressure in the real estate loan portfolios as the principal factors considered in the downgrade given recent trends in core operating performance and the difficult outlook. Their rating outlook remained negative reflecting the possibility that credit and market conditions could deteriorate further, placing additional stress on the Corporation’s turnaround prospects. Fitch Ratings indicated that a stabilization of core profitability and asset quality would have to be achieved before the rating outlook returns to stable.
     In their January 2009 report, Moody’s indicated that the downgrade of the Corporation’s ratings was prompted by the deterioration in the company’s asset quality and profitability in 2008, and the prospect of continuing weakness in these metrics in 2009. Such weakness could further undermine the Corporation’s ratio of tangible common equity to risk-weighted assets, which the rating agency indicated was comparatively weak. Moody’s believes that the deepening of the recession in the U.S. and the continuation of the recession in Puerto Rico will most likely cause the Corporation’s asset quality indicators and, hence, its profitability to remain pressured through 2009.
     In their January 2009 report, S&P indicated that the rating action resulted from several factors, including the Corporation’s reported net operating losses, a continued deterioration in credit quality, and an expected decline in capital ratios. S&P is also concerned by the increase in nonperforming assets and the potential for further deterioration, notably in the construction, mortgage, and commercial loan portfolios, as they see continued pressure on home prices and reduced sale activity. S&P views capital as adequate, but foresees more downward pressure in 2009.
     Some of the Corporation’s obligations, which may include borrowings, deposits and derivative positions, are subject to “rating triggers”, contractual provisions that may accelerate the maturity of the underlying obligations in the case of a change in rating or that may result in an adjustment to the interest rate. Therefore, the need for the Corporation to raise funding in the marketplace could increase more than usual in the case of a rating


 

59
downgrade. The amount of obligations subject to rating triggers that could accelerate the maturity of the underlying obligations or adjust their rates was $464 million at December 31, 2008.
     As of December 31, 2008, the Corporation has $350 million in senior debt issued by the bank holding companies with interest that adjusts in the event of senior debt ratings downgrades. As a result of the actions taken by the ratings agencies in 2009, the cost of that debt increased by 50 basis points, which would represent an increase in the yearly interest expense of approximately $1.75 million.
     The corporation’s preferred stock rating is currently “non-investment” grade under two rating agencies. The market for noninvestment grade securities is much smaller and less liquid than for investment grade securities. Therefore, if the company were to attempt to issue preferred stock in the capital markets, it is possible that would not be sufficient demand to complete a transaction and the cost could be substantially higher than for more highly rated securities.
Contractual Obligations and Commercial Commitments
The Corporation has various financial obligations, including contractual obligations and commercial commitments, which require future cash payments on debt and lease agreements. Also, in the normal course of business, the Corporation enters into contractual arrangements whereby it commits to future purchases of products or services from third parties. Obligations that are legally binding agreements, whereby the Corporation agrees to purchase products or services with a specific minimum quantity defined at a fixed, minimum or variable price over a specified period of time, are defined as purchase obligations.
     At December 31, 2008, the aggregate contractual cash obligations, including purchase obligations and borrowings maturities, were:
                                         
    Payments Due by Period
    Less than   1 to 3   3 to 5   After 5    
(In millions)   1 year   years   years   years   Total
 
Certificates of deposit
  $ 9,855     $ 2,355     $ 841     $ 95     $ 13,146  
Fed funds and repurchase agreements
    2,275       165       124       988       3,552  
Other short-term borrowings
    5                         5  
Long-term debt
    802       1,032       669       858       3,361  
Purchase obligations
    142       60       18       3       223  
Annual rental commitments under operating leases
    42       69       63       200       374  
Capital leases
    1       1       1       23       26  
 
Total contractual cash obligations
  $ 13,122     $ 3,682     $ 1,716     $ 2,167     $ 20,687  
 
     Purchase obligations include major legal and binding contractual obligations outstanding at the end of 2008, primarily for services, equipment and real estate construction projects. Services include software licensing and maintenance, facilities maintenance, supplies purchasing, and other goods or services used in the operation of the business. Generally, these contracts are renewable or cancelable at least annually, although in some cases the Corporation has committed to contracts that may extend for several years to secure favorable pricing concessions.
     As of December 31, 2008, the Corporation’s liability on its pension and postretirement benefit plans amounted to $374 million. During 2009, the Corporation expects to contribute $18.2 million to the pension and benefit restoration plans, and $6.1 million to the postretirement benefit plan to fund current benefit payment requirements. Obligations to these plans are based on current and projected obligations of the plans, performance of the plan assets, if applicable, and any participant contributions. Refer to Note 25 to the consolidated financial statements for further information on these plans. Despite the increase in the pension plan liability, principally due to a decline of $157 million in the fair value of plan assets, management believes that the effect of the pension and postretirement plans on liquidity is not significant to the Corporation’s overall financial condition. The Corporation’s pension and other postretirement benefit plans are funded on a current basis. Recent market conditions have resulted in an unusually high degree of volatility associated with certain plan assets. Should deterioration in market conditions continue, the Corporation’s pension asset portfolio could be adversely impacted, and it may be required to make additional contributions.

 


 

60     POPULAR, INC. 2008 ANNUAL REPORT
Management expects that the long-term return will revert to a more normalized level.
     As of December 31, 2008, the liability for uncertain tax positions, excluding associated interest and penalties, was $45 million pursuant to FIN No. 48, which was described in the Critical Accounting Policies section. This liability represents an estimate of tax positions that the Corporation has taken in its tax returns which may ultimately not be sustained upon examination by the tax authorities. The ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty. Under the statute of limitation, the liability for uncertain tax positions expires as follows: 2009 — $7 million, 2010 — $5 million, 2011 — $16 million, 2012 — $11 million and 2013 — $6 million.
     The Corporation also utilizes lending-related financial instruments in the normal course of business to accommodate the financial needs of its customers. The Corporation’s exposure to credit losses in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and commercial letters of credit is represented by the contractual notional amount of these instruments. The Corporation uses credit procedures and policies in making those commitments and conditional obligations as it does in extending loans to customers. Since many of the commitments may expire without being drawn upon, the total contractual amounts are not representative of the Corporation’s actual future credit exposure or liquidity requirements for these commitments.
     At December 31, 2008, the contractual amounts related to the Corporation’s off-balance sheet lending and other activities were the following:
                                         
    Amount of Commitment — Expiration Period
    Less than   1 to 3   3 to 5   After 5    
(In millions)   1 year   years   years   years   Total
 
Commitments to extend credit
  $ 5,980     $ 566     $ 328     $ 243     $ 7,117  
Commercial letters of credit
    19                         19  
Standby letters of credit
    140       34       7             181  
Commitments to originate mortgage loans
    67       4                   71  
Unfunded investment obligations
          2             8       10  
 
Total
  $ 6,206     $ 606     $ 335     $ 251     $ 7,398  
 
     The Corporation also enters into derivative contracts under which it is required either to receive or pay cash, depending on changes in interest rates. These contracts are carried at fair value on the consolidated statements of condition with the fair value representing the net present value of the expected future cash receipts and payments based on market rates of interest as of the statement of condition date. The fair value of the contract changes daily as interest rates change. The Corporation may also be required to post additional collateral on margin calls on the derivatives and repurchase transactions.
     The Corporation securitizes mortgage loans into guaranteed mortgage-backed securities subject to limited, and in certain instances, lifetime credit recourse on the loans that serve as collateral for the mortgage-backed securities. The Corporation may also have credit recourse on mortgage servicing portfolios for which the Corporation may have acquired the right to service the loan. Also, from time to time, the Corporation may sell in bulk sale transactions, residential mortgage loans and SBA commercial loans subject to credit recourse or to certain representations and warranties from the Corporation to the purchaser. These representations and warranties may relate to borrower creditworthiness, loan documentation, collateral, prepayment and early payment defaults. The Corporation may be required to repurchase the loans under the credit recourse agreements or representation and warranties. Generally, the Corporation retains the right to service the loans when securitized or sold with credit recourse.
     At December 31, 2008, the Corporation serviced $4.9 billion in residential mortgage loans with credit recourse or other servicer-provided credit enhancement. In the event of any customer default, pursuant to the credit recourse provided, the Corporation is required to reimburse the third party investor. The maximum potential amount of future payments that the Corporation would be required to make under the agreement in the event of nonperformance by the borrowers is equivalent to the total outstanding balance of the residential mortgage loans serviced with credit recourse. In the event of nonperformance, the Corporation has rights to the underlying collateral securing the mortgage loan, thus, historically, the losses associated to these guarantees have not been significant. At December 31, 2008, the Corporation had reserves of approximately $14 million to cover the estimated credit loss exposure related to the residential mortgage loans serviced with recourse, which are principally related to loans serviced that belong to mortgage-backed securities issued by GNMA and Freddie Mac. At December 31, 2008, the Corporation also serviced $12.7 billion in mortgage loans without recourse or other servicer-provided credit enhancement. Although the Corporation may, from time to time, be required to make advances to maintain a regular flow of scheduled interest and principal payments to investors, including special purpose entities, this does not represent an insurance against losses. These loans serviced are mostly insured by FHA, VA, and others, or the certificates arising in securitization transactions may be covered by a funds guaranty insurance policy.

 


 

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     Also, in the ordinary course of business, the Corporation sold SBA loans with recourse, in which servicing was retained. At December 31, 2008, SBA loans serviced with recourse amounted to $10 million. Due to the guaranteed nature of the SBA loans sold, the Corporation’s exposure to loss under these agreements should not be significant.
     During 2008, in connection with certain sales of assets by the discontinued operations of PFH, which approximated $2.7 billion in principal balance of loans, the Corporation provided indemnifications for the breach of certain representations or warranties. Generally, the primary indemnifications included:
      Indemnification for breaches of certain key representations and warranties, including corporate authority, due organization, required consents, no liens or encumbrances, compliance with laws as to origination and servicing, no litigation relating to violation of consumer lending laws, and absence of fraud.
 
      Indemnification for breaches of all other representations including general litigation, general compliance with laws, ownership of all relevant licenses and permits, compliance with the seller’s obligations under the pooling and servicing agreements, lawful assignment of contracts, valid security interest, good title and all files and documents are true and complete in all material respects, among others.
     Also, one of PFH’s 2008 sale agreements included a repurchase obligation for defaulted loans, which was limited and extended only for loans originated within 120 days prior to the transaction closing date and under which the borrower failed to make the first schedule monthly payment due within 45 days after such closing date. This obligation had expired as of December 31, 2008. Also, the same agreement provided for reimbursement of premium on loans that prepaid prior to the first anniversary date of the transaction closing date, which is March 1, 2009. The premium amount declined monthly over a 12-month term. As of December 31, 2008, the exposure under this obligation was not significant.
     Certain of the representations and warranties covered under the indemnifications expire within a definite time period; others survive until the expiration of the applicable statute of limitations, and others do not expire. Certain of the indemnifications are subject to a cap or maximum aggregate liability defined as a percentage of the purchase price. In the event of a breach of a representation, the Corporation may be required to repurchase the loan. The indemnifications outstanding at December 31, 2008 do not require repurchase of loans under credit recourse obligations.
     Under certain sale agreements, the repurchase obligation may be subject to (1) an obligation on the part of the buyer to confer with the Corporation on possible strategies for mitigating or curing the issue which resulted in the repurchase demand being made; (2) an obligation to pursue commercially reasonable efforts to achieve such mitigation strategies; and (3) buyer’s obligation to secure a bonafide, arms-length bid from a third party to acquire such loan, in which case the seller would have the right to either (1) acquire the loan from buyer, or (2) agree to have the loan sold at bid and pay to buyer the shortfall between the original purchase price for the loan and the bid price.
     At December 31, 2008, the Corporation has recorded a liability reserve for potential future claims under the indemnities of approximately $16 million. If there is a breach of a representation or warranty, the Corporation may be required to repurchase the loan and bear any subsequent loss related to the loan. Popular, Inc. Holding Company and Popular North America have agreed to guarantee certain obligations of PFH with respect to the indemnification obligations. In addition, the Corporation has agreed to restrict $10 million in cash or cash equivalents for a period of one year expiring in November 2009 to cover any such obligations related to the principal sale transaction that involved the sale of loans representing approximately $1.0 billion in principal balance.
     A number of the acquisition agreements to which the Corporation is a party and under which it has purchased various types of assets, including the purchase of entire businesses, require the Corporation to make additional payments in future years if certain predetermined goals, such as revenue targets, are achieved or certain specific events occur within a specified time. Management’s estimated maximum future payments at December 31, 2008 approximated $2 million. Due to the nature and size of the operations acquired, management does not anticipate that these additional payments will have a material impact on the Corporation’s financial condition or results of future operations.
     Refer to the notes to the consolidated financial statements for further information on the Corporation’s contractual obligations, commercial commitments, and derivative contracts.
Credit Risk Management and Loan Quality
Credit risk represents the possibility of loss from the failure of a borrower or counterparty to perform according to the terms of a credit-related contract. Credit risk arises primarily from the Corporation’s lending activities, as well as from other on-balance sheet and off-balance sheet credit instruments. Credit risk management is based on analyzing the creditworthiness of the borrower, the adequacy of underlying collateral given current events and conditions, and the existence and strength of any guarantor support.
     The Corporation manages credit risk by maintaining sound underwriting standards, monitoring and evaluating loan portfolio quality, its trends and collectibility, and assessing reserves and loan concentrations. Also, credit risk is mitigated by

 


 

62     POPULAR, INC. 2008 ANNUAL REPORT
implementing and monitoring lending policies and collateral requirements, and instituting credit review procedures to ensure appropriate actions to comply with laws and regulations. The Corporation’s credit policies require prompt identification and quantification of asset quality deterioration or potential loss in order to ensure the adequacy of the allowance for loan losses. Included in these policies, primarily determined by the amount, type of loan and risk characteristics of the credit facility, are various approval levels and lending limit constraints, ranging from the branch or department level to those that are more centralized. When considered necessary, the Corporation requires collateral to support credit extensions and commitments, which is generally in the form of real estate and personal property, cash on deposit and other highly liquid instruments.
     The Corporation’s Credit Strategy Committee (“CRESCO”) oversees all credit-related activities and is responsible for managing the Corporation’s overall credit exposure and developing credit policies, standards and guidelines that define, quantify, and monitor credit risk. Through the CRESCO, management reviews asset quality ratios, trends and forecasts, problem loans, evaluates the provision for loan losses and assesses the methodology and adequacy of the allowance for loan losses on a monthly basis. The analysis of the allowance adequacy is presented to the Risk Management Committee of the Board of Directors for review, consideration and ratification on a quarterly basis.
     The Corporation also has a Corporate Credit Risk Management Division (“CCRMD”), which was reorganized during 2008 to strengthen its analysis and reporting capabilities. CCRMD is a centralized unit, independent of the lending function, which oversees the credit risk rating system and reviews the adequacy of the allowance for loan losses in accordance with Generally Accepted Accounting Principles (“GAAP”) and regulatory standards. The CCRMD’s functions include managing and controlling the Corporation’s credit risk, which is accomplished through various techniques applied at different stages of the credit-granting process. A CCRMD representative, who is a permanent member of the Executive Credit Committee, oversees adherence to policies and procedures established for the initial underwriting of the credit portfolio. Also, the CCRMD performs ongoing monitoring of the portfolio, including potential areas of concern for specific borrowers and / or geographic regions. The Corporation has specialized workout officers that handle substantially all commercial loans which are past due 90 days and over, borrowers which have filed bankruptcy, or that are considered problem loans based on their risk profile.
     The Corporation also has a Credit Process Review Group within the CCRMD, which performs annual comprehensive credit process reviews of several middle markets, construction, asset-based and corporate banking lending groups in BPPR. This group evaluates the credit risk profile of each originating unit along with each unit’s credit administration effectiveness, including the assessment of the risk rating representative of the current credit quality of the loans, and the evaluation of collateral documentation. The monitoring performed by this group contributes to assess compliance with credit policies and underwriting standards, determine the current level of credit risk, evaluate the effectiveness of the credit management process and identify control deficiencies that may arise in the credit-granting process. Based on its findings, the Credit Process Review Group recommends corrective actions, if necessary, that help in maintaining a sound credit process. CCRMD has contracted an outside loan review firm to perform the credit process reviews in the U.S. mainland operations. The CCRMD participates in defining the review plan with the outside loan review firm and actively participates in the discussions of the results of the loan reviews with the business units. The CCRMD may periodically review the work performed by the outside loan review firm. CCRMD reports the results of the credit process reviews to the Risk Management Committee of the Corporation’s Board of Directors. The Corporation’s loan review plan for 2009 will be conducted by this outside loan review firm.
     The Corporation issues certain credit-related off-balance sheet financial instruments including commitments to extend credit, standby letters of credit and commercial letters of credit to meet the financing needs of its customers. For these financial instruments, the contract amount represents the credit risk associated with failure of the counterparty to perform in accordance with the terms and conditions of the contract and the decline in value of the underlying collateral. The credit risk associated with these financial instruments varies depending on the counterparty’s creditworthiness and the value of any collateral held. Refer to Note 29 to the consolidated financial statements and to the Contractual Obligations and Commercial Commitments section of this MD&A for the Corporation’s involvement in these credit-related activities.
     The Corporation is also exposed to credit risk by using derivative instruments but manages the level of risk by only dealing with counterparties of good credit standing, entering into master netting agreements whenever possible and, when appropriate, obtaining collateral. Refer to Note 33 to the consolidated financial statements for further information on the Corporation’s involvement in derivative instruments and hedging activities.
     The Corporation may also encounter risk of default in relation to its investment securities portfolio. Refer to Notes 6 and 7 for the composition of the investment securities available-for-sale and held-to-maturity. The investment securities held by the Corporation at December 31, 2008 are mostly Obligations of U.S. government sponsored entities, collateralized mortgage obligations, mortgage-backed securities and U.S. Treasury securities. The vast majority of these securities are rated the

 


 

63
Table N
Non-Performing Assets
                                         
    As of December 31,
(Dollars in thousands)   2008*   2007   2006   2005   2004
 
Non-accrual loans:
                                       
Commercial
  $ 464,802     $ 266,790     $ 158,214     $ 131,260     $ 116,969  
Construction
    319,438       95,229             2,486       5,624  
Lease financing
    11,345       10,182       11,898       2,562       3,665  
Mortgage
    338,961       349,381       499,402       371,885       395,749  
Consumer
    68,263       49,090       48,074       39,316       32,010  
 
Total non-performing loans
    1,202,809       770,672       717,588       547,509       554,017  
Other real estate
    89,721       81,410       84,816       79,008       59,717  
 
Total non-performing assets
  $ 1,292,530     $ 852,082     $ 802,404     $ 626,517     $ 613,734  
 
Accruing loans past-due 90 days or more
  $ 150,545     $ 109,569     $ 99,996     $ 86,662     $ 79,091  
 
Non-performing assets to loans held-in-portfolio
    5.02 %     3.04 %     2.51 %     2.02 %     2.19 %
Non-performing loans to loans held-in-portfolio
    4.67       2.75       2.24       1.77       1.98  
Non-performing assets to assets
    3.32       1.92       1.69       1.29       1.38  
Interest lost
  $ 48,707     $ 71,037     $ 58,223     $ 46,198     $ 45,089  
 
*   Amounts as of December 31, 2008 exclude assets from discontinued operations. Non performing loans and other real estate from discontinued operations amounted to $3 million and $0.9 million, respectively, as of December 31, 2008.
 
equivalent of AAA by the major rating agencies. A substantial portion of these instruments are guaranteed by mortgages, a U.S. government sponsored entity or the full faith and credit of the U.S. Government.
     At December 31, 2008, the Corporation’s credit exposure was centered in its $26.3 billion total loan portfolio, which represented 73% of its earning assets. The portfolio composition for the last five years is presented in Table G.
     The Corporation manages the exposure to a single borrower, industry or product type through participations and loan sales. The Corporation maintains a diversified portfolio intended to spread its risk and reduce its exposure to economic downturns, which may occur in different segments of the economy or in particular industries. Industry and loan type diversification is reviewed quarterly.
     The Corporation’s credit risk exposure is spread among individual consumers, small and medium businesses, as well as corporate borrowers engaged in a wide variety of industries. Only 313 of these commercial lending relationships have credit relations with an aggregate exposure of $10 million or more. At December 31, 2008, highly leveraged transactions and credit facilities to finance speculative real estate ventures amounted to $132 million, and there are no loans to less developed countries. The Corporation limits its exposure to concentrations of credit risk by the nature of its lending limits.
     The disrupted financial market conditions that commenced in 2007 continued to affect the economy and the financial services sector in 2008. During 2009, the Corporation expects continued market turbulence and economic uncertainty. The impact of the housing downturn and the broader economic slowdown has been significant and the length and intensity of the downturn remains unclear. Continued deterioration of the housing markets and the economy in general will negatively impact the credit quality of our loan portfolios and may result in a higher provision for loan losses in future periods.
     During 2008, management executed a series of actions to mitigate its credit risk exposure in the U.S. mainland. These actions included the closure of PFH’s retail branch network which served principally the subprime sector. Also, the Corporation exited the lending business of E-LOAN which also faced high credit losses, particularly in its HELOC and closed-end second lien loan portfolios. In the case of the banking operations, the Corporation approved a plan to close, consolidate or sell underperforming branches and exit lending businesses that do not generate deposits or fee income. The Corporation has significantly curtailed the production of non-traditional mortgages as it ceased to originate non-conventional mortgage loans in its U.S. operations. This initiative was part of the BPNA Restructuring Plan implemented in the fourth quarter of 2008. The non-conventional mortgage unit is currently focused on servicing the runoff portfolio and restructuring loans that have or show signs of credit deterioration.
     Management continues to refine the Corporation’s credit standards to meet the changing economic environment. The Corporation has adjusted its underwriting criteria, as well as enhanced its line management and collection strategies, in an

 


 

64     POPULAR, INC. 2008 ANNUAL REPORT
attempt to mitigate losses. The commercial banking group restructured and strengthened several areas to manage more effectively the current scenario, focusing strategies on critical steps in the origination and portfolio management processes to ensure the quality of incoming loans as well as detect and manage potential problem loans early. The consumer lending area also tightened underwriting standards across all business lines and reduced its exposure in areas that are more likely to be impacted under the current economic conditions. It also invested in analytical tools to enhance collection practices, redesigned operational processes and improved workforce productivity through training and revision of incentive programs. The changes both in the commercial and individual credit areas have placed the Corporation in a stronger position to manage what looks to be another challenging year in terms of credit quality.
Geographical and Government Risk
The Corporation is also exposed to geographical and government risk. The Corporation’s assets and revenue composition by geographical area and by business segment is presented in Note 35 to the consolidated financial statements.
     A significant portion of the Corporation’s financial activities and credit exposure is concentrated in Puerto Rico (the “Island”). Consequently, its financial condition and results of operations are dependent on the Island’s economic conditions. The weak fiscal position of the Puerto Rico Government and strained consumer finances, which were impacted by the effects of rising unemployment rates, oil prices, utilities and taxes, among others, has affected the Puerto Rico economy considerably. The current state of the economy and uncertainty in the private and public sectors has had an adverse effect on the credit quality of the Corporation’s loan portfolios.
     This decline in the Island’s economy has resulted in, among other things, a downturn in the Corporation’s loan originations, an increase in the level of its non-performing assets and loan loss provisions, particularly in the Corporation’s commercial and construction loan portfolios, an increase in the rate of foreclosure loss on mortgage loans and a reduction in the value of its loans and loan servicing portfolio, all of which have adversely affected its profitability. If the decline in economic activity continues, there could be further adverse effects on the Corporation’s profitability. The economic slowdown could cause those adverse effects to continue, as delinquency rates may increase in the short-term, until more sustainable growth resumes. Also, a potential reduction in consumer spending may also impact growth in the Corporation’s other interest and non-interest revenue sources.
     Puerto Rico’s general obligation ratings (“Puerto Rico ratings”) are investment-grade, and remain unchanged since 2007 when the debt was downgraded by Moody’s Investor Services to “Baa3.” In 2006, Standard & Poor’s (“S&P”) downgraded Puerto Rico ratings to “BBB-”. Both rating agencies maintain a stable outlook. The primary factors behind the rating downgrades are the ongoing recession in Puerto Rico since 2006 and its impact on tax receipts. The Commonwealth government has been unable to resolve its structural deficit and this is a major area of concern for the rating agencies. General fund net revenues were down 3 percent during the first six months of fiscal year 2009 (July to December 2008), according to the Puerto Rico Treasury Department. Moody’s “Baa3” rating and S&P’s “BBB-” take into consideration Puerto Rico’s fiscal challenges. Both ratings stand one notch above non-investment grade. Other factors could trigger an outlook change, such as the government’s ability to implement meaningful steps to curb operating expenditures or if the decline in government revenues continues for a longer time period.
     At December 31, 2008, the Corporation had $1.0 billion of credit facilities granted to or guaranteed by the P.R. Government and its political subdivisions, of which $215 million were uncommitted lines of credit, compared to $1.0 billion and $150 million, respectively, as of December 31, 2007. Of these total credit facilities granted, $943 million in loans were outstanding at December 31, 2008, compared to $914 million at December 31, 2007. A substantial portion of the Corporation’s credit exposure to the Government of Puerto Rico are either collateralized loans or obligations that have a specific source of income or revenues identified for its repayment. Some of these obligations consist of senior and subordinated loans to public corporations that obtain revenues from rates charged for services or products, such as water and electric power utilities. Public corporations have varying degrees of independence from the Central Government and many receive appropriations or other payments from it. The Corporation also has loans to various municipalities for which the good faith, credit and unlimited taxing power of the applicable municipality has been pledged to their repayment. These municipalities are required by law to levy special property taxes in such amounts as shall be required for the payment of all of its general obligation bonds and loans. Another portion of these loans consists of special obligations of various municipalities that are payable from the basic real and personal property taxes collected within such municipalities. The good faith and credit obligations of the municipalities have a first lien on the basic property taxes.
     Furthermore, as of December 31, 2008, the Corporation had outstanding $386 million in Obligations of Puerto Rico, States and Political Subdivisions as part of its investment portfolio. Refer to Notes 6 and 7 to the consolidated financial statements for additional information. Of that total, $363 million was exposed to the creditworthiness of the Puerto Rico Government and its municipalities. Of that portfolio, $47 million was in the form of Puerto Rico Commonwealth Appropriation Bonds, which are currently rated Ba1, one notch below investment grade, by Moody’s, while S&P rates them as investment grade. At December

 


 

65
31, 2008, the Puerto Rico Commonwealth Appropriation Bonds represented approximately $3.2 million in unrealized losses in the Corporation’s portfolio of investment securities available-for-sale. The Corporation is closely monitoring the political and economic situation of the Island and evaluates the portfolio for any declines in value that management may consider being other-than-temporary. Management has the intent and ability to hold these investments for a reasonable period of time or up to maturity for a forecasted recovery of fair value up to (or beyond) the cost of these investments.
     As further detailed in Notes 6 and 7 to the consolidated financial statements, a substantial portion of the Corporation’s investment securities represented exposure to the U.S. Government in the form of U.S. Treasury securities and obligations of U.S. Government sponsored entities. In addition, $187 million of residential mortgages and $406 million in commercial loans were insured or guaranteed by the U.S. Government or its agencies at December 31, 2008.
Non-Performing Assets
A summary of non-performing assets by loan categories and related ratios is presented in Table N. Non-performing assets include past-due loans that are no longer accruing interest, renegotiated loans and real estate property acquired through foreclosure.
     Non-performing commercial loans as of December 31, 2008 reflected an increase of $198 million from December 31, 2007 mainly due to the continuous downturn in the U.S. economy and the recessionary economy in Puerto Rico that is now entering its fourth year. The percentage of non-performing commercial loans to commercial loans held-in-portfolio rose from 1.95% at the end of 2007 to 3.41% at the same date in 2008. For December 31, 2006, this ratio was 1.21%. Non-performing commercial loans increased from December 31, 2007 to the same date in 2008 primarily in the Banco Popular de Puerto Rico reportable segment by $138 million and in the Banco Popular North America reportable segment by $70 million. There were two commercial loan relationships greater than $10 million in non-accrual status at December 31, 2008, both pertaining to the Puerto Rico operations. These particular commercial loans are to customers in the commercial real estate and meat by-products processing industries. Commercial loans considered impaired under the Corporation’s criteria for SFAS No. 114 amounted to $447 million at December 31, 2008, compared with $322 million at the same date in 2007. The specific reserves for the impaired commercial loans at December 31, 2008 amounted to $61 million.
     Non-performing construction loans increased $224 million from the end of 2007 to December 31, 2008 primarily in the Banco Popular de Puerto Rico reportable segment by $168 million and in the Banco Popular North America reportable segment by $62 million. The construction loans in non-performing status are primarily residential real estate construction loans which had been adversely impacted by general market economic conditions, decreases in property values, the tightening of credit origination standards and oversupply in certain areas. There were six construction loan relationships greater than $10 million in non-accrual status at December 31, 2008. Historically, the Corporation’s loss experience with real estate construction loans has been relatively low due to the sufficiency of the underlying real estate collateral. In the current stressed housing market, the value of the collateral securing the loan has become one of the most important factors in determining the amount of loss incurred and the appropriate level of the allowance for loan losses. As further described in the Allowance for Loan Losses section of this MD&A, management has increased the allowance for loan losses through specific reserves for the construction loans considered impaired under SFAS No. 114. Construction loans considered impaired under the Corporation’s criteria for SFAS 114 amounted to $375 million at December 31, 2008. The specific reserves for impaired construction loans amounted to $120 million at December 31, 2008.
     The reduction in non-performing mortgage loans held-in-portfolio from December 31, 2007 to December 31, 2008 by $10 million was associated in part to the reclassification of $2 million in non-performing mortgage loans of PFH to “Assets from discontinued operations” in the consolidated statement of condition as of December 31, 2008. PFH had $179 million in non-performing mortgage loans as of December 31, 2007. This was offset in part by increases in non-performing mortgage loans in both the Banco Popular de Puerto Rico and Banco Popular North America reportable segments by $80 million and $89 million, respectively. Mortgage loans net charge-offs in the Puerto Rico operations for the year ended December 31, 2008 amounted to approximately $2.9 million. Banco Popular de Puerto Rico reportable segment’s mortgage loan portfolio averaged approximately $2.8 billion for the year ended December 31, 2008. Mortgage loans net charge-offs in the Banco Popular North America reportable segment amounted to $50.0 million for the year ended December 31, 2008, an increase of $35.7 million compared to the previous year. This increase was related to the slowdown in the United States housing sector. The declines in residential real estate values, coupled with the reduced ability of certain homeowners to refinance or repay their residential real estate obligations, have led to higher delinquencies and losses in residential real estate loans. Banco Popular North America’s non-conventional mortgages reported a total of $76 million worth of loan modifications at December 31, 2008. These modifications were considered trouble debt restructures (“TDR”) since they involved granting a concession to borrowers under financial difficulties. Although SFAS No. 114 excludes large groups of smaller-balance homogenous loans that are collectively evaluated

 


 

66     POPULAR, INC. 2008 ANNUAL REPORT
Table O
Allowance for Loan Losses and Selected Loan Losses Statistics
                                         
(Dollars in thousands)   2008   2007   2006   2005   2004
 
Balance at beginning of year
  $ 548,832     $ 522,232     $ 461,707     $ 437,081     $ 408,542  
Allowances acquired
          7,290             6,291       13,588  
Provision for loan losses
    991,384       341,219       187,556       121,985       133,366  
Impact of change in reporting period*
                      1,586        
 
 
    1,540,216       870,741       649,263       566,943       555,496  
 
Charge-offs:
                                       
Commercial
    184,578       94,992       54,724       64,559       62,491  
Construction
    120,425                         994  
Lease financing
    22,761       23,722       24,526       20,568       37,125  
Mortgage
    53,303       15,889       4,465       4,908       5,367  
Consumer
    264,437       173,937       125,350       85,068       82,935  
 
 
    645,504       308,540       209,065       175,103       188,912  
 
Recoveries:
                                       
Commercial
    15,167       18,280       17,195       21,965       19,626  
Construction
          1,606       22              
Lease financing
    3,934       8,695       10,643       10,939       11,385  
Mortgage
    425       421       526       301       531  
Consumer
    26,014       28,902       27,327       26,292       25,927  
 
 
    45,540       57,904       55,713       59,497       57,469  
 
Net loans charged-off:
                                       
Commercial
    169,411       76,712       37,529       42,594       42,865  
Construction
    120,425       (1,606 )     (22 )           994  
Lease financing
    18,827       15,027       13,883       9,629       25,740  
Mortgage
    52,878       15,468       3,939       4,607       4,836  
Consumer
    238,423       145,035       98,023       58,776       57,008  
 
 
    599,964       250,636       153,352       115,606       131,443  
 
Write-downs related to loans transferred to loans held-for-sale
    12,430                          
Change in allowance for loan losses from discontinued operations**
    (45,015 )     (71,273 )     26,321       10,370       13,028  
 
Balance at end of year
  $ 882,807     $ 548,832     $ 522,232     $ 461,707     $ 437,081  
 
Loans held-in-portfolio:
                                       
Outstanding at year end
  $ 25,732,873     $ 28,021,456     $ 32,017,017     $ 31,011,026     $ 27,991,533  
Average
    26,162,786       24,908,943       23,533,341       21,280,242       17,315,966  
Ratios:
                                       
Allowance for loan losses to year end loans held-in-portfolio
    3.43 %     1.96 %     1.63 %     1.49 %     1.56 %
Recoveries to charge-offs
    7.05       18.77       26.65       33.98       30.42  
Net charge-offs to average loans held-in-portfolio
    2.29       1.01       0.65       0.54       0.76  
Net charge-offs earnings coverage
    1.29 x     2.53 x     4.87 x     6.84 x     5.14 x
Allowance for loan losses to net charge-offs
    1.47       2.19       3.41       3.99       3.33  
Provision for loan losses to:
                                       
Net charge-offs
    1.65       1.36       1.22       1.06       1.01  
Average loans held-in-portfolio
    3.79 %     1.37 %     0.80 %     0.57 %     0.77 %
Allowance to non-performing assets
    68.30       64.41       65.08       73.69       71.22  
Allowance to non-performing loans
    73.40       71.21       72.78       84.33       78.89  
 
*   Represents the net effect of provision for loan losses, less net charge-offs corresponding to the impact of the change in fiscal period at certain subsidiaries (change from fiscal to calendar reporting year for non-banking subsidiaries).
 
**   A positive amount represents higher provision for loan losses recorded during the period compared to net charge-offs, and vice versa for a negative amount.

 


 

67
Table P
Allocation of the Allowance for Loan Losses
                                                                                 
As of December 31,
(Dollars in millions)   2008   2007   2006   2005   2004
            Percentage of           Percentage of           Percentage of           Percentage of           Percentage of
    Allowance   Loans in Each   Allowance   Loans in Each   Allowance   Loans in Each   Allowance   Loans in Each   Allowance   Loans in Each
    for   Category to   for   Category to   for   Category to   for   Category to   for   Category to
    Loan Losses   Total Loans*   Loan Losses   Total Loans*   Loan Losses   Total Loans*   Loan Losses   Total Loans*   Loan Losses   Total Loans*
 
 
                                                                               
Commercial
  $ 294.6       53.0 %   $ 139.0       48.8 %   $ 171.3       40.9 %   $ 171.7       38.0 %   $ 169.4       37.1 %
Construction
    170.3       8.6       83.7       6.9       32.7       4.4       12.7       2.7       9.6       1.8  
Lease financing
    22.0       2.9       25.6       3.9       24.8       3.8       27.6       4.2       28.7       4.2  
Mortgage
    106.3       17.4       70.0       21.7       92.2       34.6       72.7       39.7       67.7       42.5  
Consumer
    289.6       18.1       230.5       18.7       201.2       16.3       177.0       15.4       161.7       14.4  
 
Total
  $ 882.8       100.0 %   $ 548.8       100.0 %   $ 522.2       100.0 %   $ 461.7       100.0 %   $ 437.1       100.0 %
 
*   Note: For purposes of this table, the term loans refers to loans held-in-portfolio (excludes loans held-for-sale).
 
for impairment (e.g. mortgage loans), it specifically requires its application to modifications considered TDR. These TDR mortgage loans were evaluated for impairment resulting in a reserve of $14 million at December 31, 2008. There were no commitments outstanding at December 31, 2008 to provide additional funding on these TDR mortgage loans. Non-performing mortgage loans decreased by $150 million, or 30%, from December 31, 2006 to the same date in 2007. The decline was directly related to the 2007 PFH loan recharacterization transaction which resulted in a reduction in non-performing mortgage loans of approximately $316 million, partially offset by increases in non-performing mortgage loans in PFH’s remaining owned portfolio, the Puerto Rico operations and BPNA. The increase at the BPPR and BPNA reportable segments was mainly due to the continued deterioration in the subprime market in the U.S. mainland, as well as higher delinquencies triggered by deteriorating economic conditions in Puerto Rico. Ratios of mortgage loans net charge-offs as a percentage of average mortgage loans held-in-portfolio are presented later in the Allowance for Loan Losses section of this MD&A.
     The increase in non-performing consumer loans by $19 million from December 31, 2007 to the same date in 2008 was principally associated with the Banco Popular North America reportable segment which increased by $24 million. E-LOAN reported an increase of $18 million. The increase in the U.S. mainland non-performing consumer loans was mainly attributed to the home equity lines of credit and second lien mortgage loans, which are categorized by the Corporation as consumer loans. With the downsizing of E-LOAN in late 2007, this subsidiary ceased originating these types of loans. The increase in non-performing consumer loans was in part offset by the reduction in PFH of $6 million due to the sale of its portfolio and the discontinuance of the business. Non-performing consumer loans at December 31, 2007 remained at a level very close to 2006, in part, because the portfolio growth in consumer loans was mostly in credit cards which are not placed in non-accrual status under the Corporation’s policy and in home equity lines of credit which, at that time, were a relatively newly originated portfolio from the 2007 vintage.
     Other real estate, which represents real estate property acquired through foreclosure, increased by $8 million from December 31, 2007 to the same date in 2008. This increase was principally due to an increase in the Banco Popular North America reportable segment by $28 million and Banco Popular de Puerto Rico reportable segment by $12 million, which was partially offset by $32 million in other real estate pertaining to PFH as of December 31, 2007. At December 31, 2006, PFH had $57 million in other real estate, which is included as part of other real estate in Table N. The slowdown in the housing market and continued economic deterioration in certain geographic areas also has a softening effect on the market for resale of repossessed real estate properties. Defaulted loans have increased, and these loans move through the default process to the other real estate classification. The combination of increased flow of defaulted loans from the loan portfolio to other real estate owned and the slowing of the liquidation market has resulted in an increase in the number of units on hand.
     Under standard industry practice, closed-end consumer loans are not customarily placed on non-accrual status prior to being charged-off. Excluding the closed-end consumer loans from non-accruing, adjusted non-performing assets would have been $1.2 billion at December 31, 2008, $803 million as of December 31, 2007 and $754 million at December 31, 2006.
     Once a loan is placed in non-accrual status, the interest previously accrued and uncollected is charged against current earnings and thereafter income is recorded only to the extent of any interest collected. Refer to Table N for information on the interest income that would have been realized had these loans been performing in accordance with their original terms.

 


 

68     POPULAR, INC. 2008 ANNUAL REPORT
     In addition to the non-performing loans included in Table N, there were $206 million of loans at December 31, 2008, which in management’s opinion are currently subject to potential future classification as non-performing and are considered impaired under SFAS No. 114, compared to $50 million at December 31, 2007 and $103 million at December 31, 2006. The increase from 2007 to 2008 was mainly related to commercial and construction loans in Puerto Rico. The decline from December 31, 2006 to the same date in 2007 was mainly due to a particular commercial lending relationship in the Corporation’s Puerto Rico banking operations.
     Another key measure used to evaluate and monitor the Corporation’s asset quality is loan delinquencies. Loans delinquent 30 days or more and delinquencies as a percentage of their related portfolio category at December 31, 2008 and 2007 are presented below.
                 
(Dollars in millions)   2008   2007
 
Loans delinquent 30 days or more
  $ 2,547     $ 2,011  
 
Total delinquencies as a percentage of total loans:
               
Commercial
    6.74 %     4.09 %
Construction
    19.33       11.21  
Lease financing
    4.95       4.36  
Mortgage
    18.51       12.28  
Consumer
    6.12       4.75  
 
Total
    9.69 %     6.72 %
 
     Accruing loans past due 90 days or more are composed primarily of credit cards, FHA / VA and other insured mortgage loans, and delinquent mortgage loans included in the Corporation’s financial statements pursuant to GNMA’s buy-back option program. Under SFAS No. 140, servicers of loans underlying Ginnie Mae mortgage-backed securities must report as their own assets the defaulted loans that they have the option to purchase, even when they elect not to exercise that option. Also, accruing loans past due 90 days or more include residential conventional loans purchased from other financial institutions that, although delinquent, the Corporation has received timely payment from the sellers / servicers, and, in some instances, have partial guarantees under recourse agreements.
Allowance for Loan Losses
The allowance for loan losses, which represents management’s estimate of credit losses inherent in the loan portfolio, is maintained at a sufficient level to provide for these estimated loan losses based on evaluations of inherent risks in the loan portfolios. The Corporation’s management evaluates the adequacy of the allowance for loan losses on a monthly basis. In this evaluation, management considers current economic conditions and the resulting impact on Popular’s loan portfolio, the composition of the portfolio by loan type and risk characteristics, historical loss experience, loss volatility, results of periodic credit reviews of individual loans, regulatory requirements and loan impairment measurement, among other factors. The increase in the Corporation’s allowance for loan losses level as of December 31, 2008 reflects the prevailing negative economic outlook, and specific reserves for commercial, construction and troubled debt restructured mortgage loans considered impaired under SFAS No. 114.
     The Corporation’s methodology to determine its allowance for loan losses is based on SFAS No. 114. Under SFAS No. 114, commercial and construction loans over a predetermined amount are identified for evaluation on an individual basis, and specific reserves are calculated based on impairment analyses. SFAS No. 5 provides for the recognition of a loss contingency for a group of homogeneous loans, which are not individually evaluated under SFAS No. 114, when it is probable that a loss has been incurred and the amount can be reasonably estimated. To determine the allowance for loan losses under SFAS No. 5, the Corporation uses historical net charge-offs and volatility experience segregated by loan type and legal entity.
     The result of the exercise described above is compared to stress-tested levels of historic losses over a period of time, recent tendencies of losses and industry trends. Management considers all indicators derived from the process described herein, along with qualitative factors that may cause estimated credit losses associated with the loan portfolios to differ from historical loss experience. The final outcome of the provision for loan losses and the appropriate level of the allowance for loan losses for each subsidiary and the Corporation is a determination made by the CRESCO, which actively reviews the Corporation’s allowance for loan losses.
     Management’s evaluation of the quantitative factors (historical net charge-offs, statistical loss estimates, etc.), as well as qualitative factors (current economic conditions, portfolio composition, delinquency trends, etc.), results in the final determination of the provision for loan losses to maintain a level of allowance for loan losses which is deemed to be adequate. Since the determination of the allowance for loans losses considers projections and assumptions, actual losses can vary from the estimated amounts.
     The allowance for loan losses increased from December 31, 2007 to December 31, 2008 by $334 million. The increase is mainly the result of additional reserves for specific commercial and construction loans considered impaired, as well as for certain troubled debt restructured mortgage loans, and higher reserves for Popular’s U.S. mainland consumer loan portfolio (mainly home equity lines of credit). The allowance for loan losses for commercial and construction credits has been increased based on proactive identification of risk and thorough borrower analysis.

 


 

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     Historically, the Corporation’s loss experience with real estate construction loans has been relatively low due to the sufficiency of the underlying real estate collateral. In the current stressed housing market, the value of the collateral securing the loan has become one of the most important factors in determining the amount of loss incurred and the appropriate level of allowance for loan losses. Management has increased the allowance for loan losses for construction mainly through specific reserves for the loans considered impaired under SFAS No. 114.
     Under SFAS No. 114, the Corporation considers a commercial borrower to be impaired when the outstanding debt amounts to $250,000 or more and interest and / or principal is past due 90 days or more, or, when the outstanding debt amounts to $500,000 or more and based on current information and events, management considers that the debtor will be unable to pay all amounts due according to the contractual terms of the loan agreement. Also, the Corporation considers certain mortgage loans that had been negotiated under troubled debt restructurings as part of its SFAS No. 114 evaluation.
     The Corporation’s recorded investment in impaired commercial, construction and mortgage troubled debt restructured loans and the related valuation allowance calculated under SFAS No. 114 as of December 31, 2008, 2007 and 2006 were:
                                                 
    2008   2007   2006
    Recorded   Valuation   Recorded   Valuation   Recorded   Valuation
(In millions)   Investment   Allowance   Investment   Allowance   Investment   Allowance
 
Impaired loans:
                                               
Valuation allowance
  $ 664.9     $ 194.7     $ 174.0     $ 54.0     $ 125.7     $ 37.0  
No valuation allowance required
    232.7             147.7             82.5        
 
Total impaired loans
  $ 897.6     $ 194.7     $ 321.7     $ 54.0     $ 208.2     $ 37.0  
 
     With respect to the $233 million portfolio of impaired commercial loans (including construction) for which no allowance for loan losses was required as of December 31, 2008, management followed the SFAS No. 114 guidance. As prescribed by SFAS No. 114, when a loan is impaired, the measurement of the impairment may be based on: (1) the present value of the expected future cash flows of the impaired loan discounted at the loan’s original effective interest rate; (2) the observable market price of the impaired loan; or (3) the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. The $898 million impaired loans included in the table above as of December 31, 2008 were collateral dependent loans in which management performed a detailed analysis based on the fair value of the collateral less estimated costs to sell and determined if the collateral was deemed adequate to cover any losses.
     Refer to Table O for a summary of the activity in the allowance for loan losses and selected loan losses statistics for the past 5 years.
     Table P details the breakdown of the allowance for loan losses by loan categories. The breakdown is made for analytical purposes, and it is not necessarily indicative of the categories in which future loan losses may occur.
     The following table presents net charge-offs to average loans held-in-portfolio by loan category for the years ended December 31, 2008, 2007 and 2006:
                         
    2008   2007   2006
 
Commercial
    1.24 %     0.58 %     0.31 %
Construction
    5.81       (0.10 )      
Lease financing
    1.72       1.28       1.08  
Mortgage
    1.17       0.35       0.09  
Consumer
    4.95       3.25       2.15  
 
Total
    2.29 %     1.01 %     0.65 %
 
     The ratios of net charge-offs to average loans held-in-portfolio exclude the discontinued operations of PFH for all periods presented in the above table for comparative purposes. Non-performing assets and the allowance for loan losses by loan type include the discontinued operations for 2007 and earlier years. As of December 31, 2008, the discontinued operations of PFH only had a $7 million loan portfolio that was accounted at fair value.
     The increase in commercial loans net charge-offs for the year ended December 31, 2008, compared to the previous year, was mostly associated with continued deterioration in the economic conditions in Puerto Rico and the U.S mainland which are both experiencing a recessionary cycle. Credit deterioration trends have been reflected across all industry sectors. The ratio of commercial loans net charge-offs to average commercial loans held-in-portfolio in the Banco Popular de Puerto Rico reportable segment was 1.60% for the year ended December 31, 2008, compared to 0.72% for 2007 and 0.36% for 2006. Also, an increase was experienced in the Banco Popular North America reportable segment, which had reported a ratio of 0.76% for the year 2008, compared with 0.35% for 2007 and 0.23% for 2006. The allowance for loan losses corresponding to commercial loans held-in-portfolio represented 2.16% of that portfolio at December 31, 2008, compared with 1.02% in 2007 and 1.31% in 2006. The ratio of allowance to non-performing loans in the commercial loan category was 63.39% at the end of 2008, compared with 52.10% in 2007 and 108.27% in 2006.
     The increase in construction loans net charge-offs for the year ended December 31, 2008, compared to 2007, was related to the Corporation’s Puerto Rico and U.S. mainland operations. The ratio of construction loans net charge-offs to average construction loans held-in-portfolio in the Banco Popular de Puerto Rico

 


 

70   POPULAR, INC. 2008 ANNUAL REPORT
reportable segment was 4.83% for the year ended December 31, 2008. Also, the Banco Popular North America reportable segment experienced an increase with a ratio of 7.54% for the year 2008. The construction loans charge-offs for the year ended December 31, 2008 included approximately $32 million in a $51 million syndicated commercial loan that was placed in non-performing status during the quarter ended March 31, 2008 and for which the Corporation established a specific reserve based on a third-party appraisal of value of the collateral less estimated cost to sell at that time. This syndicated commercial loan is collateralized by a marina, commercial real estate, and a high-end apartment complex in the U.S. Virgin Islands. During the fourth quarter of 2008, the Corporation charged-off $22 million in a construction loan which was considered a trouble debt restructure and was reserved under SFAS No. 114. The Corporation also recorded construction loans net charge-offs of $20.5 million during the quarter ended September 30, 2008 at BPNA. Management has identified construction loans considered impaired under SFAS No. 114 and established specific reserves based on the value of the collateral. The allowance for loan losses corresponding to construction loans represented 7.70% of that portfolio at December 31, 2008, compared with 4.31% in 2007 and 2.30% in 2006. The ratio of allowance to non-performing loans in the construction loan category was 53.32% at the end of 2008, compared with 87.86% in 2007.
     The Corporation’s allowance for loan losses for mortgage loans held-in-portfolio represented 2.38% of that portfolio at December 31, 2008, compared with 1.15% in 2007 and 0.83% in 2006. Mortgage loans net charge-offs as a percentage of average mortgage loans held-in-portfolio for the continuing operations increased primarily in the U.S. mainland operations. The Banco Popular North America reportable segment reported a ratio of mortgage loans net charge-offs to average mortgage loans held-in-portfolio of 2.91% for the year ended December 31, 2008, compared with 0.89% for the previous year. Deteriorating economic conditions in the U.S. mainland housing market have impacted the mortgage industry delinquency rates. As a result of higher delinquency and net charge-offs, BPNA recorded a higher provision for loan losses in 2008 to cover for inherent losses in this portfolio. The general level of property values in the U.S., as measured by several indexes widely followed by the market, has declined. These declines are the result of ongoing market adjustments that are aligning property values with income levels and home inventories. The supply of homes in the market has increased substantially, and additional property value decreases may be required to clear the overhang of excess inventory in the U.S. market. Declining property values could impact the credit quality of the Corporation’s U.S. mortgage loan portfolio because the value of the homes underlying the loans is a primary source of repayment in the event of foreclosure. Mortgage loans net charge-offs in the Banco Popular de Puerto Rico reportable segment amounted to $2.9 million for 2008, compared to net charge-offs of $1.2 million in 2007 and net charge-offs of $0.1 million in 2006. The slowdown in the housing sector in Puerto Rico has begun to put pressure on home prices and reduce sale activity. The ratio of mortgage loans net charge-offs to average mortgage loans held-in-portfolio for the BPPR reportable segment mortgage loans portfolio was 0.10% for the year ended December 31, 2008, compared to 0.04% for 2007. BPPR’s mortgage loans are fixed-rate fully amortizing, full-documentation loans that do not have the level of layered risk associated with subprime loans offered by certain major U.S. mortgage loan originators. Deteriorating economic conditions have impacted the mortgage delinquency rates in Puerto Rico increasing the levels of non-accruing mortgage loans. However, BPPR has not experienced significant increases in losses to date.
     Consumer loans net charge-offs as a percentage of average consumer loans held-in-portfolio rose mostly due to higher delinquencies in the U.S. mainland and in Puerto Rico. Consumer loans net charge-offs in the BPNA reportable segment rose for the year ended December 31, 2008, when compared with the previous year, by $70.9 million. The ratio of consumer loans net charge-offs to average consumer loans held-in-portfolio in the Banco Popular North America reportable segment was 6.89% for 2008, compared to 1.83% for 2007 and 1.47% for 2006. This increase was principally related to home equity lines of credit and second lien mortgage loans which are categorized by the Corporation as consumer loans. A home equity line of credit is a loan secured by a primary residence or second home. Home price declines coupled with the fact that most home equity loans are secured by second lien positions have significantly reduced and, in some cases, resulted in no collateral value after consideration of the first lien position. This drove more severe charge-offs as borrowers defaulted. E-LOAN represented approximately $52.7 million of that increase in the net charge-offs in consumer loans held-in-portfolio for the BPNA reportable segment. With the downsizing of E-LOAN in late 2007, this subsidiary ceased originating these types of loans. Consumer loans net charge-offs in the Banco Popular de Puerto Rico reportable segment rose for the year ended December 31, 2008, when compared with the previous year, by $22.5 million. The ratio of consumer loans net charge-offs to average consumer loans held-in-portfolio in the Banco Popular de Puerto Rico reportable segment was 4.21% for 2008, compared to 3.73% for 2007 and 2.43% for 2006. The allowance for loan losses for consumer loans held-in-portfolio represented 6.23% of that portfolio at December 31, 2008, compared with 4.39% in 2007 and 3.86% in 2006. The increase in this ratio was the result of increased levels of delinquencies and charge-offs.
     The Corporation maintains a reserve of approximately $15.5 million for potential losses associated with unfunded loan commitments related to commercial and consumer lines of credit. The estimated reserve is principally based on the expected draws

 


 

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on these facilities using historical trends and the application of the corresponding reserve factors determined under the Corporation’s allowance for loan losses methodology. This reserve for unfunded exposures remains separate and distinct from the allowance for loan losses and is reported as part of other liabilities in the consolidated statement of condition.
Operational Risk Management
Operational risk can manifest itself in various ways, including errors, fraud, business interruptions, inappropriate behavior of employees, and failure to perform in a timely manner, among others. These events can potentially result in financial losses and other damages to the Corporation, including reputational harm. The successful management of operational risk is particularly important to a diversified financial services company like Popular because of the nature, volume and complexity of its various businesses.
     To monitor and control operational risk and mitigate related losses, the Corporation maintains a system of comprehensive policies and controls. The Corporation’s Operational Risk Committee (“ORCO”), which is composed of senior level representatives from the business lines and corporate functions, provides executive oversight to facilitate consistency of effective policies, best practices, controls and monitoring tools for managing and assessing all types of operational risks across the Corporation. The Operational Risk Management Division, within the Corporation’s Risk Management Group, serves as ORCO’s operating arm and is responsible for establishing baseline processes to measure, monitor, limit and manage operational risk. In addition, the Internal Audit Division provides oversight about policy compliance and ensures adequate attention is paid to correct the identified issues.
     Operational risks fall into two major categories: business specific and corporate-wide affecting all business lines. The primary responsibility for the day-to-day management of business specific risks relies on business unit managers. Accordingly, business unit managers are responsible for ensuring that appropriate risk containment measures, including corporate-wide or business segment specific policies and procedures, controls and monitoring tools, are in place to minimize risk occurrence and loss exposures. Examples of these include personnel management practices, data reconciliation processes, transaction processing monitoring and analysis and contingency plans for systems interruptions. To manage corporate-wide risks, specialized groups such as Legal, Information Security, Business Continuity, Finance and Compliance, assist the business units in the development and implementation of risk management practices specific to the needs of the individual businesses.
     Operational risk management plays a different role in each category. For business specific risks, the Operational Risk Management Group works with the segments to ensure consistency in policies, processes, and assessments. With respect to corporate-wide risks, such as information security, business continuity, legal and compliance, the risks are assessed and a consolidated corporate view is developed and communicated to the business level.
Recently Issued Accounting Pronouncements and Interpretations
SFAS No. 141-R “Statement of Financial Accounting Standards No. 141(R), Business Combinations (a revision of SFAS No. 141)”
SFAS No. 141(R), issued in December 2007, will significantly change how entities apply the acquisition method to business combinations. The most significant changes affecting how the Corporation will account for business combinations under this statement include the following: the acquisition date will be the date the acquirer obtains control; all (and only) identifiable assets acquired, liabilities assumed, and noncontrolling interests in the acquiree will be stated at fair value on the acquisition date; assets or liabilities arising from noncontractual contingencies will be measured at their acquisition date at fair value only if it is more likely than not that they meet the definition of an asset or liability on the acquisition date; adjustments subsequently made to the provisional amounts recorded on the acquisition date will be made retroactively during a measurement period not to exceed one year; acquisition-related restructuring costs that do not meet the criteria in SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” will be expensed as incurred; transaction costs will be expensed as incurred; reversals of deferred income tax valuation allowances and income tax contingencies will be recognized in earnings subsequent to the measurement period; and the allowance for loan losses of an acquiree will not be permitted to be recognized by the acquirer. Additionally, SFAS No. 141(R) will require new and modified disclosures surrounding subsequent changes to acquisition-related contingencies, contingent consideration, noncontrolling interests, acquisition-related transaction costs, fair values and cash flows not expected to be collected for acquired loans, and an enhanced goodwill rollforward. The Corporation will be required to prospectively apply SFAS No. 141(R) to all business combinations completed on or after January 1, 2009. Early adoption is not permitted. For business combinations in which the acquisition date was before the effective date, the provisions of SFAS No. 141(R) will apply to the subsequent accounting for deferred income tax valuation allowances and income tax contingencies and will require any changes in those amounts to be recorded in earnings. Management will evaluate the impact of SFAS No. 141(R) on business combinations consumated in 2009 and beyond.

 


 

72     POPULAR, INC. 2008 ANNUAL REPORT
SFAS No. 160 “Statement of Financial Accounting Standards No. 160, Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51”
In December 2007, the FASB issued SFAS No. 160, which amends ARB No. 51, to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 will require entities to classify noncontrolling interests as a component of stockholders’ equity on the consolidated financial statements and will require subsequent changes in ownership interests in a subsidiary to be accounted for as an equity transaction. Additionally, SFAS No. 160 will require entities to recognize a gain or loss upon the loss of control of a subsidiary and to remeasure any ownership interest retained at fair value on that date. This statement also requires expanded disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective on a prospective basis for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, except for the presentation and disclosure requirements, which are required to be applied retrospectively. Early adoption is not permitted. Management is evaluating the effects, if any, that the adoption of this statement will have on its consolidated financial statements. The effects, if any, are not expected to be material.
SFAS No. 161 “Disclosures about Derivative Instruments and Hedging Activities”
In March 2008, the FASB issued SFAS No. 161, an amendment of SFAS No. 133. The standard requires enhanced disclosures about derivative instruments and hedged items that are accounted for under SFAS No. 133 and related interpretations. The standard will be effective for all of the Corporation’s interim and annual financial statements for periods beginning after November 15, 2008, with early adoption permitted. The standard expands the disclosure requirements for derivatives and hedged items and has no impact on how the Corporation accounts for these instruments. Management will be evaluating the enhanced disclosure requirements effective for the first quarter of 2009.
SFAS No. 162 “The Hierarchy of Generally Accepted Accounting Principles”
SFAS No. 162, issued by the FASB in May 2008, identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. This statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” Management does not expect SFAS No. 162 to have a material impact on the Corporation’s consolidated financial statements. The Board does not expect that this statement will result in a change in current accounting practice. However, transition provisions have been provided in the unusual circumstance that the application of the provisions of this statement results in a change in accounting practice.
FASB Staff Position (FSP) FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions”
The objective of FSP FAS 140-3, issued by the FASB in February 2008, is to provide implementation guidance on whether the security transfer and contemporaneous repurchase financing involving the transferred financial asset must be evaluated as one linked transaction or two separate de-linked transactions.
     Current practice records the transfer as a sale and the repurchase agreement as a financing. FSP FAS 140-3 requires the recognition of the transfer and the repurchase agreement as one linked transaction, unless all of the following criteria are met: (1) the initial transfer and the repurchase financing are not contractually contingent on one another; (2) the initial transferor has full recourse upon default, and the repurchase agreement’s price is fixed and not at fair value; (3) the financial asset is readily obtainable in the marketplace and the transfer and repurchase financing are executed at market rates; and (4) the maturity of the repurchase financing is before the maturity of the financial asset. The scope of this FSP is limited to transfers and subsequent repurchase financings that are entered into contemporaneously or in contemplation of one another.
     The Corporation adopted FSP FAS 140-3 effective on January 1, 2009. The impact of this FSP is not expected to be material.
FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets”
FSP FAS 142-3, issued by the FASB in April 2008, amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142 “Goodwill and Other Intangible Assets”. In developing these assumptions, an entity should consider its own historical experience in renewing or extending similar arrangements adjusted for entity’s specific factors or, in the absence of that experience, the assumptions that market participants would use about renewals or extensions adjusted for the entity specific factors.

 


 

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     FSP FAS 142-3 shall be applied prospectively to intangible assets acquired after the effective date. This FSP was adopted by the Corporation on January 1, 2009. The Corporation will be evaluating the potential impact of adopting this FSP to prospective transactions.
FSP No. FAS 132(R)-1 “Employers’ Disclosures about Postretirement Benefit Plan Assets”
FSP No. FAS 132(R)-1 applies to employers who are subject to the disclosure requirements of FAS 132(R) and is effective for fiscal years ending after December 15, 2009. Early application is permitted. Upon initial application, the provisions of this FSP are not required for earlier periods that are presented for comparative periods. The FSP requires the following additional disclosures: (a) the investment allocation decision making process, including the factors that are pertinent to an understanding of investment policies and strategies; (b) the fair value of each major category of plan assets, disclosed separately for pension plans and other postretirement benefit plans; (c) the inputs and valuation techniques used to measure the fair value of plan assets, including the level within the fair value hierarchy in which the fair value measurements in their entirety fall; and (d) significant concentrations of risk within plan assets. Additional detailed information is required for each category above. The Corporation will apply the new disclosure requirements commencing with the December 31, 2009 financial statements. This FSP impacts disclosures only and will not have an effect on the Corporation’s consolidated statements of condition or operations.
FSP No. EITF 03-6-1 “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities”
FSP No. EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share (“EPS”) under the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, Earnings per Share. Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. This FSP shall be effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this FSP. Early application is not permitted. This FSP will not have an impact on the Corporation’s EPS computation upon adoption.
EITF Issue No. 07-5 “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock”
In June 2008, the EITF reached consensus on Issue No. 07-5. EITF Issue No. 07-5 provides guidance about whether an instrument (such as outstanding common stock warrants) should be classified as equity and not marked to market for accounting purposes. EITF Issue No. 07-5 is effective for financial statements for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The guidance in this issue shall be applied to outstanding instruments as of the beginning of the fiscal year in which this issue is initially applied. Adoption of EITF Issue No. 07-5 was evaluated by the Corporation in accounting for the warrant associated to a preferred stock issuance in December 2008. Based on management’s analysis of EITF Issue 07-5 and other accounting guidance, the warrant was classified as an equity instrument, and adoption of EITF Issue 07-5 will not have an effect at adoption. Refer to Note 20 to the consolidated financial statements for a description of the warrant issued in 2008.
EITF 08-6 “Equity Method Investment Accounting Considerations”
EITF 08-6 clarifies the accounting for certain transactions and impairment considerations involving equity method investments. This EITF applies to all investments accounted for under the equity method. This issue is effective for fiscal years beginning on or after December 15, 2008. Early adoption is not permitted. EITF 08-6 provides guidance on (1) how the initial carrying value of an equity method investment should be determined, (2) how an impairment assessment of an underlying indefinite-lived intangible asset of an equity method investment should be performed, (3) how an equity method investee’s issuance of shares should be accounted for, and (4) how to account for a change in an investment from the equity method to the cost method. Management is evaluating the impact that the adoption of EITF 08-6 could have on the Corporation’s financial condition or results of operations.
EITF 08-7 “Accounting for Defensive Intangible Assets”
EITF 08-7 clarifies how to account for defensive intangible assets subsequent to initial measurement. EITF 08-7 applies to acquired intangible assets in situations in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset (a defensive intangible asset), except for intangible assets that are used in research and development activities. A defensive intangible asset should be accounted for as a separate unit of accounting. A defensive intangible asset shall be assigned a useful life in accordance with paragraph 11 of SFAS. No 142. EITF 08-7 is effective for intangible assets acquired on or after the beginning of the first annual reporting period beginning on or after December

 


 

74       POPULAR, INC. 2008 ANNUAL REPORT
15, 2008. Management will be evaluating the impact of adopting this EITF for future acquisitions commencing in January 2009.

 


 

75
Glossary of Selected Financial Terms
Allowance for Loan Losses — The reserve established to cover credit losses inherent in loans held-in-portfolio.
Asset Securitization — The process of converting receivables and other assets that are not readily marketable into securities that can be placed and traded in capital markets.
Basis Point — Equals to one-hundredth of one percent. Used to express changes or differences in interest yields and rates.
Book Value Per Common Share — Total common shareholders’ equity divided by the total number of common shares outstanding.
Brokered Certificate of Deposit — Deposit purchased from a broker acting as an agent for depositors. The broker, often a securities broker-dealer, pools CDs from many small investors and markets them to financial institutions and negotiates a higher rate for CDs placed with the purchaser.
Cash Flow Hedge - A derivative designated as hedging the exposure to variable cash flows of a forecasted transaction.
Common Shares Outstanding — Total number of shares of common stock issued less common shares held in treasury.
Core Deposits — A deposit category that includes all non-interest bearing deposits, savings deposits and certificates of deposit under $100,000, excluding brokered certificates of deposit with denominations under $100,000. These deposits are considered a stable source of funds.
Derivative — A contractual agreement between two parties to exchange cash or other assets in response to changes in an external factor, such as an interest rate or a foreign exchange rate.
Dividend Payout Ratio — Dividends paid on common shares divided by net income applicable to shares of common stock.
Duration — Expected life of a financial instrument taking into account its coupon yield / cost, interest payments, maturity and call features. Duration attempts to measure actual maturity, as opposed to final maturity. Duration measures the time required to recover a dollar of price in present value terms (including principal and interest), whereas average life computes the average time needed to collect one dollar of principal.
Earning Assets — Assets that earn interest, such as loans, investment securities, money market investments and trading account securities.
Efficiency Ratio — Non-interest expense divided by net interest income plus recurring non-interest income.
Effective Tax Rate — Income tax expense divided by income before taxes.
Fair Value Hedge — A derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment.
Gap — The difference that exists at a specific period of time between the maturities or repricing terms of interest-sensitive assets and interest-sensitive liabilities.
Goodwill — The excess of the purchase price of net assets over the fair value of net assets acquired in a business combination.
Interest-only Strip — The holder receives interest payments based on the current value of the loan collateral. High prepayments can return less to the holder than the dollar amount invested.
Interest Rate Caps / Floors — An interest rate cap is a contractual agreement between two counterparties in which the buyer, in return for paying a fee, will receive cash payments from the seller at specified dates if rates go above a specified interest rate level known as the strike rate (cap). An interest rate floor is a contractual agreement between two counterparties in which the buyer, in return for paying a fee, will receive cash payments from the seller at specified dates if interest rates go below the strike rate.
Interest Rate Swap — Financial transactions in which two counterparties agree to exchange streams of payments over time according to a predetermined formula. Swaps are normally used to transform the market exposure associated with a loan or bond borrowing from one interest rate base (fixed-term or floating rate).
Interest-Sensitive Assets / Liabilities — Interest-earning assets / liabilities for which interest rates are adjustable within a specified time period due to maturity or contractual arrangements.
Internal Capital Generation Rate — Rate at which a bank generates equity capital, computed by dividing net income (loss) less dividends by the average balance of stockholder’s equity for a given accounting period.
Net Charge — Offs — The amount of loans written-off as uncollectible, net of the recovery of loans previously written-off.

 


 

76     POPULAR, INC. 2008 ANNUAL REPORT
Net Income Applicable to Common Stock — Net income less dividends paid on the Corporation’s preferred stock.
Net Income Per Common Share Basic — Net income applicable to common stock divided by the number of weighted-average common shares outstanding.
Net Income Per Common Share Diluted — Net income applicable to common stock divided by the sum of weighted-average common shares outstanding plus the effect of common stock equivalents that have the potential to be converted into common shares.
Net Interest Income — The difference between the revenue generated on earning assets, less the interest cost of funding those assets.
Net Interest Margin — Net interest income divided by total average earning assets.
Net Interest Spread — Difference between the average yield on earning assets and the average rate paid on interest bearing liabilities, and the contribution of non-interest bearing funds supporting earning assets (primarily demand deposits and stockholders’ equity).
Non-Performing Assets — Includes loans on which the accrual of interest income has been discontinued due to default on interest and / or principal payments or other factors indicative of doubtful collection, loans for which the interest rates or terms of repayment have been renegotiated, and real estate which has been acquired through foreclosure.
Options Adjustable Rate Mortgage — Is an adjustable rate mortgage (“ARM”) which consists of taking an index (i.e. 12-month Treasury Average, Cost of Deposit Index, etc.), then adding a margin to total the final interest rate. Unlike other ARM’s where the principal and interest or simple interest payment is calculated from the total of the index and margin, the Options ARM may offer 4 monthly payment options every month depending on the loan program, giving the borrower the opportunity to choose which payment gets made based on the borrower’s economic condition at the time the payment is due. Four basic payment options that exist are the minimum payment option, interest-only payment, 30-year payment and 15-year payment.
Option Contract — Conveys a right, but not an obligation, to buy or sell a specified number of units of a financial instrument at a specific price per unit within a specified time period. The instrument underlying the option may be a security, a futures contract (for example, an interest rate option), a commodity, a currency, or a cash instrument. Options may be bought or sold on organized exchanges or over the counter on a principal-to-principal basis or may be individually negotiated. A call option gives the holder the right, but not the obligation, to buy the underlying instrument. A put option gives the holder the right, but not the obligation, to sell the underlying instrument.
Overcollaterization — A type of credit enhancement by which an issuer of securities pledged collateral in excess of what is needed to adequately cover the repayment of the securities plus a reserve. By pledging collateral with a higher face value than the securities being offered for sale, an issuer of mortgage-backed bonds can get a more favorable rating from a rating agency and also guard against the possibility that the bonds may be called before maturity because of mortgage prepayments.
Overhead Ratio — Operating expenses less non-interest income divided by net interest income.
Provision For Loan Losses — The periodic expense needed to maintain the level of the allowance for loan losses at a level consistent with management’s assessment of the loan portfolio in light of current economic conditions and market trends, and taking into account loan impairment and net charge-offs.
Return on Assets — Net income as a percentage of average total assets.
Return on Equity — Net income applicable to common stock as a percentage of average common stockholders’ equity.
Servicing Right — A contractual agreement to provide certain billing, bookkeeping and collection services with respect to a pool of loans.
Tangible Equity — Consists of stockholders’ equity less goodwill and other intangible assets.
Tier 1 Leverage Ratio — Tier 1 Risk-Based Capital divided by average adjusted quarterly total assets. Average adjusted quarterly assets are adjusted to exclude non-qualifying intangible assets and disallowed deferred tax assets.
Tier 1 Risk - Based Capital — Consists of common stockholders’ equity (including the related surplus, retained earnings and capital reserves), qualifying noncumulative perpetual preferred stock, senior perpetual preferred stock issued under the TARP Capital Purchase Program, qualifying trust preferred

 


 

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securities and minority interest in the equity accounts of consolidated subsidiaries, less goodwill and other disallowed intangible assets, disallowed portion of deferred tax assets and the deduction for nonfinancial equity investments.
Total Risk-Adjusted Assets — The sum of assets and credit equivalent off-balance sheet amounts that have been adjusted according to assigned regulatory risk weights, excluding the non-qualifying portion of allowance for loan and lease losses, goodwill and other intangible assets.
Total Risk-Based Capital — Consists of Tier 1 Capital plus the allowance for loan losses, qualifying subordinated debt and the allowed portion of the net unrealized gains on available-for-sale equity securities.
Treasury Stock — Common stock repurchased and held by the issuing corporation for possible future issuance.

 


 

78     POPULAR, INC. 2008 ANNUAL REPORT
Statistical Summary 2004-2008
Statements of Condition
                                         
    As of December 31,
(In thousands)   2008   2007   2006   2005   2004
 
Assets
                                       
Cash and due from banks
  $ 784,987     $ 818,825     $ 950,158     $ 906,397     $ 716,459  
 
Money market investments:
                                       
Federal funds sold and securities purchased under agreements to resell
    519,218       883,686       286,531       740,770       879,321  
Time deposits with other banks
    275,436       123,026       15,177       8,653       319  
Bankers’ acceptances
                             
 
 
    794,654       1,006,712       301,708       749,423       879,640  
 
Trading securities, at fair value
    645,903       767,955       382,325       519,338       385,139  
Investment securities available-for-sale, at fair value
    7,924,487       8,515,135       9,850,862       11,716,586       11,162,145  
Investment securities held-to-maturity, at amortized cost
    294,747       484,466       91,340       153,104       340,850  
Other investment securities, at lower of cost or realizable value
    217,667       216,584       297,394       319,103       302,440  
Loans held-for-sale, at lower of cost or market
    536,058       1,889,546       719,922       699,181       750,728  
 
Loans held-in-portfolio:
    25,857,237       28,203,566       32,325,364       31,308,639       28,253,923  
Less — Unearned income
    124,364       182,110       308,347       297,613       262,390  
Allowance for loan losses
    882,807       548,832       522,232       461,707       437,081  
 
 
    24,850,066       27,472,624       31,494,785       30,549,319       27,554,452  
 
Premises and equipment, net
    620,807       588,163       595,140       596,571       545,681  
Other real estate
    89,721       81,410       84,816       79,008       59,717  
Accrued income receivable
    156,227       216,114       248,240       245,646       207,542  
Servicing Assets
    180,306       196,645       164,999       141,489       57,183  
Other assets
    1,115,597       1,456,994       1,446,891       1,184,311       989,191  
Goodwill
    605,792       630,761       667,853       653,984       411,308  
Other intangible assets
    53,163       69,503       107,554       110,208       39,101  
Assets from discontinued operations
    12,587                          
 
 
  $ 38,882,769     $ 44,411,437     $ 47,403,987     $ 48,623,668     $ 44,401,576  
 
Liabilities and Stockholders’ Equity
                                       
Liabilities:
                                       
Deposits:
                                       
Non-interest bearing
  $ 4,293,553     $ 4,510,789     $ 4,222,133     $ 3,958,392     $ 4,173,268  
Interest bearing
    23,256,652       23,823,689       20,216,198       18,679,613       16,419,892  
 
 
    27,550,205       28,334,478       24,438,331       22,638,005       20,593,160  
Federal funds purchased and assets sold under agreements to repurchase
    3,551,608       5,437,265       5,762,445       8,702,461       6,436,853  
Other short-term borrowings
    4,934       1,501,979       4,034,125       2,700,261       3,139,639  
Notes payable
    3,386,763       4,621,352       8,737,246       9,893,577       10,180,710  
Subordinated notes
                            125,000  
Other liabilities
    1,096,229       934,372       811,424       1,240,002       821,491  
Liabilities from discontinued operations
    24,557                          
 
 
    35,614,296       40,829,446       43,783,571       45,174,306       41,296,853  
 
Minority interest in consolidated subsidiaries
    109       109       110       115       102  
 
Stockholders’ equity:
                                       
Preferred stock
    1,483,525       186,875       186,875       186,875       186,875  
Common stock
    1,773,792       1,761,908       1,753,146       1,736,443       1,680,096  
Surplus
    621,879       568,184       526,856       452,398       278,840  
Retained earnings (deficit)
    (374,488 )     1,319,467       1,594,144       1,456,612       1,129,793  
Treasury stock — at cost
    (207,515 )     (207,740 )     (206,987 )     (207,081 )     (206,437 )
Accumulated other comprehensive (loss) income, net of tax
    (28,829 )     (46,812 )     (233,728 )     (176,000 )     35,454  
 
 
    3,268,364       3,581,882       3,620,306       3,449,247       3,104,621  
 
 
  $ 38,882,769     $ 44,411,437     $ 47,403,987     $ 48,623,668     $ 44,401,576  
 

 


 

79
Statistical Summary 2004-2008
Statements of Operations
                                         
    For the year ended December 31,
(In thousands, except per                    
common share information)   2008   2007   2006   2005   2004
 
Interest Income:
                                       
Loans
  $ 1,868,462     $ 2,046,437     $ 1,888,320