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| CPF > SEC Filings for CPF > Form 10-K/A on 2-Mar-2009 | All Recent SEC Filings |
2-Mar-2009
Annual Report
Introduction
We are a bank holding company that, through our banking subsidiary, Central Pacific Bank, offers full service commercial banking in the state of Hawaii. In addition, we have offices in California serving customers there.
Our products and services focus on two areas:
· Loans: We focus our lending activities on commercial, residential and commercial mortgage, and construction loans to small and medium-sized companies, business professionals and real estate developers. Our lending activities contribute to a key component of our revenues-interest income.
· Deposits: We strive to provide exceptional customer service and products that meet our customers' needs, like our Free Plus Checking, Exceptional Savings and Super Savings accounts. We also maintain a broad branch and ATM network in the state of Hawaii. Raising funds through our deposit accounts enables us to support our lending activities. The interest paid on such deposits has a significant impact on our interest expense, an important factor in determining our earnings. In addition, fees and service charges on deposit accounts contribute to our revenues.
Additionally, we offer wealth management products and services such as non-deposit investment products, annuities, insurance, investment management, asset custody and general consultation and planning services.
In this discussion, we have included statements that may constitute "forward-looking statements" within the meaning of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements relate to our future plans and objectives, among other things. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from the results indicated in the forward-looking statements. Important factors that could, among others, cause our results to differ, possibly materially, from those indicated in the forward-looking statements are discussed above under "Business-Factors that May Affect Our Business" in Part I, Item 1 of this Annual Report on Form 10-K.
Executive Overview
Fiscal 2008 proved to be one of the most challenging periods in our fifty-four year history. Weakness and severe tightening in the overall credit markets, economic downturns in local, national and global economies, continued deterioration in the California real estate market and weakness in certain of our California commercial construction and Hawaii residential construction borrowers contributed to a net loss of $138.4 million recognized for the year. The net loss recognized in 2008 was attributable to $171.7 million in provision for loan and lease losses and a $94.3 million goodwill impairment charge, as continued weakness in our California residential construction loan portfolio negatively impacted 2008 results.
Our results for 2008 were reflective of the challenging and unprecedented economic environment that financial institutions across the country continue to experience. Despite the current turmoil and uncertainty in the financial markets, we remain committed to investing in our core Hawaii franchise and improving our asset quality.
Business Environment
The global and U.S. economies are currently experiencing a continued slowdown in
business activity as a result of disruptions in the financial system, including
a freeze and lack of confidence in the worldwide credit markets. In the U.S.,
credit conditions have worsened considerably over the course of the year and the
U.S. officially entered into a recession (as announced by the National Bureau of
Economic Research). Falling home prices, as well as increased foreclosures and
unemployment rates during the past year have resulted in significant write-downs
of asset values. These write-downs have caused many financial institutions to
seek additional capital, to merge with larger and stronger institutions and, in
some cases, to fail. As a result of the current uncertainties regarding the
stability of the financial markets, many financial institutions have reduced
and/or ceased to provide funding to borrowers, including other financial
institutions. Accordingly, the availability of credit, confidence in the
financial sector, and level of volatility in the financial markets have been
adversely affected and have contributed to the recent volatility and disruption
in the capital and credit markets which have reached unprecedented levels.
During 2008, the Fed announced a number of initiatives to provide stability and additional liquidity to the financial markets. These initiatives include providing additional liquidity to the asset-backed commercial paper and money markets and planned purchases of short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. In December 2008, the Fed lowered the federal funds benchmark rate to a range of zero to 0.25% and the discount rate to 0.50%.
The majority of our operations are concentrated in the states of Hawaii and California. Accordingly, our business performance is directly affected by conditions in the banking industry, macro economic conditions and the real estate market in those states. A favorable business environment is generally characterized by expanding gross state product, low unemployment and rising personal income while an unfavorable business environment is characterized by declining gross state product, high unemployment and declining personal income.
General economic conditions in Hawaii slowed throughout 2008 with signs of diminished growth appearing in the latter part of 2008. Tourism remains Hawaii's most significant economic driver, and according to the Hawaii Department of Business Economic Development & Tourism ("DBEDT"), 6.8 million visitors visited the state in 2008. This was a decrease of 10.8% from the number of visitor arrivals in 2007 and according to the DBEDT, total visitor arrivals are expected to further decline by 1.9% in 2009. The DBEDT also reported that total visitor spending declined to $11.3 billion in 2008 from a record $12.5 billion in 2007. The Department of Labor and Industrial Relations reported that Hawaii's seasonally adjusted unemployment rate was 5.5% in December 2008, compared to 3.1% in December 2007. Despite the increase, Hawaii's unemployment rate remained below the national seasonally adjusted unemployment rate of 7.2%. DBEDT projects real personal income to decline by approximately 0.4% in 2009, with increases in real personal income of 1.0% and 1.5% in 2010 and 2011, respectively. DBEDT also projects real gross state product growth to remain unchanged in 2009. With real estate lending as a primary focus, including construction, residential mortgage and commercial mortgage loans, we are dependent on the strength of the real estate market. The Hawaii real estate market cooled in 2008 and, according to the Honolulu Board of Realtors, Oahu unit sales volume dropped 24.4% for single-family homes and 28.5% for condominiums in 2008 from 2007. Median sales prices in 2008 for single-family homes on Oahu was $624,000, representing a 3.0% decrease from the prior year, while median sales prices for condominiums remained unchanged at $325,000. Expectations from local economists are for the Hawaii real estate market to continue its slowdown in 2009 with projected declines in both unit sales volume and median prices of 10%.
The effects of falling home prices, limited credit availability, shrinking equity values and growing unemployment stymied the California economy in 2008 as it decelerated in step with the national economy. Consumer and business spending, the core of the California economy, decreased in 2008. The outlook for the California economy calls for negative growth in 2009, followed by weak growth in 2010 improving slightly in 2011. The California Association of Realtors ("CAR") reported that December 2008 unit home sales increased by 84.9%, while the median price plunged 41.5% from year ago levels primarily driven by a significant rise in distressed sales, including foreclosures. CAR forecasts Calfornia median sales price will decline 6.0% to $358,000 in 2009, while the number of sales are projected to increase by 12.5% during the same period as distressed sales will continue to impact the market. According to the California Department of Finance ("CDOF"), average personal income is projected to have increased by 4.2% in 2008 from one year ago and projections for 2009 call for an increase of 2.1% from 2008. The CDOF also reported that California civilian workforce grew by 1.8% to 18.6 million in December 2008 from 18.3 million a year ago, while California's seasonally adjusted unemployment rate in December 2008 increased to 9.3% from 5.9% in the prior year and continues to be well above the national unemployment rate.
Our results of operations in future periods will be significantly impacted by the economies in Hawaii, California or other markets we serve. Loan demand, deposit growth, provision for loan and lease losses, asset quality, noninterest income and noninterest expense may be affected by changes in economic conditions. If the California and Hawaii residential real estate markets do not improve or continue to deteriorate, the California and Hawaii commercial real estate market worsens, or the economic environments in Hawaii, California or other markets we serve suffer an adverse change or a material external shock, our results of operations may be negatively impacted.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires that management make certain judgments and use certain estimates and assumptions that affect amounts reported and disclosures made. Accounting estimates are deemed critical when a different estimate could have reasonably been used or where changes in the estimate are reasonably likely to occur from period to period and would materially impact our consolidated financial statements as of or for the periods presented. Management has discussed the development and selection of the critical accounting estimates noted below with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the accompanying disclosures.
Allowance for Loan and Lease Losses
We maintain an allowance for loan and lease losses (the "Allowance") at an amount we expect to be sufficient to absorb probable losses inherent in our loan and lease portfolio based on a projection of probable net loan charge-offs. For loans classified as impaired, an estimated impairment loss is calculated. To estimate loan charge-offs on other loans, we evaluate the level and trend of nonperforming and potential problem loans and historical loss experience. We also consider other relevant economic conditions and borrower-specific risk characteristics, including current repayment patterns of our borrowers, the fair value of collateral securing specific loans, changes in our lending and underwriting standards and general economic factors, nationally and in the markets we serve, including the real estate market generally and the residential construction market. Estimated loss rates are determined by loan category and risk profile, and an overall required Allowance is calculated. Based on our estimate of the level of Allowance required, a provision for loan and lease losses (the "Provision") is recorded to maintain the Allowance at an appropriate level. We adjusted our Provision in 2008 and 2007 in accordance with our risk assessment policies to account for an increase in exposure throughout various portions of our loan portfolio.
Reserves for unfunded commitments are recorded separately through a valuation allowance included in other liabilities. Credit losses for off-balance sheet credit exposures are deducted from the allowance for credit losses on off-balance sheet credit exposures in the period in which the liability is settled. The allowance for credit losses on off-balance sheet credit losses is established by a charge to other operating expense.
Since we cannot predict with certainty the amount of loan and lease charge-offs that will be incurred and because the eventual level of loan and lease charge-offs are impacted by numerous conditions beyond our control, a range of loss estimates could reasonably have been used to determine the Allowance and Provision. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review our Allowance. Such agencies may require that we recognize additions to the Allowance based on their judgments about information available to them at the time of their examination. Accordingly, actual results could differ from those estimates.
Further deterioration in the California or Hawaii real estate markets could result in an increase in loan delinquencies, additional increases in our Allowance and Provision, as well as an increase in loan charge-offs.
Loans Held for Sale
Loans held for sale consists of Hawaii residential mortgage loans, as well as mainland residential and commercial construction loans. Hawaii residential mortgage loans classified as held for sale are carried at the lower of cost or fair value on an aggregate basis while mainland residential and commercial construction loans are recorded at the lower of cost or fair value on an individual basis.
Loans originated with the intent to be held in our portfolio are subsequently transferred to held for sale when a decision is made to sell these loans. At the time of a loan's transfer to the held for sale account, the loan is recorded at the lower of cost or fair value. Any reduction in the loan's value is reflected as a write-down of the recorded investment resulting in a new cost basis, with a corresponding reduction in the Allowance.
In subsequent periods, if the fair value of a loan classified as held for sale is less than its cost basis, a valuation adjustment is recognized in our consolidated statement of operations in other operating expense and the carrying value of the loan is adjusted accordingly. The valuation adjustment may be recovered in the event that the fair value increases, which is also recognized in our consolidated statement of operations in other operating expense.
The fair value of loans classified as held for sale are generally based upon
quoted prices for similar assets in active markets, acceptance of firm offer
letters with agreed upon purchase prices, discounted cash flow models that take
into account market observable assumptions, or independent appraisals of the
underlying collateral securing the loans.
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), we review the carrying amount of goodwill for impairment on an annual basis. Additionally, we perform an impairment assessment of goodwill and other intangible assets whenever events or changes in circumstances indicate that the carrying value of goodwill and other intangible assets may not be recoverable. Significant negative industry or economic trends, disruptions to our business, unexpected significant changes or planned changes in use of the assets, divestitures and market capitalization declines may result in impairments to goodwill. Absent any impairment indicators, we perform our goodwill impairment test annually.
Our impairment assessment of goodwill and other intangible assets involves the estimation of future cash flows and the fair value of reporting units to which goodwill is allocated. We reconcile the estimated fair values of our reporting units to our total market capitalization plus a control premium. Estimating future cash flows and determining fair values of the reporting units is judgmental and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of the impairment charge.
In the second quarter of 2008 and fourth quarter of 2007, we experienced significant declines in our market capitalization which we determined were indicators that impairment tests were required under SFAS 142. As a result of our impairment tests at June 30, 2008 and December 31, 2007, we determined that the goodwill associated with our Commercial Real Estate reporting unit, which includes the California residential construction loan portfolio, was impaired and we consequently recorded non-cash charges of $94.3 million and $48.0 million in the second quarter of 2008 and fourth quarter of 2007, respectively. The goodwill associated with our Hawaii Market reporting unit was not considered to be impaired at any of these periods. In the fourth quarter of 2008, we experienced a further decline in our market capitalization due to the continued deterioration of the California real estate market, however, no goodwill impairment charge was recognized as there was no goodwill remaining in our Commercial Real Estate reporting segment and no impairment was identified in our Hawaii Market reporting segment. All remaining goodwill at December 31, 2008 is attributable to our Hawaii Market reporting unit. Future declines in our market capitalization may result in the impairment of the remaining goodwill assigned to our Hawaii Market reporting unit.
The reconciliation of fair value estimates of the reporting units to our total market capitalization in the second quarter of 2008 and fourth quarter of 2007 included implied control premiums of 15.5% and 31.7%, respectively. We considered recent trends in our market capitalization and compared these implied control premiums to observable transaction premiums for other financial institutions from publicly available data sources and concluded that they were reasonable at each period end.
Deferred Tax Assets and Tax Contingencies
We account for income taxes in accordance with SFAS 109, "Accounting for Income Taxes" and FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48"). Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to temporary differences and carryforwards. A valuation allowance may be required if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining whether a valuation allowance is necessary, we consider the level of taxable income in prior years, to the extent that carrybacks are permitted under current tax laws, as well as estimates of future taxable income and tax planning strategies that could be implemented to accelerate taxable income if necessary. If our estimates of future taxable income were materially overstated or if our assumptions regarding the tax consequences of tax planning strategies were inaccurate, some or all of our deferred tax assets may not be realized, which would result in a charge to earnings.
We have established income tax contingency reserves for potential tax liabilities related to uncertain tax positions. Tax benefits are recognized when we determine that it is more likely than not that such benefits will be realized. Where uncertainty exists due to the complexity of income tax statutes and where the potential tax amounts are significant, we generally seek independent tax opinions to support our positions. If our evaluation of the likelihood of the realization of benefits is inaccurate, we could incur additional income tax and interest expense that would adversely impact earnings, or we could receive tax benefits greater than anticipated which would positively impact earnings.
Defined benefit plan obligations and related assets of our defined benefit retirement plan are presented in Note 16 to the Consolidated Financial Statements. In 2002, the defined benefit retirement plan was curtailed and all plan benefits were fixed as of that date. Plan assets, which consist primarily of marketable equity and debt securities, are typically valued using market quotations. Plan obligations and the annual pension expense are determined by independent actuaries through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate, we utilize a yield that reflects the top 50% of the universe of bonds, ranked in the order of the highest yield. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plans.
At December 31, 2008, we used a weighted-average discount rate of 6.6% and an expected long-term rate of return on plan assets of 8.0%, which affected the amount of pension liability recorded as of year-end 2008 and the amount of pension expense to be recorded in 2009. At December 31, 2007, a weighted-average discount rate of 6.5% and an expected long-term rate of return on plan assets of 8.0% were used in determining the pension liability recorded as of year-end 2007 and the amount of pension expense recorded in 2008. For both the discount rate and the asset return rate, a range of estimates could reasonably have been used which would affect the amount of pension expense and pension liability recorded.
An increase in the discount rate or asset return rate would reduce pension expense in 2008, while a decrease in the discount rate or asset return rate would have the opposite effect. A 0.25% change in the discount rate assumption would impact 2009 pension expense by $0.1 million and year-end 2008 pension liability by $0.7 million, while a 0.25% change in the asset return rate would impact 2009 pension expense by less than $0.1 million.
Overview of Results of Operations
2008 vs. 2007 Comparison
In 2008, we recognized a net loss of $138.4 million compared to net income of $5.8 million in 2007. The net loss recognized in 2008 was primarily driven by an increase in credit costs and the write off of the remaining goodwill assigned to our Commercial Real Estate reporting segment as continued weakness in the California residential construction market persisted throughout the year. Credit costs in 2008, which included the provision for loan and lease losses of $171.7 million, write-downs of loans classified as held for sale of $23.8 million, write-downs of foreclosed property of $7.4 million and a decrease to the reserve for unfunded loan commitments of $1.5 million, increased by $144.3 million, or 244.4% over credit costs recognized in 2007. The net loss recognized in 2008 was also impacted by a non-cash mortgage servicing rights impairment charge totaling $3.4 million and a $2.8 million net loss on a counterparty financing transaction with Lehman Brothers, Inc. ("LBI").
Our diluted loss per share was $4.83 for 2008 compared to diluted earnings per share of $0.19 in 2007. We declared cash dividends of $0.70 per common share in 2008, representing a decrease of $0.28, or 28.6%, from the prior year. Loss on average assets and average shareholders' equity for 2008 was 2.45% and 23.07%, respectively, compared to a return on average assets and average shareholders' equity of 0.10% and 0.77%, respectively, in 2007. Our efficiency ratio, which measures operating expenses before the amortization, impairment and write-down of intangible assets, goodwill, loans held for sale and foreclosed property; loss on counterparty financing transaction and loss on sale of commercial real estate loans as a percentage of net operating revenue (net interest income on a taxable equivalent basis plus other operating income before securities transactions), was 53.93% in 2008 compared to 47.80% in 2007. The increase in our efficiency ratio from the prior year was primarily attributable to the increase in operating expenses, which are described below.
Our net income of $5.8 million in 2007 was a decrease of $73.4 million, or 92.7%, from the $79.2 million recognized in 2006. The decrease in our net income for 2007 was driven by $53.0 million in provision for loan and lease losses directly attributable to the significant and rapid deterioration in the California residential construction market which began to affect us in the second half of 2007, as well as a $48.0 million goodwill impairment charge associated with our Commercial Real Estate reporting segment, which included the California residential construction loan portfolio. In 2006, the provision for loan and lease losses was $1.4 million and there was no goodwill impairment. Partially offsetting the negative effects of the increase in the provision for loan and lease losses and the goodwill impairment charge was the decrease in income tax expense as there was a disproportionate recognition of federal and state tax credits compared to our taxable income. The Company earns a tax benefit from tax credits and tax-exempt income irrespective of the level of pre-tax income. This results in a favorable impact to the total tax benefit and the effective tax rate especially during periods in which the Company is near break-even or experiencing a pre-tax loss. Net income in 2007 was also impacted by $2.4 million of additional income tax expense resulting from the settlement of a tax contingency item, $2.0 million of income tax benefit related to certain income tax adjustments, a $1.1 million after tax reversal of prior year incentive compensation accruals and a $1.0 million after tax loss on an investment portfolio repositioning.
Diluted earnings per share of $0.19 for 2007 decreased by $2.38, or 92.6%, from 2006, while cash dividends declared of $0.98 per common share increased by $0.10, or 11.4%, over prior year amounts. Return on average assets of 0.10% in 2007 decreased from 1.50% in 2006 and return on average equity was 0.77% in 2007 compared to 11.16% in 2006. Our efficiency ratio was 47.80% in 2007 compared to 49.67% in 2006.
Table 1 sets forth information concerning average interest earning assets and interest-bearing liabilities and the yields and rates thereon. Table 2 presents an analysis of changes in components of net interest income between years. Net interest income, when expressed as a percentage of average interest earning assets, is referred to as "net interest margin." Interest income, which includes . . .
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