ITEM 1. BUSINESS
TeleBanc Financial Corporation ("TeleBanc" or the "Company") is a savings and loan holding company organized under the laws of Delaware in 1994.
We are the nation's leading branchless bank providing high value financial products and services primarily over the Internet. We offer a wide range of FDIC-insured and other banking products and services with significantly higher rates and lower fees than traditional banks with brick-and-mortar branches.
We have been providing branchless banking for ten years using electronic delivery channels. With the advent of the Internet, we have positioned ourselves to exploit the low cost distribution, increased functionality and broader reach it offers. We believe that the low cost structure of our Internet-based platform provides us with significant cost advantages over traditional banks who must support their branch networks.
Currently, approximately 60% of our customer contacts occur over the Internet. Using our secure, comprehensive and customer friendly web site (www.telebankonline.com), individuals can open an account, transfer funds between accounts, view account balances, pay bills and compare our premium rates to national averages. Customers can deposit funds using direct deposit, wire or U.S. mail, and can withdraw cash from over 430,000 automated teller machines on the Cirrus(R) network worldwide. To support our products and services and build customer loyalty, we strive to provide superior customer service through our 24-hour call centers. We also offer a wide array of complementary products, including residential mortgage loans and fixed annuities, through alliances with strategic partners.
Our comprehensive marketing plan targets customers in all 50 states who value the convenience and premium rates of our high value products. The four main initiatives of our marketing plan are national advertising through print, radio and online media, strategic alliances with popular web sites such as Yahoo! and E-Loan, affinity partnerships with national organizations such as Sam's Club and referral programs using our existing customer base. As of December 31, 1998, we had approximately 50,000 customer accounts, $2.3 billion in total assets and $1.1 billion in retail deposits. During 1998, our retail deposits and customer accounts grew 119% and 133%.
Our executive offices are located at 1111 North Highland Street, Arlington, Virginia 22201, telephone (703) 247-3700. Our web site address is located at www.telebankonline.com.
LENDING ACTIVITIES
GENERAL. We purchase whole loans and mortgage-backed and related securities rather than produce or originate loans.
LOAN PORTFOLIO COMPOSITION. At December 31, 1998, our net loans receivable totaled $904.8 million, or 39.6% of total assets. As of the same date, $897.2 million, or 97.5%, of the total gross loan portfolio, consisted of one- to four-family residential mortgage loans. Prior to 1990, we originated a limited number of loans for the purchase or construction of multifamily and commercial real estate. However, as part of our general operating strategy and in response to risks associated with multifamily and commercial real estate lending and prevailing economic conditions, we stopped originating and purchasing such loans. At December 31, 1998, multifamily, commercial, and mixed-use real estate loans amounted to $13.1 million, or 1.4%, of our total loan portfolio. The loan portfolio also included second trust residential mortgages, home equity lines of credit, automobile loans and loans secured by savings deposits totaling $8.7 million, or 0.9%, of our total loan portfolio at December 31, 1998.
The following table presents information concerning our loan portfolio in dollar amounts and in percentages, by type of loan.
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(1) Includes primarily loans secured by deposit accounts in TeleBank, and to a lesser extent, unsecured consumer credit.
MATURITY OF LOAN PORTFOLIO. The following table shows, as of December 31, 1998, the dollar amount of loans maturing in our portfolio in the time periods indicated. This information includes scheduled principal repayments, based on the loans' contractual maturities. We report demand loans, loans with no stated repayment schedule and no stated maturity, and overdrafts as due within one year. The table below does not include any estimate of prepayments. Prepayments may significantly shorten the average life of a loan and may cause our actual repayment experience to differ from that shown below.
The following table shows, as of December 31, 1998, the dollar amount of our loans that mature after December 31, 1999. We have allocated these loans between those with fixed interest rates and those with adjustable interest rates.
Scheduled principal repayments set forth in loan contracts may not reflect the actual life of the loans. Prepayments may cause the average life of loans to be substantially less than their contractual terms. In addition, some loans contain due-on-sale clauses, which give us the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the property. However, if market interest rates on current mortgage loans climb to a level substantially higher than rates on loans that we own, the average life of our loans tends to increase. Conversely, the average life of our mortgage loans tends to decrease when market interest rates on current loans fall substantially below rates on loans that we own.
Origination, Purchase, and Sale of Loans.
The following table shows our loan purchases and originations during the periods indicated.
Additionally, during 1998, we acquired approximately $150.0 million in loans through our merger with DFC.
The following table shows our loan origination, purchase, sale, and repayment activity during the periods indicated.
During fiscal 1998 and 1997, we purchased whole loans in the secondary market, principally from private investors. In 1998, we purchased 164 pools with 2,437 loans. We purchased 92 pools with 2,900 loans in 1997. In 1996, we purchased 35 pools with 1,253 loans and originated a minimal number of loans.
We did not originate any loans during 1998 or 1997. From time to time we may originate consumer loans as an accommodation to our customers or purchase such loans as part of larger loan packages.
Under existing master loan servicing contracts, we receive servicing fees that we withhold from the monthly payments we make to the loan holders. Our aggregate loan servicing fee income amounted to $1.0 million, $942,000 and $790,000 in 1998, 1997 and 1996, respectively.
On August 1, 1998, mortgage loans which were serviced in-house were transferred to Dovenmuehle Mortgage, Inc., pursuant to a subservicing agreement dated May 6, 1998. While we continue to earn servicing fee income, we pay Dovenmuehle Mortgage, Inc., a flat fee ranging from $6 to $7 per loan per month. At December 31, 1998, Dovenmuehle Mortgage, Inc., serviced $217.4 million, or 23.6%, of our gross loan portfolio and $135.2 million in mortgage loans that we had previously serviced for others. The remainder of our loan portfolio is serviced by other lenders, who perform the functions described above. To receive this service, we pay a fee ranging from a minimum of $6 per loan per month to a maximum of 79 basis points of the principal balance of the loan per annum.
CRA LENDING ACTIVITIES. TeleBank participates in various community development programs in an effort to meet its responsibilities under the Community Reinvestment Act (the "CRA"). In order to meet its CRA responsibilities, TeleBank has committed to invest up to $500,000 in an investment tax credit fund that qualifies for CRA purposes.
In 1995, the federal financial regulatory agencies revised the regulations that implement the CRA. The revised regulations outline special evaluations for wholesale institutions. The Bank has been approved as a wholesale institution that serves the credit needs of the entire nation.
MORTGAGE-BACKED AND RELATED SECURITIES
We maintain a significant portfolio of mortgage-backed securities, primarily in the following forms:
- privately insured mortgage pass-through securities
- Government National Mortgage Association ("GNMA") participation certificates
- Fannie Mae participation certificates
- Freddie Mac participation certificates
- securities issued by other non-agency organizations
Principal and interest on GNMA certificates are guaranteed by the full faith and credit of the United States. Fannie Mae and Freddie Mac certificates are each guaranteed by their respective agencies. Mortgage-backed securities generally entitle us to receive a pro rata portion of the cash flows from an identified pool of mortgages. We also invest in collateralized mortgage obligations ("CMOs"). CMOs are securities issued by special purpose entities generally collateralized by pools of mortgage-backed securities. The cash flows from these pools are segmented and paid in accordance with a predetermined priority to various classes of securities issued by the entity. Our CMOs are senior tranches collateralized by federal agency securities or whole loans.
The following table shows the activity in our mortgage-backed securities available-for-sale portfolio during the periods indicated.
- --------------- (1) Includes mortgage-backed securities on which call options have been exercised.
In 1997, we began to acquire mortgage-backed and related securities for trading purposes. We buy and hold trading securities principally for the purpose of selling them in the near term. We carry these securities at market value with unrealized gains and losses recognized in income. At December 31, 1998 and 1997, we held $29.6 million and $21.1 million of trading securities, respectively. No securities were classified as trading securities at December 31, 1996. For the periods ending December 31, 1998 and 1997, we recognized approximately $569,000 and $564,000, respectively, in realized gains from the sale of trading assets and approximately ($612,000) and $640,000, respectively, in unrealized depreciation or appreciation of trading assets.
The following table shows the scheduled maturities, carrying values, and current yields for our portfolio of mortgage-backed and related securities, both available-for-sale and trading, at December 31, 1998:
NONPERFORMING, DELINQUENT AND OTHER PROBLEM ASSETS
GENERAL. We continually monitor our loan portfolio so that we will be able to anticipate and address potential and actual delinquencies. Generally, we perform annual valuations on real estate owned ("REO"). If the fair value of a property has changed, we establish an allowance for losses on REO by recognizing an operating expense.
NONPERFORMING ASSETS. Nonperforming assets consist of the following:
- loans on which we no longer accrue interest
- troubled debt restructurings ("TDRs"), which are loans that have been restructured in order to allow the borrower to retain possession of the collateral
- real estate acquired by foreclosure
- real estate upon which deeds in lieu of foreclosure have been accepted
We write down restructured loans and REO to estimated fair value, based on estimates of the cash flow we expect to receive from the underlying collateral.
The following table presents information about our non-accrual loans, REO and TDRs at the dates indicated.
During 1998, our non-performing assets decreased by $1.3 million or 11.2%. As a matter of policy, we actively monitor our non-performing assets.
During the years ended December 31, 1998, 1997, 1996, 1995 and 1994, if our non-accruing loans had been performing in accordance with their terms, we would have recorded interest income of approximately $597,000, $739,000, $789,000, $365,000 and $113,000, respectively. However, we did not recognize any interest income on non-accruing loans during these years.
TDRs are loans that have been restructured and to which we have granted concessions in order to allow the borrower to retain possession of the collateral. We take into consideration, among other things, the borrower's financial difficulty. In granting these concessions, our goal is to maximize our recovery from the investment by modifying its terms. These modifications may include the following:
- reducing the stated rate
- extending maturity at a more favorable rate
- reducing the accrued interest
TDRs totaled approximately $0, $425,000, $435,000, $365,000, and $688,000 at December 31, 1998, 1997, 1996, 1995 and 1994, respectively. We recorded approximately $0, $28,000, $28,000, $45,000 and $9,000 in interest income on TDRs in 1998, 1997, 1996, 1995 and 1994, respectively. We monitor TDRs closely because they are inherently risky.
In some cases, information we know about a borrower's possible credit problems may cause us to have serious doubts about the borrower's ability to repay under the loan's present terms, even if that loan is not classified as non-accrual, past due 90 days or more or a TDR. We consider these loans potential problem loans. At December 31, 1998, loans that we had identified as potential problem loans that were still accruing interest approximated $822,000. The majority of these loans, identified as "special mention" loans, include non-residential loans that were delinquent but had not yet been placed on non-accrual.
ALLOWANCE FOR LOAN LOSSES. We recognize that, from time to time, we will experience credit losses as a normal effect of owning loans. We believe the risk of credit loss varies with, among other things, the following:
- the type of loan
- the creditworthiness of the borrower over the term of the loan
- general economic conditions
- in the case of a secured loan, the quality of the security for the loan
Our policy is to maintain an adequate allowance for loan losses based on, among other things, the following:
- our historical loan loss experience
- regular reviews of delinquencies and loan portfolio quality
- the industry's historical loan loss experience for similar asset types
- evaluation of economic conditions
We increase our allowance for loan losses when we estimate that losses have been incurred by charging provisions for possible loan losses against income. Charge-offs reduce the allowance when losses are confirmed.
In establishing the allowance for loan losses, we set up specific allowances for probable losses that we have identified on specific loans. Additionally, we provide additional amounts for estimated expected losses in the remainder of the loan portfolio. The allowances established by management are subject to review and
approval by the Company's Board of Directors. Each month, we review the allowance for adequacy, based on our assessment of the risk in our loan portfolio as a whole, considering the following factors:
- the composition and quality of the portfolio
- delinquency trends
- current charge-off and loss experience
- the state of the real estate market
- general economic conditions
During 1998, we recorded a net increase of $1.2 million in the allowance for loan losses. The increase resulted from an additional provision of $905,000, $723,000 from the acquisition of DFC, offset by net charge-offs of $457,000.
The level of provision recorded for 1998 was based upon the level of charge-offs, the significant growth in the portfolio and the $15.0 million increase in commercial mortgage and home equity loans from the DFC acquisition.
As of December 31, 1998, total loans receivable included nine pools of credit-enhanced one- to four-family mortgage loans totaling $43.1 million, or 4.7%, of total gross loans outstanding. One of these pools, totaling $22.2 million, has a credit reserve from the seller equal to 2.3% of the unpaid principal balance at the time of purchase to offset any losses. Three pools, totaling $13.0 million, have certain recourse whereby the seller must repurchase any loan that becomes more than 90 days past due at any time during the life of the loan. The five remaining pools, which total $7.9 million, have other forms of credit enhancement, including letters of credit and offsetting cash reserves designed to protect us from credit losses. We believe that the combination of our loan loss allowance, net credit discount, and credit enhancement on certain loan pools are adequate to cover estimated losses. See "Management Discussion and Analysis of Financial Condition and Results of Operations."
We believe that we have established our existing loss allowances in accordance with generally accepted accounting principles. However, in reviewing our loan portfolio, regulators may request us to increase our allowance for losses. Such an increase would negatively affect our financial condition and earnings.
The following table allocates the allowance for loan losses by loan category at the dates indicated. This allocation does not necessarily restrict the use of the allowance to absorb losses in any other category. The table also shows the percentage of total loans that each loan category represents.
The above amounts include specific reserves totaling $449,000, $510,000, $579,000, $392,000, and $201,000, at December 31, 1998, 1997, 1996, 1995, and 1994, respectively, related to loans classified as loss.
The following table shows the activity in our allowance for loan losses during the periods indicated.
REO. We initially record REO at estimated fair value less selling costs. Fair value is defined as the estimated amount that a real estate parcel would yield in a current sale between a willing buyer and a willing seller. Subsequent to foreclosure, management periodically reviews REO and establishes an allowance if the estimated fair value of the property, less estimated costs to sell, declines.
As of December 31, 1998, all of our REO consisted of one- to four-family real estate.
INVESTMENT SECURITIES
The following table shows the cost basis and fair value of our investment portfolio other than mortgage-backed securities at the dates indicated.
The following table shows the scheduled maturities, carrying values, and current yields for our investment portfolio of debt securities at December 31, 1998:
- --------------- (a) Yields on tax exempt obligations are computed on a tax equivalent basis.
DEPOSITS AND OTHER SOURCES OF FUNDS
The following table presents information about the various categories of TeleBank deposits as of December 31, 1998.
The following table shows the dollar changes in our various types of deposit accounts between the dates indicated:
The following table classifies our certificates of deposit and money market accounts by rate at the dates indicated.
The following table classifies the amount of our large certificates of deposit ($100,000 or more) by time remaining until maturity, as of December 31, 1998.
BORROWINGS
Although deposits are our primary source of funds, we also borrow from the Federal Home Loan Bank ("FHLB") of Atlanta and sell securities under agreements to repurchase to acquire additional funding. We are a member of the FHLB system, which, among other things, functions in a reserve credit capacity for savings institutions. This membership requires us to own capital stock in the FHLB of Atlanta. It also authorizes us to apply for advances on the security of FHLB stock and various home mortgages and other assets -- principally securities that are obligations of, or guaranteed by, the United States of America -- provided we meet certain creditworthiness standards.
As of December 31, 1998 our outstanding advances from the FHLB of Atlanta totaled $472.5 million at interest rates ranging from 5.13% to 5.73% and at a weighted average rate of 5.19%.
We also borrow funds by selling securities to nationally recognized investment banking firms under agreements to repurchase the same securities. The investment banking firms hold the securities in custody. We treat repurchase agreements as borrowings and secure them with designated fixed and variable rate securities. We use the proceeds of these transactions to meet our cash flow or asset/liability matching needs. The following table presents information regarding repurchase agreements for the dates indicated:
The following table sets forth information regarding the weighted average interest rates and the highest and average month end balances of our borrowings.
EMPLOYEES
At December 31, 1998, we had 96 full-time employees and 25 part-time employees. Management considers its relations with its employees to be excellent. Our employees are not represented by any collective bargaining group.
REGULATION
TeleBanc, as a savings and loan holding company, and TeleBank, as a federally chartered savings bank, are subject to extensive regulation, supervision and examination by the OTS as their primary federal regulator. TeleBank also is subject to regulation, supervision and examination by the FDIC.
TeleBanc Capital Markets, Inc., a wholly owned subsidiary of TeleBanc, is a registered broker-dealer under the Securities Exchange Act of 1934. As such, TeleBanc Capital Markets, Inc. is regulated by the SEC.
TeleBanc Insurance Services, Inc., a subsidiary of TeleBanc, is required to be licensed in each state where it sells insurance products and is subject to the regulatory requirements of these states. Currently, TeleBanc Insurance is licensed in six states.
In September 1996, legislation (the "1996 Legislation") was enacted to address the undercapitalization of the Savings Association Insurance Fund (the "SAIF"), of which TeleBank is a member. The 1996 Legislation contemplates the merger of the SAIF with the Bank Insurance Fund (the "BIF"), which generally insures deposits in national and state-chartered banks. As a condition to the combined insurance fund, however, the 1996 Legislation contemplates that no insured depository institution would be chartered as a savings association (such as TeleBank). Several proposals for abolishing the federal thrift charter were introduced in Congress during 1998 in bills addressing financial services modernization of the 1996 Legislation. While no legislation was enacted in 1998, financial modernization legislation continues to be discussed by Congress. If final legislation is passed abolishing the federal thrift charter, TeleBank could be required to convert its federal charter to a national bank charter, a new federal type of bank charter or a state depository institution charter, and the Company could be subject to regulation by the Federal Reserve Board or another agency, and could be subject to capital requirements that are not currently applicable to holding companies under OTS regulation.
ITEM 2.
ITEM 2. PROPERTIES
The Company leases its principal office located at 1111 North Highland Street, Arlington, Virginia 22201. The Company leases approximately 19,000 square feet in that location. The lease expires in 2005. During 1998, the Company leased approximately 1,400 square feet of office space in Los Angeles, California as a small business development office. The lease expires in 2003. Also during 1998, the Company became the lessee of an office in Gibbsboro, New Jersey through its acquisition of Direct Financial Corporation. This office consists of approximately 8,000 square feet and is leased until 2000.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no material pending legal proceedings, other than ordinary routine litigation incidental to its business, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders during the fourth quarter of the year ended December 31, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Common Stock has been quoted on the Nasdaq Market National Market under the symbol "TBFC" since July 1998. Prior to that time, the common stock was traded in the over-the-counter market under the same symbol. The following table sets forth the high and low closing sale prices for the Common Stock for the periods indicated.
No dividends were paid in 1997 and 1998. The closing per share price of the Common Stock on February 9, 1999 was $40.50. The approximate number of holders of record of the Company's Common Stock at February 9, 1999 was 60.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
- --------------- (1) Minority interest reflects expense related to payments on trust preferred securities issued by TeleBanc Capital Trust I and TeleBanc Capital Trust II. TeleBanc Capital Trust I and TeleBanc Capital Trust II are business trusts formed for the purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures issued by TeleBanc.
(2) Pursuant to a conversion agreement dated May 15, 1998, 29,900 of our outstanding shares of preferred stock converted to 2,399,479 shares of common stock upon consummation of our July 1998 equity offering. In addition, upon the conversion, we issued a special dividend in the amount of 119,975 shares of common stock to the holders of the preferred stock. In connection with the special dividend, we recorded a $1.7 million nonrecurring, non-cash charge related to the additional preferred stock dividend payable in common stock, based on the fair market value of the common stock at the time the dividend was paid.
(3) Includes mortgage-backed securities available-for-sale and trading.
(4) Consists of trust preferred securities of TeleBanc Capital Trust I and TeleBanc Capital Trust II. See Note 14 to the consolidated financial statements.
(5) Excludes one-time pre-tax charge of $1.7 million, $1.1 million after tax, to recapitalize the Savings Association Insurance Fund. Giving effect to the charge, return on average assets, return on average stockholders' equity, and selling, general and administrative expenses to total assets for 1996 were 0.42%, 11.4% and 1.29%.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are the nation's leading branchless bank providing high value financial products and services primarily over the Internet. By avoiding the costs of brick-and-mortar branches, we are able to offer significantly higher rates and lower fees on our FDIC-insured and other banking products and services than traditional banks. Our branchless platform allows us to deliver these services worldwide through the convenient anytime, anywhere access of the Internet and other electronic delivery channels.
Our revenue consists of interest income and, to a lesser degree, non-interest income, which includes income primarily from services and gains on the sale of loans and securities. Our net interest income is the difference between the rates of interest earned on our loans and other interest-earning assets and the rates of interest paid on our deposits and borrowed funds. An indicator of an institution's profitability is its net interest margin or net yield on interest-earning assets, which is its annualized net interest income divided by the average balance of interest-earning assets. Fluctuations in interest rates as well as volume and composition changes in interest-earning assets and interest-bearing liabilities may materially affect net interest income.
Our asset acquisition strategy is to purchase pools of one-to-four family first lien mortgages and mortgage-related securities. We do not currently originate loans. We believe that by purchasing a seasoned and geographically diverse mortgage loan portfolio, we reduce expenses related to loan acquisition and are better able to actively manage our credit quality risk.
We actively monitor our net interest rate sensitivity position. Effective interest rate sensitivity management seeks to ensure that net interest income and the market value of equity are protected from the impact of changes in interest rates. To this end, we have established an asset-liability committee and implemented a risk measurement guideline employing market value of equity and gap methodologies and other measures. In an effort to manage interest rate exposure, we use various hedging techniques such as caps, floors, interest rate swaps, futures and financial options.
In 1998, we implemented a strategy to build the "TeleBank" brand name by expanding the marketing of high value savings and investment and other financial products, superior customer service and anytime, anywhere convenience. We believe that associating our brand name with our services and delivery channels will enable us to attract a growing number of customers who are increasingly relying on alternative channels for the delivery of their financial services. In pursuing this strategy, we increased our marketing expenditures significantly to implement a targeted, national advertising campaign and marketing initiative. We plan to continue this strategy to further strengthen the "TeleBank" brand. See "-- Results of Operations -- Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 -- Non-interest Expenses".
DIRECT FINANCIAL CORPORATION ACQUISITION
On August 10, 1998, we acquired Direct Financial Corporation, the thrift holding company of Premium Bank, F.S.B. Premium Bank employed a direct marketing strategy similar to ours. Premium Bank operated from a single branch in New Jersey, and its deposit base was concentrated in the mid-Atlantic region of the United States. We are using Premium Bank's former office as a back-up call center and operations center pending a final systems conversion of Premium Bank, expected to be completed in March 1999. We paid approximately $22.3 million cash in the transaction. At the time of the acquisition, Direct Financial Corporation had $307.1 million in deposits and 19,263 accounts.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
INTEREST INCOME. Total interest income increased by $40.8 million, or 68.8%, to $100.1 million for the year ended December 31, 1998 from $59.3 million for the year ended December 31, 1997. A portion of this increase was caused by a $16.8 million increase in interest income from mortgage-backed and related securities. This increase in income from mortgage-backed and related securities is primarily volume-related, as we increased our securities portfolio significantly in 1998 following the completion of our securities offerings and the acquisition of Direct Financial Corporation. We also increased our mortgage loan portfolio, which generated a $16.5 million, or 47.6%, increase in interest income on mortgage loans to $51.2 million in 1998 from $34.7 million in 1997. The increase in the portfolio of interest-earning assets was slightly offset
as a result of a decline in the yield on our interest-earning assets to 7.28% during 1998 from 7.70% during 1997, primarily due to overall declines in market interest rates during the year. Additionally, interest income from investment securities available for sale increased by $4.2 million during 1998 reflecting an $83.7 million increase in the average balance of such securities, slightly offset by a 0.09% decrease in the yield.
INTEREST EXPENSE. Total interest expense increased by $34.2 million from $46.1 million in 1997 to $80.3 million in 1998, an increase of 74.2%. This increase is almost entirely volume-driven, as the average interest cost of liabilities decreased during 1998. The significant increase in retail deposits during 1998 caused interest expense on retail deposits to increase $19.0 million, or 73.4%, from $25.9 million in 1997 to $44.9 million in 1998. The cost of our interest-bearing liabilities decreased from 6.21% in 1997 to 6.08% in 1998, due to declining interest rates during 1998. We saw the majority of this decrease in our short-term borrowings, while the cost of our deposits declined only two basis points from 6.00% to 5.98%. Also during 1998, we initiated a brokered callable certificate of deposit program. The average balance of these deposits was $54.5 million in 1998, and the average rate paid was 6.68%.
LOAN LOSS PROVISION. The provision for loan losses is the annual cost of providing an allowance for estimated losses in the loan portfolio. The provision reflects management's judgment as to the reserve necessary to absorb loan losses based upon our assessment of a number of factors, including delinquent loan trends and historical loss experience, current and anticipated economic conditions, the mix of loans in our portfolio, and our internal credit review process. The provision for loan losses decreased slightly to $905,000 for the year ended December 31, 1998, compared to $921,000 for the year ended December 31, 1997, despite a significant increase in the loan portfolio. This decrease in the provision reflects the historically low level of net charge-offs that we have experienced, due in part to our focus on geographically diverse first lien residential mortgage assets. Net charge-offs during 1998 totaled $457,000, or seven basis points of average loan balances for the year, compared to six basis points during 1997. As of December 31, 1998, our total loan loss allowance was $4.8 million, or 0.53% of total loans outstanding. The total loan loss allowance at December 31, 1997 was $3.6 million, or 0.66% of total loans outstanding. Total loan loss allowance as a percentage of total non-performing loans was 53.7% as of December 31, 1998, compared to 31.7% as of December 31, 1997.
NON-INTEREST INCOME. Total non-interest income increased by $3.5 million to $7.6 million for the year ended December 31, 1998, from $4.1 million for the year ended December 31, 1997, an increase of 85.4%. This increase in non-interest income consisted primarily of $3.5 million of gains on sales of mortgage-backed and investment securities during 1998, compared to gains of $1.0 million in 1997, as well as $2.1 million from gain on sale from loans held for sale, compared to $1.1 million in 1997. The increase in the gain on sale of loans in 1998 reflects the sale of primarily home equity loans. In 1998, non-interest income totaled 7.0% of total revenue, compared to 6.5% in 1997. Total revenue is comprised of total interest income and total non-interest income.
NON-INTEREST EXPENSES. Total non-interest expenses increased substantially during 1998 to $22.1 million, compared to $10.1 million in 1997, an increase of $12.0 million, or 118.8%. In 1998, we implemented a strategy of increasing marketing expenses associated with brand building that seeks to establish TeleBank as the premier national provider of high-value banking products. This strategy resulted in the $4.0 million increase in advertising and marketing expenses to $4.6 million in 1998 from $600,000 in 1997. For 1999, we anticipate our marketing strategy will result in significantly greater increases in marketing expenses. In addition, compensation costs increased $2.9 million, or 59.2%, from $4.9 million for the year ended December 31, 1997, to $7.8 million for the year ended December 31, 1998, as a result of hiring additional personnel.
Other non-interest expenses increased $1.2 million to $2.3 million during the year ended December 31, 1998 from $1.1 million during the year ended December 31, 1997, primarily as a result of the amortization of goodwill resulting from the Direct Financial Corporation acquisition in August 1998.
INCOME TAX EXPENSE. Income tax expense for the year ended December 31, 1998 was $1.6 million, compared with $1.7 million for the year ended December 31, 1997. TeleBanc's effective tax rate for 1998 was 37.6%, compared to 26.4% for 1997. The effective tax rate increased largely as a result of
goodwill acquired in the Direct Financial Corporation acquisition, since goodwill amortization expense is not deductible for tax purposes.
NET INCOME. Net income for the year ended December 31, 1998 decreased $2.8 million to $1.4 million from $4.2 million for the year ended December 31, 1997, a decrease of 66.7%. Net income in 1998 consisted primarily of $19.8 million in net interest income and $7.6 million in non-interest income, which was offset by $22.1 million in non-interest expenses, $905,000 in provision for loan losses, and $1.6 million in income tax expense. Net income available to common stockholders which decreased $4.4 million, or 118.9%, from 1997, to a loss of $737,000 in 1998, includes a non-cash charge totaling $1.7 million, related to a one-time dividend paid to the holders of our preferred stock in the form of 119,975 shares of common stock. We paid this dividend upon conversion of 29,900 outstanding shares of preferred stock to 2,399,479 shares of common stock. We based the $1.7 million charge related to the special dividend on the fair market value of the common stock on the date we paid the dividend.
Our net interest margin decreased from 1.73% in 1997 to 1.42% in 1998. This decline reflects falling interest rates and increased competition for high-yielding mortgage products.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
INTEREST INCOME. Total interest income increased by $13.5 million to $59.3 million for the year ended December 31, 1997 from $45.8 million for the year ended December 31, 1996, an increase of 29.5%. This increase is due primarily to the $11.6 million increase in interest income on mortgages and other loans, an increase of 50.4% in 1997, principally due to a significant increase in the average loan balance during the period. Interest income on mortgage-backed and related securities decreased slightly to $17.6 million at December 31, 1997 from $18.0 million at December 31, 1996 largely as a result of a decline in the yield.
INTEREST EXPENSE. Total interest expense increased by $11.3 million to $46.1 million for the year ended December 31, 1997 from $34.8 million for the year ended December 31, 1996, an increase of 32.5%. The increase is attributable to both an increase in interest-bearing liabilities and a slight increase in the average interest rate paid.
LOAN LOSS PROVISION. The provision for loan losses remained substantially unchanged at $921,000 for the year ended December 31, 1997, compared to $919,000 for the year ended December 31, 1996. The ratio of net charge-offs to net average loans outstanding during 1997 was 0.06%, compared to 0.10% during 1996. Total loan loss allowance as a percentage of total non-performing loans was 31.7% as of December 31, 1997, compared to 27.7% as of December 31, 1996.
NON-INTEREST INCOME. Total non-interest income increased by $1.3 million to $4.1 million for the year ended December 31, 1997, from $2.8 million for the year ended December 31, 1996, an increase of 46.4%. Non-interest income increased primarily because we recognized $1.2 million of non-interest income as gain on trading securities during 1997. In addition, we recognized an $864,000 decline in equity investment primarily attributable to the write-off of the equity investment by TeleBank in AGT Mortgage Services, which had provided our loan servicing services for a fee and ceased operations in July 1997.
NON-INTEREST EXPENSES. Total non-interest expenses, principally selling, general and administrative expenses, increased $1.0 million to $10.1 million for the year ended December 31, 1997, from $9.1 million for the year ended December 31, 1996, an increase of 11.0%. Selling, general and administrative expenses increased $600,000 to $9.0 million during 1997 from $8.4 million during 1996, an increase of 7.1%, primarily as a result of a $1.2 million increase in compensation and employee benefits in 1997. During 1996, we incurred a one-time $1.7 million assessment to recapitalize the Savings Association Insurance Fund.
Other non-interest expenses increased $400,000 to $1.1 million during the year ended December 31, 1997 from $700,000 during the year ended December 31, 1996, an increase of 57.1%, primarily as a result of increased amortization of purchased mortgage servicing rights.
INCOME TAX EXPENSE. Income tax expense for the year ended December 31, 1997 was $1.7 million, compared with $1.2 million for the year ended December 31, 1996. Our effective tax rate for 1997 was 26.4%, compared to 31.9% for 1996. The effective tax rate decreased largely as a result of an increase during 1997 in interest earned on municipal bonds, which generally were tax-exempt.
NET INCOME. Net income for the year ended December 31, 1997 increased $1.6 million to $4.2 million from $2.6 million for the year ended December 31, 1996, an increase of 61.5%. Net income for 1997 consisted primarily of $12.3 million in net interest income, $3.3 million in net gain on the sale of trading securities, loans held for sale, and mortgage-backed and investment securities, which was offset by $10.1 million in non-interest expenses, $921,000 in provision for loan losses, and $1.7 million in income tax expense. Net income available to common stockholders increased $1.1 million in 1996 to $3.7 million in 1997, or 42.3%.
QUARTERLY RESULTS
The following table sets forth our selected unaudited quarterly financial data for each of the eight quarters in the two-year period ended December 31, 1998. The consolidated financial data presented below have been prepared on a basis consistent with our audited consolidated financial statements and, in the opinion of management, include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of this information. This information should be read in conjunction with our consolidated financial statements and notes beginning on page. The operating results for any quarter are not necessarily indicative of results for any future period.
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(1) Minority interest reflects expense related to payments on trust preferred securities issued by TeleBanc Capital Trust I and TeleBanc Capital Trust II.
(2) Includes a $1.7 million non-recurring, non-cash charge related to the additional preferred stock dividend payable in common stock, based on the fair market value of the common stock at the time such dividend was paid. The charge reduced net income available to common stockholders by the same amount and diluted earnings per share in the third quarter of 1998 by $0.18 per share.
(3) Other comprehensive income is comprised of unrealized gains and losses on available-for-sale securities.
During the second quarter of 1998, we focused on maintaining stable asset levels and sufficient liquidity in anticipation of our acquisition of Direct Financial Corporation in August 1998. As a result, our interest income and selling, general and administrative expenses remained relatively steady, as compared to the first quarter of 1998. In the third quarter of 1998, the completion of our equity and trust preferred offerings and our acquisition of Direct Financial Corporation resulted in a substantial increase in our asset size.
Other comprehensive income represents unrealized gains and losses on securities that we consider available for sale. We experienced wide swings in other comprehensive income during the third and fourth quarters of 1998, due primarily to increased volatility in the fixed-income market.
FINANCIAL CONDITION
Total assets increased by $1.2 billion to $2.3 billion at December 31, 1998 from $1.1 billion at December 31, 1997, an increase of 109.1%. The growth in total assets is primarily the result of a $693.0 million increase in mortgage-backed securities and a $364.1 million increase in loans receivable. The primary sources of funds for this growth in assets were deposits, borrowings and capital raised through our 1998 equity offering and trust preferred offering.
Loans receivable, net and loans receivable held-for-sale, increased $364.1 million to $904.8 million at December 31, 1998 from $540.7 million at December 31, 1997, an increase of 67.3%. The increase reflects whole loan purchases of $668.1 million, offset in part by $280.2 million of principal repayments and $20.6 million of loans sold in 1998. During 1997, we recorded whole loan purchases of $342.9 million, offset in part by $94.9 million of principal repayments and $60.7 million of loans sold.
Mortgage-backed securities available-for-sale increased $693.0 million to $1.0 billion at December 31, 1998 from $319.2 million at December 31, 1997, an increase of 217.1%. Investment securities available-for-sale increased $129.2 million to $220.4 million at December 31, 1998 from $91.2 million at December 31, 1997, an increase of 141.7%. We hold these investment securities for liquidity purposes, and the increases in these categories of assets are consistent with the overall growth of our assets in 1998.
Retail deposits increased $620.2 million to $1.1 billion at December 31, 1998 from $522.2 million at December 31, 1997, an increase of 118.8%, largely as a result of our continued targeted marketing efforts to attract new customers and deposit accounts. During the year ended December 31, 1998, we credited approximately $45.0 million of interest to retail deposit accounts, and deposits exceeded withdrawals by $577.9 million, resulting in the net overall increase in deposits.
Federal Home Loan Bank, or FHLB, advances increased $272.5 million to $472.5 million at December 31, 1998, from $200.0 million at December 31, 1997, an increase of 136.3%. Other borrowings, composed primarily of securities sold under agreements to repurchase, increased $124.5 million to $404.4 million at December 31, 1998 from $279.9 million at December 31, 1997, an increase of 44.5%. At December 31, 1998, subordinated debt, net of original issue discount, consisting of the 9.5% senior subordinated debentures issued in February 1997 and the 11.5% subordinated debentures issued in the second quarter of 1994, totaled $29.9 million. Additionally, we issued $67.1 million of callable certificates of deposit during 1998 as relatively cost-effective borrowings with hedging properties that improve our overall interest rate risk position.
In June 1997, we formed TeleBanc Capital Trust I, which sold an aggregate of $10.0 million in shares of capital securities, series A, with an annual dividend rate of 11.0% payable semi-annually, beginning in December 1997, callable beginning December 2007. In July 1998, we formed TeleBanc Capital Trust II, which sold an aggregate of $27.5 million in shares of beneficial unsecured securities, series A, with an annual dividend rate of 9.0% payable quarterly, beginning in September 1998, callable beginning September 2003.
Stockholders' equity increased $67.6 million to $113.4 million at December 31, 1998 from $45.8 million at December 31, 1997. The increase is primarily the result of the receipt of approximately $70.0 million in net proceeds from the issuance of common stock in July and August 1998. This increase was offset by net income during 1998 of $1.4 million, less preferred stock dividends of $2.1 million. Additionally, our unrealized gain on securities available for sale decreased to $1.9 million
at December 31, 1998. Upon consummation of the July 1998 common stock offering, 29,900 outstanding shares of preferred stock converted to 2,399,479 shares of common stock. In addition, upon the conversion, we issued 119,975 shares of common stock as a special dividend to the holders of the preferred stock. The dividend had a value of $1.7 million, based on the fair market value of the common stock on the date the dividend was paid.
LIQUIDITY
Liquidity represents our ability to raise funds to support asset growth, fund operations and meet obligations, including deposit withdrawals, maturing liabilities, and other payment obligations, to maintain reserve requirements and to otherwise meet our ongoing obligations. We have historically met our liquidity needs primarily through financing activities, consisting principally of increases in core deposit accounts, maturing short-term investments, loans and repayments of investment securities, and to a lesser extent, sales of loans or securities. We believe that we will be able to renew or replace our funding sources at then-existing market rates, which may be higher or lower than current rates. Pursuant to applicable Office of Thrift Supervision, or OTS, regulations, TeleBank is required to maintain an average liquidity ratio of 4.0% of certain borrowings and its deposits, which requirement it fully met during 1998. Prior to November 24, 1997, this requirement was 5.0%, which TeleBank fully met during 1996 and 1997.
In the third quarter of 1998, we raised capital through our common stock offering, in which we sold 5,175,000 shares of common stock to the public at an offering price of $14.50. We also raised $27.5 million in the third quarter of 1998 through TeleBanc Capital Trust II's sale of 1,100,000 shares of 9.0% trust preferred securities, series A. We are using the net proceeds of both offerings to fund continued growth.
We seek to maintain a stable funding source for future periods in part by attracting core deposit accounts, which are accounts that tend to be relatively stable even in a changing interest rate environment. Typically, time deposit accounts and accounts that maintain a relatively high balance provide a relatively stable source of funding. At December 31, 1998, our average retail account balance was approximately $22,000, and our average customer maintained 1.7 accounts. Savings and transactional deposits increased $91.8 million to $215.4 million during the year ended December 31, 1998, an increase of 74.3%. Retail certificates of deposit increased $528.4 million to $927.0 million during the year ended December 31, 1998, an increase of 132.6%. During 1998, we also began to offer callable certificates of deposit, which totaled $67.1 million at December 31, 1998.
We also rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase, to provide liquidity. Total borrowings increased $397.0 million to $876.9 million at December 31, 1998, an increase of 82.7%. At December 31, 1998, TeleBank had approximately $667.3 million in additional borrowing capacity.
At December 31, 1998, we had outstanding $31.0 million face amount of subordinated debentures. In addition, at the same date, we also had outstanding $37.5 million face amount of junior subordinated debentures held by our trust preferred subsidiaries. Additionally, from January 1, 1998 through July 28, 1998, we had outstanding $15.3 million of preferred stock, which converted to 2,399,479 shares of common stock upon consummation of our 1998 common stock offering. We paid $373,000 in cash dividends on the preferred stock during 1998. Our aggregate annual interest expense on the subordinated debentures and junior subordinated debentures is $6.9 million.
Subject to the approval of the OTS and compliance with federal regulations, TeleBank pays a dividend to TeleBanc semi-annually in an amount equal to the aggregate debt service and dividend obligations. Under current OTS capital distribution regulations, as long as TeleBank meets the OTS capital requirements before and after the payment of dividends, TeleBank may pay dividends to us without prior OTS approval in an amount equal to the net income to date over the calendar year, plus retained net income over the preceding two years. In addition, the OTS has discretion to prohibit any otherwise permitted capital distribution on general safety and soundness grounds, and we must give 30 days' advance notice to the OTS of all capital distributions, during which time it may object to any proposed distribution. As of December 31, 1998, TeleBank had approximately $21.3 million available for payment of dividends under applicable restrictions without regulatory approval. Under the terms of the indenture pursuant to which the 11.5% subordinated debentures were issued and the terms of the
9.5% subordinated debentures, TeleBanc currently is required to maintain, on an unconsolidated basis, liquid assets in an amount equal to or greater than $7.0 million, which represents 100% of the aggregate interest expense for one year on our outstanding subordinated debentures and junior subordinated debentures. We had $10.0 million in liquid assets as of December 31, 1998.
CAPITAL
As of December 31, 1998, TeleBank was in compliance with all of its regulatory capital requirements and its capital ratios exceeded the ratios for "well capitalized" institutions under OTS regulations.
The following table sets forth TeleBank's regulatory capital levels as of December 31, 1998 in relation to the regulatory requirements in effect at that date. The information below reflects only the regulatory capital of TeleBank and does not give effect to additional available capital of its parent TeleBanc. See Note 4 to the consolidated financial statements.
RATE/VOLUME TABLE
The following table allocates the period-to-period changes in our various categories of interest income and expense between changes due to (1) changes in volume, calculated by multiplying the change in average volume of the related interest-earning asset or interest-bearing liability category by the prior year's rate, and (2) changes in rate, calculated by multiplying changes in rate by the prior year's volume. Changes due to changes in rate-volume, which is calculated as the change in rate multiplied by changes in volume, have been allocated proportionately between changes in volume and changes in rate.
AVERAGE BALANCE TABLE
The following table presents consolidated average balance sheet data, income and expense and related interest yields and rates for each of the three years in the period ended December 31, 1998. The table also presents information for the periods indicated with respect to net interest margin, an indica-
tor of an institution's profitability. Another indicator is net interest spread, which is the difference between the weighted average yield earned on interest-earning assets and weighted average rate paid on interest-bearing liabilities. Interest income includes the incremental tax benefit of tax exempt income.
INTEREST RATE SENSITIVITY MANAGEMENT
We actively monitor our net interest rate sensitivity position. Effective interest rate sensitivity management seeks to ensure that net interest income and the market value of equity are protected from the impact of changes in interest rates. The risk management function is responsible for measuring, monitoring and controlling market risk and communicating risk limits in connection with our asset/liability management activities and trading.
Our strategies are intended to stabilize our net interest margin and its exposure to market risk under a variety of changes in interest rates. By actively managing the maturities of our interest-sensitive assets and liabilities, we seek to maintain a relatively consistent net interest margin and mitigate much of the interest rate risk associated with such assets and liabilities.
Management uses a risk management process that allows risk-taking within specific limits. To this end, we have established an asset-liability committee and implemented a risk measurement guideline employing market value of equity and gap methodologies and other measures.
The asset-liability committee establishes the policies and guidelines for the management of our assets and liabilities. The committee's policy is directed toward reducing the variability of the market value of our equity under a wide range of interest rate environments. Fair value of equity represents the net fair value of our financial assets and liabilities, including off-balance sheet hedges. We monitor the sensitivity of changes in the fair value of equity with respect to various interest rate environments and report regularly to the asset- liability committee. Effective fair value management maximizes net interest income while constraining the changes in the fair value of equity with respect to changes in interest rates to acceptable levels. The model calculates a benchmark fair value of equity for current market conditions.
We use sensitivity analysis to evaluate the rate and extent of changes to our fair value of equity under various market environments. In preparing simulation analyses, we break down the aggregate investment portfolio into discrete product types that share similar properties, such as fixed or adjustable rate, similar coupon and similar age. Under this analysis, we calculate net present value of expected cashflows for interest sensitive assets and liabilities under various interest rate scenarios. In conducting this sensitivity analysis, the model considers all assets, liabilities and off-balance sheet hedges, including whole loan mortgages, mortgage-backed securities, mortgage derivatives, corporate bonds, and interest rate swaps, caps, floors and options. The range of interest rate scenarios evaluated encompasses significant changes to current market conditions. By this process, we subject our interest rate sensitive assets and liabilities to substantial market stress and evaluate the fair value of equity resulting from various market scenarios. The asset-liability committee reviews the results of these stress tests and establishes appropriate strategies to promote continued compliance with established guidelines.
Management measures the efficiency of its asset/liability management strategies by analyzing, on a quarterly basis, TeleBank's theoretical fair value of equity and the expected effect of changes in interest rates. The board of directors establishes limits within which such changes in the fair value of equity are to be maintained in the event of changes in interest rates.
We calculated a theoretical fair value of equity in response to a hypothetical change in market interest risk. The model addresses the exposure to TeleBank of its market sensitive non-trading financial instruments. The model excludes TeleBank's trading portfolio, which, based on management's analysis, has an immaterial impact on TeleBank's fair value of equity. A hypothetical instantaneous 1% rise in interest rates would cause the fair value of equity to decrease by 9.0%.
Every method of market value sensitivity analysis contains inherent limitations and express and implied assumptions that can affect the resulting calculations. For example, each interest rate scenario reflects unique prepayment and repricing assumptions. In addition, this analysis offers a static view of assets, liabilities and hedges held as of December 31, 1998 and makes no assumptions regarding transactions we might enter into in response to changing market conditions.
We employ various hedging techniques to implement the asset-liability committee's strategies directed toward managing the variability of the fair value of equity by controlling the relative sensitivity of market value of interest-earning assets and interest-bearing liabilities. The sensitivity of changes in market value of assets and liabilities is affected by factors, including the level of interest rates, market
expectations regarding future interest rates, projected related loan prepayments and the repricing characteristics of interest-bearing liabilities. We use hedging techniques to reduce the variability of fair value of equity and its overall interest rate risk exposure over a one- to seven-year period.
We also monitor our assets and liabilities by examining the extent to which such assets and liabilities are interest rate sensitive and by monitoring the interest rate sensitivity gap. An asset or liability is said to be interest rate sensitive within a specific period if it will mature or reprice within that period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within the same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities and is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income, while a positive gap would result in an increase in net interest income. Our current asset-liability management strategy is to maintain an evenly matched one-to-five year gap giving effect to hedging, but depending on market conditions and related circumstances, a positive or negative one-to-five year gap of up to 20% may be acceptable. Inclusive of our hedging activities, our one-year gap at December 31, 1998 was (3.4)%. Our hedge-affected one-to-five year gap at such date was (11.4)%.
We used the following assumptions to prepare our gap table at December 31, 1998. Non-amortizing investment securities are shown in the period in which they contractually mature. Investment securities that contain embedded options such as puts or calls are shown in the period in which that security is currently expected to be put or called or to mature. The table assumes that fully indexed, adjustable-rate, residential mortgage loans and mortgage-backed securities prepay at an annual rate between 10% and 15%, based on estimated future prepayment rates for comparable market benchmark securities and our prepayment history. The table also assumes that fixed-rate, current-coupon residential loans prepay at an annual rate of between 10% and 15%. The above assumptions were adjusted up or down on a pool-by-pool basis to model the effects of product type, coupon rate, rate adjustment frequency, lifetime cap, net coupon reset margin and periodic rate caps upon prevailing annual prepayment rates. Time deposits are shown in the period in which they contractually mature, and savings deposits are shown to reprice immediately. The interest rate sensitivity of our assets and liabilities could vary substantially if different assumptions were used or if actual experience differs from the assumptions used.
The following table sets forth our gap at December 31, 1998.
IMPACT OF INFLATION AND CHANGING PRICES
The impact inflation has on us is different from the impact on an industrial company because substantially all of our assets and liabilities are monetary in nature, and interest rates and inflation rates do not always move in concert. We believe that the impact of inflation on financial results depends upon our ability to manage interest rate sensitivity and, by such management, reduce the inflationary impact upon performance. The most direct impact of an extended period of inflation would be to increase interest rates and to place upward pressure on our operating expenses. The actual effect of inflation on our net interest income, however, would depend on the extent to which we were able to maintain a spread between the average yield on our interest-earning assets and the average cost of our interest-bearing liabilities, which would depend to a significant extent on our asset-liability sensitivity. As discussed above, we seek to manage the relationship between interest-sensitive assets and liabilities to protect against wide interest rate fluctuations, including those resulting from inflation. The effect of inflation on our results of operations for the past three years has been minimal.
YEAR 2000 READINESS DISCLOSURE STATEMENT
In 1997, we began Year 2000 planning, following the five steps recommended by the Federal Financial Institutions Examination Council. We have completed phases focused on awareness and assessment and continue to update the results of these phases for new information received. Currently, the renovation phase, which consists of implementing changes and monitoring vendor renovation, and the validation phase, which consists of testing renovated systems, are underway. We are monitoring vendors for final compliance certification statements and software updates and have begun to receive such certifications. Following the receipt of certification statements relating to those systems identified as mission critical in the assessment phase, we internally validate such certifications through testing. To date, we have identified no significant Year 2000 issues through our testing of mission critical systems. Our mission critical systems include the deposit processing system, general ledger system and Internet banking applications. We plan to be substantially complete with renovation, validation and implementation of all mission critical systems by the end of the first quarter of 1999, and with all other systems to be tested by June 30, 1999.
Our steady growth over the past several years has required that we continually upgrade our systems; we do not anticipate that we will incur material costs related to our Year 2000 remediation efforts. We have analyzed the impact of Year 2000 issues on our non-information technology systems such as embedded chips necessary for proper operation of mechanical systems and have concluded that these issues do not present a significant risk to our operations.
To date, we have not hired any outside consultants to address the Year 2000 issue, and few upgrades have been accelerated due to the Year 2000 issue. We estimate that we have spent approximately $25,000 on upgrades related to our Year 2000 remediation efforts, with an additional $75,000 expected to be spent before the year 2000.
The majority of our loans are serviced by a large company that uses the same system as several of the largest loan servicers in the United States and that is expected to be Year 2000 compliant. We are currently monitoring this servicer's Year 2000 plan and testing. However, approximately 38% of our loans are serviced by smaller loan servicers whose systems may not be Year 2000 compliant. If these systems were to fail, principal and interest payments on the loans serviced by these servicers could be delayed, and we would lose interest income that we would normally earn on these funds. We have developed a contingency plan to address this loan servicing issue specifically. Under the contingency plan, we have notified these servicers that if we have not received confirmation of compliance by March 31, 1999, we will begin transferring servicing of these loans to servicers who are known to be Year 2000 compliant. We hope to complete any such transfers that are necessary by June 30, 1999.
Based upon current information, we do not anticipate costs associated with the Year 2000 issue to have a material financial impact. There may, however, be interruptions or other limitations of financial and operating systems' functionality and we may incur additional costs to avoid such interruptions or limitations. Our expectations about future costs associated with the Year 2000 issue are subject to uncertainties that could cause actual results to have a greater financial impact than cur-
rently anticipated. Factors that could influence the amount and timing of future costs include:
- our success in identifying systems and programs that contain two-digit year codes;
- the nature and amount of programming required to upgrade or replace each of the affected programs;
- the rate and magnitude of related labor and consulting costs; and
- our success in addressing the Year 2000 issues with third-parties with which we do business.
CHANGES IN ACCOUNTING PRINCIPLES
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). The statement establishes accounting and reporting standards requiring that every derivative instrument, including derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at fair value. SFAS 133 requires that changes in the derivative instrument's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative instrument's gains and losses to offset related results on the hedged item in the income statement and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting treatment.
SFAS 133 is effective for fiscal years beginning after June 15, 1999, although a company may implement the statement as of the beginning of any fiscal quarter after issuance, that is, fiscal quarters beginning June 16, 1998 and after. SFAS 133 cannot be applied retroactively. SFAS 133 must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired or substantively modified after December 31, 1997 and, at our election, before January 1, 1998.
We plan to adopt SFAS 133 as of January 1, 2000 but have not yet quantified the impact of adopting SFAS 133 on our financial statements. However, the statement could increase volatility in earnings and other comprehensive income.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-5, Reporting on the Cost of Start-up Activities ("SOP 98-5"), which is effective for fiscal years beginning after December 18, 1998. The statement requires that the cost of start-up activities be expensed as incurred rather than capitalized, with initial application reported as the cumulative effect of a change in accounting principle, as described in Accounting Principles Board Opinion Number 20, Accounting Changes. As of December 31, 1998, we carried on our books approximately $740,000 of capitalized start-up costs, relating primarily to the establishment of TeleBanc Insurance Services, Inc. We intend to implement SOP 98-5 on January 1, 1999, and, as a result, will recognize this amount, net of tax, as an expense classified as the cumulative effect of a change in accounting principle.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to "Interest Rate Sensitivity Management" in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of TeleBanc Financial Corporation and Subsidiaries
We have audited the accompanying consolidated statements of financial condition of TeleBanc Financial Corporation (a Delaware Corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations and comprehensive income, stockholders' equity, and cash flows for each of the three years ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of TeleBanc Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years ended December 31, 1998, in conformity with generally accepted accounting principles.
/s/ ARTHUR ANDERSEN LLP
Vienna, Virginia February 10, 1999
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (DOLLARS IN THOUSANDS)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996 (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
See accompanying notes to consolidated financial statements.
The Company purchased all of the capital stock of DFC for $22.3 million, in a merger transaction consummated on August 10, 1998. The total fair value of assets acquired was $333.7 million and total fair value of liabilities assumed was $315.4 million.
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
TeleBanc Financial Corporation ("TeleBanc" or the "Company") is a savings and loan holding company organized under the laws of Delaware in 1994. The primary business of the Company is the activities conducted by TeleBank (the "Bank") and TeleBanc Capital Markets, Inc. ("TCM"). The Bank is a federally chartered savings bank that provides deposit accounts insured by the Federal Deposit Insurance Corporation ("FDIC") to customers nationwide. TCM is a funds manager and registered broker-dealer. Telebanc Capital Trust I ("TCT I") and TeleBanc Capital Trust II ("TCT II") are business trusts formed for the purpose of issuing capital securities and investing the proceeds in junior subordinated debentures issued by the Company. The Bank, through its wholly owned subsidiary TeleBanc Servicing Corporation ("TSC"), owns 100% of TeleBanc Insurance Services ("TBIS"), which was formed in May 1998 to offer co-branded insurance products. In 1997, TSC funded 50% of the capital commitment for two entities, AGT Mortgage Services, LLC ("AGT") and AGT PRA, LLC ("AGT PRA"). AGT, which ceased operation on July 31, 1997, serviced performing loans and administered workouts for troubled or defaulted loans for a fee. The primary business of AGT PRA is its two-thirds investment in Portfolio Recovery Associates, LLC ("PRA"). PRA acquires and collects delinquent consumer debt obligations for its own portfolio.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of TeleBank, TCM, TCT I, TCT II and TSC. All significant intercompany transactions and balances are eliminated in consolidation. The investment in AGT PRA is accounted for under the equity method. The Company's net equity investment in AGT PRA at December 31, 1998 totaled approximately $4.0 million. During 1998, 1997 and 1996, TeleBank recorded $526,000, ($487,000), and ($155,000) in earnings/(loss) from its investment in AGT PRA, respectively.
On June 22, 1998, the Board of Directors of the Company approved the distribution of a 100% stock dividend on its outstanding common stock, par value $0.01 (the "Common Stock"). The effect of the stock dividend has been retroactively applied in the Consolidated Financial Statements for all periods presented.
Basis of Financial Statement Presentation
The accompanying financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities, and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates for which a change is reasonably possible in the near-term relate to the determination of the allowance for loan losses, the fair value of investments and mortgage-backed securities available-for-sale, loans receivable held for sale, trading securities and the valuation of real estate acquired in connection with foreclosures and mortgage servicing rights. In addition, the regulatory agencies that supervise the financial services industry periodically review the Bank's allowance for losses on loans. This review, which is an integral part of their examination process, may result in additions or deductions to the allowance for loan losses based on judgments with regard to available information provided at the time of their examinations.
Cash and Cash Equivalents
Cash and cash equivalents are composed of interest-bearing and non-interest-bearing deposits, certificates of deposit, funds due from banks, and federal funds sold with original maturities of three months or less. The Company is required to maintain an overnight balance of $2.4 million in its account with the Federal Reserve Bank of Richmond. As of December 31, 1998, the Company had $18.1 million of interest-bearing deposits that were held at other depository institutions.
Investment Securities and Mortgage-Backed Securities
The Company generally classifies its debt and marketable equity securities in one of three categories: held-to-maturity, trading, or available-for-sale. During 1997 and 1998, the Company held no investment or mortgage-backed securities that it classified as held-to-maturity.
Trading securities are bought and held principally for the purpose of selling them in the near term. Securities purchased for trading are carried at market value with the corresponding realized and unrealized gains and losses recognized by credits or charges to non-interest income. The Company had $29.6 million and $21.1 million classified as trading securities at December 31, 1998 and 1997, respectively. For the years ending December 31, 1998, 1997 and 1996, the Company recognized $569,000, $564,000 and $0, respectively, in realized gains from the sale of trading assets, as well as ($612,000), $640,000 and $0, respectively, in unrealized depreciation or appreciation of trading assets. All other securities not included in the trading category are classified as available-for-sale. Available-for-sale securities are recorded at fair value. Unrealized gains and losses on available-for-sale securities, net of the related tax effects, are reported as a separate component of stockholders' equity until realized. A decline in market value of any available-for-sale asset below its cost, that is deemed other than temporary, is charged to earnings, resulting in the establishment of a new cost basis for the asset. Transfers of securities into the available-for-sale category are recorded at fair value at the date of the transfer. Any unrealized gain or loss at the date of transfer from held-to-maturity is recognized as a separate component of stockholders' equity, net of tax effect. Dividend and interest income is recognized when earned. Realized gains and losses for securities classified as available-for-sale and trading are included in earnings and are derived using the specific identification method for determining the cost of the security sold.
Loans Held for Sale
Mortgages acquired by the Company and intended for sale in the secondary market are carried at lower of cost or estimated market value in the aggregate. The market value of these mortgage loans is determined by obtaining market quotes for loans with similar characteristics.
Loans Receivable
Loans receivable consist of mortgages that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off. These loans are carried at amortized cost adjusted for charge-offs, the allowance for loan losses, any deferred fees or costs on purchased or originated loans and unamortized premiums or discounts on purchased loans. The loan portfolio is reviewed by the Company's management to set provisions for estimated losses on loans, which are charged to earnings in the current period. In this review, particular attention is paid to delinquent loans and loans in the process of foreclosure. The allowance and provision for loan losses are based on several factors, including continuing examinations and appraisals of the loan portfolio by management, examinations by supervisory authorities, continuing reviews of problem loans and overall portfolio quality, analytical reviews of loan loss experience in relation to outstanding loans, and management's judgment with respect to economic conditions and their impact on the loan portfolio.
Nonperforming Assets
Nonperforming assets consist of loans for which interest is no longer being accrued, troubled loans that have been restructured in order to increase the opportunity to collect amounts due on the loan, real estate acquired in settlement of loans. Interest previously accrued but not collected on nonaccrual loans is reversed against current income when a loan is placed on nonaccrual status. Accretion of deferred fees is discontinued for nonaccrual loans. All loans at least ninety days past due, as well as other loans considered uncollectable, are placed on nonaccrual status. Payments received on nonaccrual loans are recognized as interest income or applied to principal when it is doubtful that full payment will be collected.
Loan and Commitment Fees, Discounts and Premiums
Loan fees and certain direct loan acquisition costs are deferred and the net fee or cost recognized into interest income using the interest method over the contractual life of the loans. Premiums and discounts on loans receivable are amortized or accreted, respectively, into income using the interest method over the remaining period to contractual maturity and adjusted for anticipated prepayments. Discounts on loans held for sale are recognized as part of the loss or gain upon sale and not amortized or accreted, respectively.
Real Estate Acquired through Foreclosure and Held for Sale
Real estate properties acquired through foreclosure and held for sale are recorded at fair value less estimated selling costs at acquisition. Fair value is determined by appraisal or other appropriate method of valuation. Losses estimated at the time of acquisition are charged to the allowance for loan losses. Management performs periodic valuations and establishes an allowance for losses through a charge to income if the carrying value of a property exceeds its estimated fair value less selling costs.
Deferred Financing Costs
Deferred financing costs related to the issuance of the subordinated notes have been capitalized and are being amortized using the interest method over the life of the subordinated notes.
Income Taxes
Effective January 1, 1993, the Bank adopted the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS No. 109"). Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Financial Instruments
The Company uses interest rate swaps, caps, floors and futures in the management of its interest-rate risk. The Company is generally exposed to rising interest rates because of the nature of the repricing of rate-sensitive assets as compared with rate-sensitive liabilities. These instruments are used primarily to hedge specific assets and liabilities. For interest rate swaps, the net interest received or paid is treated as an adjustment to the interest income or expense related to the hedged assets or obligations in the period in which such amounts are due.
In order to be eligible for hedge accounting treatment, high correlation must be probable at the inception of the hedge transaction and must be maintained throughout the hedge period. Upon the sale or disposition of the hedged item, the hedging instrument is marked-to-market with changes recorded in the income statement. Any gain or loss that is incurred upon termination of a hedging instrument is added to the carrying value of the hedged item and amortized over its remaining life. Premiums and fees associated with interest rate caps are amortized to interest income or expense on a straight-line basis over the lives of the contracts. For instruments that are not designated or do not qualify as hedges, realized and unrealized gains and losses are recognized in the income statement as gain or loss on trading securities in the period during which they are incurred.
Other Assets
Other assets include purchased loan servicing rights, premiums paid on interest rate caps, and prepaid assets. The Bank services loans totaling $245.0 million as of December 31, 1998, which underlie these servicing rights. The cost of the loan servicing rights is amortized in proportion to, and over the period of, the estimated net servicing income. For the period ending December 31, 1998, amortization expense of loan servicing rights was $925,000. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. For
purposes of measuring impairment, the rights are stratified based on mortgage product types. The amount of impairment recognized is the amount by which the capitalized mortgage servicing rights exceed their fair value in aggregate. As of December 31, 1998, the amortized cost and fair value of the loan servicing rights were $2.4 million. No valuation allowance was recognized at December 31, 1998. Effective January 1, 1997, the Company adopted Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("SFAS 125"), as amended by Statement of Financial Accounting Standards No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125 -- An Amendment of FASB Statement No. 125 ("SFAS 127"). The implementation of SFAS 125 did not have a material impact on the Company's financial position.
Federal Home Loan Bank Stock
The Federal Home Loan Bank ("FHLB") stock is carried at its amortized cost of $25.2 and $10.0 million as of December 31, 1998 and 1997, respectively.
Advertising Costs
The Company's policy is to expense advertising costs when incurred. For the years ended December 31, 1998, 1997, and 1996, the Company incurred advertising expense of $4.6 million, $606,000, and $93,000, respectively.
Effects of Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS No. 130"), effective for fiscal years beginning after December 15, 1997. This statement requires that certain financial activity typically disclosed in stockholders' equity be reported in the financial statements as an adjustment to net income in determining comprehensive income. The Company adopted SFAS No. 130 effective January 1, 1998. As a result, comprehensive income for the periods ending December 31, 1998 and 1997 is reported in the Consolidated Statement of Operations.
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information("SFAS No. 131"), effective for fiscal years beginning after December 15, 1997. This statement requires entities to disclose selected information regarding "reportable segments," which are defined as material operating segments, and certain enterprise-wide information in quarterly and annual reports. Segment disclosures are unnecessary, because only one operating segment meets the materiality test to be considered a reportable segment. As of December 31, 1998, the Bank, considered one segment, accounted for approximately 97.5% of the Company's combined total assets and approximately 96.0% of the Company's combined 1998 revenues. As of December 31, 1998, the Company's other operating segment, TCM, was not sufficiently material to be considered a reportable segment, as defined by SFAS No. 131. In 1998, the Company did not earn significant revenue from foreign sources and did not hold a material amount of long-lived assets in foreign countries. Additionally, the Company does not rely on any one source for a significant portion of its revenue.
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"). The statement establishes accounting and reporting standards requiring that every derivative instrument, including derivative instruments embedded in other contracts, be recorded in the balance sheet as either an asset or liability measured at fair value. SFAS No. 133 requires that changes in the derivative instrument's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative instrument's gains and losses to offset related results on the hedged item in the income statement and requires that a company formally document, designate and assess the effectiveness of transactions that receive hedge accounting treatment. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999, although a company may implement the statement as of the beginning of any fiscal quarter after issuance, that is, fiscal quarters beginning June 16, 1998 and after. SFAS 133 cannot be applied retroactively. SFAS No. 133 must be
applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997 and, at the Company's election, before January 1, 1998. We plan to adopt SFAS 133 as of January 1, 2000 but have not yet quantified the impact of adopting SFAS 133 on our financial statements. However, the statement could increase volatility in earnings and other comprehensive income.
In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-5, Reporting on the Cost of Start-up Activities("SOP 98-5"), which is effective for fiscal years beginning after December 15, 1998. The statement requires that the cost of start-up activities be expensed as incurred rather than capitalized, with initial application reported as the cumulative effect of a change in accounting principle, as described in Accounting Principles Board Opinion Number 20, Accounting Changes. As of December 31, 1998, the Company carries on its books approximately $740,000 of capitalized start-up costs, relating primarily to the establishment of TBIS. The Company intends to implement SOP 8-5 on January 1, 1999, and, as a result, will recognize this amount, net of tax, as an expense classified as the cumulative effect of a change in accounting principle.
Reclassifications
Certain reclassifications of the 1997 and 1996 financial statements have been made to conform to the 1998 presentation.
3. BUSINESS ACQUISITIONS
Effective August 10, 1998, the Company acquired Direct Financial Corporation ("DFC"), a regional savings and loan holding company, and its wholly owned subsidiary, Premium Bank F.S.B., a federal savings bank ("Premium Bank"), in a merger transaction for approximately $22.3 million in cash (the "DFC Acquisition"). This transaction has been accounted for under the purchase method of accounting. The Company recorded the excess of the purchase price over the estimated fair value of the net tangible assets acquired, as well as the direct costs of the DFC Acquisition, as goodwill. The Company plans to amortize goodwill over a period of 15 years using the straight-line method. At December 31, 1998, goodwill totaled $17.5 million, net of accumulated amortization of $584,000. Operating results of DFC have been included with those of the Company from the closing date.
The following pro forma combined financial information presents the historical results of operations of the Company and DFC for the years ended December 31, 1997 and 1998, with pro forma adjustments as if DFC had been acquired as of the beginning of the periods presented. The pro forma information presented is not necessarily indicative of what the results of operations actually would have been if the transaction had occurred on the date indicated, or of future results of operations.
- --------------- (a) The impact of the Company's outstanding options, warrants, and convertible preferred stock is antidilutive for the year ended December 31, 1998.
In April 1998, the Company purchased and assumed substantially all of the assets and liabilities of MET Holdings Corporation ("MET") in accordance with the Amended and Restated Acquisition Agreement between MET and the Company (the "Agreement"), dated as of March 17, 1998. Thereafter, MET dissolved. Pursuant to the Agreement, MET sold substantially all of its assets, including 2,866,162 shares of Common Stock owned by MET, and assigned substantially all of its liabilities to the Company in exchange for 2,876,162 shares of Common Stock, which shares were distributed to the shareholders of MET upon MET's dissolution. The Company accounted for this transaction under the purchase method of accounting and recorded the excess of the purchase price over the estimated fair value of the net tangible assets acquired as goodwill. Goodwill from this transaction totaled $275,000 at December 31, 1998, net of accumulated amortization of $12,000. The Company amortizes this goodwill using the straight-line method over a period of 15 years.
4. CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory -- and possibly additional discretionary -- actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and Tier I capital to risk-weighted assets and of Tier I capital to average assets. Management believes, as of December 31, 1998, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 1998 and 1997, the Office of Thrift Supervision categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution's category.
The Bank's actual capital amounts and ratios are presented in the table below (dollars in thousands):
5. INVESTMENT SECURITIES
The cost basis and estimated fair values of available-for-sale investment securities other than mortgage-backed securities at December 31, 1998 and 1997, by contractual maturity, are shown below (in thousands):
The proceeds from sale and gross realized gains and losses on investment securities available for sale that were sold in 1998 were $85.7 million, $1.3 million, and $8,000, respectively. The proceeds from sale and gross realized gains and losses on investment securities available for sale that were sold in 1997 were $25.9 million,
$423,000, and $34,000, respectively. The proceeds from sale and gross realized gains and losses on investment securities available for sale that were sold in 1996 were $25.1 million, $311,000, and $153,000, respectively.
6. MORTGAGE-BACKED AND RELATED SECURITIES
Mortgage-backed and related securities represent participating interests in pools of long-term first mortgage loans originated and serviced by the issuers of the securities. The Company has also invested in collateralized mortgage obligations ("CMOs"), which are securities issued by special purpose entities generally collateralized by pools of mortgage-backed securities. The Company's CMOs are senior tranches collateralized by federal agency securities or whole loans. The fair value of mortgage-backed and related securities fluctuates according to current interest rate conditions and prepayments. Fair value is estimated using quoted market prices. For illiquid securities, market prices are estimated by obtaining market price quotes on similar liquid securities and adjusting the price to reflect differences between the two securities, such as credit risk, liquidity, term, coupon, payment characteristics, and other information.
The amortized cost basis and estimated fair values of mortgage-backed securities available-for-sale at December 31, 1998 and 1997, by contractual maturity, are shown as follows (in thousands):
The Company pledged $439.0 million and $104.7 million of private issuer mortgage-backed securities as collateral for repurchase agreements at December 31, 1998 and 1997, respectively. The proceeds from sale and
gross realized gains and losses on mortgage-backed securities available for sale that were sold in 1998 were $294.8 million, $2.4 million, and $113,000, respectively. The proceeds from sale and gross realized gains and losses on mortgage-backed securities available for sale that were sold in 1997 were $112.4 million, $845,000, and $253,000, respectively. The proceeds from sale and realized gains and losses on mortgage-backed securities available for sale that were sold in 1996 were $185.2 million, $1.4 million, and $707,000.
7. LOANS RECEIVABLE
Loans receivable at December 31, 1998 and 1997 are summarized as follows (in thousands):
The mortgage loans are located primarily in California, New Jersey, and New York according to the following percentages 24.8%, 10.4%, and 8.0%, respectively. As of December 31, 1998, the mortgage loan portfolio consisted of variable rate loans of $436.3 million, or 47.6%, and fixed rate loans of $480.1 million, or 52.4%. The weighted average maturity of mortgage loans secured by one- to four-family residences is 291 months as of December 31, 1998. The unpaid principal balance of mortgage loans owned by the Company but serviced by other companies was $904.9 million and $301.5 million at December 31, 1998 and 1997, respectively. Loans past due ninety days or more, and therefore on non-accrual status at December 31, 1998 and 1997, are summarized as follows (in thousands):
The interest accrual balance for each loan that enters non-accrual is reversed from income. If all non-performing loans had been performing during 1998, 1997, and 1996, the Bank would have recorded $597,000, $739,000 and $789,000, respectively, in additional interest income. There were no commitments to lend additional funds to these borrowers as of December 31, 1998 and 1997.
Activity in the allowance for loan losses for the years ended December 31, 1998, 1997, and 1996 is summarized as follows (in thousands):
According to Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan ("SFAS No. 114"), a loan is considered impaired when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The term "all amounts due" includes both the contractual interest and principal payments of a loan as scheduled in the loan agreement. The Company has determined that once a loan becomes 90 or more days past due, collection of all amounts due is no longer probable and is therefore considered impaired. The amount of impairment is measured based upon the fair value of the underlying collateral and is reflected through the creation of a valuation allowance.
The table below presents impaired loans as of December 31, 1998 and 1997 (in thousands):
The average recorded investment in impaired loans, as of December 31, 1998, 1997, and 1996 was $1.4 million, $2.3 million and $2.2 million, respectively. The related amount of interest income the Company would recognize as additional interest income for the years ended December 31, 1998, 1997, and 1996 was $597,000, $739,000 and $789,000, respectively. The Company's charge-off policy for impaired loans is consistent with its charge-off policy for other loans; impaired loans are charged-off when, in the opinion of management, all
principal and interest due on the impaired loan will not be fully collected. Consistent with the Company's method for non-accrual loans, payments received on impaired loans is recognized as interest income or applied to principal when it is doubtful that full payment will be collected.
8. REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS
Real estate acquired through foreclosure at December 31, 1998 and December 31, 1997 was $1.5 million and $681,000, respectively.
9. LOANS SERVICED FOR OTHERS
Mortgage loans master serviced by the Bank for others are not included in the accompanying consolidated statements of financial condition because the related loans are not owned by the Company or any of its subsidiaries. The unpaid principal balances of these loans at December 31, 1998 and 1997 are summarized as follows (in thousands):
Custodial escrow balances held in connection with the foregoing loans serviced were approximately $740,000 and $120,000 at December 31, 1998 and 1997, respectively.
Included in other assets is purchased mortgage servicing rights of $2.4 million and $3.3 million as of December 31, 1998 and 1997, respectively.
10. DEPOSITS
The Bank initiates deposits directly with customers through contact on the Internet, the phone, the mail, and walk-in at its headquarters. Deposits at December 31, 1998 and 1997 are summarized as follows (in thousands):
Certificates of deposit and money market accounts, classified by rates as of December 31, 1998 and 1997 are as follows (in thousands):
At December 31, 1998, scheduled maturities of certificates of deposit and money market accounts are as follows (in thousands):
The aggregate amount of certificates of deposit with denominations greater than or equal to $100,000 was $197.5 million and $47.5 million at December 31, 1998 and 1997, respectively.
Interest expense on deposits for the years ended December 31, 1998, 1997, and 1996 is summarized as follows (in thousands):
Accrued interest payable on deposits at December 31, 1998 and 1997 was $3.4 million and $728,000, respectively.
11. ADVANCES FROM THE FHLB OF ATLANTA
Advances to the Bank from the FHLB of Atlanta at December 31, 1998 and 1997 were as follows (dollars in thousands):
All advances are floating rate advances and adjust daily to the Federal Funds Rate or quarterly or semi-annually to the London InterBank Offering Rate ("LIBOR") rate. In 1998 and 1997, the advances were collateralized by a specific lien on mortgage loans in accordance with an "Advances, Specific Collateral Pledge and Security Agreement" with the FHLB of Atlanta, executed September 10, 1980. Under this agreement, the Bank is required to maintain qualified collateral equal to 120 to 160 percent of the Bank's FHLB advances, depending on the collateral type. As of December 31, 1998 and 1997, the Company secured these advances with an assignment of specific mortgage loan collateral from its loan and mortgage-backed security portfolio. These one- to four-family whole first mortgage loans and securities pledged as collateral totaled approximately $647.6 million and $259.9 million at December 31, 1998 and 1997, respectively. The Company is required to be a member of the FHLB System and to maintain an investment in the stock of the FHLB of Atlanta at least equal to the greater of 1 percent of the unpaid principal balance of its residential mortgage loans or 1 percent of 30 percent of its total assets or 1/20 of its outstanding advances from the FHLB.
12. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Information concerning borrowings under fixed and variable rate coupon repurchase agreements is summarized as follows (dollars in thousands):
The securities sold under the repurchase agreements at December 31, 1998 are due in less than one year. The Company enters into sales of securities under agreements to repurchase the same securities. Repurchase agreements are collateralized by fixed and variable rate mortgage-backed securities or investment grade securities. Repurchase agreements are treated as financings, and the obligations to repurchase securities sold are reflected as a liability in the balance sheet. The dollar amount of securities underlying the agreement remains in the asset accounts. The securities underlying the agreements are physical and book entry securities and the brokers retain possession of the securities collateralizing the repurchase agreements. If the counterparty in a repurchase agreement were to fail, the Company may incur an accounting loss for the excess collateral posted with the counterparty. As of December 31, 1998, there were no counterparties with which the Company's amount at risk exceeded 10% of the Company's stockholders' equity.
As of December 31, 1998, the Company carried borrowings of approximately $3.3 million that were secured by a pool of loans owned by the Company. Under the borrowing agreement, which expires in August 1999, the Company may not sell or otherwise transfer the pledged assets.
13. SUBORDINATED DEBT
In May and June 1994, the Company issued 15,000 units of subordinated debt at a price of $15.0 million and 2,250 units at a price of $2.3 million, respectively. The units each consist of $1,000 of 11.5% subordinated notes due in 2004 and 20 detachable warrants to purchase two shares each of TeleBanc Common Stock. The notes are subordinated to all senior indebtedness of the Company and may not be redeemed prior to May 1, 1999. The notes are redeemable at the option of the Company after May 1, 1999, at an initial redemption price of 105.75% of the principal amount plus accrued interest with the redemption price declining to 104.60%, 103.45%, 102.30%, and 101.15% annually each year thereafter. Interest is payable semi-annually on May 1 and November 1, commencing November 1, 1994. The indenture, among other things, restricts the ability of the Company under certain circumstances to incur additional indebtedness, limits cash dividends and other capital distributions by the Company, requires the maintenance of a reserve equal to 100% of the Company's annual interest expense on all indebtedness, restricts disposition of the Bank or its assets, and limits transactions with affiliates. The annual interest expense to service the subordinated debt is $2.0 million. The total value of the 690,000 warrants was $948,750, which resulted in an original issue discount on the subordinated debt in the amount of $899,288. The original issue discount is amortized on a level yield basis over the life of the debt. The warrants became transferable on November 27, 1994 and are exercisable on or after May 27, 1995. The exercise price of each warrant is $3.8281.
On February 28, 1997, the Company sold $29.9 million of units in the form of 4% convertible preferred stock and 9.5% senior subordinated notes and warrants to investment partnerships managed by Conning & Co., CIBC Wood Gundy Argosy Merchant Fund 2, LLC, General American Life Insurance Company, The Progressive Corporation, and The Northwestern Mutual Life Insurance Company. Upon the sale of the units, representatives from the Conning partnerships and the CIBC Merchant Fund were appointed to the Company's Board. The units consist of $13.7 million in 9.5% senior subordinated notes with 396,176 detachable warrants, $16.2 million in 4.0% convertible preferred stock, par value $0.01 (the "Preferred Stock"), and rights to 411,126 contingent warrants. The senior subordinated notes, which are subordinated to all senior indebtedness of the Company, are due on March 31, 2004 and stipulate increases over time in interest rates subsequent to March 31, 2002 from 9.5% up to 15.25%. The warrants, each of which entitles the bearer to purchase two shares of Common Stock, are exercisable at $4.75 with an expiration date of February 28, 2005. The Preferred Stock, which consisted of Series A Voting Convertible Preferred Stock, Series B Nonvoting Convertible Preferred Stock, and Series C Nonvoting Convertible Preferred Stock, converted to 2,399,479 shares of Common Stock upon consummation of the Company's Equity Offering on July 28, 1998. The contingent warrants, each of which entitles the bearer to purchase two shares of Common Stock, may be exercised upon a change of control or at any time after February 19, 2002 ("Exercise Event"). If the Company's annual internal rate of return is less than 25% at the time of an Exercise Event, unit holders may exercise the contingent warrants for $0.005 until an internal rate of return of 25% is reached. The annual interest expense to service the senior subordinated notes is $1.3 million. The Company paid $2.1 million and $546,000 in dividends on the preferred stock in 1998 and 1997, respectively.
14. TRUST PREFERRED SECURITIES
In June 1997, the Company formed TCT I, which in turn sold, at par, 10,000 shares of trust preferred securities, Series A, liquidation amount of $1,000, for a total of $10,000,000 in a private placement. TCT I is a business trust formed for the purpose of issuing capital securities and investing the proceeds in junior subordinated debentures issued by the Company. The trust preferred securities, which are subordinated to the 11.5% subordinated notes and the 9.5% subordinated notes, mature in 2027 and have an annual dividend rate of 11.0%, or $1.1 million, payable semi-annually, beginning in December 1997. The net proceeds were used for general corporate purposes, including to fund Bank operations and the creation and expansion of its financial service and product operations.
In July 1998, the Company formed TCT II, a business trust formed solely for the purpose of issuing capital securities. TCT II sold, at par, 1,100,000 shares of Beneficial Unsecured Securities, Series A, (the "BLUS(SM)"), with a liquidation amount of $25, for a total of $27.5 million and invested the net proceeds in the Company's 9.0% Junior Subordinated Deferrable Interest Debentures, Series A. The BLUS(SM), which are subordinated to the 11.5% subordinated notes and the 9.5% subordinated notes, mature in 2028 and have an annual dividend rate of 9.0%, payable quarterly, beginning in September 1998. The net proceeds were used for general corporate purposes, which include funding the Company's continued growth and augmenting working capital.
15. STOCKHOLDERS' EQUITY
As of December 31, 1998, the authorized capital stock of the Company consisted of 29.5 million shares of Common Stock and 500,000 shares of Preferred Stock. In July and August 1998, the Company sold 5,175,000 shares of Common Stock to the public at an offering price of $14.50 (the "Equity Offering"). Simultaneously, pursuant to a conversion agreement dated May 15, 1998, the Company's 29,900 outstanding shares of Preferred Stock converted to 2,399,479 shares of Common Stock, upon consummation of the Equity Offering on July 28, 1998. In addition, upon the conversion, the Company issued a special dividend in the amount of 119,975 shares of Common Stock to the holders of the Preferred Stock.
16. EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128 "Earnings per Share" ("SFAS 128"), effective December 15, 1997. This statement specifies the computation, presentation, and disclosure requirements for earnings per share ("EPS") for entities with publicly held common stock or potential common stock.
Basic earnings per common share, as required by SFAS 128, is computed by dividing adjusted net income by the total of the weighted average number of common shares outstanding during the respective periods. Diluted earnings per common share for the years ended December 31, 1998, 1997, and 1996 were determined on the assumptions that the dilutive options and warrants were exercised upon issuance. The options and warrants are deemed to be dilutive if (a) the average market price of the related common stock for a period exceeds the exercise price or (b) the security to be tendered is selling at a price below that at which it may be tendered under the option or warrant agreement and the resulting discount is sufficient to establish an effective exercise price below the market price of the common stock obtainable upon exercise. The Company's year to date weighted average number of common shares outstanding was 7,840,214 at December 31, 1998, 4,382,910 at December 31, 1997 and 4,099,000 at December 31, 1996. For diluted earnings per share computation, weighted average shares outstanding also include potentially dilutive securities.
EPS CALCULATION
- --------------- (a) The impact of the Company's outstanding options, warrants, and convertible preferred stock is antidilutive for the year ended December 31, 1998.
17. INCOME TAXES
Income tax expense for the years ended December 31, 1998, 1997, and 1996 is summarized as follows (in thousands):
A reconciliation of the statutory Federal income tax rate to the Company's effective income tax rate for the years ended December 31, 1998, 1997, and 1996 is as follows:
Deferred income taxes result from temporary differences in the recognition of income and expense for tax versus financial reporting purposes. The sources of these temporary differences and the related tax effects for the years ended December 31, 1998 and 1997 are as follows (in thousands):
18. FINANCIAL INSTRUMENTS
The Company is party to a variety of interest rate caps, floors, swaps and futures to manage interest rate exposure. The Company enters into interest rate swap agreements to assume fixed-rate interest payments in exchange for variable market-indexed interest payments. The effect of these agreements is to lengthen short-term variable liabilities into longer-term fixed-rate liabilities or to shorten long-term fixed rate assets into short-term variable rate assets. The interest rate swaps are specifically designated to specific liabilities or, to a lesser extent, assets at their acquisition. The net payments of these agreements are charged to interest expense or interest income, depending on whether the agreement is designated to hedge a liability or an asset.
Interest rate swap agreements for the years ended December 31, 1998 and 1997 are summarized as follows (dollars in thousands):
The counterparties to the interest rate swap agreements described above are Goldman Sachs, Merrill Lynch, NationsBank, Nomura, and Salomon Brothers. As of December 31, 1998, the Company had no credit risk associated with any of the aforementioned counterparties. The interest rate swap agreements described above required the Company to post cash of approximately $9.8 million as collateral.
The Company enters into interest rate cap agreements to hedge outstanding mortgage loans, mortgage-backed securities, FHLB advances and repurchase agreements. Under the terms of the interest rate cap agreements, the Company generally would receive an amount equal to the difference between 3 month LIBOR or 6 month LIBOR and the cap's strike rate, multiplied by the notional amount. Premiums paid for
the caps are amortized into expense based on the term of the cap. The interest rate cap agreements are summarized as follows (dollars in thousands):
The counterparties to the interest rate cap agreements described above are Goldman Sachs, Lehman Brothers, Merrill Lynch, NationsBank, Nomura, Salomon Brothers, and UBS. As of December 31, 1998, the associated credit risk with the aforementioned counterparties was $3.6 million, $366,000, $68,000, $1.8 million, $11,000, $203,000, and $353,000, respectively. The credit risk is attributable to the unamortized cap premium and any amounts due from the counterparty as of December 31, 1998.
As of December 31, 1998, the Company was party to four interest rate caps and one interest rate floor that were not designated as hedges. Realized and unrealized gains and losses on these instruments have been recognized in the income statement as gain or loss on trading securities. The following table summarizes the Company's interest rate cap and floor agreements that were not designated as hedges as of December 31, 1998 (dollars in thousands):
The counterparties to the interest rate cap and floor agreements described above are Lehman Brothers and Salomon Brothers. As of December 31, 1998, the associated credit risk with the aforementioned counterparties was $152,000 and $205,000, respectively. The total amortization expense for premiums on all interest rate caps and floors was $1.6 million, $777,000 and $638,000 for the years ended December 31, 1998, 1997, and 1996, respectively.
19. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS
The fair value information for financial instruments that is provided below is based on the requirements of Statement of Financial Accounting Standards No. 107, Disclosure About Fair Value of Financial Instruments ("SFAS No. 107") and does not represent the aggregate net fair value of the Bank. Much of the information used to determine fair value is subjective and judgmental in nature. Therefore, fair value estimates, especially for less marketable securities, may vary. In addition, the amounts actually realized or paid upon settlement or maturity could be significantly different. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is reasonable to estimate that value:
CASH AND INTEREST-BEARING DEPOSITS -- Fair value is estimated to be carrying value.
FEDERAL FUNDS SOLD -- Fair value is estimated to be carrying value.
SECURITIES PURCHASED UNDER AGREEMENT TO RESELL -- Fair value is estimated to be carrying value.
INVESTMENT SECURITIES -- Fair value is estimated by using quoted market prices for most securities. For illiquid securities, market prices are estimated by obtaining market price quotes on similar liquid securities and adjusting the price to reflect differences between the two securities, such as credit risk, liquidity, term coupon, payment characteristics, and other information.
MORTGAGE-BACKED AND RELATED SECURITIES -- Fair value is estimated using quoted market prices. For illiquid securities, market prices are estimated by obtaining market price quotes on similar liquid securities and adjusting the price to reflect differences between the two securities, such as credit risk, liquidity, term coupon, payment characteristics, and other information.
INTEREST RATE CAPS -- Fair value is based on quotes received from third parties.
LOANS RECEIVABLE -- For certain residential mortgage loans, fair value is estimated using quoted market prices for similar types of products. The fair value of certain other types of loans is estimated using quoted market prices for securities backed by similar loans. The fair value for loans that could not be reasonably established using the previous two methods was estimated by discounting future cash flows using current rates for similar loans. Management adjusts the discount rate to reflect the individual characteristics of the loan, such as credit risk, coupon, term, payment characteristics, and the liquidity of the secondary market for these types of loans.
DEPOSITS -- For passbook savings, checking and money market accounts, fair value is estimated at carrying value. For fixed maturity certificates of deposit, fair value is estimated by discounting future cash flows at the currently offered rates for deposits of similar remaining maturities.
ADVANCES FROM THE FHLB OF ATLANTA -- For adjustable rate advances, fair value is estimated at carrying value. For fixed rate advances, fair value is estimated by discounting future cash flows at the currently offered rates for fixed-rate advances of similar remaining maturities.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE -- Fair value is estimated using carrying value. The securities are repriced on a semiannual basis.
SUBORDINATED DEBT -- For subordinated debt, fair value is estimated using quoted market prices.
OFF-BALANCE SHEET INSTRUMENTS -- The fair value of interest rate exchange agreements is the net cost to the Company to terminate the agreement as determined from market quotes.
The fair value of financial instruments as of December 31, 1998 and 1997 is as follows (in thousands):
20. DISTRIBUTIONS
The Bank is subject to certain restrictions on the amount of dividends it may declare without prior regulatory approval. At December 31, 1998, approximately $21.3 million of retained earnings was available for dividend declaration.
21. EMPLOYEE STOCK OWNERSHIP PLAN
The Company sponsors an Employee Stock Ownership Plan ("ESOP"). All employees of the Company who meet limited qualifications participate in the ESOP. Under the ESOP, the Company contributes to a separate trust fund maintained exclusively for the benefit of those employees who have become participants. The ESOP has borrowed from the Company and used the proceeds to acquire Company stock. The ESOP shares initially were pledged as collateral for its debt to the Company. As the debt is repaid, shares are released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the shares pledged as collateral are reported as unearned ESOP shares in the statement of financial position. As shares are released from collateral, the Company reports compensation expense equal to the current market price of the shares. As of December 31, 1998 and 1997, the ESOP owned 419,095 and 261,094 shares, respectively, of the Company's stock, with approximately 223,000 and 196,536 shares allocated, respectively. As of December 31, 1998 and 1997, the fair value of unearned shares held by the ESOP was $6.7 million and $254,000, respectively. Compensation expense was $391,000, $247,000 and $224,000 for the years ended December 31, 1998, 1997, and 1996, respectively.
22. STOCK BASED COMPENSATION
In 1998, the Company authorized and issued 959,710 options to directors, officers and employees to purchase 959,710 shares of TeleBanc Common Stock at prices ranging from $9.75 to $14.50. In 1997, directors, officers and employees were issued 698,402 options to purchase 698,402 shares of TeleBanc Common Stock at prices ranging from $1.33 to $6.75. As of December 31, 1998 and 1997, 904,797 and 598,248 of the options outstanding, respectively, were vested at exercise prices ranging from $1.33 to $14.50. The maximum term for the outstanding options is 10 years. At the discretion of management, options are
assigned a vesting period of five years, with 20% of options vesting at the end of each year, or four years, with 20% of options vesting on the grant date and the remaining 80% vesting ratably over the 4 years. As of December 31, 1998, the total number of authorized options was 2,737,996. The options' exercise price was the market value of the stock at the date of issuance.
The following table summarizes information about fixed options outstanding at December 31, 1998:
Because the method of accounting required by SFAS No. 123 has not been applied to options granted prior to January 1996, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model with the following weighted average assumptions for grants; risk-free interest rates of 4.71 percent, 5.08 percent and 5.25 percent for 1998, 1997, and 1996, respectively; expected life of 5 years in 1998 and 10 years in 1997 and 1996 for all options granted; expected volatility of 81.6 percent, 25.0 percent and 23 percent for 1998, 1997, and 1996, respectively.
The Company accounts for this plan under APB No. 25, under which no compensation cost has been recognized. Had compensation cost for the plan been determined consistent with SFAS No. 123, the Company's net income and net income per share would have been reduced to the following pro forma amounts:
23. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has various outstanding commitments and contingent liabilities that are not reflected in the accompanying consolidated financial statements. The principal commitments of the Company are as follows:
At December 31, 1998, the Company was obligated under three operating leases for office space with original terms ranging from three to ten years. Net rent expense under operating leases was approximately $333,000, $238,000 and $142,000 for the years ended December 31, 1998, 1997, and 1996, respectively.
The projected minimum rental payments under the terms of the lease are as follows:
As of December 31, 1998, the Company had commitments to purchase $53.3 million of mortgage loans.
24. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
STATEMENTS OF FINANCIAL CONDITION ($ IN THOUSANDS)
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME ($ IN THOUSANDS)
STATEMENTS OF CASH FLOWS ($ IN THOUSANDS)
TeleBanc Financial Corporation commenced activities on January 27, 1994, the effective date of its formation as a holding company of the Bank. The Bank paid dividends of $0 and $992,000 to TeleBanc for subordinated interest expense payments for the years ended December 31, 1998 and 1997, respectively.
25. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Condensed quarterly financial data for the years ended December 31, 1998 and 1997 is shown as follows:
- --------------- (1) Reflects a $1.7 million nonrecurring, noncash charge related to the additional Preferred Stock dividend payable in Common Stock, based on the fair market value of the Common Stock at the time such dividend was paid. The charge reduced net income available to common stockholders by the same amount and diluted earnings per share in the third quarter of 1998 by $0.18 per share.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES
The following table lists the current directors, executive officers and certain key employees of the Company:
David A. Smilow has served as the Chairman of the Board of Directors since March 1994 and as Chief Executive Officer of the Company from March 1994 to April 1998. He has also served as the Chairman of the Board of Directors of TeleBank since January 1994 and as Chief Risk Management Officer of TeleBank since February 1996. Prior to January 1994, Mr. Smilow served as President of TeleBank. Mr. Smilow also serves as President of TCM. Mr. Smilow is the brother-in-law of Mr. Opsahl.
Mitchell H. Caplan has served as the Vice Chairman of the Board of Directors and President of the Company since January 1994 and has served as Chief Executive Officer of the Company since April 1998. Mr. Caplan has also served as Vice Chairman, President and Chief Executive Officer of TeleBank since January 1994. Mr. Caplan also serves as Vice President of TCM. From 1985 until September 1990, Mr. Caplan was an associate of the law firm of Shearman and Sterling, where he represented and advised private and public commercial institutions.
Aileen Lopez Pugh has served as Executive Vice President and Chief Financial Officer of the Company and TeleBank since August 1994. Prior to joining management of the Company and TeleBank, Ms. Pugh served as a director of the Company from April 1993 to August 1994. From December 1993 to May 1994, she served as a consultant to MET Holdings in connection with the organization of the Company and its initial public offering.
Laurence P. Greenberg has served as Executive Vice President and Chief Marketing Officer of the Company and TeleBank since 1995. He is responsible for developing and implementing the Company's marketing strategy and overseeing the call center and deposit operations functions. From October 1994 to 1995, Mr. Greenberg served as Senior Vice President of Marketing. Prior to joining management of the Company and TeleBank, Mr. Greenberg served as consultant to TeleBank between April and September 1994. From 1993 to April 1994, Mr. Greenberg was a Senior Associate at T.H. Land Research Group, Inc., a marketing research company serving direct marketing companies. From 1989 to 1993, Mr. Greenberg was a Marketing Manager for specialty publications with Capital Cities/ABC, Inc.
Michael Opsahl has served as Executive Vice President and Chief Credit Officer of the Company, TeleBank, and TCM, or their predecessors since 1990. He is responsible for the development of the loan acquisition process, including the acquisition and pricing of loans and the swapping of purchased loan pools for mortgage-backed securities. Prior to joining the Company, Mr. Opsahl served as a trading assistant at the Federal Home Loan Mortgage Corporation. Mr. Opsahl is the brother-in-law of Mr. Smilow.
Sang-Hee Yi has served as Executive Vice President and Chief Operating Officer of the Company and TeleBank since April 1996, she is responsible for operations and regulatory compliance. Prior to serving in her current position, Ms. Yi served as the compliance officer of the Company. From 1986 to April 1994, she was a federal thrift regulator at the OTS.
Ross C. Atkinson has served as Executive Vice President and Chief Information Officer of the Company and TeleBank since June 1998, he is responsible for the strategic direction of all information processing, communication systems and operations. From 1997 until June 1998, Mr. Atkinson served as a principal consultant with Platinum Technology, Inc., a database systems and information management software provider. From 1991 through 1996, Mr. Atkinson served as a systems engineer for Electronic Data Systems.
Arlen W. Gelbard has served as Executive Vice President and General Counsel of the Company and TeleBank since June 1998. From 1982 until June 1998, Mr. Gelbard was a member of the law firm of Hofheimer Gartlir & Gross, LLP, New York, where he specialized in transactional real estate, lending, leasing, foreclosures and workouts. Prior to joining management of the Company, from April 1996 to June 1998, Mr. Gelbard served as a director, as well as Chairman of the Compensation Committees of the Company and TeleBank.
Stephen G. Dervenis has served as Executive Vice President of the Company, as well as Chief Executive Officer of TCM since June 1998. From October 1997 to June 1998, Mr. Dervenis served as Director of Amortizing and Emerging Assets Securitization at Barclays Capital in New York. From April 1994 to September 1997, Mr. Dervenis served as a Managing Director of Furman Selz, and from January 1993 to March 1994, as a Vice President at J.P. Morgan, both in New York.
David R. DeCamp has served as a director of the Company since its formation in March 1994 and as a director of TeleBank since July 1992. Mr. DeCamp is a Senior Vice President of Grubb & Ellis, a commercial real estate broker. From 1988 to 1996, Mr. DeCamp was a commercial real estate broker with Cassidy & Pinkard, Inc. Mr. DeCamp is the Chairman of the Audit and Compliance Committees of the Company and TeleBank, respectively.
Dean C. Kehler has served as a director of the Company and TeleBank since March 1997. Mr. Kehler has been a Managing Director of CIBC Oppenheimer Corp., a subsidiary of CIBC, and co-head of the High Yield Group since August 1995. From February 1990 to August 1995, Mr. Kehler was a founding partner and Managing Director of The Argosy Group, L.P., which was acquired by CIBC in August 1995. He is also a director of Global Crossing Ltd and Booth Creek Ski Group, Inc.
Marcia Myerberg has served as a director of the Company and TeleBank since May 1998. Ms. Myerberg has been Chief Executive Officer of Myerberg & Company, L.P., an investment banking firm specializing in the mortgage-backed securities markets, since February 1994. Prior to her current position, from March 1989 to February 1994, Ms. Myerberg was a Senior Managing Director of The Bear Stearns Companies, Inc. From July 1985 to February 1985, she was a Director of Salomon Brothers, Inc., and from November 1979 to June 1989 she was the Senior Vice President-Corporate Finance and Treasurer of Federal Home Loan Mortgage Corporation.
Steven F. Piaker has served as a director of the Company and TeleBank since March 1997. Since January 1997, Mr. Piaker has been a Senior Vice President of Conning & Company, a provider of asset management, private equity capital, corporate finance services and research to the insurance and financial services industries, which he joined in 1994. From September 1992 to June 1994, Mr. Piaker served as a Senior Vice President of Conseco, Inc. where he was involved in company-sponsored leveraged buyouts and private placements in the insurance industry.
Mark Rollinson has served as a director of the Company since its formation in March 1994 and as a director of TeleBank since 1992. He has been a self-employed attorney in Leesburg, Virginia for the past ten years.
Messrs. Kehler and Piaker were elected to the Board of Directors of the Company pursuant to a provision in the Certificate of Designation of the Preferred Stock (the "Certificate of Designation").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION
The following table sets forth the compensation paid and earned during the periods indicated by the Company and TeleBank to the executive officers of the Company (the "Named Executive Officers") for services rendered to the Company in all capacities. The Company has not granted any stock appreciation rights ("SARs").
- --------------- (1) The total amounts shown for each of the years presented represent dollar value of contributions made by the Company to its Employee Stock Ownership Plan for the account of the Named Executive Officer.
STOCK OPTIONS GRANTS IN 1998
The following table contains information with respect to options to purchase Common Stock granted to the Named Executive Officers in 1998. All options were granted under the Company's 1994, 1997 or 1998 Stock Option Plans. The Company has not granted any SARs.
- --------------- (1) The dollar amounts under these columns are the result of calculations at the 5% and 10% assumed annual growth rates mandated by the rules and regulations promulgated by the Commission and, therefore, are not intended to forecast possible future appreciation, if any, in the Common Stock price.
(2) The options vested 20% upon grant on October 23, 1998, and 20% vests ratably on each of the next four anniversaries of the grant.
(3) The options vested 20% upon grant on January 27, 1998 and 20% vests ratably on each of the next four anniversaries of the grant.
The following table sets forth information with respect to outstanding options held by the Named Executive Officers at December 31, 1998.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION VALUES
- --------------- (1) Based on last reported sale price of the Common Stock on December 31, 1998 of $34.00 per share and applicable per share exercise price for the options.
(2) On April 28, 1994, Messrs. Smilow and Caplan were each granted options to purchase 85,234 shares of Common Stock with an exercise price of $3.0625 and options to purchase 125,496 shares of Common Stock with an exercise price equal to $3.5625. The options expire in April 2004. Also Messrs. Smilow and Caplan were each granted options to purchase 200,000 shares of Common Stock on February 28, 1997 with an exercise price of $6.75 and an expiration date of February 28, 2007. On October 23, 1998, Messrs. Smilow and Caplan were each granted options to purchase 200,000 shares of Common Stock, with an exercise price of $14.50 and an expiration date of October 23, 1998. For each of these grants, the options vested 20% upon grant, and 20% vest ratably on each of the next four anniversaries of the grant.
(3) The Company has granted a total of 130,000 options to Ms. Pugh: 10,000 options granted on April 28, 1994 with an exercise price of $3.0625, 10,000 options granted on February 15, 1995 with an exercise price of $2.75, 30,000 options granted on February 15, 1996 with an exercise price of $3.875, 20,000 options granted on February 15, 1997 with an exercise price of $6.75 and 60,000 options granted on January 27, 1998 with an exercise price of $9.75. The options expire in April 2004, February 2005, February 2006, February 2007 and January 2008, respectively. The options vested 20% upon grant, and 20% vest ratably on each of the next four anniversaries of the grant.
(4) The Company has granted a total of 130,000 options to Mr. Greenberg: 10,000 options granted on February 15, 1995 with an exercise price of $2.75, 10,000 options granted on February 15, 1996 with an exercise price of $3.875, 50,000 options granted on February 15, 1997 with an exercise price of $6.75 and 60,000 options granted on January 27, 1998 with an exercise price of $9.75. The options expire in February 2005, February 2006, February 2007 and January 2008, respectively. The options vested 20% upon grant, and 20% vest ratably on each of the next four anniversaries of the grant.
COMPENSATION OF DIRECTORS
Non-employee directors of the Company receive $3,000 per director annually. Non-employee directors of TeleBank receive $12,000 per director annually. In addition, non-employee directors are reimbursed for travel costs and other out-of-pocket expenses incurred in attending meetings.
As additional compensation for services provided to the Company, in May 1994, the Company granted to each of Messrs. DeCamp and Rollinson options to acquire 10,000 shares of Common Stock, at an exercise price of $1.53 per share. As of the date of this Annual Report, these options are fully vested. Mr. Rollinson has exercised options to acquire 10,000 shares of Common Stock. In August 1996, the Company granted to each of Messrs. DeCamp, Gelbard and Rollinson options to acquire 20,000 shares of Common Stock, of which options to acquire 36,000 in the aggregate are vested. In October 1998, the Company granted to Messrs. Kehler and Piaker options to acquire 20,000 shares of Common Stock, of which options to acquire 8,000 in the aggregate are vested. Also in October 1998, the Company granted Ms. Myerberg options to acquire 10,000 shares of Common Stock, of which options to acquire 2,000 in the aggregate are vested. As of
the date of this Annual Report, options to acquire 120,000 shares of Common Stock held in the aggregate by such directors are outstanding.
INTERLOCKS AND INSIDER PARTICIPATIONS
CIBC Oppenheimer, an affiliate of CIBC WGArgosy Merchant Fund 2, LLC, of which Mr. Kehler is a managing director, served as an underwriter for the Company's Equity Offering and Trust Preferred Offering in July and August 1998. CIBC Oppenheimer earned underwriters' fees totaling $2.3 million in connection with the offerings.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding the beneficial ownership of the Company's Common Stock (the "Voting Securities") as of December 31, 1998 by (i) any person known to the Company to be the beneficial owner of more than 5% of any class of the Company's Voting Securities, (ii) each director and person nominated to be a director as of December 31, 1998, (iii) the Chief Executive Officer and the Named Executive Officers, and (iv) all directors and executive officers as a group. Except as otherwise noted, each beneficial owner has sole investment and voting power with respect to the listed shares.
SECURITY OWNERSHIP OF THE COMPANY'S SECURITIES
- --------------- * Less than 1%.
(1) Unless otherwise indicated, the address of each beneficial owner listed above is c/o TeleBanc Financial Corporation, 1111 North Highland Street, Arlington, Virginia 22201.
(2) Includes 344,064 shares of Common Stock issuable upon exercise of options and 64,200 shares issuable upon exercise of warrants exercisable within 60 days of this filing and 33,096 shares of Common Stock held by the ESOP and allocated to Mr. Smilow's account. Excludes 385,999 shares of Common Stock and warrants to acquire 50,000 shares of Common Stock held by the ESOP (excluding the shares allocated to his account), of which Mr. Smilow is a trustee.
(3) Includes 370,730 shares of Common Stock issuable upon exercise of options and 46,000 shares issuable upon exercise of warrants exercisable within 60 days of this filing and 15,809 shares of Common Stock held by the ESOP and allocated to Mr. Caplan's account. Excludes 403,286 shares of Common Stock and warrants to acquire 50,000 shares of Common Stock held by the ESOP (excluding the shares
allocated to his account), of which Mr. Caplan is a trustee. Mr. Caplan disclaims beneficial ownership of warrants to acquire 23,000 shares of Common Stock listed above.
(4) Includes 79,998 shares of Common Stock issuable upon exercise of options and 12,200 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing and 7,481 shares of Common Stock held by the ESOP and allocated to Ms. Pugh's account.
(5) Includes 71,999 shares of Common Stock issuable upon exercise of options and 2,000 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing and 7,507 shares of Common Stock held by the ESOP and allocated to Mr. Greenberg's account.
(6) Includes 22,000 shares of Common Stock issuable upon exercise of options exercisable within 60 days of this filing. Mr. DeCamp's address is Grubb & Ellis, 1717 Pennsylvania Avenue, N.W., Suite 250, Washington, D.C. 20006.
(7) Mr. Kehler is the designated director for CIBC WG Argosy Merchant Fund 2 LLC ("CIBC Merchant Fund"), which directly holds 589,840 shares of Common Stock and 92,750 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing. Mr. Kehler is a partner of CIBC Merchant Fund and disclaims beneficial ownership of such shares. Mr. Kehler's beneficial ownership interest includes 4,000 shares of Common Stock issuable upon exercise of options exercisable within 60 days of December 31, 1998, which are not part of CIBC's holdings. Mr. Kehler's address is c/o CIBC Oppenheimer, 425 Lexington Avenue, 3rd Floor, New York, New York 10017.
(8) Includes 4,000 shares of Common Stock issuable upon exercise of options exercisable within 60 days of this filing. Mr. Piaker is the designated director for Conning & Company and serves as its Senior Vice President. Mr. Piaker does not exercise voting or investment control over the shares held by Conning & Company. Mr. Piaker's address is c/o Conning & Company, City Place II, 185 Asylum Street, Hartford, Connecticut 06103.
(9) Represents common stock issuable upon exercise of options exercisable within 60 days of the date of this filing. Ms. Myerberg's address is 201 E. 87th Street, Apt. 16R, New York, NY 10128.
(10) Includes 12,000 shares of Common Stock issuable upon exercise of options exercisable within 60 days of this filing. Mr. Rollinson's address is P.O. Box 826, Leesburg, Virginia 22075.
(11) Conning Insurance Capital Limited Partnership III ("CICLP III") directly holds 558,441 shares of Common Stock and 76,188 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of December 31, 1998. Conning Insurance Capital International Partners III, L.P. ("CICIP III") directly holds 121,399 shares of Common Stock and 16,562 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing. Conning & Company controls the general partner of each of CICLP III and CICIP III. The address of Conning & Company is City Place II, 185 Asylum Street, Hartford, Connecticut 06103.
(12) General American Life Insurance Company ("General American"), an indirect subsidiary of General American Mutual Holding Company directly holds 168,526 shares of Common Stock and 26,500 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing. General American Mutual Holding Company indirectly controls Conning & Company and may be deemed to beneficially own all of the shares held by CICLP III and CICIP III. Accordingly, the shares held by Conning & Company are also included in the table above. The address of General American is 700 Market Street, St. Louis, Missouri 63101.
(13) PC Investment Company holds 749,940 shares of Common Stock, as well as 117,926 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing. The address of PC Investment Company is 401 Theodore Freund Avenue, Rye, New York 10580.
(14) Includes 910,791 shares of Common Stock issuable upon exercise of options and 217,150 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of this filing. Excludes 355,202 shares of Common Stock (except for any shares allocable to the accounts of Messrs. Smilow and Caplan and Ms. Pugh) and warrants to acquire 50,000 shares of Common Stock exercisable within 60 days of December 31, 1998, held by the ESOP, of which Messrs. Smilow and Caplan act as trustees.
(15) Includes 50,000 shares of Common Stock issuable upon exercise of warrants exercisable within 60 days of December 31, 1998.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CIBC Oppenheimer, an affiliate of CIBC WG Argosy Merchant Fund 2, LLC, of which Mr. Kehler is a managing director, served as an underwriter for the Company's Equity Offering and Trust Preferred Offering in July and August 1998. CIBC Oppenheimer earned underwriters' fees totaling $2.3 million in connection with the offerings.
Prior to resigning from the Board of Directors and joining the Company as general counsel, Mr. Gelbard served as a partner of Hofheimer, Gartlir & Gross, LLC, which performed legal services for the Company. During 1998, Hofheimer, Gartlir & Gross, LLC, received approximately $106,000 in legal fees and expenses for work performed through June 30, 1998.
The Company paid $204,000 in consulting fees to Myerberg & Company, of which Ms. Myerberg is the Chief Executive Officer, in connection with the establishment of an agreement to purchase funding notes collateralized by consumer loans.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) The following consolidated financial statements of the Company and its subsidiaries and report of independent auditors are included in Item 8 beginning on page 34 hereof.
Report of Independent Public Accountants.
Consolidated Statements of Financial Condition -- December 31, 1998 and 1997.
Consolidated Statements of Operations -- Years Ended December 31, 1998, 1997, and 1996.
Consolidated Statements of Changes in Stockholders' Equity -- Years Ended December 31, 1998, 1997, and 1996.
Consolidated Statements of Cash Flows -- Years Ended December 31, 1998, 1997, and 1996.
Notes to Consolidated Financial Statements.
(a)(2) All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
(a)(3) The following exhibits are either filed with this Annual Report or are incorporated herein by reference:
- --------------- * Indicates compensatory plan or arrangement.
(b) Reports on Form 8-K
On August 25, 1998, the Company reported to the Securities and Exchange Commission on Form 8-K under Item 2, Acquisition or Disposition of Assets, that on August 10, 1998, the Company had acquired DFC and its wholly-owned subsidiary, Premium Bank. Included in the filing was the Agreement and Plan of Merger dated January 14, 1998, as amended by the First Amendment to the Agreement and Plan of Merger, dated May 29, 1998. The Company amended the Form 8-K and filed the financial statements required under Item 7, Required Financial Statements, on October 26, 1998.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TELEBANC FINANCIAL CORPORATION (Registrant)
By: /s/ MITCHELL H. CAPLAN ------------------------------------ Mitchell H. Caplan Vice Chairman, Chief Executive Officer and President
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated as of February 11th, 1999.