ITEM 1. BUSINESS
General
B.F. Saul Real Estate Investment Trust (the "Trust") operates as a Maryland real estate investment trust. The Trust began its operations in 1964 as an unincorporated business trust organized under a Declaration of Trust governed by District of Columbia law. The Trust terminated its status as a qualified real estate investment trust for federal income tax purposes in 1978 and is now taxable as a corporation. On October 24, 1988, the Trust amended its Declaration of Trust to qualify the Trust as a statutory real estate investment trust under Maryland law.
The principal business activity of the Trust and its real estate subsidiaries is the ownership and development of income-producing properties. The Trust owns 80% of the outstanding common stock of Chevy Chase Bank, F.S.B. ("Chevy Chase" or the "Bank"), whose assets accounted for 95% of the Trust's consolidated assets at September 30, 1998. The Trust is a thrift holding company by virtue of its ownership of a majority interest in Chevy Chase. See "Real Estate - Holding Company Regulation."
The Trust recorded net income of $66.1 million in the fiscal year ended September 30, 1998, compared to a net income of $18.9 million in the fiscal year ended September 30, 1997 and a net loss of $78,000 in the fiscal year ended September 30, 1996.
The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The Term "Trust" used in the text and the financial statements included herein refers to the combined entity, which includes B. F. Saul Real Estate Trust and its subsidiaries, including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust" refers to B. F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase's subsidiaries. The operations conducted by the Real Estate Trust are designated as "Real Estate," while the business conducted by Chevy Chase and its subsidiaries is identified by "Banking."
The principal offices of the Trust are located at 8401 Connecticut Avenue, Chevy Chase, Maryland 20815, and the Trust's telephone number is (301) 986-6000.
Real Estate. The Real Estate Trust's long-term objectives are to increase cash flow from operations and to maximize capital appreciation of its real estate. The properties owned by the Real Estate Trust are located predominantly in the Mid-Atlantic and Southeastern regions of the United States and consist principally of hotels, office and industrial projects, and undeveloped land parcels.
Banking. Chevy Chase is a federally chartered and federally insured stock savings bank which at September 30, 1998 was conducting business from 143 full-service branch offices, including 11 in-store banking centers, and 696 automated teller machines ("ATMs") in Maryland, Virginia and the District of Columbia. The Bank has its home office in McLean, Virginia and its executive offices in Chevy Chase, Maryland, both suburban communities of Washington, D.C. The Bank also maintains 14 mortgage loan production offices in the mid-Atlantic region, 13 of which are operated by a wholly-owned mortgage banking subsidiary, and 31 consumer loan production offices, 24 of which are operated by a wholly-owned finance subsidiary. At September 30, 1998, the Bank had total assets of $6.7 billion and total deposits of $4.9 billion. Based on total assets at September 30, 1998, Chevy Chase is the largest bank headquartered in the Washington, D.C. metropolitan area.
Chevy Chase is a consumer oriented, full service banking institution principally engaged in the business of attracting deposits from the public and using such deposits, together with borrowings and other funds, to make loans secured by real estate, primarily residential mortgage loans and consumer loans. The Bank also has an active commercial lending program. The Bank's principal deposit and lending markets are located in the Washington, D.C. metropolitan area. As a complement to its basic deposit and lending activities, the Bank provides a number of related financial services to its customers, including securities brokerage and insurance products offered through its subsidiaries. On November 12, 1997, the Bank acquired ASB Capital Management, Inc. ("ASB"), one of the largest SEC-registered investment managers headquartered in the Washington, D.C. metropolitan area, through which the Bank provides a variety of investment products and fiduciary services to a primarily institutional customer base.
On September 30, 1998, the Bank sold its credit card operations to First USA Bank, N.A. ("FUSA"). The credit card portfolio purchased by FUSA included approximately $4.8 billion of managed credit card loans and 3.1 million Visa and Mastercard credit card accounts. The Bank recognized a net gain on this sale of $288.3 million. See Note 8 to the Consolidated Financial Statements in this Report. Management believes that the ongoing consolidation in the credit card industry was making it increasingly difficult for relatively smaller institutions like the Bank to make the investments in technology and other resources necessary to compete effectively with increasingly larger and more specialized issuers. In light of these competitive considerations, management believes that selling the Bank's credit card business will relieve the Bank of the substantial financial commitments necessary to maintain its credit card operations, and enable the Bank to concentrate its resources on capitalizing on the Bank's status as the largest locally-headquartered bank in the Washington, D.C. metropolitan area and further its community banking objectives. Accordingly, the Bank will continue to build its branch and alternative delivery systems, maintain and expand its mortgage banking operations, and continue to offer a broad range of non-credit card consumer products, including home equity lines of credit, home improvement loans and automobile loans. In addition, the Bank anticipates expanding its business banking program, with an emphasis on businesses in the Washington, D.C. metropolitan area. The Bank will also seek to develop further the fee based services it can provide to customers, including securities brokerage, asset management and insurance products offered through its subsidiaries.
Chevy Chase recorded operating income of $184.4 million for the year ended September 30, 1998, compared to operating income of $80.2 million for the year ended September 30, 1997. At September 30, 1998, the Bank's tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios were 7.93%, 7.93%, 12.93% and 20.70%, respectively. The Bank's regulatory capital ratios exceeded the requirements under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") as well as the standards established for well capitalized institutions under the prompt corrective action regulations established pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA").
Chevy Chase is subject to comprehensive regulation, examination and supervision by the Office of Thrift Supervision (the "OTS") and, to a lesser extent, by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank's deposit accounts are fully insured up to $100,000 per insured depositor by the SAIF, which is administered by the FDIC.
REAL ESTATE
Real Estate Investments
The following tables set forth, at and for the periods indicated, certain information regarding the properties in the Real Estate Trust's investment portfolio at September 30, 1998.
OTHER REAL ESTATE INVESTMENTS
Location Name --------------- ------------------------------ PURCHASE - LEASEBACK PROPERTIES (1)
APARTMENTS Number of Units -------- LOUISIANA Metairie Chateau Dijon 336
TENNESSEE Knoxville Country Club 232 --- Total 568
SHOPPING CENTERS
Gross Leasable Area (2) -------- GEORGIA Atlanta Old National 160,000 Warner Robbins Houston Mall 264,000 ------- Total 424,000
APARTMENT PROJECT Number of Units TEXAS -------- Dallas San Simeon 124
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(1) The Trust owns the ground under certain income-producing properties and receives fixed ground rent, which is subject to periodic escalation, from the owners of the improvements. In certain instances, the Real Estate Trust also receives percentage rent based upon the income generated by the properties. (2) Square feet.
The investment portfolio consists principally of seasoned operating properties. The Real Estate Trust expects to hold its properties as long-term investments and has no maximum period for retention of any investment. It may acquire additional income-producing properties, expand and improve its properties, or sell such properties, as and when circumstances warrant. The Real Estate Trust also may participate with other entities in property ownership, through joint ventures or other types of co-ownership.
Investment in Saul Holdings Limited Partnership
On August 26, 1993, the Real Estate Trust consummated a series of transactions (together with related transactions, the "Formation Transactions") in which it transferred its 22 shopping center properties and one of its office properties (the "Transferred Properties"), together with the debt associated with such properties, to a newly organized limited partnership, Saul Holdings Limited Partnership ("Saul Holdings Partnership"), and one of two newly organized subsidiary limited partnerships of Saul Holdings Partnership (the "Subsidiary Partnerships" and, collectively with Saul Holdings Partnership, the "Partnerships"). In exchange for the Transferred Properties, the Real Estate Trust received securities representing a 21.5% limited partnership interest in Saul Holdings Partnership. Entities under common control with the Trust (the "Trust Affiliates") received limited partnership interests collectively representing a 5.5% partnership interest in Saul Holdings Partnership in exchange for the transfer of property management functions (the "Management Functions") and certain other properties to the Partnerships. Saul Centers, Inc. ("Saul Centers"), a newly organized, publicly held real estate investment trust, received a 73.0% general partnership interest in Saul Holdings Partnership in exchange for the contribution of approximately $220.7 million to Saul Holdings Partnership. The Trust Affiliates received certain cash distributions from Saul Holdings Partnership and purchased 4.0% of the common stock of Saul Centers in a private offering consummated concurrently with the initial public offering of such common stock. B. Francis Saul II, the Chairman of the Board of Trustees and Chief Executive Officer of the Trust, also serves as Chairman of the Board of Directors and Chief Executive Officer of Saul Centers.
The Real Estate Trust and the Trust Affiliates own rights (the "Rights") enabling them to convert their limited partnership interests in Saul Holdings Partnership into shares of Saul Centers common stock on the basis of one share of Saul Centers common stock for each partnership unit provided that they do not own rights to the extent that they collectively would be treated as owning, directly or indirectly, more than 24.9% of the value of the outstanding equity securities of Saul Centers. The shares of Saul Centers common stock are listed on the New York Stock Exchange (trading symbol "BFS").
In July 1994, Saul Centers established Saul QRS, Inc. and SC Finance Corporation as wholly owned subsidiaries of Saul Centers. Saul QRS, Inc. was established to succeed to the interest of Saul Centers as the sole general partner of one of the Subsidiary Partnerships, Saul Subsidiary I Limited Partnership, and SC Finance Corporation was established for the purpose of issuing $128 million of collateralized floating rate mortgage notes (the "Mortgage Notes"). In connection with these transactions, Saul Holdings Partnership transferred ten shopping centers previously owned by it to Saul Subsidiary I Limited Partnership as a capital contribution and the second Subsidiary Partnership, Saul Subsidiary II Limited Partnership, transferred one shopping center previously owned by it to Saul Subsidiary I Limited Partnership as a capital contribution in return for a limited partnership interest in Saul Subsidiary I Limited Partnership. As a consequence of these transfers, Saul Subsidiary I Limited Partnership owned a total of 17 shopping centers (the "Mortgaged Properties"). The Mortgaged Properties, which continued to be managed by Saul Holdings Partnership, secured the mortgage purchased with the proceeds of issuance of the Mortgage Notes.
On October 1, 1997 Saul Centers closed a $147 million mortgage loan secured by nine of the company's retail properties. The loan term is 15 years and requires payments based on a fixed rate of 7.67% and 25 year principal amortization. At the same time Saul Centers closed a new three-year $60 million unsecured revolving credit line which replaced a secured credit line. Proceeds from the new loans were used to repay the $128 million of collateralized floating rate debt mentioned above and the outstanding balance of other floating rate debt. Saul Centers currently has fixed interest rates on approximately 95% of its total outstanding debt which has a weighted remaining term of approximately 14 years.
As a consequence of the Formation Transactions and the later transactions described above undertaken in connection with financings, Saul Centers serves as the sole general partner of Saul Subsidiary II Limited Partnership, and Saul QRS, Inc. serves as the sole general partner of Saul Subsidiary I Limited Partnership. Each such general partner holds a 1% general partnership interest in the applicable Subsidiary Partnership. The remaining 99% interests in Saul Subsidiary I Limited Partnership and Saul Subsidiary II Limited Partnership are held by Saul Holdings Partnership as the sole limited partner.
In January 1998, in accordance with its obligation under the Exclusivity Agreement described below, the Real Estate Trust offered Saul Centers the right to purchase its newly constructed, 100% leased office/flex building (Avenel IV) located in the Avenel Business Park adjacent to Saul Centers' Avenel I - III buildings. The new building contained 46,227 square feet of leasable area. An independent appraisal determined the purchase price of $5.6 million. Saul Centers agreed to purchase the property as of April 1, 1998, by assuming the mortgage of $3.7 million and issuing 105,992 new units in Saul Centers' operating partnership to the Real Estate Trust.
At September 30, 1998, Saul Holdings Partnership owned, directly or indirectly through the Subsidiary Partnerships, 29 community and neighborhood shopping centers located in seven states and the District of Columbia, one office property and one office/retail property located in the District of Columbia, one research park located in a Maryland suburb of Washington, D.C. and one property planned to be converted to an industrial/warehouse facility located in Oklahoma (collectively, the "Portfolio Properties").
Saul Centers. Saul Centers made an election to be treated as a real estate investment trust ("REIT") for federal income tax purposes under Sections 856 through 860 of the Internal Revenue Code commencing with the year ended December 31, 1993. Under the Internal Revenue Code, REITs are subject to numerous organizational and operational requirements. If Saul Centers continues to qualify as a REIT, it generally will not be subject to federal income tax, provided it makes certain distributions to its stockholders and meets certain organizational and other requirements. Saul Centers has announced that it intends to make regular quarterly dividend distributions to its stockholders.
Management of the Properties. The Partnerships manage the Portfolio Properties and any subsequently acquired properties through the Management Functions, which include personnel and such functions as property management, leasing, design, renovation, development and accounting. The Management Functions provide the Partnerships with a fully integrated property management capability through approximately 150 professionals and staff personnel and with an extensive and mature network of relationships with tenants and potential tenants as well as with members of the brokerage and property owners' communities.
Saul Centers shares with the Trust Affiliates certain ancillary functions at cost, such as computer and payroll services, benefit administration and in-house legal services, and shares insurance expense on a pro rata basis. The Trust Affiliates sublease office space to Saul Centers at their cost. The terms of all sharing arrangements, including payments related thereto, are reviewed periodically by the independent directors of Saul Centers, who constitute five of the nine members of the board of directors.
Exclusivity Agreement and Right of First Refusal. The Real Estate Trust has entered into an Exclusivity Agreement (the "Exclusivity Agreement") with, and has granted a right of first refusal (the "Right of First Refusal") to, Saul Centers and the Partnerships (collectively, the "Company"). The purpose of these agreements is to minimize potential conflicts of interest between the Real Estate Trust and the Company. The Exclusivity Agreement and Right of First Refusal generally require the Real Estate Trust to conduct its shopping center business exclusively through the Company and to grant the Company a right of first refusal to purchase commercial properties and development sites that become available to the Real Estate Trust in the District of Columbia or adjacent suburban Maryland. Subject to the Exclusivity Agreement and Right of First Refusal, the Real Estate Trust will continue to develop, acquire, own and manage commercial properties and own land suitable for development as, among other things, shopping centers and other commercial properties.
Allocations and Distributions of Saul Holdings Partnership. The net income or net loss of Saul Holdings Partnership for tax purposes generally will be allocated to Saul Centers and the limited partners in accordance with their percentage interests, subject to compliance with the applicable provisions of the Internal Revenue Code and the regulations promulgated thereunder. Net cash flow after reserves of Saul Holdings Partnership and after reimbursement of specified expenses will be distributed quarterly to the partners in proportion to their respective partnership interests.
Reimbursement Agreement. Pursuant to a reimbursement agreement among the partners of the Partnerships, the Real Estate Trust and two of its subsidiaries that are partners in the Partnerships have agreed to reimburse Saul Centers and the other partners in the event the Partnerships fail to make payments with respect to certain portions of the Partnerships' debt obligations and Saul Centers or any such other partners personally make payments with respect to such debt obligations. The maximum potential obligations of the Real Estate Trust and its subsidiaries under this agreement total $115.5 million. See Note 2 to the Consolidated Financial Statements in this report. The Real Estate Trust believes that the Partnerships will be able to make all payments due with respect to their debt obligations.
Tax Conflicts. The fair market value of each of the properties contributed to the Partnerships by the Real Estate Trust and its subsidiaries at the date of the Formation Transactions (the "FMV" of each such property) exceeded the tax basis of such property (with respect to each property, such excess is referred to as the "FMV-Tax Difference"). In the event Saul Centers or Saul QRS, Inc., acting as general partner of a Partnership, causes such Partnership to dispose of, or there is an involuntary disposition of, one or more of such properties, a disproportionately large share of the total gain for federal income tax purposes would be allocated to the Real Estate Trust or its subsidiaries as a result of the property disposition. In general, if the gain recognized by the Partnership on such a property disposition is less than or equal to the FMV-Tax Difference for such property (as previously reduced by the amounts of special tax allocations of depreciation deductions to the partners), all such gain will be allocated to the Real Estate Trust or its subsidiaries. To the extent the gain recognized by the Partnerships on the property disposition exceeds the FMV-Tax Difference (as adjusted), such excess generally will be allocated among all partners in Saul Holdings based on their relative percentage interests. In general, the amount of federal income tax liability in respect of gain allocated to the Real Estate Trust or its subsidiaries in the event of such a property disposition is likely to exceed, perhaps substantially, the amount of cash, if any, distributable to the Real Estate Trust or its subsidiaries as a result of the property disposition. In addition, future reductions in the level of the Partnerships' debt, any release of the guarantees of such debt by the Real Estate Trust or its subsidiaries (described above under "Reimbursement Agreement") or any refinancings in which the Real Estate Trust or its subsidiaries do not assume a comparable obligation to that contained in the Reimbursement Agreement could cause the Real Estate Trust or its subsidiaries to have taxable constructive distributions without the receipt of any corresponding amounts of cash. See Note 2 to the Consolidated Financial Statements in this report.
Registration Rights. Saul Centers has granted the Real Estate Trust and the Trust Affiliates certain "demand" and "piggyback" registration rights (collectively, the "Registration Rights") with respect to the shares of Saul Centers common stock acquired in connection with the Formation Transactions or as a consequence of exercise of the Rights (the "Registration Shares"). Subject to certain limitations, the Registration Rights grant the holders of Registration Shares the opportunity to cause Saul Centers to register all or any portion of their respective Registration Shares once in each calendar year and to have such Shares registered incidentally to any registration, by Saul Centers, of shares of common stock or other securities substantially similar to common stock. Except with respect to the Registration Rights incident to a pledge of Registration Shares or Saul Holdings Partnership interests, the demand Registration Rights may be exercised only prior to such time, if any, as the holder is permitted to sell the Registration Shares pursuant to Rule 144 (k) under the Securities Act of 1933. Saul Centers will bear expenses incident to its registration obligations upon exercise of the Registration Rights, except that it will not bear any underwriting discounts or commissions, Securities and Exchange Commission or state Blue Sky registration fees, or transfer taxes relating to registration of Registration Shares.
Competition
As an owner of, or investor in, commercial real estate properties, the Real Estate Trust is subject to competition from a variety of other owners of similar properties in connection with their sale, lease or other disposition and use. Management believes that success in such competition is dependent upon the geographic location of the property, the performance of property managers, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors with respect to commercial and industrial properties are the ease of access to the property, the adequacy of related facilities such as parking, and the ability to provide rent concessions and additional tenant improvements without increasing rent. Management believes that general economic circumstances and trends and new properties in the vicinity of each of the Real Estate Trust's properties also will be competitive factors.
Environmental Matters
The Real Estate Trust's properties are subject to various laws and regulations relating to environmental and pollution controls. The Real Estate Trust requires an environmental study to be performed with respect to a property that may be subject to possible environmental hazards prior to its acquisition to ascertain that there are no material environmental hazards associated with such property. Although the effect upon the Real Estate Trust of the application of environmental and pollution laws and regulations cannot be predicted with certainty, management believes that their application either prospectively or retrospectively will not have a material adverse effect on the Real Estate Trust's property operations.
Relationships with the B. F. Saul Company
The Real Estate Trust has significant relationships with B. F. Saul Company (the "Saul Company") and two of the Saul Company's wholly owned subsidiaries, B. F. Saul Advisory Company (the "Advisor") and Franklin Property Company ("Franklin"). The Saul Company, founded in 1892, specializes in real estate investment services, including acquisitions, financing, management and leasing, and insurance. B. Francis Saul II, Chairman of the Board of Trustees and Chief Executive Officer of the Trust, is Chairman of the Board and President of the Saul Company and the Advisor.
The Advisor acts as the Real Estate Trust's investment advisor and manages the day-to-day financial, accounting, legal and administrative affairs of the Real Estate Trust. Franklin acts as leasing and management agent for the income-producing properties owned by the Real Estate Trust, and plans and oversees the development of new properties and the expansion and renovation of existing properties.
The Trustees, including the two independent Trustees, review the fees and compensation arrangements between the Real Estate Trust and the Saul Company and its related entities and affiliates and believe that such fees and compensation arrangements are as favorable to the Real Estate Trust as would be obtainable from unaffiliated sources. See "Certain Relationships and Related Transactions."
Holding Company Regulation
The Trust and the Saul Company, by virtue of their direct and indirect control of the Bank, and Chevy Chase Property Company ("CCPC") and CCPC's wholly-owned subsidiary, Westminster Investing Corporation ("Westminster"), by virture of Westminster's direct and indirect ownership of 24.9% of the common stock of the Trust (collectively the "Holding Companies"), are "savings and loan holding companies" subject to regulation, examination and supervision by the OTS. The Bank is prohibited from making or guaranteeing loans or advances to or for the benefit of the Holding Companies or other affiliates engaged in activities beyond those permissible for bank holding companies and from investing in the securities of the Holding Companies or other affiliates. Further, transactions between the Bank and the Holding Companies must be on terms substantially the same, or at least as favorable to the Bank, as those that would be available to non-affiliates. The Holding Companies must obtain the prior approval of the OTS before acquiring by merger, consolidation or purchase of assets any federally insured savings institution or any savings and loan holding company. As unitary savings and loan holding companies, the Holding Companies are virtually unrestricted in the types of business activities in which they may engage, provided the Bank continues to meet the qualified thrift lender test. See "Banking - Regulation - Qualified Thrift Lender ("QTL") Test." If the Holding Companies were to acquire one or more federally insured institutions and operate them as separate subsidiaries rather than merging them into the Bank, the Holding Companies would become "multiple" savings and loan holding companies. As multiple savings and loan holding companies, the Holding Companies would be subject to limitations on the types of business activities in which they would be permitted to engage, unless the additional thrifts were troubled institutions acquired pursuant to certain emergency acquisition provisions and all subsidiary thrifts met the QTL test. The Holding Companies may acquire and operate additional savings institution subsidiaries outside of Maryland and Virginia only if the laws of the target institution's state specifically permit such acquisitions or if the acquisitions are made pursuant to emergency acquisition provisions.
The Trust and the Saul Company entered into an agreement with OTS's predecessor, the Federal Savings and Loan Insurance Corporation, to maintain the Bank's regulatory capital at the required levels, and, if necessary, to infuse additional capital to enable the Bank to meet those requirements. Since the execution of this agreement, the OTS has changed its policy and now accepts more limited agreements from those acquiring thrift institutions. In addition, the regulatory capital requirements applicable to the Bank have changed significantly as a result of FIRREA. The OTS has stated that capital maintenance agreements entered into prior to such modification of OTS policy and the enactment of FIRREA were not affected by such changes. The Trust and the Saul Company have not sought to modify the existing agreement. To the extent the Bank is unable to meet regulatory capital requirements in the future, the OTS could seek to enforce the obligations of the Trust and the Saul Company under the agreement. The Bank's business plan does not contemplate any future capital contributions from the Trust or the Saul Company.
If the Bank were to become "undercapitalized" under the prompt corrective action regulations, it would be required to file a capital restoration plan with the OTS setting forth, among other things, the steps the Bank would take to become "adequately capitalized." The OTS could not accept the plan unless the Holding Companies guaranteed in writing the Bank's compliance with that plan. The aggregate liability of the Holding Companies under such a commitment would be limited to the lesser of (i) an amount equal to 5.0% of the Bank's total assets at the time the Bank became "undercapitalized" and (ii) the amount necessary to bring the Bank into compliance with all applicable capital standards as of the time the Bank fails to comply with its capital plan. If the holding companies refused to provide the guarantee, the Bank would be subject to the more restrictive supervisory actions applicable to "significantly undercapitalized" institutions.
Federal Taxation
The Trust terminated its status as a real estate investment trust for federal income tax purposes in 1978 and is now taxable as a corporation. The Trust and its subsidiaries join in the filing of a consolidated federal income tax return using the accrual method of accounting on the basis of a fiscal year ending September 30.
Since June 28, 1990 the Bank and its subsidiaries have joined in the consolidated federal income tax returns filed by the Trust on a fiscal year basis. Each member of an affiliated group of corporations which files consolidated income tax returns is liable for the group's federal income tax liability. Prior to June 28, 1990, the Bank and its subsidiaries filed a consolidated federal income tax return on a calendar-year basis.
Savings institutions such as the Bank generally are taxed in the same manner as other corporations. There are, however, several special rules that apply principally to savings institutions (and, in some cases, other financial institutions). Certain significant aspects of the federal income taxation of the Bank are discussed below.
The Internal Revenue Service ("IRS") has concluded the audits of the federal income tax returns of the Trust for the taxable years ended September 30, 1992, September 30, 1993 and September 30, 1994. The IRS audit adjustments did not have a significant adverse effect on the Trust's reported earnings under generally accepted accounting principles. The IRS has notified the Trust that its consolidated federal tax return for the fiscal year ended September 30, 1995 has been selected for review, which could lead to an IRS audit.
Bad Debt Reserve. For taxable years beginning before December 31, 1995, savings institutions that satisfied certain requirements were permitted to establish reserves for bad debts and to deduct each year reasonable additions to those reserves in lieu of taking a deduction for bad debts actually sustained during the taxable year. To qualify for this treatment, at least 60% of a savings institution's assets had to be "qualifying assets," including cash, certain U.S. and state government securities, and loans secured by interests in residential real property.
In establishing its reserves from calendar year 1988 through fiscal year 1996, the Bank calculated its bad debt deduction for tax purposes using the experience method. The experience method was based on the institution's actual loan loss experience over a prescribed period. For the year ended September 30, 1996, accumulated reserves were approximately $111.8 million.
Provisions that repealed the thrift bad debt provisions of the Internal Revenue Code were included in the Small Business Act of 1996 and took effect for tax years beginning after December 31, 1995. As a result, for its fiscal year 1997 and fiscal year 1998, the Bank is no longer able to use the "reserve method" for computing its bad debt deduction and can deduct only those bad debts actually incurred during the respective taxable years. The bad debt provisions of this legislation also require thrifts to recapture and pay tax on bad debt reserves accumulated since 1987 over a six year period, beginning with a thrift's taxable year starting after December 31, 1995 (or, if the thrift meets a loan origination test, beginning up to two years later). The Bank's accumulated reserves since 1987 which are subject to recapture under this rule are $101.3 million. The tax liability related to the recapture of the bad debt reserves accumulated since 1987 has been reflected in the Bank's financial statements as of September 30, 1998 and 1997.
Consolidated Tax Returns; Tax Sharing Payments. Generally, the operations of the Trust have generated significant net operating losses ("NOL's"). The Bank's taxable income in the current year was sufficient to fully utilize the current year tax loss of the Trust. Under the terms of a tax sharing agreement dated June 28, 1990, as amended (the "Tax Sharing Agreement"), the Bank is obligated to make payments to the Trust based on its taxable income, as explained more fully below. Under the terms of the Bank's board resolution, the Bank is permitted to make tax sharing payments to the Trust of up to $15.0 million relating to any fiscal year without OTS approval.
The Tax Sharing Agreement generally provides that each member of the Trust's affiliated group is required to pay the Trust an amount equal to 100% of the tax liability that the member would have been required to pay to the IRS if the member had filed on a separate return basis. These amounts generally must be paid even if the affiliated group has no tax liability or the group's tax liability is less than the sum of such amounts. Under the Tax Sharing Agreement, the Trust, in turn, is obligated to pay to the applicable tax authorities the overall tax liability, if any, of the group. In addition, to the extent the net operating losses or tax credits of a particular member reduce the overall tax liability of the group, the Trust is required to reimburse such member on a dollar-for-dollar basis, thereby compensating the member for the group's use of its net operating losses or tax credits. Under the Tax Sharing Agreement, the Bank and its subsidiaries are treated as a single member of the Trust's affiliated group.
The Bank made tax sharing payments of $5.6 million in fiscal 1998. The tax sharing payments were conditioned on a pledge by the Trust of certain Trust or other assets to secure certain of its obligations under the Tax Sharing Agreement. At September 30, 1998, the amount of tax sharing payments due to the Trust from the Bank was $6.6 million, which was paid subsequent to the fiscal year end. It is expected that the Bank will have taxable income in future years and additional operating losses of the Trust will be utilized to reduce the overall tax liability of the group which would otherwise arise from such taxable income of the Bank (or from the taxable income of other members of the Trust's affiliated group).
In general, if the Bank has net operating losses or unused tax credits in any taxable year, under the Tax Sharing Agreement the Trust is obligated to reimburse the Bank in an amount generally equal to (i) the tax benefit to the group of using such tax losses or unused tax credits in the group's consolidated federal income tax return for such year, plus (ii) to the extent such losses or credits are not used by the group in such year, the amount of the tax refunds which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group (but not in excess of the net amount paid by the Bank to the Trust pursuant to the Tax Sharing Agreement). There is no assurance that the Trust would be able to fulfill this obligation. If the Trust did not make the reimbursement, the OTS could attempt to characterize such nonpayment as an unsecured extension of credit by the Bank to the Trust which, as described above under "Holding Company Regulation," is prohibited under current law. The Tax Sharing Agreement itself does not provide for any remedies upon a breach by any party of its obligations under the Agreement.
The Bank, as a member of an affiliated group of corporations filing consolidated income tax returns, is liable under the Internal Revenue Code for the group's tax liability. Although the Bank would be entitled to reimbursement under the Tax Sharing Agreement for income tax paid with respect to the income of other members of the affiliated group, there can be no assurance that the Trust or other members would be able to fulfill this obligation.
State Taxation
Maryland law does not allow the filing of consolidated income tax returns, and thus the Trust and its subsidiaries, which includes the Bank and its subsidiaries, that are subject to Maryland income tax, are required to file separately in Maryland. The Trust and its subsidiaries are also subject to income taxes in other states, some of which allow or require combined or consolidated filing. The Commonwealth of Virginia has concluded audits of the consolidated state income tax returns of the Trust for the taxable years ended September 30, 1991, September 30, 1992 and September 30, 1993. The audit adjustments did not have a significant adverse effect on the Trust's reported earnings.
BANKING
Regulation
Federal Home Loan Bank System. The Bank is a member of the Federal Home Loan Bank (the "FHLB") of Atlanta. The 12 FHLBs are administered by the Federal Housing Finance Board, an independent agency within the executive branch of the federal government. The FHLBs serve as a central credit facility for their members. Their primary credit mission is to enhance the availability of residential mortgages. From time to time, the Bank obtains advances from the FHLB. At September 30, 1998, the Bank had outstanding advances from the FHLB of Atlanta of $352.0 million. See Note 21 to the Consolidated Financial Statements in this report and "Deposits and Other Sources of Funds Borrowings."
As a member of the FHLB of Atlanta, the Bank is required to acquire and hold shares of capital stock in that bank in an amount equal to the greater of: (i) 1.0% of mortgage-related assets (i.e., home mortgage loans, home-purchase contracts and similar obligations); (ii) 0.3% of total assets; (iii) $500; or (iv) 5.0% of outstanding advances. Pursuant to this requirement, the Bank had an investment of $49.0 million in FHLB stock at September 30, 1998. The Bank earned dividends of $2.4 million and $2.0 million during the years ended September 30, 1998 and 1997, respectively.
Liquidity Requirements. The Bank is required to maintain a daily average balance of liquid assets (including cash, federal funds, certain time deposits, certain bankers' acceptances, certain corporate debt securities and commercial paper, securities of certain mutual funds, certain mortgage-related securities, certain mortgage loans and U.S. Government, state government and federal agency obligations) equal to a specified percentage of its average daily balance of deposits (based upon the preceding quarter's average balances), plus borrowings (or portions thereof) payable in one year or less. Effective November 24, 1997, the OTS reduced the minimum liquidity requirement to 4.0% from 5.0% and changed the reporting requirement to quarterly instead of monthly. If an institution's liquid assets at any time do not at least equal (on an average daily basis for the quarter) the amount required by the OTS, the institution could be subject to various monetary penalties imposed by the OTS. At September 30, 1998, the Bank was in compliance with the liquidity requirement, with a liquid assets ratio of 10.4%.
Deposit Insurance Premiums. Under FDIC insurance regulations, the Bank is required to pay premiums to the Savings Association Insurance Fund (the "SAIF") for insurance of its deposit accounts. The FDIC utilizes a risk-based premium system in which an institution pays premiums for deposit insurance on its SAIF-insured deposits based on supervisory evaluations and on the institution's capital category under the OTS's prompt corrective action regulations. See "Prompt Corrective Action."
Although the FDIC insures commercial banks as well as thrifts, the insurance funds for commercial banks and thrifts have been segregated into the Bank Insurance Fund (the "BIF" ) and the SAIF, respectively. The FDIC is required to maintain the reserve levels of both the BIF and the SAIF at 1.25% of insured deposits. As a result of a one-time special assessment paid by thrift institutions pursuant to legislation enacted in 1996 to recapitalize the SAIF, a prior differential between BIF and SAIF assessment rates was eliminated and the rates for SAIF members are identical to the rates for BIF members. Beginning in 1997, commercial banks have been required to share in the payment of interest due on Financing Corporation ("FICO") bonds used to provide liquidity to the savings and loan industry in the 1980s. Annualized FICO assessments which were added to deposit insurance premiums equaled 6.25 basis points for SAIF members and 1.25 basis points for BIF members for the first semi-annual period of 1998 and 5.96 basis points for SAIF members and 1.192 basis points for BIF members for the second semi-annual period of 1998. This differential is expected to remain in effect through December 31, 1999, after which BIF and SAIF members will pay identical FICO assessments, which are expected to be approximately 2.4 basis points. Thus, the Bank and other institutions with SAIF-assessable deposits will continue to pay somewhat higher deposit insurance premiums than institutions with BIF-assessable deposits, which could lead to a competitive disadvantage in the pricing of loans and deposits.
SAIF insurance may be terminated by the FDIC, after notice and a 30-day corrective period, upon a finding by the FDIC that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The 30-day period may be eliminated by the FDIC with the approval of the OTS.
Regulatory Capital. Under OTS regulations implementing the capital requirements imposed by FIRREA, savings institutions, such as the Bank, are subject to a minimum tangible capital requirement, a minimum core (or leverage) capital requirement, and a minimum total risk-based capital requirement. Each of these requirements generally must be no less stringent than the capital standards for national banks. At September 30, 1998, the Bank's tangible, core and total risk-based regulatory capital ratios were 7.93%, 7.93% and 20.70%, respectively, compared to the minimum requirements under FIRREA of 1.50%, 3.00% and 8.00%, respectively, in effect at that date.
Under FIRREA's minimum leverage ratio, Chevy Chase must maintain a ratio of core capital to tangible assets of not less than 3.0%. However, under the OTS prompt corrective action regulations, an institution that is not in the highest supervisory category must maintain a minimum leverage ratio of 4.0% to be considered an adequately capitalized institution. See "Prompt Corrective Action." In October 1997, the OTS proposed amendments to its FIRREA capital regulations that would establish a minimum leverage ratio of 4.0% for institutions not in the highest supervisory category. Core capital generally includes common shareholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, less investments in certain subsidiaries and certain intangible assets. Prior to October 1, 1998, under interim guidance issued by the OTS, servicing assets (both mortgage and non-mortgage) and purchased credit card relationships ("PCCRs") could be included up to an aggregate amount of 50% of core capital and PCCRs and non-mortgage servicing assets were also subject to a sublimit of 25% of core capital. For these purposes, servicing assets and PCCRs are valued at the lesser of 90% of fair market value or 100% of the current unamortized book value. At September 30, 1998, the Bank had qualifying servicing assets of $27.0 million, which constituted 5.1% of core capital at that date, and had no PCCRs.
Effective October 1, 1998, the OTS and the other federal bank regulatory agencies amended their regulatory capital requirements relating to servicing assets. The final rule increases the maximum amount of servicing assets (both mortgage and non-mortgage) and PCCRs that can be included in Tier 1 capital from 50% to 100%. PCCRs and non-mortgage servicing assets are still subject to a sublimit of 25% of core capital.
Deductions from capital apply for investments in, and loans to, subsidiaries engaged in activities not permissible for national banks, for equity investments that are not permissible for national banks and for the portion of land loans and non-residential construction loans in excess of an 80% loan-to-value ratio.
The tangible capital requirement adopted by the OTS requires a savings institution to maintain tangible capital in an amount not less than 1.5% of tangible assets, which is the minimum ratio required by FIRREA. Tangible capital is defined as core capital less investments in certain subsidiaries and any intangible assets (including supervisory goodwill), plus qualifying servicing assets valued at the amount includable in core capital.
The risk-based capital requirements issued by the OTS provide that the capital ratio applicable to an asset is adjusted to reflect the degree of credit risk associated with that asset and that the asset base for computing a savings institution's capital requirement includes off-balance- sheet assets. Capital must be maintained against assets sold with recourse despite the fact that the assets are accounted for as having been sold. Pursuant to OTS's capital requirements, the Bank maintains dollar-for-dollar capital against the securitized assets in an amount equal to (i) the amounts on deposit in spread accounts, (ii) the amount of any interest-only strips relating to the securitized assets, and (iii) certain other items representing recourse for regulatory capital purposes, up to the otherwise applicable capital requirement on the underlying loans.
The OTS and the other federal bank regulatory agencies have proposed revisions to their risk-based capital regulations to address the regulatory capital treatment of recourse obligations and direct credit substitutes involving exposure to credit risk. The proposal (i) would define recourse to include, among other things, providing credit enhancement beyond any contractual obligation to support assets sold and providing representations and warranties other than those that relate to an existing state of facts that the seller can either control or verify with reasonable due diligence at the time the assets are sold; (ii) would treat direct credit substitutes and recourse obligations consistently; and (iii) would use credit ratings and possibly certain other alternative approaches to match the risk-based capital assessment more closely to an institution's relative risk of loss in asset securitizations. The agencies intend that any final rules adopted in connection with the proposal that result in increased risk-based capital requirements for an institution will apply only to transactions consummated after the effective date of any final rules.
There are currently four categories of risk-weightings: 0% for cash and similar assets, 20% for qualifying mortgage-backed securities, 50% for qualifying residential permanent real estate loans and 100% for other assets, including consumer loans, commercial real estate loans and loans more than 90 days past due and for real estate acquired in settlement of loans. Savings institutions generally are required to maintain risk-based capital equal to 8.0% of risk- weighted assets, with at least half of that amount in the form of core capital.
A savings institution's supplementary capital may be used to satisfy the risk-based capital requirement only to the extent of the institution's core capital. Supplementary capital includes cumulative perpetual preferred stock, qualifying non-perpetual preferred stock, qualifying subordinated debt, nonwithdrawable accounts and pledged deposits, and allowances for loan and lease losses (up to a maximum of 1.25% of risk-weighted assets). At September 30, 1998, the Bank had $53.0 million in allowances for general loan and lease losses, all of which was includable as supplementary capital.
Subordinated debt may be included in supplementary capital with OTS approval subject to a phase-out based on its remaining term to maturity. The phase-out established for such maturing capital instruments by the OTS permits an institution to include such instruments in supplementary capital under one of two phase-out options: (i) at the beginning of each of the last five years prior to the maturity date of the instrument, the institution may reduce the amount eligible to be included by 20% of the original amount or (ii) the institution may include only the aggregate amount of maturing capital instruments that mature in any one year during the seven years immediately prior to an instrument's maturity that does not exceed 20% of the institution's capital. Once an institution selects either the first or second option, it must continue to select the same option for all subsequent issuances of maturing capital instruments as long as there is any outstanding balance of such instruments for which an option has been selected. At September 30, 1998, the Bank had $250.0 million in maturing subordinated capital instruments, all of which was includable as supplementary capital. Of that amount, $150.0 million matures in 2005 and $100.0 million matures in 2008. See "Deposits and Other Sources of Funds - Borrowings."
The OTS has indefinitely delayed implementation of an interest-rate risk component of its risk-based capital regulation. Under that component, an institution that would experience a change in portfolio equity in an amount in excess of 2.0% of the institution's assets as a result of a 200 basis point increase or decrease in the general level of interest rates would be required to maintain additional amounts of risk-based capital based on the lowest interest rate exposure at the end of the three previous quarters. At September 30, 1998, the Bank would not have been required to maintain additional amounts of risk-based capital had the interest-rate risk component of the capital regulations been in effect.
The OTS also considers concentration of credit risk and risks arising from non-traditional activities, as well as a thrift's ability to manage these risks, in evaluating whether the thrift should be subject to an individual minimum capital requirement.
OTS regulations contain special rules affecting savings institutions with certain kinds of subsidiaries. For purposes of determining compliance with each of the capital standards, a savings institution's investments in, and extensions of credit to, subsidiaries engaged in activities not permissible for a national bank ("non-includable subsidiaries") are, with certain exceptions, deducted from the savings institution's capital. At September 30, 1998, investments in non- includable subsidiaries were fully deducted from all three FIRREA capital requirements. All or a portion of the assets of each of a savings institution's subsidiaries are generally consolidated with the assets of the savings institution for regulatory capital purposes unless all of the savings institution's investments in, and extensions of credit to, such subsidiary are deducted from capital. Chevy Chase's real estate development subsidiaries are its only subsidiaries engaged in activities not permissible for a national bank. At September 30, 1998, the Bank's investments in, and extensions of credit to, its non-includable subsidiaries totaled approximately $4.1 million, of which $3.9 million constituted a deduction from tangible capital.
OTS capital regulations also require the 100% deduction from total capital of all equity investments that are not permissible for national banks and the portion of land loans and non- residential construction loans in excess of an 80% loan-to-value ratio. The Bank's equity investments at September 30, 1998 were certain properties classified as real estate held for sale which the Bank has agreed to treat as equity investments for regulatory capital purposes. At September 30, 1998, the book value of these properties after subsequent valuation allowances, was $11.7 million, of which $11.1 million was required to be deducted from total capital. The Bank had no land loans or non-residential construction loans with loan-to-value ratios greater than 80% at September 30, 1998. The Bank has $0.8 million of general valuation allowances maintained against its non-includable subsidiaries and equity investments which, pursuant to OTS guidelines, are available as a credit against the deductions from capital otherwise required.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for real estate acquired in settlement of loans ("REO" or "real estate held for sale") to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from risk-based capital. In February 1998, the Bank received from the OTS extensions through February 17, 1999 of the holding periods for certain of its REO properties acquired through foreclosure in fiscal 1990, 1991 and 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Condition - Capital."
The Bank's ability to maintain capital compliance is dependent on a number of factors, including, for example, general economic conditions and the condition of local real estate markets. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Capital."
The OTS has the authority to require an institution to maintain capital at levels above the minimum levels generally required, but has not taken any such action with respect to the Bank.
Prompt Corrective Action. Pursuant to FDICIA, the OTS and the other federal agencies regulating financial institutions have adopted regulations which apply to every FDIC- insured commercial bank and thrift institution a system of mandatory and discretionary supervisory actions which generally become more severe as the capital levels of an individual institution decline. The regulations establish five capital categories to which institutions are assigned for purposes of determining their treatment under these prompt corrective action provisions. An institution is categorized as well capitalized under the regulations if (i) it has a leverage ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%, and (ii) is not subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level. An institution is considered adequately capitalized if such capital ratios are at least 4.0% (3.0% if rated in the highest supervisory category), 4.0% and 8.0%, respectively. An institution with a leverage ratio below 4.0% (3.0% if rated in the highest supervisory category), a tier 1 risk-based capital ratio below 4.0% or a total risk-based capital ratio below 8.0% is considered undercapitalized and an institution with ratios under 3.0%, 3.0% or 6.0%, respectively, is considered significantly undercapitalized. Finally, an institution is considered critically undercapitalized, and subject to provisions mandating appointment of a conservator or receiver, if its ratio of tangible equity (generally defined by the OTS as core capital plus cumulative perpetual preferred stock) to total assets is 2.0% or less. An institution's classification category could be downgraded if, after notice and an opportunity for a hearing, the OTS determined that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity.
At September 30, 1998, the Bank's leverage, tier 1 risk-based and total risk-based regulatory capital ratios were 7.93%, 12.93% and 20.70%, respectively, which exceeded the minimum ratios established for well capitalized institutions.
Board Resolution. At the request of the OTS, the Board of Directors of the Bank adopted a resolution in March 1996 which, among other things, permits the Bank: (i) to make tax sharing payments without OTS approval to the B.F. Saul Real Estate Investment Trust (the Trust ), which owns 80% of the Bank's Common Stock, of up to $15.0 million relating to any single fiscal year; and (ii) to declare dividends on its stock in any quarterly period up to the lesser of (A) 50% of its after tax net income for the immediately preceding quarter or (B) 50% of the average quarterly after tax net income for the immediately preceding four quarter period, minus (in either case) dividends declared on the Bank's preferred stock during that quarterly period. The resolution also provides that the Bank will present a plan annually to the OTS detailing anticipated consumer loan securitization activity.
Qualified Thrift Lender ("QTL") Test. Insured savings institutions like the Bank must meet a QTL test to avoid imposition of certain restrictions. The QTL test requires thrifts to maintain a thrift investment percentage equal to a minimum of 65%. The numerator of such percentage is the thrift's qualified thrift investments and the denominator is the thrift's portfolio assets. Portfolio assets is defined as total assets minus (i) the thrift's premises and equipment used to conduct its business, (ii) liquid assets, as defined up to 20 percent of total assets, and (iii) intangible assets, including goodwill. The QTL test must be met on a monthly average basis in nine out of every 12 months.
The Bank had 86.7% of its assets invested in qualified thrift investments at September 30, 1998, and met the QTL test in each of the previous 12 months.
A thrift's qualified thrift investments consist of residential housing loans (including home equity loans and manufactured housing loans), mortgage-backed securities, FHLB and Federal National Mortgage Association stock, small business loans, credit card and educational loans. Portions of other assets are also includable, provided that the total of these assets does not exceed 20% of portfolio assets. Assets in this category include consumer loans (other than credit card and educational loans), 50% of residential housing loans originated and sold within 90 days, investments in real estate-oriented service corporations, 200% of mortgage loans for residences, churches, schools, nursing homes and small businesses in areas with unmet credit needs (low or moderate income areas where credit demand exceeds supply). Intangible assets, including goodwill, are specifically excluded from qualified thrift investments.
An institution that fails to meet the QTL test is subject to significant penalties. Immediately after an institution ceases to meet the QTL test, it (i) may not make any new investment or engage directly or indirectly in any other new activity unless the investment or activity would be permissible for a national bank, (ii) may not establish any new branch office at any location at which a national bank could not establish a branch office, (iii) may not obtain new advances from the applicable FHLB and (iv) may not pay dividends beyond the amounts permissible if it were a national bank. One year following an institution's failure to meet the test, the institution's holding company parent must register and be subject to supervision as a bank holding company. Three years after failure to meet the QTL test, an institution may not retain any investments or engage in any activities that would be impermissible for a national bank, and must repay any outstanding FHLB advances as promptly as possible consistent with the safe and sound operation of the institution. Failure to meet the QTL test also could limit the Bank's ability to establish and maintain branches outside of its home state of Virginia.
Because Chevy Chase is engaged in activities that are not currently permissible for national banks, such as investing in subsidiaries that engage in real estate development activities, failure to satisfy the QTL test would require Chevy Chase to terminate these activities and divest itself of any prohibited assets held at such time. Based on a review of the Bank's current activities, management of the Bank believes that compliance with these restrictions would not have a significant adverse effect on the Bank. In addition, because the Trust is engaged in real estate ownership and development, which are activities that are currently prohibited for bank holding companies, failure by Chevy Chase to meet the QTL test, in the absence of a significant restructuring of the Trust's operations, would, in effect, require the Trust to reduce its ownership of Chevy Chase to a level at which it no longer would be deemed to control the Bank.
The Bank has taken, and will continue to take, steps to meet the QTL test by structuring its balance sheet to include the required percentage of qualified thrift investments.
Dividends and Other Capital Distributions. Under OTS regulations, the ability of thrift institutions such as the Bank to make capital distributions (defined to include payment of dividends, stock repurchases, cash-out mergers and other distributions charged against the capital accounts of an institution) varies depending primarily on the institution's earnings and regulatory capital levels. The regulations do not apply to interest or principal payments on debt, including interest or principal payments on the Bank's outstanding subordinated debentures.
Institutions are divided into two tiers for purposes of these regulations. Tier 1 institutions are those in compliance with their capital requirements and which have not been notified by the OTS that they are in need of more than normal supervision. Tier 1 institutions may make capital distributions without regulatory approval in amounts up to the greater of (i) 100% of net income for the calendar year to date, plus up to one-half of the institution's surplus capital (i.e., the excess of capital over the fully phased-in requirements) at the beginning of the calendar year in which the distribution is made or (ii) 75% of net income for the most recent four quarters. Tier 1 institutions that make capital distributions under the foregoing rules must continue to meet the applicable capital requirements on a pro forma basis after giving effect to such distributions. Tier 1 institutions may seek OTS approval to pay dividends beyond these amounts.
The definition of Tier 2 institutions is no longer applicable because all deductions from capital requirements have been fully phased-in as of July 1, 1996. All institutions are classified as either Tier 1 or Tier 3 institutions since that date.
Tier 3 institutions have capital levels below their current required minimum levels and may not make any capital distributions without the prior written approval of the OTS.
At September 30, 1998, the Bank had sufficient levels of capital to be a Tier 1 institution for purposes of the capital distribution regulation. However, the OTS retains discretion under its capital distribution regulation to treat an institution that is in need of more than normal supervision (after written notice) as a Tier 2 or Tier 3 institution.
The OTS retains general discretion to prohibit any otherwise permitted capital distributions on general safety and soundness grounds and must be given 30 days advance notice of all capital distributions. The OTS has approved the payment of dividends on the Bank's outstanding 13% Noncumulative Perpetual Preferred Stock, Series A (the "13% Preferred Stock"), provided that (i) immediately after giving effect to the dividend payment, the Bank's core and risk-based regulatory capital ratios would not be less than 4.0% and 8.0%, respectively; (ii) dividends are earned and payable in accordance with the OTS capital distribution regulation; and (iii) the Bank continues to make progress in the disposition and reduction of its non-performing loans and real estate owned.
Although the Bank believes that dividends paid on the 10 3/8% Noncumulative Exchangeable Preferred Stock, Series, A, (the "REIT Preferred Stock") issued by Chevy Chase Preferred Capital Corporation (the "REIT Subsidiary") should not be considered capital distributions for this purpose, there can be no assurances that the OTS would agree with this position. Without addressing the issue of whether dividends on the REIT Preferred Stock are capital distributions subject to the regulations, the OTS has indicated that it would not object to the REIT Subsidiary's payment of quarterly dividends on the REIT Preferred Stock in an amount up to the amount of the REIT Subsidiary's net income for that quarter. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Capital." The REIT Subsidiary currently expects that its net income will be in excess of amounts needed to pay dividends on the REIT Preferred Stock. However, dividends paid on the REIT Preferred Stock in excess of the REIT Subsidiary's net income could be treated as capital distributions by the OTS, in which case the REIT Subsidiary's payment of such dividends would be subject to restrictions under the OTS capital distribution regulations. Moreover, if dividends on the REIT Preferred Stock were treated as capital distributions, they would be included, together with dividends paid on the 13% Preferred Stock and the common stock of the Bank, in calculating the amount of capital distributions that could be paid by the Bank without obtaining OTS approval.
In January 1998, the OTS proposed to amend its capital distribution regulations. The proposal would expand the definition of capital distribution to include repurchases of subordinated debt and requested comment on whether to treat dividends paid by an operating subsidiary such as the REIT Subsidiary as capital distributions. Under the proposal, the Bank would be required to file an application with the OTS to make any capital distribution regardless of its size if the Bank did not qualify for expedited treatment under OTS regulations. If the Bank qualified for expedited treatment, an application would be required only if the total amount of all of the Bank's capital distributions for the year exceeded the sum of the Bank's net income for the year and the retained net income for the previous two years. However, as is the case under current OTS regulations, a notice would be required for any capital distribution because the Bank is a subsidiary of a savings and loan holding company. In considering an application or notice, the proposal provides that the OTS will not permit a capital distribution if (i) the Bank would be undercapitalized following the distribution; (ii) the capital distribution raises safety and soundness concerns; or (iii) the capital distribution violates any statute, regulation, agreement with the OTS, or condition imposed by the OTS.
In May 1988, in connection with the merger of a Virginia thrift into the Bank, the B.F. Saul Company (the "Saul Company") and the Trust entered into a capital maintenance agreement in which they agreed not to cause the Bank without prior written approval of its federal regulator to pay dividends in any fiscal year in excess of 50% of the Bank's net income for that fiscal year, provided that any dividends permitted under such limitation could be deferred and paid in a subsequent year. However, under both the current and the proposed OTS capital distribution rule, with the approval of the OTS, the Bank could substitute the requirements of the OTS capital distribution rule for any more stringent requirements imposed on it by a previous written agreement.
The Bank is subject to other limitations on its ability to pay dividends. The indenture pursuant to which $150 million principal amount of the Bank's 9 1/4% Subordinated Debentures due 2005 was issued in 1993 (the "1993 Indenture") provides that the Bank may not pay dividends on its capital stock unless, after giving effect to the dividend, no event of a continuing default shall have occurred and the Bank is in compliance with its regulatory capital requirements. In addition, the amount of the proposed dividend may not exceed the sum of (i) $15 million, (ii) 66 2/3% of the Bank's consolidated net income (as defined) accrued on a cumulative basis commencing on October 1, 1993 and (iii) the aggregate net cash proceeds received by the Bank after October 1, 1993 from the sale of qualified capital stock or certain debt securities, minus the aggregate amount of any restricted payments made by the Bank. Notwithstanding these restrictions on dividends, provided no event of default has occurred or is continuing under the 1993 Indenture, the 1993 Indenture does not restrict the payment of dividends on the 13% Preferred Stock or any payment-in-kind preferred stock issued in lieu of cash dividends on the 13% Preferred Stock or the redemption of any such payment-in-kind preferred stock. The indenture pursuant to which $100 million principal amount of the Bank's 1996 Debentures was issued provides that the proposed dividend may not exceed the sum of the restrictions discussed above for the 1993 Indenture and the aggregate liquidation preference of the Bank's 10 3/8% Noncumulative Preferred Stock, Series B (the "Series B Preferred Stock"), if issued in exchange for the outstanding REIT Preferred Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Capital and Security Ownership of Certain Beneficial Owners and Management."
At the request of the OTS, the Board of Directors of the Bank adopted a resolution which permits the Bank to declare dividends on its stock in any quarterly period up to the lesser of (i) 50% of its after tax net income for the immediately preceding quarter or (ii) 50% of the average quarterly after tax net income for the immediately preceding four quarter period, minus (in either case) dividends declared on the Bank's 13% Preferred Stock during that quarterly period.
The payment of any dividends on the Bank's common stock and preferred stock will be determined by the Board of Directors based on the Bank's liquidity, asset quality profile, capital adequacy and recent earnings history, as well as economic conditions and other factors deemed relevant by the Board of Directors, including applicable government regulations and policies. See "Deposits and Other Sources of Funds - Borrowings."
Lending Limits. With certain exceptions, the Bank is prohibited from lending to one borrower (including certain related entities of the borrower) amounts in excess of 15% of the institution's unimpaired capital and unimpaired surplus, plus an additional 10% for loans fully secured by readily marketable collateral. The Bank's regulatory loans-to-one-borrower limit was approximately $125.6 million at September 30, 1998, and no group relationships exceeded this limit at that date.
Safety and Soundness Standards. The federal financial institution regulators have developed standards to evaluate the operations of depository institutions, as well as standards relating to asset quality, earnings and compensation. The operational standards cover internal controls and audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and employee compensation. An institution that fails to meet a standard that is imposed through regulation may be required to submit a plan for corrective action within 30 days. If a savings association fails to submit or implement an acceptable plan, the OTS must order it to correct the deficiency, and may restrict its rate of asset growth, prohibit asset growth entirely, require the institution to increase its ratio of tangible equity to assets, restrict the interest rate paid on deposits to the prevailing rates of interest on deposits of comparable amounts and maturities, or require the institution to take any other action the OTS determines will better carry out the purpose of prompt corrective action. Imposition of these sanctions is within the discretion of the OTS in most cases, but is mandatory if the savings institution commenced operations or experienced a change in control during the 24 months preceding the institution's failure to meet these standards, or underwent extraordinary growth during the preceding 18 months.
The asset quality standards require that an insured depository institution establish and maintain a system to identify problem assets and prevent deterioration in those assets. The earnings standards require that an insured depository institution establish and maintain a system to evaluate and monitor earnings and ensure that earnings are sufficient to maintain adequate capital and reserves.
Regulatory Assessments. The OTS imposes the following fees to fund its operations: (i) asset-based assessments for all savings institutions, (ii) examination fees for certain affiliates of savings associations, (iii) application fees, (iv) securities filing fees and (v) publication fees. Of these fees, the semi-annual asset-based assessments (which for the Bank totaled $867,000 for the twelve-month period ending December 31, 1998) are the most significant.
Effective January 1, 1999, the OTS will charge examination and supervisory assessments based on a revised formula intended to more accurately reflect OTS's estimates of the actual cost of examining and supervising an institution. Unlike the current formula, the revised formula will impose a surcharge on institutions with a CAMELS rating of 3 (in addition to institutions with a CAMELS rating of 4 or 5 that currently pay a surcharge) and on complex institutions, which OTS defines as any institution with significant amounts (i.e., over $1 billion) of certain off-balance sheet assets (specifically, loans serviced for others, trust assets and recourse obligations or direct credit substitutes). The Bank anticipates that its assessments will increase under the revised formula.
Other Regulations and Legislation. Chevy Chase must obtain prior approval of the OTS before merging with another institution or before increasing its insured accounts through merger, consolidation, purchase of assets or assumption of liabilities. Also, as a SAIF-insured institution, the Bank is subject to limitations on its ability to buy or sell deposits from or to, or to combine with, a BIF-insured institution. Despite these restrictions, SAIF-insured thrifts may be acquired by banks or by bank holding companies under certain circumstances.
The federal agencies regulating financial institutions possess broad enforcement authority over the institutions they regulate, including the authority to impose civil money penalties of up to $1 million per day for violations of laws and regulations.
Federally chartered thrifts like Chevy Chase generally are permitted to establish new branches anywhere in the United States, provided that they meet the QTL test and their regulatory capital requirements and have at least a satisfactory rating under the Community Reinvestment Act ("CRA").
Amounts realized by the FDIC from the liquidation or other resolution of any insured depository institution must be distributed to pay claims (other than secured claims to the extent of any such security) in the following order of priority: (i) administrative expenses of the receiver, (ii) any deposit liability of the institution, (iii) any other general or senior liability of the institution (which is not an obligation described in clause (iv) or (v)), (iv) any obligation subordinated to depositors or general creditors (which is not an obligation described in clause (v)) and (v) any obligation to stockholders arising as a result of their status as stockholders.
The OTS and the other federal bank regulatory agencies have requested comment on possible changes to the existing regulatory classification policies for retail credit. Among the changes being considered are adoption of: (i) a uniform charge-off policy for open-end and closed-end credit; (ii) a charge-off policy for loans affected by bankruptcy, fraudulent activity, and/or death of a borrower; (iii) a policy for treatment of partial payments; (iv) a prudent reaging policy for past due accounts; and (v) a classification policy for delinquent residential mortgage and home equity loans. The Bank is unable to predict at this time what, if any, changes will be made to the existing policies.
Pending Legislation
Thrift Charter Legislation. Legislation passed in 1996 requires the merger of the BIF and the SAIF into a single Deposit Insurance Fund on January 1, 1999, but only if the thrift charter is eliminated by that date. Because the 105th Congress did not enact legislation eliminating the thrift charter, no such merger will take place on January 1, 1999. Although earlier versions of financial modernization legislation considered by the 105th Congress would have required federal thrifts, like the Bank, to convert their charters to national or state bank charters, the versions of the legislation passed by the House of Representatives and by the Senate Banking Committee prior to adjournment would not have required the Bank to convert its charter. If legislation requiring the Bank to convert its charter were enacted and did not contain appropriate grandfather provisions, such legislation could have an adverse effect on the Bank and the Trust because, among other things, the Trust engages in activities that are not permissible for bank holding companies and the regulatory capital and accounting treatment for banks and thrifts differs in certain significant respects. The Bank cannot determine at this time whether, or in what form, such legislation may eventually be enacted, and there can be no assurances that any such legislation that is enacted will contain adequate grandfather rights for the Bank or the Trust.
Federal Reserve System
The Federal Reserve Board (the "FRB") requires depository institutions, including federal savings banks, to maintain reserves against their transaction accounts and certain non-personal deposit accounts. Because reserves generally must be maintained in cash or non-interest-bearing accounts, the effect of the reserve requirement is to decrease the Bank's earning asset base. FRB regulations generally require that reserves be maintained against net transaction accounts. Prior to December 1, 1998, the first $4.7 million of a depository institution's transaction accounts were subject to a 0% reserve requirement. The next $43.1 million in net transaction accounts were subject to a 3.0% reserve requirement and any net transaction accounts over $47.8 million were subject to a 10.0% reserve requirement. Effective December 1, 1998, the FRB increased the amount of transaction accounts subject to a 0% reserve requirement from $4.7 million to $4.9 million and decreased the low reserve tranche from $43.1 million to $41.6 million. The Bank met its reserve requirements for each period during the year ended September 30, 1998. The balances maintained to meet the reserve requirements imposed by the FRB also may be used to satisfy liquidity requirements which are imposed by the OTS.
Savings institutions may borrow from the FRB discount window, although FRB regulations require these institutions to exhaust all reasonable alternate sources of funds, including FHLB sources, before borrowing from the FRB. FDICIA imposes additional limitations on the ability of the FRB to lend to undercapitalized institutions through the discount window.
Community Reinvestment Act
Under the CRA and the OTS's regulations, a savings association has a continuing and affirmative obligation to help meet the credit needs of its local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In connection with its examination of a savings association, the OTS is required to assess the institution's record in satisfying the intent of the CRA. In addition, the OTS is required to take into account the institution's record of meeting the credit needs of its community in determining whether to grant approval for certain types of applications.
The Bank is committed to fulfilling its CRA obligation by providing access to a full range of credit-related products and services to all segments of its community. Based on the last OTS examination covering the period from January 1995 through June 1997, the Bank received an outstanding CRA rating, the highest rating given by the OTS.
Institutions like the Bank, with more than $250 million in assets, are evaluated primarily on the basis of their lending and investment in, and provision of services, to low- and moderate-income areas unless they request designation and receive approval as wholesale or limited purpose institutions or have been approved for evaluation under a strategic plan.
In August 1994, Chevy Chase and its subsidiary, B. F. Saul Mortgage Company (together, the "Companies"), entered into an agreement with the United States Department of Justice (the "Department") which committed them to continue the types of lending practices, branching strategies and promotional programs that are designed to increase the level of banking services available to traditionally underserved areas of the Washington, D.C. metropolitan area. Specifically, the Companies agreed to invest $11.0 million in the African-American community of the Washington, D.C. metropolitan area over a five-year period. This commitment obligated the Companies to (i) provide $7.0 million over the five-year period in subsidies for below- market mortgage loans to residents of designated majority African-American neighborhoods in Washington, D.C. and Prince George's County, Maryland; (ii) open two additional mortgage offices in majority African-American neighborhoods in the metropolitan Washington, D.C. area; and (iii) open one new deposit branch in the Anacostia area of Washington, D.C. The Companies also agreed over the same five-year period, among other things, to continue efforts to increase their promotional efforts targeted to residents of African-American neighborhoods, to continue efforts to recruit African-Americans for loan production positions, and to continue various employee training programs. The Companies view these efforts as continuations of their existing programs.
Other Aspects of Federal Law
The Bank is also subject to federal statutory provisions covering other items, including security procedures, currency transactions reporting, insider and affiliated party transactions, management interlocks, truth-in-lending, electronic funds transfers, funds availability and equal credit opportunity.
Holding Company Regulation
The Trust and the Saul Company. The Trust and the Saul Company, by virtue of their direct and indirect control of the Bank (see "Security Ownership of Certain Beneficial Owners and Management"), and Chevy Chase Property Company ("CCPC") and CCPC's wholly-owned subsidiary Westminster Investing Corporation ("Westminster"), by virtue of Westminster's direct and indirect ownership of 24.9% of the common stock of the Trust (collectively the "Holding Companies"), are savings and loan holding companies subject to regulation, examination and supervision by the OTS. The Bank is prohibited from making or guaranteeing loans or advances to or for the benefit of the Holding Companies or other affiliates engaged in activities beyond those permissible for bank holding companies and from investing in the securities of the Holding Companies or other affiliates. Further, transactions between the Bank and the Holding Companies must be on terms substantially the same, or at least as favorable to the Bank, as those that would be available to non-affiliates.
The Holding Companies must obtain the prior approval of the OTS before acquiring by merger, consolidation or purchase of assets any federally insured savings institution or any savings and loan holding company. As unitary savings and loan holding companies, the Holding
Companies are virtually unrestricted in the types of business activities in which they may engage, provided the Bank continues to meet the QTL test. See "Qualified Thrift Lender ("QTL") Test." If the Holding Companies were to acquire one or more federally insured institutions and operate them as separate subsidiaries rather than merging them into the Bank, the Holding Companies would become multiple savings and loan holding companies. As multiple savings and loan holding companies, the Holding Companies would be subject to limitations on the types of business activities in which they would be permitted to engage, unless the additional thrifts were troubled institutions acquired pursuant to certain emergency acquisition provisions and all subsidiary thrifts met the QTL test. The Holding Companies may acquire and operate additional savings institution subsidiaries outside of Maryland and Virginia only if the laws of the target institution's state specifically permit such acquisitions or if the acquisitions are made pursuant to emergency acquisition provisions.
The Trust and the Saul Company entered into an agreement with OTS's predecessor, the Federal Savings and Loan Insurance Corporation, to maintain the Bank's regulatory capital at the required levels, and, if necessary, to infuse additional capital to enable the Bank to meet those requirements. Since the execution of this agreement, the OTS has changed its policy and now accepts more limited agreements from those acquiring thrift institutions. In addition, the regulatory capital requirements applicable to the Bank have changed significantly as a result of FIRREA. The OTS has stated that capital maintenance agreements entered into prior to such modification of OTS policy and the enactment of FIRREA were not affected by such changes. The Trust and the Saul Company have not sought to modify the existing agreement. To the extent the Bank is unable to meet regulatory capital requirements in the future, the OTS could seek to enforce the obligations of the Trust and the Saul Company under the agreement. The Bank's business plan does not contemplate any future capital contributions from the Trust or the Saul Company.
If the Bank were to become undercapitalized under the prompt corrective action regulations, it would be required to file a capital restoration plan with the OTS setting forth, among other things, the steps the Bank would take to become adequately capitalized. The OTS could not accept the plan unless the Holding Companies guaranteed in writing the Bank's compliance with that plan. The aggregate liability of the Holding Companies under such a commitment would be limited to the lesser of (i) an amount equal to 5.0% of the Bank's total assets at the time the Bank became undercapitalized and (ii) the amount necessary to bring the Bank into compliance with all applicable capital standards as of the time the Bank fails to comply with its capital plan. If the holding companies refused to provide the guarantee, the Bank would be subject to the more restrictive supervisory actions applicable to significantly undercapitalized institutions. See "Prompt Corrective Action."
Recent Accounting Pronouncements
SFAS No. 130, Reporting Comprehensive Income ("SFAS 130") was issued in June 1997 and establishes accounting standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 also requires an enterprise to classify items of other comprehensive income by their nature in a financial statement and to display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS 130 is effective for fiscal years beginning after December 15, 1997. Because SFAS 130 addresses only disclosure related issues, its adoption will not have an impact on the Bank's financial condition or its results of operations.
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information ("SFAS 131"), was also issued in June 1997. SFAS 131 establishes accounting standards for the way business enterprises report information about operating segments in annual and interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS 131 requires that a business enterprise report financial and descriptive information, including profit or loss, certain specific revenue and expense items, and segment assets, about its reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by management in deciding how to allocate resources and in assessing performance. SFAS 131 is effective for financial statements for fiscal years beginning after December 15, 1997. Because SFAS 131 addresses only disclosure related issues, its adoption will not have an impact on the Bank's financial condition or its results of operations.
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued in June 1998 and establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS 133 is effective for fiscal years beginning after June 15, 1999. The impact of SFAS 133 on the Bank's financial statements has not yet been determined.
SFAS No. 134, Accounting for Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of FASB Statement No. 65 ("SFAS 134"), was issued in October 1Mortgage Banking Activities to require that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. SFAS 134 conforms the subsequent accounting for securities retained after the securitization of mortgage loans by a mortgage banking enterprise with the subsequent accounting for securities retained after the securitization of other types of assets by a nonmortgage banking enterprise. SFAS 134 is effective for the first fiscal quarter beginning after December 15, 1998.
Market Area
The Bank's principal deposit and lending markets are located in the Washington, D.C. metropolitan area. Service industries and federal, state and local governments employ a significant portion of the Washington, D.C. area labor force, while a substantial number of the nation's 500 largest corporations have some presence in the area. The Washington, D.C. area's seasonally unadjusted unemployment rate is generally below the national rate and was 3.3% in September 1998, compared to the national rate of 4.4%.
Chevy Chase historically has relied on retail deposits originated in its branch network as its primary funding source. See "Deposits and Other Sources of Funds." Chevy Chase's principal market for deposits consists of Montgomery and Prince George's Counties in Maryland and Fairfax County in Virginia. Approximately 13.3% of the Bank's deposits at September 30, 1998 were obtained from depositors residing outside of Maryland and Northern Virginia. Chevy Chase had the largest market share of deposits in Montgomery County, and ranked third in market share of deposits in Prince George's County at June 30, 1997, according to the most recently published industry statistics. The per capita income of each of Montgomery and Fairfax Counties ranks among the highest of counties and equivalent jurisdictions nationally. These two counties are also the Washington, D.C. area's largest suburban employment centers, with a substantial portion of their labor force consisting of federal, state and local government employees. Private employment is concentrated in services and retail trade centers. Unemployment in Montgomery and Fairfax Counties in September 1998 (2.4% and 1.9%, respectively) was below the national rate (4.4%) and state rates (4.3% for Maryland and 3.2% for Virginia) for the same month.
The Bank historically has concentrated its lending activities in the Washington, D.C. metropolitan area. See "Lending Activities."
Investment and Other Securities
The Bank is required by OTS regulations to maintain a specific minimum amount of liquid assets and short-term liquid assets invested in certain qualifying types of investments. See "Regulation - Liquidity Requirements." To meet these requirements, the Bank maintains a portfolio of cash, federal funds and mortgage-backed securities with final maturities of five years or less. The balance of investments in excess of regulatory requirements reflects management's objective of maintaining liquidity at a level sufficient to assure adequate funds to meet expected and unexpected balance sheet fluctuations.
The Bank classifies its investment and mortgage-backed securities as either held-to-maturity, available-for-sale or trading at the time such securities are acquired. All investment securities and mortgage-backed securities are classified as held-to-maturity at September 30, 1998 and 1997.
As part of its mortgage banking activities, the Bank exchanges loans held for sale for mortgage-backed securities and then sells the mortgage-backed securities, which are classified as trading securities, to third party investors in the month of issuance. Gains and losses on sales of trading securities are determined using the specific identification method. There were no mortgage-backed securities classified as trading securities at September 30, 1998 and 1997.
At September 30, 1998 and 1997, the Bank held automobile receivables-backed securities which were classified as trading securities. These securities were established in conjunction with two automobile loan securitization transactions and represent subordinate classes of certificates retained by the Bank.
Lending Activities
Loan Portfolio Composition. At September 30, 1998, the Bank's loan portfolio totaled $2.8 billion, which represented 41.2% of its total assets. (All references in this report to the Bank's loan portfolio refer to loans, whether they are held for sale and/or securitization or for investment, and exclude mortgage-backed securities.) Loans collateralized by single-family residences constituted 70.6% of the loan portfolio at that date.
The following table sets forth information concerning the Bank's loan portfolio (net of unfunded commitments) for the periods indicated.
The Bank adjusts the composition of its loan portfolio in response to a variety of factors, including regulatory requirements and asset and liability management objectives. In addition, the composition of the Bank's loan portfolio as of September 30, 1998 was significantly affected by the sale of the Bank's credit card portfolio on that date. See "Regulation - Regulatory Capital," "Qualified Thrift Lender ("QTL") Test" and "Federal Taxation - Bad Debt Reserve" and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Asset and Liability Management."
Contractual Principal Repayments of Loans. The following table shows the scheduled contractual principal repayments of the Bank's loans at September 30, 1998. The entire balance of loans held for sale and/or securitization is shown in the year ending September 30, 1999, because such loans are expected to be sold in less than one year.
Actual payments may not reflect scheduled contractual principal repayments due to the effect of loan refinancings, prepayments and enforcement of due-on-sale clauses, which give the Bank the right to declare a conventional loan -- one that is neither insured by the Federal Housing Administration ("FHA") nor partially guaranteed by the Veterans' Administration ("VA") -- immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. Although the Bank's single- family residential loans historically have had stated maturities of generally 30 years, such loans normally have remained outstanding for substantially shorter periods because of these factors. At September 30, 1998, principal repayments of $211.0 million are contractually due within the next year. Of this amount, $69.1 million is contractually due on fixed-rate loans and $141.9 million is contractually due on adjustable-rate loans.
Origination, Purchase and Sale of Real Estate Loans. As a federally chartered savings institution, the Bank has general authority to make loans secured by real estate located throughout the United States. The following table shows changes in the composition of the Bank's real estate loan portfolio and the net change in mortgage-backed securities.
Single-Family Residential Real Estate Lending. The Bank originates a variety of loans secured by single-family residential structures. At September 30, 1998, $2.0 billion (or 70.6%) of the Bank's loan portfolio consisted of loans secured by first or second mortgages on such properties, as compared to $944.0 million (or 36.9%) at September 30, 1997. Of these amounts, $25.5 million and $13.4 million consisted of FHA-insured or VA-guaranteed loans at September 30, 1998 and 1997, respectively. Approximately 77.8% of the Bank's single-family residential real estate loans at September 30, 1998, by principal balance, were secured by properties located in Maryland, Virginia or the District of Columbia.
The Bank originates VA, FHA and a wide variety of conventional residential mortgage loans through its wholly-owned mortgage banking subsidiary, B. F. Saul Mortgage Company, and through Chevy Chase Mortgage, a division of the Bank. Chevy Chase currently offers fixed-rate loans with maturities of 10 to 30 years and adjustable-rate residential mortgage loans ("ARMs"), principally with maturities of 30 years.
The Bank maintains a wholesale network of correspondents, including loan brokers and financial institutions, in order to supplement its direct origination of single-family residential mortgage loans. The Bank determines the specific loan products and rates under which the correspondents originate the loans, and subjects the loans to the Bank's underwriting criteria and review. During the year ended September 30, 1998, approximately $1.6 billion of loans settled under the correspondent program.
Interest rates on the majority of the Bank's ARMs are adjusted based on changes in yields on U.S. Treasury securities of varying maturities. The interest rate adjustment provisions of the Bank's ARMs contain limitations on the frequency and maximum amount of interest rate adjustments, although such limitations are not required by law. These limitations are determined by a variety of factors, including mortgage loan competition in the Bank's markets. The ARMs currently offered by the Bank are generally subject to a limitation on the annual increase in the interest rate of 2.0% and a limitation on the increase in the interest rate over the term of the loan ranging from 6.0% to 9.0%. At September 30, 1998, 36.0% of the Bank's residential mortgage loans were comprised of ARMs.
During the current fiscal year, the Bank continued to fulfill its $1.0 billion five-year loan commitment made in 1994 to meet the credit needs of low- and moderate-income borrowers in the various communities which it serves. As part of this commitment, the Bank's Community Development Fund is providing $140.0 million of mortgage financing over a five- year period, with $7.0 million in subsidies for below-market mortgage loans, to families in minority neighborhoods in the District of Columbia and Prince George's County, Maryland.
Loan sales provide the Bank with liquidity and additional funds for lending, enabling the Bank to increase the volume of loans originated and thereby increase loan interest and fee income, and in recent periods have produced additional non-interest income in the form of gains on sales of loans. In fiscal 1998, sales of mortgage loans originated or purchased for sale by the Bank totaled $124.3 million. The marketability of loans, loan participations and mortgage- backed securities depends on purchasers' investment limitations, general market and competitive conditions, mortgage loan demand and other factors. The Bank's conforming fixed-rate, single- family loans are originated on terms which conform to Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA") and Government National Mortgage Association ("GNMA") guidelines in order to facilitate the sale and/or securitization of the mortgage loan. In order to manage its interest-rate exposure, the Bank hedges its held for sale fixed-rate mortgage loan pipeline by entering into whole loan and mortgage-backed security forward sale commitments. Sales of residential mortgage loans are generally made without recourse to the Bank. At September 30, 1998, the Bank had $56.3 million of single-family residential loans held for sale to investors.
From time to time, as part of its capital and liquidity management plans, the Bank may consider exchanging loans held in its portfolio for lower risk-weighted mortgage-backed securities and retaining those securities in its portfolio rather than selling them in the secondary mortgage market. During fiscal 1998, the Bank exchanged $1.2 billion of single-family residential loans held in its portfolio for mortgage-backed securities which the Bank retained for its own portfolio.
When the Bank sells a residential whole loan or loan participation and retains servicing, or purchases mortgage servicing assets from third parties, it collects and remits loan payments, inspects the properties, makes certain insurance and tax payments on behalf of borrowers and otherwise services the loans. The servicing fee, generally ranging from 0.25% to 0.50% of the outstanding loan principal amount per annum, is recognized as income over the life of the loans. The Bank also typically derives income from temporary investment for its own account of loan collections pending remittance to the participation or whole loan purchaser. At September 30, 1998, the Bank was servicing residential permanent loans totaling $4.0 billion for other investors. See "Loan Servicing."
Sales of Mortgage-Backed Securities. The Bank originates and sells mortgage-backed securities pursuant to its normal mortgage banking operations, which are generally issued in the same month as they are sold. The securities are formed from conforming fixed-rate loans originated for sale or from conforming fixed-rate loans resulting from the borrower's election to convert from an adjustable-rate loan to a fixed-rate loan. Mortgage-backed securities held for sale in conjunction with mortgage banking activities are classified as trading securities. As a result of the sale of trading securities in the month such securities are formed, the Consolidated Statements of Cash Flows in this report reflect significant proceeds from the sales of trading securities, even though there are no balances of such securities at September 30, 1998.
Home Equity Lending. The Bank's home equity credit line loan provides revolving credit secured principally by a second mortgage on the borrower's home. Such loans are originated directly by the Bank. Home equity credit line loans bear interest at a variable rate that adjusts monthly based on changes in the applicable interest rate index and generally are subject to a maximum annual interest rate of between 18.0% and 24.0%. Generally, except for any amortization of principal that may occur as a result of monthly payments, there are no required payments of principal until maturity. In order to promote its home equity credit line loan program, the Bank currently offers prospective borrowers a below-market interest rate for an introductory period and settlement without closing costs.
During fiscal 1998, the Bank purchased $53.2 million of home equity credit line loans at a premium. The Bank may make additional purchases of such loans in the future as a way to supplement its direct origination of such loans.
Securitization and sale of home equity receivables has been an important element of the Bank's strategies to enhance liquidity and to maintain compliance with regulatory capital requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Condition." The Bank transferred $298.8 million, $170.6 million and $96.5 million of home equity receivables in fiscal 1998, fiscal 1997 and fiscal 1996, respectively, to trusts for securitization and sale to investors. Gains of $19.7 million, $11.8 million and $4.7 million were recognized by the Bank as a result of these transactions. The Bank continues to service the underlying accounts.
Commercial Real Estate and Construction Lending. Commercial real estate, real estate construction and ground loans are originated directly by the Bank. Aggregate balances of residential and commercial construction, ground and commercial real estate and multifamily loans increased 68.2% in fiscal 1998 to $182.5 million at September 30, 1998, from $108.5 million at September 30, 1997. The Bank provides financing, generally at market rates, to certain purchasers of its real estate owned ("REO"). Additionally, the Bank finances the construction of residential real estate, principally single-family detached homes and townhouses, but generally only when a home is under contract for sale by the builder to a consumer.
Commercial Lending. Commercial loans are originated, underwritten, and managed by the Bank's Business Banking Group. The Bank makes loans to business entities for a variety of purposes, including working capital, acquisitions of machinery and equipment or other assets, and facilitating cash flows. The Bank also provides acquisition, construction and permanent financing of real estate used in the borrower's business. A wide variety of products are offered, including revolving lines of credit for working capital or seasonal needs; term loans for the financing of fixed assets; letters of credit; cash management services; and other deposit and investment products. Business development efforts have been concentrated in the major industry groups in the metropolitan Washington, D.C. area, as well as a broad base of businesses and community service organizations. Commercial loans increased $75.8 million during fiscal 1998 from $98.3 million at September 30, 1997 to $174.1 million at September 30, 1998. Of the $174.1 million, 26.9% represents participations by the Bank in commercial loans originated by other financial institutions. The Bank believes its balances of commercial loans will increase as it continues to expand this aspect of its business. In addition, management believes that the acquisition of ASB can enhance the operations of the Business Banking Group by allowing the Bank to offer a broader variety of investment products and fiduciary services to institutional customers.
Federal laws and regulations limit the Bank's commercial loan portfolio to 20% of assets, with at least 10% consisting of small business loans.
Consumer Lending. Chevy Chase currently offers a variety of consumer loans, including automobile loans, overdraft lines of credit, home improvement loans and other unsecured loans for traditional consumer purchases and needs. In addition, through a wholly-owned subsidiary, the Bank offers non-prime automobile loans. Non-prime refers to a category of loans made to applicants who have experienced certain adverse credit events, but who meet certain other creditworthiness tests. See "Consumer Loan Underwriting." During fiscal 1998, the Bank provided consumer credit through its credit card program, which offered Visa(R) and MasterCard(R) credit cards. At June 30, 1998, credit card loans outstanding totaled $938.7 million. Following the sale of the credit card portfolio to FUSA on September 30, 1998, the Bank no longer offers its own credit card loans, but has entered into an agreement with FUSA pursuant to which the Bank will provide credit cards issued by FUSA to the Bank's local customers. The Bank's portfolios of automobile loans, home improvement and related loans and other consumer loans totaled $357.8 million, $67.4 million and $33.5 million, respectively, at September 30, 1998, which accounted for a combined 16.5% of total loans at that date. The largest areas of recent growth have been in automobile loans and home improvement loans. During fiscal 1998, the Bank purchased or originated $715.2 million and $108.5 million of automobile loans and home improvement loans, respectively, which was partially offset by the transfers of $534.7 million and $45.9 million, respectively, of receivables to trusts for securitization and sale to investors.
Federal laws and regulations limit the Bank's secured and unsecured consumer loans to 35% of its total assets. Certain consumer loans, which include home improvement, secured deposit account and educational loans, are not included in the 35% limit.
Real Estate Loan Underwriting. In the loan approval process, Chevy Chase assesses both the borrower's ability to repay the loan and, in appropriate cases, the adequacy of the proposed security. Credit approval is vested with the Board of Directors and delegated to the Executive Loan Committee and certain senior officers in accordance with the credit authorizations approved by the Board of Directors. Generally, all construction and commercial real estate loans are reviewed and approved by the Executive Loan Committee. Any significant loan not conforming to the Bank's approved policies must be approved by the Executive Loan Committee or the Chief Executive Officer. Prior to October 1998, all loans of $15 million or more were presented to the Board of Directors for final approval. Effective October 1998, the Bank increased this threshold to $30 million.
The approval process for all types of real estate loans includes appraisals or evaluations of the properties securing such loans and a review of the applicant's financial statements and credit, payment and banking history, financial statements of any guarantors, and tax returns of guarantors of construction and commercial real estate loans.
In an effort to minimize the increased risk of loss associated with construction and development loans, Chevy Chase considers the reputation of the borrower and the contractor, reviews pre-construction sale and leasing information, and requires an independent inspecting engineer or architect to review the progress of multifamily and commercial real estate projects. In addition, the Bank generally requires personal guarantees of developers for all development loans and, if a general contractor is used by the developer, may require the posting of a performance bond.
The Bank generally lends up to 95% of the appraised value of single-family residential dwellings to be owner-occupied. The Bank also lends up to 85% of the appraised value of the completed project to finance the construction of such dwellings, and, on a case-by-case basis, the Bank occasionally may lend up to 90% of such appraised value when such financing is limited to pre-sold units. The loan-to-value ratio generally applied by the Bank to commercial real estate loans and multifamily residential loans has been 80% of the appraised value of the completed project. Currently, the Bank generally does not originate a traditional second mortgage loan (excluding home equity credit line loans) if the aggregate loan-to-value ratio of the second loan and the related first mortgage loan exceeds 80% of the appraised value of the property. In some circumstances, the Bank originates a first and second mortgage loan simultaneously where the total loan value does not exceed 90% of the appraised value of the property. Currently, the Bank offers home equity credit line loans up to a 125% maximum loan-to-value ratio. Private mortgage insurance is generally obtained for the amount over 80% of the value of the underlying property. Loan-to-value ratios are determined at the time a loan is originated. Consequently, subsequent declines in the value of a loan's collateral could expose the Bank to losses. The Bank's ability to make loans with a loan-to-value ratio above 90 percent without mortgage insurance is limited to 100 percent of the Bank's total risk-based capital.
OTS regulations require institutions to adopt internal real estate lending policies, including loan-to-value limitations conforming to specific guidelines established by the OTS. The Bank's current lending policies conform to these regulations.
On all loans secured by real estate (other than home improvement and related loans and certain home equity credit line loans), Chevy Chase requires title insurance policies protecting the priority of the Bank's liens. The Bank requires fire and casualty insurance for permanent loans (including home equity credit line loans) and fire, casualty and builders' risk insurance for construction loans. The borrower selects the insurance carrier, subject to Chevy Chase's approval. Generally, for any residential loan (including home equity credit line loans) in an amount exceeding 80% of the appraised value of the security property, Chevy Chase currently requires mortgage insurance from an independent mortgage insurance company. The majority of the Bank's mortgage insurance is placed with four carriers.
Substantially all fixed-rate mortgage loans originated by the Bank contain a due on sale clause providing that the Bank may declare a loan immediately due and payable in the event, among other things, that the borrower sells the property securing the loan without the consent of the Bank. The Bank's ARMs generally are assumable.
Commercial Loan Underwriting. All commercial loan requests are underwritten and approved under authorities granted to specified committees and individuals as outlined in the Bank's credit policies. The scope and depth of the underwriting for a particular request are generally dictated by the size of the proposed transaction. All commercial loans greater than $100,000 are assigned a risk rating at inception, utilizing a risk-rating system as defined in the Bank's credit policies.
Consumer Loan Underwriting. Consumer loans (which include automobile loans and home improvement and related loans and overdraft lines of credit) are originated or purchased by the Bank after a review by the Bank in accordance with its established underwriting procedures.
The underwriting procedures are designed to provide a basis for assessing the borrower's ability and willingness to repay the loan. In conducting this assessment, the Bank considers the borrower's ratio of debt to income and evaluates the borrower's credit history through a review of a written credit report compiled by a recognized consumer credit reporting bureau. The borrower's equity in the collateral and the terms of the loan are also considered. The Bank's guidelines are intended only to provide a basis for lending decisions, and exceptions to such guidelines may, within certain limits, be made based upon the credit judgment of the Bank's lending officer. The Bank periodically conducts quality audits to ensure compliance with its established policies and procedures.
The Bank also makes automobile loans through one of its operating subsidiaries. The underwriting guidelines for this subsidiary apply to a category of lending in which loans may be made to applicants who have experienced certain adverse credit events (and therefore would not necessarily meet all of the Bank's guidelines for its traditional loan program), but who meet certain other creditworthiness tests. Such loans may experience higher rates of delinquencies, repossessions and losses, especially under adverse economic conditions, compared with loans originated pursuant to the Bank's traditional lending program. See "Subsidiaries Operating Subsidiaries."
Loan Servicing. In addition to interest earned on loans, the Bank receives income through servicing of loans and fees in connection with loan origination, loan modification, late payments, changes of property ownership and miscellaneous services related to its loans. Servicing income earned on single-family residential mortgage loans owned by third parties and the Bank's securitization and servicing of credit card, home equity, automobile and home loan receivables portfolios, has been a source of substantial earnings for the Bank in recent periods. Income from these activities varies with the volume and type of loans originated and sold.
The following table sets forth certain information relating to the Bank's servicing income as of or for the years indicated.
As of or For the Year Ended September 30, ----------------------------------------- (In thousands) 1998 1997 1996 - ------------------------------ ------------ ------------ ------------- Residential................... $ 4,003,946 $ 3,930,371 $ 3,045,650 Credit card................... -- 4,015,172 3,889,704 Home equity................... 421,432 459,130 416,365 Automobile.................... 1,055,746 1,083,026 505,638 Home loans.................... 200,033 244,140 141,106 ------------ ------------ ------------- Total amount of loans serviced for others (1).... $ 5,681,157 $ 9,731,839 $ 7,998,463 ============ ============ ============= Servicing and securitization income (2)................. $ 233,271 $ 305,192 $ 284,964 ============ ============ ============= - --------------------- (1)...The Bank's basis in its servicing assets and interest-only strips at September 30, 1998, 1997 and 1996 was $40.7 million, $128.8 million and $75.4 million, respectively.
(2)...In each of the years ended September 30, 1998, 1997 and 1996, servicing and securitization income as a percentage of net interest income before provision for loan losses was 118.2%, 143.6% and 142.9%, respectively.
The Bank earns fees in connection with the servicing of home equity loans, home loans, automobile loans and single-family residential mortgage loans (and credit card loans prior to the sale of the credit card portfolio on September 30, 1998). The Bank's level of servicing and securitization income varies based in large part on the amount of the Bank's securitization activities with respect to these loan types. As the Bank securitizes and sells assets, acquires servicing assets either through purchase or origination, or sells mortgage loans and retains the servicing rights on those loans, the level of servicing and securitization income generally increases. During fiscal 1998, the Bank securitized and sold $1.0 billion of credit card receivables, $298.8 million of home equity receivables, $534.7 million of automobile loan receivables and $45.9 million of home loan receivables. The Bank's servicing and securitization income decreased from the level achieved in fiscal 1997 principally because of increases in unrealized losses on interest-only strips in addition to increases in the amortization of interest-only strips related to prior gains on sales of loans. The Bank's level of servicing and securitization income also declines upon repayment of assets previously securitized and sold and repayment of mortgage loans serviced for others.
The Bank's investment in servicing assets (including servicing assets and interest-only strips), and the amortization of such assets, are periodically evaluated for impairment. Interest-only strips are evaluated quarterly based on the discounted value of estimated future net cash flows to be generated by the underlying loans. The difference between the book value of these assets and the discounted value is recognized as an unrealized gain or loss in the period in which the change occurs. Several estimates are used when determining the discounted value, the most significant of which are the estimated rate of repayment of the underlying loans and estimated credit losses. The Bank evaluates its servicing assets for impairment based on fair value. To measure fair value of its servicing assets, the Bank uses either quoted market prices or discounted cash flow analyses using appropriate assumptions for servicing fee income, servicing costs, prepayment rates and discount rates. If actual prepayment or default rates significantly exceed the estimates used to calculate the carrying values of the servicing assets, the actual amount of future cash flow could be less than the expected amount and the value of the servicing assets, as well as the Bank's earnings, could be negatively impacted. No assurance can be given that the Bank's receivables will not experience significant increases in prepayment or default rates or that the Bank may not have to continue to write down the value of its servicing assets. Additionally, the Bank stratifies its capitalized servicing assets for purposes of evaluating impairment by taking into consideration relevant risk characteristics, including loan type, note rate and date of acquisition. See Summary of Significant Accounting Policies - The Bank in this report.
The Bank prices its single-family mortgage loans to achieve a competitive yield. Loan origination and commitment fees, and the related costs associated with making the loans, are deferred. For fully amortizing loans originated for the Bank's portfolio, the net deferred fees are accreted to interest income over the estimated life of the loans using the level-yield method. Fees deferred on revolving credit lines or loans which have no scheduled amortization originated for the Bank's portfolio are accreted to income over the estimated lives of the underlying loans using the straight-line method. Fees deferred on loans originated and held for sale are not accreted to income but instead are used in determining the gain or loss on the sale of the loans.
Delinquencies, Foreclosures and Allowances for Losses
Delinquencies and Foreclosures. When a borrower fails to make a required payment on a mortgage loan, the loan is considered delinquent and, after expiration of the applicable cure period, the borrower is charged a late fee. The Bank follows practices customary in the banking industry in attempting to cure delinquencies and in pursuing remedies upon default. Generally, if the borrower does not cure the delinquency within 90 days, the Bank initiates foreclosure action. If the loan is not reinstated, paid in full or refinanced, the security property is sold. In some instances, the Bank may be the purchaser. Thereafter, such acquired property is listed in the Bank's account for real estate acquired in settlement of loans until the property is sold. Deficiency judgments generally may be enforced against borrowers in Maryland, Virginia and the District of Columbia, but may not be available or may be subject to limitations in other jurisdictions in which loans are originated by the Bank.
See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Asset Quality - Delinquent Loans" for a discussion of the Bank's delinquent loan portfolio at September 30, 1998.
Allowances for Losses. It is the Bank's policy to maintain adequate allowances for estimated losses on loans and real estate. Generally, the allowances are based on, among other things, historical loan loss experience, evaluation of economic conditions in general and in various sectors of the Bank's customer base, and periodic reviews of loan portfolio quality by Bank personnel. The Bank's specific methods for establishing the appropriate levels of allowances vary depending upon the assets involved. Allowances for losses on loans and real estate are based on current events or facts that may ultimately lead to future losses. In addition to reviews of individual portfolio segments, the Bank regularly reviews its overall loan portfolio consisting of performing non-classified assets and, based on such review, may establish additional allowances for losses. The Bank's actual losses may vary from management's current estimates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Asset Quality - Allowances for Losses."
The Bank's allowance on its consumer loans is based on a number of factors, including historical charge-off and repayment experience. The Bank's reserve methodology is based on an analysis of the characteristics of the portfolio and trends at any particular time. In this regard, the Bank considers various historical information relative to the origination date, borrower profiles, delinquencies and other factors. In the case of automobile loans, management also considers the value of the underlying collateral, which can be adversely impacted by the time required to liquidate the collateral as well as the age and type of the collateral, and geographic trends.
The Bank's methods for determining the allowance on loans secured by real estate vary depending on whether the loans are secured by residential homes or by other real estate. For residential mortgage loans, management analyzes the allowance by stratifying residential permanent loans on a state by state and ownership (i.e., investor or homeowner) basis. After the residential permanent portfolio has been stratified by state, historical loss ratios (as adjusted for predictable or quantifiable trends, if known) for the specific states are applied to delinquent loans. Based on this analysis, a reserve component is assigned to residential permanent loans. In the Bank's experience, this approach has resulted in timely recognition of necessary allowances, which has been generally supported by the Bank's favorable results on the ultimate disposition of the underlying collateral.
The Bank assesses the adequacy of its general valuation allowances on non-residential (i.e., other than single-family residential) mortgage loans, REO and real estate held for investment based primarily on an ongoing evaluation of individual assets. This evaluation takes into consideration a variety of factors, including cash flow analyses, independent appraisals, market studies, economic trends and management's knowledge of the market and experience with particular borrowers. The Bank obtains current appraisals when properties are classified as REO. The Bank periodically reviews appraisals and orders new appraisals as appropriate based on a number of factors, including the date of the previous appraisal, changes in market conditions and regulatory requirements.
In addition to the general valuation allowances described above, valuation allowances are provided for individual loans where the ultimate collection is considered questionable by management after reviewing the current status of loans which are contractually past due and considering the net realizable value of the collateral or guarantees, if applicable.
From fiscal 1994 through fiscal 1998, the Bank provided additional general valuation allowances, which were equal to, or exceeded, the net earnings generated by the development and sale of land in the Communities. See "Managements' Discussion and Analyses of Financial Condition and Results of Operations - Financial Condition - Asset Quality - Allowances for Losses."
REO is carried at the lower of cost or fair value, less selling costs. To date, sales of REO, non-residential mortgage loans and loans classified as investments in real estate have resulted in no material additional aggregate loss to the Bank above the amounts already reserved. However, these results do not necessarily assure that the Bank will not suffer losses in the future beyond its level of allowances.
The Bank's individualized asset review takes place within its Asset Review Committee and the Asset Classification Committee (the "Committee"). The Asset Review Committee accumulates and analyzes data relating to classified and potential problem assets of $5.0 million or more and makes appropriate recommendations regarding asset classifications to the Committee. The Committee meets on a regular basis to discuss classifications of such assets and to review the allowances for losses. The Committee generally reviews the status of various projects, including, for example, data on recent lot sales for residential development projects. Actual progress is compared to projections made when the related loan was underwritten. Local economic conditions and known trends are also reviewed. The Committee also considers steps being taken by borrowers to address problems, and reviews financial information relating to borrowers and guarantors as well as reports by loan officers who are responsible for continually evaluating the projects. The actions of the Committee are reported to the Board of Directors.
The Federal Financial Institution Examination Council, which is composed of the OTS and the other federal banking agencies, has issued guidelines regarding the appropriate levels of general valuation allowances that should be maintained by insured institutions. The Bank believes that its levels of general valuation allowances at September 30, 1998 comply with the guidelines.
The Bank's assets are subject to review and classification by the OTS upon examination. Based on such examinations, the Bank could be required to establish additional valuation allowances or incur additional charge-offs.
Deposits and Other Sources of Funds
General. Deposits are the primary source of the Bank's funds for use in lending and for other general business purposes. In addition to deposits, Chevy Chase receives funds from loan repayments and loan sales. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are influenced by general interest rates and money-market conditions. Borrowings may be used to compensate for reductions in normal sources of funds, such as deposit inflows at less than projected levels or deposit outflows, or to support the Bank's operating or investing activities.
Deposits. Chevy Chase currently offers a variety of deposit accounts with a range of interest rates and maturities designed to attract both long-term and short-term deposits. Deposit programs include Super Statement Savings, Super NOW, Insured Money Fund, Checking, Simple Statement Savings, Young Savers, Certificate, and special programs for Individual Retirement and Keogh self-employed retirement accounts. At September 30, 1998, all outstanding jumbo certificates of deposit had been sold directly by the Bank to depositors, either through its branches or through its treasury management services division.
Chevy Chase attracts deposits through its branch network and advertisements, and offers depositors access to their accounts through 696 ATMs, including 219 ATMs located in grocery stores. The Bank also has the right to install ATMs in certain additional grocery stores in the greater Washington, D.C./Baltimore/Richmond area which do not currently have ATM service. These ATMs and installation rights significantly enhance the Bank's position as a leading provider of convenient ATM service in its primary market area. The Bank is a member of the regional HONOR (R) ATM network which offers over 50,000 locations nationwide. The Bank is also a member of the PLUS (R) ATM network, which offers over 457,000 locations worldwide. In addition, the Bank has a partnership agreement with a regional grocery store to provide in-store banking centers at up to 160 Baltimore and Washington area stores.
The Bank obtains deposits primarily from customers residing in Montgomery and Prince George's Counties in Maryland and Northern Virginia. Approximately 31.2% of the Bank's deposits at September 30, 1998 were obtained from depositors residing outside of Maryland, with approximately 17.9% of the Bank's deposits being obtained from depositors residing in Northern Virginia.
The following table shows the amounts of Chevy Chase's deposits by type of account at the dates indicated.
The range of deposit account products offered by the Bank through its extensive branch and ATM network allows the Bank to be competitive in obtaining funds from its local retail deposit market. At the same time, however, as customers have become increasingly responsive to changes in interest rates, the Bank has experienced some fluctuations in deposit flows. Chevy Chase's ability to attract and maintain deposits and its cost of funds will continue to be significantly affected by market conditions and its pricing strategy. The Bank had $0 and $315.1 million of brokered deposits at September 30, 1998 and 1997, respectively. Chevy Chase began accepting brokered deposits in fiscal 1997 as a way to diversify the Bank's funding sources. The Bank does not currently place significant reliance on brokered deposits as a key source of funding. Under FDIC regulations, the Bank is permitted to accept brokered deposits as long as it meets the capital standards established for well capitalized institutions (or with FDIC approval, adequately-capitalized institutions) under the prompt corrective action regulations.
The following table sets forth Chevy Chase's deposit flows during the periods indicated.
Deposit Flows Year Ended September 30, ----------------------------------------- (In thousands) 1998 1997 1996 - ------------------------------ ------------- ------------- ------------- Deposits...................... $ 24,799,407 $ 18,915,801 $ 15,312,125 Withdrawals from accounts.................... (24,984,251) (18,354,989) (15,469,909) ------------- ------------- ------------- Net cash to (from) accounts.................... (184,844) 560,812 (157,784) Interest credited to accounts.................... 179,318 168,907 162,569 ------------- ------------- ------------- Net increase (decrease) in deposit balances.................... $ (5,526) $ 729,719 $ 4,785 ============= ============= =============
Deposit growth may be moderated by the Bank from time to time either to take advantage of lower cost funding alternatives or in response to more modest expectations for loan and other asset growth.
The following table sets forth, by weighted average interest rates, the types and amounts of deposits as of September 30, 1998 which will mature during the fiscal years indicated.
The following table summarizes maturities of certificate accounts in amounts of $100,000 or greater as of September 30, 1998.
Year Ending September 30, Amount Weighted Average Rate - -------------------------- --------------------- --------------------- (Dollars in thousands) 1999 .................. $ 343,610 5.29% 2000 .................. 17,737 6.47% 2001 .................. 2,597 5.56% 2002 .................. 2,994 5.67% 2003 .................. 3,118 5.80% ----------- ----- Total................. $ 370,056 5.69% =========== =====
The following table represents the amounts of deposits by various interest rate categories as of September 30, 1998 maturing during the fiscal years indicated.
Borrowings. The FHLB system functions as a central reserve bank providing credit for member institutions. As a member of the FHLB of Atlanta, Chevy Chase is required to own capital stock in the FHLB of Atlanta and is authorized to apply for advances on the security of such stock and certain of its mortgages and other assets (principally securities which are obligations of, or guaranteed by, the United States or its agencies), provided certain standards related to creditworthiness have been met.
Under the credit policies of the FHLB of Atlanta, credit may be extended to creditworthy institutions based upon their financial condition, and the adequacy of collateral pledged to secure the extension of credit. Such extensions of credit or borrowings may be obtained pursuant to several different credit programs, each of which has its own rate and range of maturities. Advances from the FHLB of Atlanta must be secured by certain types of collateral with a value, as determined by the FHLB of Atlanta, at least equal to 100% of the borrower's outstanding advances. The Bank had outstanding FHLB advances of $352.0 million at September 30, 1998.
From time to time, the Bank enters into repurchase agreements, which are treated as financings. The Bank sells securities (usually mortgage-backed securities) to a dealer and agrees to buy back the same securities at a specified time (generally within seven to 90 days). The Bank pays a stated interest rate for the use of the funds for the specified time period to the dealer. The obligation to repurchase the securities sold is reflected as a liability and the securities underlying the agreements are included in assets in the Consolidated Balance Sheets in this report. These arrangements are, in effect, borrowings by the Bank secured by the securities sold. The Bank had outstanding repurchase agreements of $387.3 million at September 30, 1998.
The following table sets forth a summary of the repurchase agreements of the Bank as of the dates and for the years indicated.
September 30, ------------------------ (Dollars in thousands) 1998 1997 - --------------------------------------------- ---------- ----------- Securities sold under repurchase agreements: Balance at year-end........................ $ 387,305 $ 2,606 Average amount outstanding during the year................................ 302,564 483,076 Maximum amount outstanding at any month-end................................ 806,393 946,090 Weighted average interest rate during the year................................. 5.68% 5.48% Weighted average interest rate on year-end balances..................... 5.63% 5.35%
On November 23, 1993, the Bank sold $150 million principal amount of its 9 1/4% Subordinated Debentures due 2005 (the "1993 Debentures"). Interest on the 1993 Debentures is payable semiannually on December 1 and June 1 of each year. The OTS approved the inclusion of the principal amount of the 1993 Debentures in the Bank's supplementary capital for regulatory capital purposes. As of December 1, 1998, the 1993 Debentures are redeemable, in whole or in part, at any time at the option of the Bank.
On December 3, 1996, the Bank sold $100 million principal amount of its 9 1/4% Subordinated Debentures due 2008 (the "1996 Debentures"). Interest on the 1996 Debentures is payable semiannually on December 1 and June 1 of each year. The OTS approved the inclusion of the principal amount of the 1996 Debentures in the Bank's supplementary capital for regulatory capital purposes. On or after December 1, 2001, the 1996 Debentures will be redeemable, in whole or in part, at any time at the option of the Bank.
Under the OTS capital regulations, redemption of the 1993 Debentures or the 1996 Debentures prior to their stated maturity would be subject to prior approval of the OTS unless the debentures are redeemed with the proceeds of, or replaced by, a like amount of a similar or higher quality capital instrument.
Subsidiaries
OTS regulations generally permit the Bank to make investments in service corporation subsidiaries in an amount not to exceed 3.0% of the Bank's assets, provided that any investment in excess of 2.0% of assets serves primarily community, inner city or community development purposes. Such regulations also permit the Bank to make conforming loans to such subsidiaries and joint ventures in an amount not to exceed 50% of the Bank's regulatory capital. At September 30, 1998, 2.0% and 3.0% of the Bank's assets was equal to $135.0 million and $202.5 million, respectively, and the Bank had $9.3 million invested in its service corporation subsidiaries, $5.0 million of which was in the form of conforming loans.
The Bank is required to provide 30 days advance notice to the OTS and to the FDIC before establishing a new subsidiary or conducting a new activity in an existing subsidiary. With prior written approval from the OTS, the Bank may also establish operating subsidiaries to engage in any activities in which the Bank may engage directly. The Bank engages in a variety of other activities through its subsidiaries, including those described below.
Real Estate Development Activities. Manor Investment Company ("Manor") was engaged in certain real estate development activities commenced prior to the enactment of FIRREA and continues to manage the two remaining properties it holds. As a result of the stringent capital requirements that FIRREA applies to investments in subsidiaries, such as Manor, that engage in activities impermissible for national banks, Manor has not entered, and does not intend to enter, into any new real estate development arrangements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Asset Quality."
Securities Brokerage Services. Chevy Chase Securities, Inc., is a subsidiary of Chevy Chase Financial Services Corporation ("CCFS"), a wholly-owned subsidiary of Chevy Chase. Chevy Chase Securities, Inc. is a licensed broker-dealer, selling securities on a retail basis to the general public, including customers and depositors of the Bank.
Insurance Services. Chevy Chase Insurance Agency, Inc., a subsidiary of CCFS, is a licensed insurance broker offering a variety of personal line insurance programs in the property and casualty field (primarily homeowner and automobile insurance) and in the life insurance field (primarily mortgage and credit card life and disability programs) to the general public, including customers and depositors of the Bank.
Special Purpose Subsidiaries. At September 30, 1998, Chevy Chase Real Estate Corporation ("CCRC"), a subsidiary of Chevy Chase, held 100% of the common stock of 23 subsidiaries (14 of which are active) a majority of which were formed for the sole purpose of acquiring title to various real estate projects pursuant to foreclosure or deed-in-lieu of foreclosure. The Bank's investment in the subsidiaries was $111.3 million at September 30, 1998. The Bank's investment in CCRC is not subject to the 3.0% service corporation investment limit discussed above.
Operating Subsidiaries. Chevy Chase engages in significant mortgage lending activities through B. F. Saul Mortgage Company ("BFSMC"). See "Lending Activities." Consumer Finance Corporation was formed as an operating subsidiary in December 1994 to engage in automobile lending. Chevy Chase Preferred Capital Corporation was formed as an operating subsidiary to issue the REIT Preferred Stock.
On November 12, 1997, a newly formed operating subsidiary of the Bank acquired ASB Capital Management, Inc. through which the Bank offers investment, management and fiduciary services to primarily institutional customers.
CCB Holding Corporation ("CCBH") was a Delaware corporation created by the Bank as an operating subsidiary in September 1994 in connection with its credit card securitization activities. Subsequent to the sale of the Bank's credit card portfolio and related operations, CCBH was merged into the Bank on September 30, 1998.
Employees
The Bank and its subsidiaries had 3,923 full-time and 595 part-time employees at September 30, 1998. In connection with the sale of the credit card portfolio and related operations to FUSA on September 30, 1998, the Bank entered into an agreement with FUSA to lease the Bank's 1,173 credit card employees to FUSA for the quarter ending December 31, 1998, after which FUSA agreed to offer employment to all such employees.
The Bank provides its employees with a comprehensive range of employee benefit programs, including group health benefits, life insurance, disability insurance, paid sick leave and an employee loan program. The Bank offers home mortgage loans to employees at prevailing market rates, but waives up to one point of any loan origination fees on home mortgage loans, and provides a yearly rebate equal to 0.5% of the outstanding loan balance of home mortgage loans at calendar year-end. The Bank also offers employees a one percent discount on the interest rate on overdraft lines of credit. None of the Bank's employees is represented by a collective bargaining agent. The Bank believes that its employee relations are good.
Competition
Chevy Chase encounters strong competition both in attracting deposits and making real estate and other loans in its markets. The Bank's most direct competition for deposits has come from other thrifts, commercial banks and credit unions, as well as from money market funds and corporate and government securities. In addition to offering competitive interest rates, Chevy Chase offers a variety of services, convenient ATM locations and convenient office locations and hours to attract deposits. Competition for real estate and other loans comes principally from other thrifts, banks, mortgage banking companies, insurance companies and other institutional lenders. Chevy Chase competes for loans through interest rates, loan fees and the variety and quality of services provided to borrowers and brokers.
The Bank's major competition historically has come from local depository institutions, but deregulation of the financial services industry and changing market demands in recent years have eroded distinctions between providers of financial services. In addition, both depository and non-depository institutions have greater nationwide access to attractive markets, such as the Washington, D.C. area, than they have had in past years. Chevy Chase now competes with regional financial institutions and national providers of investment alternatives, as well as with a number of large money center and regional banks that have acquired institutions in the area.
The Bank estimates that it competes principally with approximately thirteen depository institutions in its deposit-taking activities in the Washington, DC metropolitan area. The Bank also competes with such institutions in the origination of single-family residential mortgage loans and home equity credit line loans. According to the most recently published industry statistics, Chevy Chase had the largest market share (approximately 23%) of deposits in Montgomery County, Maryland, and ranked third in market share (approximately 10%) of deposits in Prince George's County, Maryland at June 30, 1997. Based on publicly available information, Chevy Chase estimates that, in the Washington, DC metropolitan area, it maintains the leading market share of single-family residential mortgage and home equity credit line loans.
ITEM 2.
ITEM 2. PROPERTIES
Real Estate
A list of the investment properties of the Real Estate Trust is set forth under "Business - Real- Estate - Real Estate Investments."
The Trust conducts its principal business from its executive offices at 8401 Connecticut Avenue, Chevy Chase, Maryland. The Trust sells its unsecured notes due one year to ten years from date of issue from a sales office located at 7200 Wisconsin Avenue, Suite 903, Bethesda, Maryland. The Saul Company leases both office facilities on behalf of the Trust.
Banking
At September 30, 1998, the Bank conducted its business from its home office at 7926 Jones Branch Drive, McLean, Virginia and its executive offices at 8401 Connecticut Avenue, Chevy Chase, Maryland; its operations centers at 6151 and 6200 Chevy Chase Drive, Laurel, Maryland; its office facilities at 7700 Old Georgetown Road, Bethesda, Maryland, 7735 Old Georgetown Road, Bethesda, Maryland and 1101 Pennsylvania Avenue, NW, Washington, DC; and 143 full-service offices located in Maryland, Virginia and the District of Columbia. On that date, the Bank owned the building and land for 26 of its branch offices and leased its remaining 117 branch offices. Chevy Chase leases the office facilities at 8401 Connecticut Avenue, 6200 Chevy Chase Drive, 7735 Old Georgetown Road, 1101 Pennsylvania Avenue, NW and the land at 7700 Old Georgetown Road. Chevy Chase owns the building at 7700 Old Georgetown Road. In addition, the Bank leases office space in which its subsidiaries are housed. The office facility leases have various terms expiring from 1999 to 2019 and the ground leases have terms expiring from 2029 to 2080. The Bank also owns the building and land at 5202 President's Court, Frederick, Maryland. In connection with the sale of the credit card portfolio and related operations on September 30, 1998, the Bank entered into a lease agreement with FUSA for this facility. See Note 18 to the Consolidated Financial Statements in this report for lease expense and commitments.
As of November, 1998, the Bank has received OTS approval to open fifteen full-service branch offices. The branches, seven in Virginia, seven in Maryland and the Bank's first branch in Delaware, are scheduled to open during fiscal 1999.
The following table sets forth the location of the Bank's 143 full-service branch offices at September 30, 1998.
1 Catoctin Circle 14245R Centreville Square Leesburg, VA 22075 Centreville, VA 20121
8201 Greensboro Drive 1100 W. Broad Street McLean, VA 22102 Falls Church, VA 22046
234 Maple Avenue East 3941 Pickett Road McLean, VA 22180 Fairfax, VA 22031
8436 Old Keene Mill Road 1439 Chain Bridge Road Springfield, VA 22152 McLean, VA 22031
75 West Lee Highway 8120 Sudley Road Warrenton, VA 22186 Manassas, VA 22110
6367 Seven Corners Center 1100 S. Hayes Street Falls Church, VA 22044 Arlington, VA 22202
11800 Sunrise Valley Drive 13344-A Franklin Farms Road Reston, VA 22091 Herndon, VA 20165
2952-H Chain Bridge Road 20970 Southbanks Street Oakton, VA 22124 Sterling, VA 20165
1201 Elden Street 21800 Towncenter Plaza Herndon, VA 20170 Sterling, VA 20164
5613 Stone Road 7030 Little River Turnpike Centreville, VA 22020 Annandale, VA 22003
44151 Ashburn Village Way 3095 Nutley Street Ashburn, VA 22011 Fairfax, VA 22031
3690-A King Street 4700 Lee Highway Alexandria, VA 22302 Arlington, VA 22207
6609 Springfield Mall 5851 Crossroads Center Way Springfield, VA 22150 Falls Church, VA 22041
500 South Washington Street 13813 Foulger's Square Alexandria, VA 22314 Woodbridge, VA 22192
10100 Dumfries Road 6800 Richmond Highway Manassas, VA 22192 Alexandria, VA 22306
5870 Kingstowne Boulevard 6335 Multiplex Drive Alexandria, VA 23210 Centreville, VA 22022
43761 Parkhurst Plaza 6025-A Burke Town Center Parkway Ashburn, VA 22011 Burke, VA 22015
3499 S. Jefferson Street 7935 L Tysons Corner Center Baileys Crossroads, VA 22041 McLean, VA 22102
3046 Gatehouse Plaza 11874 Spectrum Center Falls Church, VA 22042 Reston, VA 20190
1621 B Crystal Square Arcade 5230-A Port Royal Road Arlington, VA 22202 Springfield, VA 22151
1100 Wilson Boulevard 8628 Richmond Highway Arlington, VA 22209 Alexandria, VA 22309
4299 Merchant Plaza 46160 Potomac Run Plaza Woodbridge, VA 22192 Sterling, VA 20190
7500 Old Georgetown Road 11301 Rockville Pike Bethesda, MD 20814 Kensington, MD 20895
5370 Westbard Avenue 26001 Ridge Road Bethesda, MD 20816 Damascus, MD 20872
7340 Westlake Terrace 17831 Georgia Avenue Bethesda, MD 20817 Olney, MD 20832
1327 Lamberton Drive 11261 New Hampshire Avenue Silver Spring, MD 20902 Silver Spring, MD 20904
2215 Bel Pre Road 1609-B Rockville Pike Wheaton, MD 20906 Rockville, MD 20852
8401 Connecticut Avenue 6107 Greenbelt Road Chevy Chase, MD 20815 Berwyn Heights, MD 20740
5424 Western Avenue 4 Bureau Drive Chevy Chase, MD 20815 Gaithersburg, MD 20878
13641 Connecticut Avenue 19610 Club House Road Wheaton, MD 20906 Gaithersburg, MD 20879
8315 Georgia Avenue 812 Muddy Branch Road Silver Spring, MD 20910 Gaithersburg, MD 20878
4701 Sangamore Road 10211 River Road Bethesda, MD 20816 Potomac, MD 20854
Landover Mall 11413 Baltimore Avenue Landover, MD 20785 Laurel, MD 20707
6200 Annapolis Road 7290-A Cradlerock Way Landover Hills, MD 20784 Columbia, MD 21045
33 West Franklin Street 1151 Maryland Route 3 North Hagerstown, MD 21740 Gambrills, MD 21054
6400 Belcrest Road 12228 Viers Mill Road Hyattsville, MD 20782 Silver Spring, MD 20906
8740 Arliss Street 317 Kentlands Boulevard Silver Spring, MD 20901 Gaithersburg, MD 20878
2409 Wootton Parkway 215 N. Washington Street Rockville, MD 20850 Rockville, MD 20850
8889 Woodyard Road 1336 Crain Highway South Clinton, MD 20735 Mitchellville, MD 20716
1181 University Boulevard 543 Ritchie Highway Langley Park, MD 20783 Severna Park, MD 21146
12921 Wisteria Drive 4745 Dorsey Hall Drive Germantown, MD 20874 Ellicott City, MD 21042
1009 West Patrick Street 1130 Smallwood Drive Frederick, MD 21701 Waldorf, MD 20603
7937 Ritchie Highway 10800 Baltimore Avenue Glen Burnie, MD 21061 Beltsville, MD 20705
19781-83 Frederick Road 1040 Largo Center Drive Germantown, MD 20876 Landover, MD 20785
16827 Crabbs Branch Way 6335 Marlboro Pike Rockville, MD 20855 District Heights, MD 20747
2321-A Forest Drive 7530 Annapolis Road Annapolis, MD 21401 Lanham, MD 20784
15460 Annapolis Road 11241 Georgia Avenue Bowie, MD 20715 Wheaton, MD 20902
20000 Goshen Road 13484 New Hampshire Avenue Gaithersburg, MD 20879 Silver Spring, MD 20904
12097 Rockville Pike 2401 Cleanleigh Drive Rockville, MD 20852 Baltimore, MD 21234
10159 New Hampshire Avenue 7101 Democracy Boulevard Hillandale, MD 20903 Bethesda, MD 20814
6264 Central Avenue 4825 Cordell Avenue Seat Pleasant, MD 20743 Bethesda, MD 20814
7700 Old Georgetown Road 7515 Greenbelt Road Bethesda, MD 20814 Greenbelt, MD 20770
15777 Columbia Pike 2722 N. Salisbury Boulevard Burtonsville, MD 20866 Salisbury, MD 21801
18104 Town Center Drive 509 N. Frederick Avenue Olney, MD 20832 Gaithersburg, MD 20877
6197 Oxon Hill Road 504 Ridgeville Boulevard Oxon Hill, MD 20745 Mt. Airy, MD 21771
10821 Connecticut Avenue 5823 Eastern Avenue Kensington, MD 20895 Chillum, MD 20782
18006 Mateny Road 3355 Corridor Market Place Germantown, MD 20874 Laurel, MD 20724
7406 Baltimore Avenue 10400 Old Georgetown Road College Park, MD 20740 Bethesda, MD 20814
980 E. Swan Creek Road 115 University Boulevard West Fort Washington, MD 20744 Silver Spring, MD 20901
3828 International Drive 9707 Old Georgetown Road Silver Spring, MD 20906 Bethesda, MD 20814
3400 Crain Highway 7941 Tuckerman Lane Bowie, MD 20716 Potomac, MD 20854
2315 Randolph Road P.O. Box 170, Stamp Student Union Silver Spring, MD 20906 College, Park, MD 20742
6020 Marshalee Drive 5400 Corporate Drive Elkridge, MD 21227 Frederick, MD 21703
2950 Donnell Drive 20944 Frederick Road Forestville, MD 20747 Germantown, MD 20876
135 East Baltimore Street 3601 St. Barnabas Road Baltimore, MD 21202 Silver Hill, MD 20746
2807 University Boulevard West 1850 K Street, NW Kensington, MD 20895 Washington, DC 20006
4860 Massachusetts Avenue, NW 4000 Wisconsin Avenue, NW Washington, DC 20016 Washington, DC 20016
210 Michigan Avenue, NE 1717 Pennsylvania Avenue, NW Washington, DC 20017 Washington, DC 20006
4455 Connecticut Avenue, NW 925 15th Street, NW Washington, DC 20008 Washington, DC 20005
2831 Alabama Avenue, SE 1299 Pennsylvania Avenue, N.W. Washington, DC 20020 Washington, DC 20006
1800 M Street, NW 5714 Connecticut Avenue, N.W. Washington, DC 20036 Washington, DC 20015
1545 Wisconsin Avenue, NW Washington, DC 20007
At September 30, 1998, the net book value of the Bank's office facilities (including leasehold improvements) was $149.4 million. See Note 17 to the Consolidated Financial Statements in this report.
During fiscal 1998, the Bank entered into an agreement to lease approximately 3.5 acres of land located at 7501 Wisconsin Avenue, Bethesda, Maryland, on which the Bank intends to develop and occupy an office building to use as its new corporate headquarters. At September 30, 1998, the Bank had invested $5.5 million related to this facility.
The Bank owns additional assets, including furniture and data processing equipment. At September 30, 1998, these other assets had a net book value of $131.0 million. The Bank also has operating leases, primarily for certain data processing equipment and software. Such leases have month-to-month or year-to-year terms.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Trust is involved in certain litigation, including litigation arising out of the collection of loans, the enforcement or defense of the priority of its security interests, the continued development and marketing of certain of its real estate properties, and certain employment claims. In the opinion of management, litigation which is currently pending will not have a material adverse impact on the financial condition or future operations of the Trust.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There currently is no established public trading market for the Trust's Common Shares of Beneficial Interest (the "Common Shares"). At December 4, 1998, there were nine corporate or individual holders of record of Common Shares. All holders of Common Shares at such date were affiliated with the Trust. The Trust did not pay any cash dividends on the Common Shares during the past two fiscal years. See "Security Ownership of Certain Beneficial Owners and Management."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Trust herein have been derived from the Consolidated Financial Statements of the Trust. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements included elsewhere in this report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The term "Trust" used in the text and the financial statements included herein refers to the combined entity, which includes B. F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust" refers to B. F. Saul Real Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase's subsidiaries. The operations conducted by the Real Estate Trust are designated as "Real Estate," while the business conducted by the Bank and its subsidiaries is identified by the term "Banking."
Financial Condition
Real Estate
The Real Estate Trust's investment portfolio at September 30, 1998 consisted primarily of hotels, office and industrial projects, and land parcels. See "Business - Real Estate - Real Estate Investments." In the first quarter of fiscal 1998, the Real Estate Trust purchased a 308-room Holiday Inn in Arlington, Virginia.
Office space in the Real Estate Trust's office property portfolio was 100% leased at September 30, 1998, compared to a leasing rate of 99% at September 30, 1997. At September 30, 1998, the Real Estate Trust's office property portfolio had a total gross leasable area of approximately 1.3 million square feet, of which 259,000 square feet (20.4%) and 209,000 square feet (16.5%) are subject to leases whose terms expire in fiscal 1999 and fiscal 2000, respectively.
Overall, the hotel portfolio experienced an average occupancy rate of 68% and average room rate of $81.01 during the year ended September 30, 1998. For the nine hotels owned by the Real Estate Trust throughout fiscal 1998 and fiscal 1997, the average occupancy rates were 69% and 70%, respectively, and the average room rates were $79.31 and $72.58, respectively. Three of these hotels registered improved occupancies and eight registered higher average room rates in the current fiscal year.
Banking
General. The Bank recorded operating income of $184.4 million during fiscal 1998, compared to operating income of $80.2 million during fiscal 1997. The increase in income for fiscal 1998 was primarily attributable to a $230.8 million increase in other (non-interest) income, largely attributable to the sale of the Bank's credit card portfolio, which was partially offset by an $85.7 million increase in operating (non-interest) expenses and a $25.7 million increase in the provision for loan losses. See "Results of Operations."
Gain on sales of loans of $290.4 million, representing an increase of $288.9 million over fiscal 1997, was a large component of the Bank's non-interest income during the current year and resulted primarily from the sale of the Bank's credit card portfolio and related operations on September 30, 1998. The credit card portfolio included approximately $4.8 billion of managed credit card loans and 3.1 million Visa and MasterCard credit card accounts. The Bank recognized a net gain of $288.3 million on this sale. See Note 8 to the Consolidated Financial Statements in this report.
Servicing and securitization income decreased $71.9 million (or 23.6%) during fiscal 1998 and resulted from increases in the amortization of and unrealized losses on interest-only strips. The Bank recognized net unrealized losses on interest-only strips of $42.9 million during fiscal 1998 compared to net unrealized gains of $7.0 million during fiscal 1997. In addition, amortization of $99.0 million on interest-only strips related to prior gains on sales of loans was recorded in fiscal 1998 compared to $24.8 million in fiscal 1997. Offsetting these amounts were gains on the securitization and sale of loan receivables. During fiscal 1998, the Bank securitized and sold $1.9 billion of receivables, of which $1.0 billion, $298.8 million, $534.7 million and $45.9 million, related to securitizations and sales of credit card, home equity, automobile and home loan receivables, respectively, and recognized gains of $81.6 million, $19.7 million, $23.1 million and $3.4 million, respectively, on these transactions. In addition, the Bank securitized and sold $36.0 million of amounts on deposit in certain spread accounts established in connection with certain of the Bank's credit card securitizations. See Notes to the Consolidated Financial Statements in this report. See "Liquidity."
Real estate owned, net of valuation allowances, declined 27.9% during fiscal 1998 to $65.4 million at September 30, 1998, from $90.7 million at September 30, 1997. This reduction was primarily due to sales in the Communities and other properties and additional valuation allowances. See "REO."
At September 30, 1998, the Bank's tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios were 7.93%, 7.93%, 12.93% and 20.70%, respectively. The Bank's capital ratios exceeded the requirements under FIRREA as well as the standards established for well-capitalized institutions under the prompt corrective action regulations issued pursuant to FDICIA. See "Capital."
On November 12, 1997 the Bank purchased ASB Capital Management, Inc. ("ASB"), a wholly-owned subsidiary of NationsBank Corporation and one of the largest SEC-registered investment managers headquartered in the Washington, D.C. metropolitan area, through which the Bank provides a variety of investment products and fiduciary services to a primarily institutional customer base.
During fiscal 1998, the Bank declared and paid, out of the retained earnings of the Bank, cash dividends on its Common Stock in the aggregate amount of $650 per share. Subsequent to September 30, 1998, the Bank declared, out of the retained earnings of the Bank, cash dividends on its Common Stock in the amount of $2,300 per share. Of this amount, $2,100 per share was paid in December 1998, and the remaining $200 per share is payable in January 1999.
The Bank's assets are subject to review and classification by the OTS upon examination. The Bank has been notified that the OTS will begin its annual safety and soundness examination in December 1998.
The sale of the credit card portfolio has improved the Bank's regulatory capital ratios and the overall credit quality of the Bank's loan portfolio. In addition, the Bank anticipates additional long-term savings on overhead expenses as a result of the sale. However, the credit card program has historically been a major source of earnings for the Bank. Although the Bank believes it will be able to operate profitably by relying on its core deposit franchise as a significant source of low-cost funds, and investing those funds in assets that, although offering lower yields than credit cards, involve less credit risk and overhead costs, achieving acceptable levels of profitability may take some period of time as the Bank restructures its operations.
Asset Quality. Non-Performing Assets. The Bank's level of non-performing assets continued to decline during fiscal 1998. The following table sets forth information concerning the Bank's non-performing assets at the dates indicated. The figures shown are after charge-offs and, in the case of real estate acquired in settlement of loans, after all valuation allowances.
Non-performing assets include non-accrual loans (loans contractually past due 90 days or more or with respect to which other factors indicate that full payment of principal and interest is unlikely), non-accrual real estate held for investment ("non-accrual REI"), and REO, acquired either through foreclosure or deed-in-lieu of foreclosure, or pursuant to in-substance foreclosure.
Prior to the sale of its credit card portfolio and related operations and effective June 30, 1997, the Bank conformed its reporting practices for credit card loans to those of most credit card issuers and excluded credit card loans from non-accrual loans and non-performing assets. Credit card loans were not placed on non-accrual status, but continued to accrue interest until the loan was either paid-off or charged-off.
Non-performing assets totaled $78.0 million, after valuation allowances on REO of $153.6 million, at September 30, 1998, compared to $104.5 million, after valuation allowances on REO of $140.7 million, at September 30, 1997. In addition to the valuation allowances on REO, the Bank maintained $4.6 million and $1.4 million of valuation allowances on its non- accrual loans at September 30, 1998, and September 30, 1997, respectively. The $26.5 million decrease in non-performing assets was comprised of a net decrease in REO of $25.3 million and a decrease in non-accrual loans of $1.2 million.
Non-accrual Loans. The Bank's non-accrual loans totaled $12.6 million at September 30, 1998, compared to $13.8 million at September 30, 1997. At September 30, 1998, non- accrual loans consisted primarily of $8.1 million of non-accrual real estate loans and $4.5 million of non-accrual consumer and other loans.
REO. At September 30, 1998, the Bank's REO totaled $65.4 million, after valuation allowances on such assets of $153.6 million as set forth in the following table.
Balance Before All Balance After # of Valuation Valuation Valuation Percent (Dollars in thousands) Properties Allowances Allowances Allowances of Total - ---------------------- ---------- ----------- ----------- ------------- -------- Communities........... 5 $199,406 $144,642 $54,764 83.7% Residential ground.... 3 6,494 3,122 3,372 5.2% Commercial ground..... 3 10,045 5,800 4,245 6.5% Single-family residential properties........ 19 3,027 - 3,027 4.6% -- --------- ------------ ------------- --------
Total REO........... 30 $218,972 $153,564 $65,408 100.0% == ========= ============ ============= ========
During fiscal 1998, REO decreased $25.3 million, which was attributable to $12.5 million of sales in the Communities and other residential properties, partially offset by additional capitalized costs, and $12.8 million of additional valuation allowances.
During fiscal 1998, the Bank received revenues of $32.5 million from dispositions of 422 residential lots or units in the Communities ($21.6 million), approximately 75 acres of commercial land in two of the Communities and four commercial ground properties ($6.1 million) and various single-family residential properties ($4.8 million).
At September 30, 1998, the Bank had an executed contract to sell one residential ground property at its book value of $1.3 million at that date. The Bank's objective with respect to its REO is to sell such properties as expeditiously as possible and in a manner which will best preserve the value of the Bank's assets. The Bank's ability to achieve this objective will depend on a number of factors, some of which are beyond its control, such as the general economic conditions in the Washington, D.C. metropolitan area.
The principal component of REO consists of the five Communities, four of which are under active development. At September 30, 1998, two of the active Communities had 1,883 remaining residential lots, of which 927 lots (49.2%) were under contract and pending settlement. Four of the active Communities had approximately 249 remaining acres of land designated for commercial use, of which one acre (0.4%) was under contract and pending settlement. In addition, at September 30, 1998, the Bank was engaged in discussions with potential purchasers regarding the sale of additional residential units and retail land.
In addition to the four active Communities, REO includes a fifth Community, consisting of approximately 2,000 acres, in Loudoun County, Virginia, which is in the pre-development stage and was to be developed into approximately 6,200 residential units. At September 30, 1998, this property had a book value of $4.7 million, after valuation allowances.
The Bank capitalizes costs relating to development and improvement of REO. Interest costs are capitalized on real estate properties under development. During fiscal 1998, the Bank capitalized interest in the amount of $2.0 million relating to its four active Communities.
The Bank will continue to monitor closely its major non-performing and potential problem assets in light of current and anticipated market conditions. The Bank's asset workout group focuses its efforts in resolving these problem assets as expeditiously as possible. The Bank does not anticipate any significant increases in non-performing and potential problem assets.
Potential Problem Assets. Although not considered non-performing assets, primarily because the loans are not 90 or more days past due and the borrowers have not abandoned control of the properties, potential problem assets are experiencing problems sufficient to cause management to have serious doubts as to the ability of the borrowers to comply with present repayment terms. At September 30, 1998 and 1997, none of the Bank's assets were deemed by management to be potential problem assets.
Delinquent Loans. At September 30, 1998, delinquent loans totaled $20.7 million (or 0.7% of loans) compared to $84.6 million (or 3.5% of loans) at September 30, 1997. The following table sets forth information regarding the Bank's delinquent loans at September 30, 1998.
Principal Balance ----------------------------------- Total as a Mortgage Non-Mortgage Percentage (Dollars in thousands) Loans Loans Total of Loans (1) - ------------------------- ----------- ------------ --------- -------------- Loans delinquent for: 30-59 days............... $ 3,486 $ 11,777 $ 15,263 0.5% 60-89 days............... 1,582 3,866 5,448 0.2% ------- -------- -------- ---- Total................... $ 5,068 $ 15,643 $ 20,711 0.7% ======= ======== ======== ====
- -------------------------- (1) Includes loans held for sale and/or securitization, before deduction of valuation allowances, unearned premiums and discounts and deferred loan origination fees (costs).
Mortgage loans classified as delinquent 30-89 days consists entirely of single-family permanent residential mortgage loans and home equity credit line loans. Total delinquent mortgage loans decreased to $5.1 million at September 30, 1998, from $8.5 million at September 30, 1997.
Non-mortgage loans delinquent 30-89 days decreased to $15.6 million at September 30, 1998 from $50.4 million at September 30, 1997, and decreased as a percentage of total non-mortgage loans outstanding to 2.5% at September 30, 1998 from 3.4% at September 30, 1997. The decreased percentage of delinquent non-mortgage loans to total non-mortgage loans outstanding resulted primarily from the sale of the Bank's credit card portfolio on September 30, 1998.
Troubled Debt Restructurings. A troubled debt restructuring occurs when the Bank agrees to modify significant terms of a loan in favor of the borrower when the borrower is experiencing financial difficulties. In aggregate, troubled debt restructurings totaled $11.8 million and $11.9 million at September 30, 1998 and 1997, respectively.
At September 30, 1998, loans accounted for as troubled debt restructurings included one commercial permanent loan with a principal balance of $11.7 million and one commercial collateralized loan with a principal balance of $0.1 million. The $0.1 million decrease in loans accounted for as troubled debt restructurings from September 30, 1997, was a result of net principal reductions. At September 30, 1998, the Bank had commitments to lend $0.1 million of additional funds on loans that have been restructured.
Real Estate Held for Investment. At September 30, 1998 and 1997, real estate held for investment consisted of two properties with an aggregate book value of $3.6 million, net of valuation allowances of $0.2 million.
Allowances for Losses. The following tables show loss experience by asset type and the components of the allowance for losses on loans and the allowance for losses on real estate held for investment or sale. These tables reflect charge-offs taken against assets during the years indicated and may include charge-offs taken against assets which the Bank disposed of during such years.
The Bank maintains valuation allowances for estimated losses on loans and real estate. The Bank's total valuation allowances for losses on loans and real estate held for investment or sale decreased by $32.7 million from the level at September 30, 1997, to $213.9 million at September 30, 1998. The $32.7 million decrease was primarily attributable to an $87.6 million reduction in allowances due to the sale of the Bank's credit card portfolio on September 30, 1998. Offsetting this reduction were increased valuation allowances on consumer loans and the Communities.
The allowance for losses on loans secured by real estate and real estate held for investment or sale totaled $170.3 million at September 30, 1998, which constituted 75.0% of total non-performing real estate assets, before valuation allowances. This amount represented a $19.8 million increase from the September 30, 1997 level of $150.5 million, or 62.5% of total non-performing real estate assets, before valuation allowances at that date.
During fiscal 1998, the Bank provided an additional $4.2 million of general valuation allowances pursuant to its policy of providing additional general valuation allowances which were equal to, or exceeded, the amount of the net earnings generated by the development and sale of land in the Communities.
When real estate collateral securing an extension of credit is initially recorded as REO, it is recorded at the lower of cost or fair value, less estimated selling costs, on the basis of an appraisal. As circumstances change, it may be necessary to provide additional valuation allowances based on new information. The allowance for losses on real estate held for sale at September 30, 1998 is in addition to approximately $48.6 million of cumulative charge-offs previously taken against assets remaining in the Bank's portfolio at September 30, 1998.
The Bank from time to time obtains updated appraisals on its real estate acquired in settlement of loans. As a result of such updated appraisals, the Bank could be required to increase its valuation allowances.
Net charge-offs of credit card loans for fiscal 1998 were $95.6 million, compared to $105.5 million for fiscal 1997. The decrease in net charge-offs reflected management's implementation of more stringent underwriting and other lending policies designed to reduce such losses. The allowance at any balance sheet date related only to receivable balances that existed as of that date. Because of the nature of a revolving credit card account, the cardholder may have entered into transactions (such as retail purchases and cash advances) subsequent to a balance sheet date which increased the outstanding balance of the account. Accordingly, charge-offs in any fiscal period related both to balances and conditions or events that existed at the beginning of the period and to balances created during the period, and may therefore have exceeded the levels of valuation allowances established at the beginning of the fiscal period.
The allowance for losses on consumer loans (automobile, home improvement, overdraft lines of credit and other consumer loans) increased to $34.1 million at September 30, 1998 from $6.3 million at September 30, 1997. Management increased the allowance for losses on automobile loans from $3.1 million (or 1.3% of outstanding loans) to $29.0 million (8.1%) primarily because of adverse trends in delinquencies and losses in the subprime segment of the automobile loan portfolio and an increase in the size of this portfolio. Losses in this portfolio increased from $3.2 million (or 3.7% of average loans) in fiscal 1997 to $7.0 million (or 5.0% of average loans) in fiscal 1998. However, the amount of loans in the Bank's portfolio has increased from $116.6 million at September 30, 1997, to $236.5 million at September 30, 1998 and, on a six month lagged basis, the annualized loss rate for the September quarter was 9.76%. Management believes that this lagged loss rate is a better indication of losses inherent in this portfolio because the portfolio contains a higher proportion of new loans as a result of its recent growth and losses are generally not experienced on automobile loans until the loans are five to seven months seasoned. Although management has taken steps in recent months to mitigate losses in this portfolio, including expansion of collection efforts and adjustment of underwriting criteria, losses are not expected to show improvement until the second half of fiscal 1999. Accordingly, based on recent experience, management increased the allowance for losses at September 30, 1998.
Asset and Liability Management. A key element of banking is the monitoring and management of liquidity risk and interest-rate risk. The process of planning and controlling asset and liability mix, volume and maturity to stabilize the net interest spread is referred to as asset and liability management. The objective of asset and liability management is to maximize the net interest yield within the constraints imposed by prudent lending and investing practices, liquidity needs and capital planning.
The Bank's assets and liabilities are inherently sensitive to changes in interest rates. These movements can result in variations to the overall level of income and market value of equity. Based on the characteristics of a specific asset or liability (including maturity, repricing frequency and interest caps) a change in interest rates can significantly affect the contribution to net income and market value for the instrument. If, in the aggregate, the Bank's assets mature or reprice more quickly or to a greater extent than its liabilities, the Bank is termed asset sensitive and will tend to experience increased income and market value during periods of rising interest rates and declining income and value during periods of falling interest rates. Conversely, if the Bank's liabilities mature or reprice more quickly or to a greater extent than its assets, the Bank is termed liability sensitive and will tend to experience decreased income and market value during periods of rising interest rates and increased income and value during periods of falling interest rates.
The Bank pursues an asset-liability management strategy designed both to control risk from changes in market interest rates and to maximize interest income in its loan portfolio. To achieve this strategy, the Bank emphasized the origination and retention of a mix of both adjustable-rate and fixed-rate loan products. In addition to adjustable-rate mortgages and adjustable-rate home equity credit line loans, fixed-rate mortgage loans were originated and retained in the Bank's portfolio during fiscal 1998 to a significantly larger degree than in prior years. At September 30, 1998, adjustable-rate loans accounted for 36.0% of total loans compared to 79.5% in fiscal 1997.
Declining interest rates throughout 1998 contributed to an increased demand for fixed-rate loan products. Due to this rising demand, the Bank increased its volume of fixed-rate mortgage originations as adjustable-rate loan demand fell. The Bank continuously monitors its sensitivity to changes in market interest rates and attempts to minimize the impact of interest-rate changes to net income. The Bank's policy is generally to sell, or have the ability to sell, some portion of its long-term fixed-rate mortgage production in order to reduce its exposure to market interest rate fluctuations typically associated with long-term fixed-rate lending.
A traditional measure of interest-rate risk within the banking industry is the interest sensitivity gap, which is the sum of all interest-earning assets minus all interest-bearing liabilities subject to repricing within the same period. Gap analysis is a tool used by management to evaluate interest-rate risk which results from the difference between repricing and maturity characteristics of the Bank's assets and those of the liabilities that fund them. By analyzing these differences, management can attempt to estimate how changes in interest rates affect the Bank's future net interest income.
The Bank views control over interest rate sensitivity as a key element in its financial planning process and monitors interest rate sensitivity through its forecasting system. The Bank manages interest rate exposure and will narrow or widen its gap, depending on its perception of interest rate movements and the composition of its balance sheet. For the reasons discussed above, the Bank might take action to narrow its gap if it believes that market interest rates will experience a significant prolonged increase, and might widen its gap if it believes that market interest rates will decline or remain relatively stable.
A number of asset and liability management strategies are available to the Bank in structuring its balance sheet. These include selling or retaining certain portions of the Bank's current residential mortgage loan production; altering the Bank's pricing on certain deposit products to emphasize or de-emphasize particular maturity categories; altering the type and maturity of securities acquired for the Bank's investment portfolio when replacing securities following normal portfolio maturation and turnover; lengthening or shortening the maturity or repricing terms for any current period asset securitizations; and altering the maturity or interest rate reset profile of borrowed funds, if any, including funds borrowed from the FHLB of Atlanta.
The following table presents the interest rate sensitivity of the Bank's interest-earning assets and interest-bearing liabilities at September 30, 1998, which reflects management's estimate of mortgage loan prepayments and amortization and provisions for adjustable interest rates. Adjustable and floating rate loans are included in the period in which their interest rates are next scheduled to adjust, and prepayment rates are assumed for the Bank's loans based on recent actual experience. Statement savings and passbook accounts with balances under $20,000 are classified based upon management's assumed attrition rate of 17.5%, and those with balances of $20,000 or more, as well as all NOW accounts, are assumed to be subject to repricing within six months or less.
The one-year gap, adjusted for the effect of the Bank's interest rate caps, as a percentage of total assets, was a negative 16.6% at September 30, 1998, compared to 4.5% at September 30, 1997. The decline in the Bank's one-year gap was primarily attributable to an increase in fixed-rate mortgage loans during fiscal 1998 which were funded primarily by short-term borrowings.
During fiscal 1995, the Bank purchased a series of interest rate caps designed to limit its exposure to rising short-term interest rates during a four-year period which began July 1, 1995 and will end June 30, 1999. The Bank's Interest Rate Sensitivity Table reflects the reduction in risk provided by these caps. The initial level of the protection was a notional principal amount of $600 million, and such protection declined to $205.6 million at September 30, 1998, and will decline to $200 million by March 31, 1999. The remaining $200 million of protection will expire on June 30, 1999. In the event that the one-month London Inter-Bank Offered Rate ("LIBOR") exceeds 7.00% on certain predetermined dates, the Bank is entitled to receive compensatory payments from the cap provider, which is a counterparty receiving the highest investment rating from Standard & Poor's Corporation. Such payments would be equal to the product of (a) the amount by which one-month LIBOR exceeds 7.00% and (b) the then outstanding notional principal amount for a predetermined period of time. The Bank has no obligation to make payments to the provider of the cap or any other party.
During fiscal 1997, an additional interest rate cap agreement with a notional amount of $5.6 million and $72.2 million at September 30, 1998 and 1997, respectively, was transferred and assigned to the Bank at the termination of one of the Bank's credit card securitization transactions. This interest rate cap agreement terminated October 15, 1998.
In addition to gap measurements, the Bank measures and manages interest-rate risk with the extensive use of computer simulation. This simulation includes calculations of Market Value of Portfolio Equity and Net Interest Margin as promulgated by the OTS's Thrift Bulletin 13 ("TB 13"). Under this regulation, institutions are required to establish limits on the sensitivity of their net interest income and net portfolio value ("NPV") to parallel changes in interest rates. Such changes in interest rates are defined as instantaneous and sustained movements to rates in 100 basis point increments. The following table shows the estimated impact of parallel shifts in interest rates at September 30, 1998, calculated in a manner consistent with the requirements of TB 13.
Change In --------------------------------------- Change in Interest Rates Net Interest Net Portolio (Basis Points) Income(1) Value(2) - ------------------------ ------------------ ----------------- (Dollars in thousands) Percent Amount Percent Amount ------- ---------- ------- --------- + 200 (11.2)% $ (25,767) (11.0)% $(102,239) + 100 (5.0)% $ (11,567) (2.7)% $ (25,576) - 100 12.1 % $ 27,859 7.3 % $ 68,007 - 200 20.3 % $ 46,799 12.0 % $ 112,045 - ------------------------------------------------------------------------------- (1) Represents the difference between net interest income for 12 months in a stable interest rate environment and the various interest rate scenarios.
(2) Represents the difference between net portfolio value (NPV) of the Bank's equity in a stable interest rate environment and the NPV in the various rate scenarios. The OTS defines NPV as the present value of expected net cash flows from existing assets minus the present value of expected existing liabilities plus the present value of expected net cashflows from existing off-balance sheet contracts.
Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, prepayments and deposit run-offs and should not be relied upon as indicative of actual results. Certain limitations are inherent in such computations. Although certain assets and liabilities may have similar maturity or periods of repricing, they may react at different times and in different degrees to changes in the market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable rate mortgage loans, generally have features which restrict changes in their interest rates on a short term basis and over the life of the asset. In the event of a change in interest rates, loan prepayments and early deposit withdrawal levels could deviate significantly from those assumed in making the calculations set forth above. Additionally, credit risk may increase if an interest rate increase adversely affects the ability of many borrowers to service their debt.
At September 30, 1998, the Bank would not have been required to maintain additional amounts of risk-based capital had the interest-rate risk component of the OTS capital regulations been in effect. See "Business - Regulation Regulatory Capital."
In December 1998, the Office of Thrift Supervision released Management of Interest Rate Risk, Investment Securities, and Derivatives Analysis ("TB13a") to replace prior thrift bulletins concerned with the measurement of interest rate risk. The Bank currently measures interest-rate risk and the effect of changes in interest rates on both net interest income and market value on a regular basis. TB13a requires the Bank to modify its existing interest-rate risk analyses to include a new measure, Net Portfolio Value Ratio, and to measure the sensitivity of this ratio through interest rate shock scenarios. The Bank is currently in the process of reviewing TB13a and incorporating this new measurement into its regular analyses; however, based on a preliminary review of TB13a and its impact to the Bank's measurement of interest rate sensitivity, management believes its impact will be minimal.
Nevertheless, the sale of the Bank's credit card portfolio and current market conditions are likely to result in a higher proportion of the Bank's assets being comprised of assets with longer durations and greater sensitivity to market interest rates than credit card loans. Accordingly, management expects to consider steps it can take during fiscal 1999 to reduce to some degree the Bank's exposure to increases in market interest rates based on the change in composition of the Bank's loan portfolio.
Inflation. The impact of inflation on the Bank is different from the impact on an industrial company, because substantially all of the assets and liabilities of the Bank are monetary in nature. The most direct impact of an extended period of inflation would be to increase interest rates, and to place upward pressure on the operating expenses of the Bank. However, the actual effect of inflation on the net interest income of the Bank would depend on the extent to which the Bank was able to maintain a spread between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, which would depend to a significant extent on its asset-liability sensitivity. The effect of inflation on the Bank's results of operations for the past three fiscal years has been minimal.
Deferred Tax Asset. At September 30, 1998, the Bank recorded a net deferred tax asset of $81.6 million, which generally represents the cumulative excess of the Bank's actual income tax liability over its income tax expense for financial reporting purposes. See Note 26 to the Consolidated Financial Statements in this report.
Tax Sharing Payments. During fiscal 1998, after receiving OTS approval, the Bank made tax sharing payments totaling $5.6 million to the Trust. Subsequent to September 30, 1998, the Bank made a tax sharing payment of $6.6 million to the Trust. See Note 32 to the Consolidated Financial Statements in this report.
Capital. At September 30, 1998, the Bank was in compliance with all of its regulatory capital requirements under FIRREA, and its capital ratios exceeded the ratios established for well capitalized institutions under OTS prompt corrective action regulations.
The following table shows the Bank's regulatory capital levels at September 30, 1998, in relation to the regulatory requirements in effect at that date. The information below is based upon the Bank's understanding of the regulations and interpretations currently in effect and may be subject to change.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from total risk-based capital. In February 1998, the Bank received from the OTS an extension of the holding periods for certain of its REO properties through February 17, 1999. The following table sets forth the Bank's REO at September 30, 1998, after valuation allowances of $153.6 million, by the fiscal year in which the property was acquired through foreclosure.
Fiscal Year (In thousands) ------------------------------- -------------- 1990(1)(2)..................... $ 19,023 1991(2)........................ 36,619 1992(2)........................ 100 1993........................... - 1994........................... 732 1995........................... 5,907 1996........................... - 1997........................... - 1998......................... 3,027 -------------- Total REO.................... $ 65,408 ==============
(1) Includes REO with an aggregate net book value of $11.1 million, which the Bank treats as equity investments for regulatory capital purposes.
(2) Includes REO, with an aggregate net book value of $44.6 million, for which the Bank received an extension of the holding periods through February 17, 1999.
Under the OTS prompt corrective action regulations, an institution is categorized as well capitalized if it has a leverage (or core capital) ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0%, a total risk-based capital ratio of at least 10.0% and is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level. At September 30, 1998, the Bank's leverage, tier 1 risk-based and total risk-based capital ratios were 7.93%, 12.93% and 20.70%, respectively, which exceeded the ratios established for well capitalized institutions. The OTS has the discretion to reclassify an institution from one category to the next lower category, for example from well capitalized to adequately capitalized, if, after notice and an opportunity for a hearing, the OTS determines that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity.
Failure to obtain the REO extensions discussed above could adversely affect the Bank's regulatory capital ratios. The Bank's ability to maintain or increase its capital levels in future periods also will be subject to general economic conditions, particularly in the Bank's local markets. Adverse general economic conditions or a renewed downturn in local real estate markets could require further additions to the Bank's allowances for losses and further charge-offs. Any such developments would adversely affect the Bank's earnings and thus its regulatory capital levels.
LIQUIDITY AND CAPITAL RESOURCES
Real Estate
General. The Real Estate Trust's primary cash requirements fall into four categories: operating expenses (exclusive of interest on outstanding debt), capital improvements, interest on outstanding debt and repayment of outstanding debt.
Historically, the Real Estate Trust's total cash requirements have exceeded the cash generated by its operations. This condition is currently the case and is expected to continue to be so for the foreseeable future. The Real Estate Trust's internal sources of funds, primarily cash flow generated by its income-producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding unsecured notes ("Unsecured Notes") sold to the public, the payment of interest on its Senior Secured Notes, and the payment of capital improvement costs. In the past, the Real Estate Trust funded such shortfalls through a combination of external funding sources, primarily new financings (including the sale of Unsecured Notes), refinancings of maturing mortgage debt, asset sales and tax sharing payments from the Bank. See the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements in this report.
The Real Estate Trust's ability to meet its liquidity needs, including debt service payments in fiscal 1999 and subsequent years, will depend in significant part on its receipt of dividends from the Bank and tax sharing payments from the Bank pursuant to the Tax Sharing Agreement among the Trust, the Bank, and their subsidiaries. The availability and amount of tax sharing payments and dividends in future periods is dependent upon, among other things, the Bank's operating performance and income, regulatory restrictions on such payments, including availability of Trust collateral to support such payments, and (in the case of tax sharing payments), the continued consolidation of the Bank and the Bank's subsidiaries with the Trust for federal income tax purposes. See also the discussion of potential limitations on the payment of dividends by the Bank contained in "Business - Banking - Regulation Dividends and Other Capital Distributions."
The Real Estate Trust believes that the financial condition and operating results of the Bank in recent periods, as well as the Bank's board resolution adopted in connection with the release of its written agreement with the OTS (see "Banking - Regulation - Regulatory Capital") should enhance prospects for the Real Estate Trust to receive tax sharing payments and dividends from the Bank. During fiscal 1998, the Bank made tax sharing payments totalling $5.6 million and dividend payments totalling $5.2 million to the Real Estate Trust.
In recent years, the operations of the Trust have generated net operating losses while the Bank has reported net income. It is anticipated that the Trust's consolidation of the Bank's operations into the Trust's federal income tax return will result in the use of the Trust's net operating losses to reduce the federal income taxes the Bank would otherwise owe. If in any future year, the Bank has taxable losses or unused credits, the Trust would be obligated to reimburse the Bank for the greater of (i) the tax benefit to the group using such tax losses or unused tax credits in the group's consolidated federal income tax returns or (ii) the amount of the refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group.
Through September 30, 1998, the Real Estate Trust has purchased either in the open market or through dividend reinvestment 2,091,176 shares of common stock of Saul Centers (representing 16.4% of such company's outstanding common stock). As of September 30, 1998, the market value of these unpledged shares was approximately $35.5 million.
In fiscal 1994, the Real Estate Trust refinanced a significant portion of its outstanding secured indebtedness with the proceeds of the issuance of $175.0 million aggregate principal amount of 11 5/8% Senior Secured Notes due 2002 (the "1994 Notes"). See Note 4 to the Consolidated Financial Statements in this report. In March 1998, the Real Estate Trust issued $200.0 million aggregate principal amount of 9 3/4% Senior Secured Notes due 2008 (the "1998 Notes"). After providing for the retirement of the 1994 Notes, including a prepayment premium of $10.0 million and debt issuance costs of approximately $5.9 million, the Real Estate Trust realized approximately $9.1 million in new funds. In addition, the Real Estate Trust received about $13.2 million in cash which had been held as additional collateral by the indenture agent under the 1994 Notes. The 1998 Notes are secured by a first priority perfected security interest in 8,000 shares (80%) of the issued and outstanding common stock of the Bank, which constitute all of the Bank common stock held by the Real Estate Trust. The 1998 Notes are nonrecourse obligations of the Real Estate Trust.
The Real Estate Trust is currently selling Unsecured Notes, with a maturity ranging from one to ten years, primarily to provide funds to repay maturing Unsecured Notes. To the degree that the Real Estate Trust does not sell new Unsecured Notes in an amount sufficient to finance completely the scheduled repayment of outstanding Unsecured Notes as they mature, it will finance such repayments from other sources of funds.
In fiscal 1995, the Real Estate Trust established a $15.0 million secured revolving credit line with an unrelated bank. This facility was for an initial two-year period subject to extension for one or more additional one-year terms. In fiscal 1997, the facility was increased to $20.0 million and was renewed for an additional two-year period. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $8.4 million.
In fiscal 1996, the Real Estate Trust established an $8.0 million secured revolving credit line with an unrelated bank. This facility was for a one-year term, after which any outstanding loan amount would amortize over a two-year period. During fiscal 1997, the line of credit was increased to $10.0 million and was extended for a year. During fiscal 1998, the line of credit was increased to $20.0 million and was extended for an additional year. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $4.3 million.
During fiscal 1997, the Real Estate Trust refinanced two hotel and three office properties with five- year floating rate debt. After payment of all financing costs, the Real Estate Trust received net proceeds of approximately $11.0 million.
The maturity schedule for the Real Estate Trust's outstanding debt at September 30, 1998 for fiscal years commencing October 1, 1998 is set forth in the following table:
Debt Maturity Schedule (In thousands) - -------------------------------------------------------------------- Notes Notes Fiscal Mortgage Payable- Payable- Year Notes Secured Unsecured Total - -------------------------------------------------------------------- 1999 $10,055 $ -- $16,149 $ 26,204 2000 10,193 -- 8,893 19,086 2001 12,618 -- 5,916 18,534 2002 14,367 -- 5,284 19,651 2003 12,663 -- 9,046 21,709 Thereafter 138,978 200,000 5,047 344,025 --------- ---------- --------- ---------- Total $198,874 $200,000 $50,335 $449,209 ========= ========== ========= ========== - --------------------------------------------------------------------
Of the $198.9 million of mortgage debt outstanding at September 30, 1998, $169.8 million was nonrecourse to the Real Estate Trust.
As the owner, directly and through two wholly-owned subsidiaries, of a 21.5% limited partnership interest in Saul Holdings Partnership, the Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale of properties. The partnership agreement of Saul Holdings Partnership provides for quarterly cash distributions to the partners out of net cash flow. See "Business - Real Estate - Investment in Saul Holdings Limited Partnership." In fiscal 1998, the Real Estate Trust received total cash distributions of $5.6 million from Saul Holdings Partnership. Beginning in April 1998 the Real Estate Trust has reinvested its quarterly distributions and obtained additional partnership units in Saul Holdings.
Development and Capital Expenditures
During the third quarter of fiscal 1997, the Real Estate Trust commenced development of a 46,000 square foot single-story office research and development building on 3 acres of its Avenel Business Park land parcel located in Gaithersburg, Maryland ("Avenel Phase IV"). The Real Estate Trust financed the project with a construction/permanent loan. The project was substantially completed in January 1998 and was offered to Saul Holdings in accordance with the Real Estate Trust's obligations under the Right of First Refusal Agreement. An independent appraisal of the project indicated a market value of $5,600,000. The fully funded balance of the loan was $3,657,000, resulting in an equity position of $1,943,000 for the Real Estate Trust. The Board of Directors of Saul Centers, Inc., general partner of Saul Holdings, agreed to purchase the Real Estate Trust's equity position through the issuance of additional limited partnership units in Saul Holdings. Accordingly, as of April 1, 1998, Saul Holdings insured 105,922 new limited partnership units and a corresponding limited partnership interest to the Real Estate Trust in exchange for the ownership of Avenel Phase IV and the assumption of the loan.
In September 1997, the Real Estate Trust commenced development of a 95-unit extended stay hotel on a 3 acre parcel located adjacent to its Hampton Inn and Holiday Inn near the Washington Dulles International Airport in Sterling, Virginia. The new hotel was franchised as a TownePlace Suites by Marriott and opened for business in August 1998. Development costs were $5.8 million and were largely financed by a construction loan of $4.5 million. The loan is for two years with two extension options for two year and one year periods, respectively. The loan covered all costs except for the land, fees to related parties, taxes and insurance.
On December 10, 1997, the Real Estate Trust purchased a 308-room Holiday Inn located in Arlington, Virginia, near the Washington National Airport and the Real Estate Trust's Howard Johnson Hotel. The purchase price was $25.8 million. Also on December 10, 1997, the Real Estate Trust refinanced five other hotels in its portfolio. Funds for the two transactions were provided by a lender in the amount of $52.5 million. The new loans have a 15 year term, a fixed interest rate of 7.57%, and amortization based on a 25 year schedule.
During the quarter ended June 30, 1998, the Real Estate Trust commenced development of four new extended stay hotels:
TownePlace Suites by Marriott containing 91 units to be located on a 2 acre site owned by the Trust in Avenel Business Park in Gaithersburg, Maryland. Opening is scheduled for mid-April 1999.
TownePlace Suites by Marriott containing 91 units to be located on part of a 9 acre site owned by the Real Estate Trust in the Arvida Park of Commerce in Boca Raton, Florida. Opening is scheduled for mid-July 1999.
SpringHill Suites by Marriott containing 146-units to be located on part of a 9 acre site owned by the Real Estate Trust in the Arvida Park of Commerce in Boca Raton, Florida. Opening is scheduled for mid-July 1999.
TownePlace Suites by Marriott containing 95-units to be located on a 3 acre site owned by the Real Estate Trust in Ft. Lauderdale Commerce Center, Ft. Lauderdale, Florida. Opening is scheduled for mid-August 1999.
The projected costs for the four hotels aggregate $32 million and will largely be funded by the proceeds of a three year bank loan in the amount of $25.9 million. The loan has two one-year renewal options.
During the quarter ended June 30, 1998, the Real Estate Trust also began development of a 78,000 square floor single-story office/research and development building located on a 7 acre site owned by the Real Estate Trust in Dulles North Corporate Park, Sterling, Virginia. This project is adjacent to the Real Estate Trust's Dulles North office building and near three of the Real Estate Trust's hotel properties. The development cost is $6.6 million with bank financing of $6.5 million for a five-year term and a two-year extension option. Completion is expected in early fiscal 1999. A lease for approximately 25% of the space has been signed.
During the quarter ended September 30, 1998, the Real Estate Trust began the conversion of its two hotels located in Crystal City, Arlington, Virginia. The present 308-room Crystal City Holiday Inn will be converted into a Holiday Inn Crown Plaza, while the present 279-room Howard Johnsons will be converted into a Holiday Inn. The new brands are expected to position the hotels to generate higher room rates and revenues along with improved occupancy levels consistent with the overall market. The renovations are largely an acceleration of normal capital improvement work as well as some exterior and interior signage, new marketing materials and a facade upgrade at the Howard Johnson hotel. A restaurant, which had been operated by an unaffiliated company, will also be renovated. The incremental costs for the two conversions will be funded by the Real Estate Trust in part from its internal resources and in part from its lines of credit.
The Real Estate Trust believes that the capital improvement costs for its income-producing properties will be in range of $6.5 to $8.0 million per year for the next several fiscal years.
Year 2000 Statement - Pursuant to The Year 2000 Information And Readiness Disclosure Act
The Real Estate Trust has reviewed all its financial and accounting systems for the purpose of assessing the impact of Year 2000 on both internally developed and externally provided systems. The Real Estate Trust currently uses an IBM AS/400, which has been certified by the manufacturer to be Year 2000 compliant. All software purchased over the past five years has been certified by the various manufacturers to be Year 2000 compliant. All internally developed software had already been modified or will be modified by December 1998 to make it Year 2000 compliant. Property management systems for shopping centers, office buildings, hotels, and construction and development have been certified as Year 2000 compliant by applicable vendors. At present, only one area of property management, apartments, has software which requires replacement to meet Year 2000 compliance, and that replacement is scheduled to be completed by May 1999. The Real Estate Trust had no information, which would suggest that its financial systems would not continue to function effectively after the turn of the century.
Using the Building Owners and Manager Association's guidelines to identify building systems and critical services that might be vulnerable to the Year 2000 software problem, the Real Estate Trust has contacted the manufacturer, supplier, or the vendor supporting the system and requested information regarding Year 2000 compliance. The majority of the replies have indicated that the systems or services are Year 2000 compliant. We are presently assessing whether any of the internal systems should be tested or whether further investigation is necessary. The Real Estate Trust has no information, which would suggest that any system would not continue to function effectively the after turn of the century. Except with regard to internally developed software, all information regarding Year 2000 compliance is based on a republication (as defined in The Year 2000 Information and Readiness Disclosure Act) of Year 2000 statements or disclosures made by others.
The Real Estate Trust believes that there is risk that its operations may be affected by vendors and tenants who are unable to perform as contracted due to their own Year 2000 exposure. It is very difficult to identify the most reasonably likely worst case scenario at this time. Although the Real Estate Trust's potential exposure is widespread, there is no known major direct exposure. The Real Estate Trust's commercial leases contain provisions empowering it to take certain actions to enforce its right to the timely payment of rent regardless of the tenants's Year 2000 exposure. While it is not possible at this time to determine the likely impact of these potential problems, the Real Estate Trust will continue to evaluate these areas and development contingency plans as appropriate. The Real Estate Trust estimates that its incremental costs to meet year 2000 compliance is less that $250,000.
Banking
The standard measure of liquidity in the savings industry is the ratio of cash and short-term U.S. Government and other specified securities to net withdrawable accounts and borrowings payable in one year or less.
The OTS has established a minimum liquidity requirement, which may vary from time to time depending upon economic conditions and deposit flows. The required liquidity level under OTS regulations in effect at September 30, 1998 was 4.0%. The Bank's liquidity ratio for the quarter ended September 30, 1998 was 10.4%, compared to 11.1% for the month ended September 30, 1997. The Bank met the liquidity level requirements for each quarter of fiscal 1998. Effective November 24, 1997, the OTS reduced the minimum liquidity requirement to 4% from 5% and changed the reporting requirement to quarterly instead of monthly. See "Business - Regulation - Liquidity Requirements."
The Bank's primary sources of funds historically have consisted of (i) principal and interest payments on loans and mortgage-backed securities, (ii) savings deposits, (iii) sales of loans and trading securities (iv) securitizations and sales of loans and (v) borrowed funds (including funds borrowed from the FHLB of Atlanta). The Bank's holdings of readily marketable securities constitute another important source of liquidity. At September 30, 1998, the Bank's portfolio included mortgage loans, U.S. Government securities and mortgage-backed securities with outstanding principal balances of $103.7 million, $44.0 million and $2.0 billion, respectively. The estimated borrowing capacity against mortgage loans, U.S. Government securities and mortgage-backed securities that are available to be pledged to the FHLB of Atlanta and various security dealers totaled $1.9 billion at September 30, 1998, after market-value and other adjustments.
Chevy Chase has accessed the capital markets as an additional means of funding its operations and managing its capital ratios and asset growth. Specifically, the Bank has securitized financial assets, including credit card, home equity, home loan and automobile loan receivables, as well as single-family residential loans, because such securitizations provide the Bank with a source of financing at competitive rates and assist the Bank in maintaining compliance with regulatory capital requirements. Additionally, the securitizations have permitted the Bank to limit the credit risk associated with these assets while continuing to earn servicing fees and other income associated with the securitized assets.
Since 1988, the Bank has securitized approximately $13.0 billion of credit card, home equity, automobile and home loan receivables. These transactions depend on sophisticated back-office systems to service complex securitization structures and on personnel with the experience to design, install and manage those systems. At September 30, 1998, the Bank serviced $417.9 million, $1.1 billion and $204.5 million of securitized home equity, automobile and home loan receivables, respectively. Chevy Chase derives fee-based income from servicing these securitized portfolios. However, such fee-based income has been adversely affected in recent periods by increases in delinquencies and charge-offs related to the receivables placed in these securitized pools.
The Bank's securitization transactions transfer the risk of repayment on securitized assets to a trust which holds the receivables and issues the asset-backed certificates and ultimately the risk of repayment is transferred to the holders of those certificates. The Bank retains risk with respect to the assets transferred to the trust only to the extent that it retains recourse based on the performance of the assets or holds certificates issued by the trust (such as a "seller certificate"). In its securitizations, the Bank typically retains a limited amount of recourse through one or more means, most often, through the establishment of "spread accounts." Occasionally other structures, such as overcollateralization of receivables or subordinated asset-backed securities, are used. Spread accounts are funded by initial deposits, if required, and by amounts generated by the securitized assets over and above the amount required to pay interest, defaults and other charges and fees on the investors' interest in the securitization transaction. Because amounts on deposit in the spread accounts are at risk depending upon performance of the securitized receivables, those amounts represent recourse to the Bank.
Pursuant to OTS's "low level recourse rule" (which sets capital requirements for assets sold with recourse at the lower of the applicable capital requirement or the amount of recourse retained), the Bank maintains dollar-for-dollar capital against the securitized assets in the amount of the recourse retained up to the otherwise applicable capital requirement. Even if defaults on outstanding receivables significantly exceed projected and historical levels so that a "pay out event" is triggered, the immediate consequence is that investors will begin receiving payments of principal from the securitized assets earlier than originally scheduled. Even if payments are insufficient to repay investors in full, the Bank's assets are not exposed to risk of loss beyond the relevant amount of recourse retained (including amounts outstanding in the spread accounts and the amount of any overcollateralization of receivables or subordinated interest), which, as noted above, constitute a dollar-for-dollar capital requirement for the Bank. The Bank also retains risk through the Bank's interest in any seller certificate. Seller certificates share collections on the securitized assets on an unsubordinated basis with the investor certificates (unless and to the extent recourse is retained through an express subordination) and are on-balance sheet assets against which the Bank must maintain capital.
In recent periods, the proceeds from the securitization and sale of credit card, home equity, automobile and home loan receivables have been significant sources of liquidity for the Bank. The Bank securitized and sold $1.0 billion of credit card receivables, $534.7 million of automobile loan receivables, $298.8 million of home equity receivables and $45.9 million of home loan receivables during fiscal 1998. Additionally, during fiscal 1998, the Bank securitized and sold $36.0 million of amounts on deposit in certain spread accounts established in connection with certain of the Bank's credit card securitizations. At September 30, 1998, the Bank was considering the securitization and sale of approximately $200.0 million of automobile loan receivables, including $125.0 million of receivables outstanding at September 30, 1998 and $75.0 million of receivables which the Bank expects to become available through additional fundings during the six months ending March 31, 1999.
In connection with the sale of the Bank's credit card portfolio and related operations, the Bank transferred all of its rights, interests, liabilities and obligations (including recourse obligations) relating to its credit card securitizations to FUSA.
As part of its operating strategy, the Bank will continue to explore opportunities to sell assets and to securitize and sell home equity, automobile and home loan receivables to meet liquidity and other balance sheet objectives. However, management expects to rely less on securitizations as a source of liquidity in fiscal 1999 because, among other things, changes in the composition of the Bank's loan portfolio following the sale of its credit card business as well as changes in market and other conditions have made other sources of liquidity such as Federal Home Loan Bank advances relatively more attractive sources of funding.
The Bank uses its liquidity primarily to meet its commitments to fund maturing savings certificates and deposit withdrawals, fund existing and continuing loan commitments, repay borrowings and meet operating expenses. During fiscal 1998, the Bank used the cash provided by operating, investing and financing activities primarily to meet its commitments to fund maturing savings certificates and deposit withdrawals of $24.8 billion, repay borrowings of $19.9 billion, fund existing and continuing loan commitments (including real estate held for investment or sale) of $3.5 billion, purchase investments and loans of $1.7 billion and meet operating expenses, before depreciation and amortization, of $464.2 million. These commitments were funded primarily through proceeds from customer deposits and sales of certificates of deposit of $24.8 billion, proceeds from borrowings of $20.4 billion, proceeds from sales of loans, trading securities and real estate of $3.7 billion, and principal and interest collected on investments, loans, and securities of $1.8 billion.
The Bank is obligated under various recourse provisions (primarily related to credit losses) related to the securitization and sale of receivables. As a result of these recourse provisions, the Bank maintained restricted cash accounts and overcollateralization of receivables amounting to $110.2 million and $12.5 million, respectively, at September 30, 1998, and $117.7 million and $8.0 million, respectively, at September 30, 1997. In addition, the Bank owned subordinated automobile receivables-backed securities with carrying values of $11.3 million and $7.9 million at September 30, 1998 and 1997, respectively, which were classified as trading securities in the Consolidated Balance Sheets.
The Bank is also obligated under various recourse provisions related to the swap of single-family residential loans for mortgage-backed securities issued by the Bank. At September 30, 1998, recourse to the Bank under these arrangements was $6.5 million, consisting of restricted cash accounts amounting to $2.6 million and overcollateralization of receivables of $3.9 million.
The Bank's commitments to extend credit at September 30, 1998 are set forth in the following table:
(In thousands) --------------
Commitments to originate loans.................. $ 266,067 -------------
Loans in process (collateralized loans):........ Home equity................................... 582,280 Real estate construction and ground........... 100,868 Commercial real estate and multifamily........ 1,713 Commercial.................................... 69,780 ------------- 754,641 ------------- Loans in process (unsecured loans): Overdraft lines............................... 88,665 Commercial.................................... 35,560 ------------- 124,225 ------------- Total commitments to extend credit............ $1,144,933 =============
The sale of the credit card portfolio substantially reduced the Bank's level of commitments to extend credit at September 30, 1998. Based on historical experience, the Bank expects to fund substantially less than the total amount of its outstanding overdraft line and home equity credit line commitments, which together accounted for 58.6% of commitments to extend credit at September 30, 1998.
At September 30, 1998, repayments of borrowed money scheduled to occur during the next 12 months were $795.7 million. Certificates of deposit maturing during the next 12 months amounted to $1.2 billion, of which a substantial portion is expected to remain with the Bank.
There were no material commitments for capital expenditures at September 30, 1998. During fiscal 1998, the Bank leased 3.5 acres of land at 7501 Wisconsin Avenue in Bethesda, Maryland, on which the Bank intends to develop and occupy an office building to use as its new corporate headquarters. Construction on this project is scheduled to begin in June 1999.
The Bank's liquidity requirements in years subsequent to fiscal 1998 will continue to be affected both by the asset size of the Bank, the growth of which may be constrained by capital requirements, and the composition of the asset portfolio. Management believes that the Bank's primary sources of funds, described above, will be sufficient to meet the Bank's foreseeable long-term liquidity needs. The mix of funding sources utilized from time to time will be determined by a number of factors, including capital planning objectives, lending and investment strategies and market conditions.
YEAR 2000 ISSUES
The "Year 2000 problem" is caused by deficiencies in computer systems that are designed to assume that the first two digits of a particular year are always "19" and therefore these systems may have difficulty accurately processing transactions using dates later than December 31, 1999. These deficiencies, if not properly identified and remediated, could lead to internal and industry-wide malfunctions and cause substantial business disruptions.
Under the direction of the Bank's management, the Bank has launched a corporate-wide Year 2000 program (the "Program") to prepare its internal computer systems, applications and infrastructure to correctly process dates up through and after December 31, 1999, and to mitigate external risks to the Bank. The Program is supported by a working group that organizes and conducts specific Year 2000 projects, including projects dealing with the Bank's facilities, counterparties and critical vendors and service providers.
The Program, which is based on the Federal Financial Institutions Examination Council's guidelines, consists of five components relating to mission-critical technology:
1. The awareness phase, which raised internal awareness of the Program;
2. The inventory/assessment phase, during which the Bank completed a corporate-wide inventory of information technology ("IT") and non-IT applications, identified key relationships with outside parties and developed plans and target dates for the Program;
3. The renovation/replacement phase, in which the Bank identified components in need of replacement or repair and made hardware and software upgrades, code enhancements, system replacements and other changes;
4. The validation phase, in which the Bank conducted tests of system-wide applications and evaluated user acceptance; and
5. The implementation phase, in which the Bank is converting its systems to year 2000-tested applications and products.
The awareness, assessment, renovation and validation phases have been completed and the implementation phase is substantially complete.
The Bank is working to mitigate external risks through a variety of projects. The Bank has assessed, and will continue to assess, the Year 2000 readiness of key counterparties and of customers. In addition, the Bank has assessed the Year 2000 readiness of critical vendors and service providers, including telecommunications, hardware and software, office equipment and financial services providers.
The Bank is developing contingency plans to address problems which may be created by external parties who may not be Year 2000 compliant. As part of this effort, the Bank is assessing significant services provided by third parties to determine the extent to which the Bank may be affected by inadequate Year 2000 preparedness. The Bank plans to identify significant Year 2000 risks, assess the probability of their occurrence and take necessary actions to mitigate those risks by developing contingency plans in response to those risks.
The Bank does not expect to incur a material loss as a result of the Year 2000 problem. However, because the Bank ultimately has no control over the remediation of systems of third parties with whom the Bank has relationships, there can be no assurance that the Bank's Program, including its contingency plans, will fully mitigate the effects of third-party failures.
The Bank expects to invest $14.6 million towards the Year 2000 program, excluding the cost of its own staff, of which $2.3 million was charged to expense in fiscal 1998 and $6.4 million and $1.0 million will be charged to expense in fiscal 1999 and fiscal 2000, respectively. Remaining amounts, which are related to equipment purchases, will be amortized to expense over the estimated useful lives of the equipment. The Bank's cost estimates are based on variables and assumptions that could cause actual results to differ from these projections.
RESULTS OF OPERATIONS
The Real Estate Trust's ability to generate revenues from property ownership and development is significantly influenced by a number of factors, including national and local economic conditions, the level of mortgage interest rates, governmental actions (such as changes in real estate tax rates) and the type, location, size and stage of development of the Real Estate Trust's properties. Debt service payments and most of the operating expenses associated with income-producing properties are not decreased by reductions in occupancy or rental income. Therefore, the ability of the Real Estate Trust to produce net income in any year from its income-producing properties is highly dependent on the Real Estate Trust's ability to maintain or increase the properties' levels of gross income. The relative illiquidity of real estate investments tends to limit the ability of the Real Estate Trust to vary its portfolio promptly in response to changes in economic, demographic, social, financial and investment conditions.
The Bank's operating results historically have depended primarily on its "net interest spread," which is the difference between the rates of interest earned on its loans and securities investments and the rates of interest paid on its deposits and borrowings. In the last three fiscal years, non-interest income from securitizations of credit card and home equity credit line receivables and income from gains on sales of credit card accounts (or "relationships"), loans and mortgage-backed securities have had a significant effect on net income. In addition to interest paid on its interest-bearing liabilities, the Bank's principal expenses are operating expenses.
Fiscal 1998 Compared to Fiscal 1997
Real Estate
The Real Estate Trust recorded loss before depreciation and amortization of debt expense of $6.9 million and an operating loss of $18.5 million for fiscal 1998, compared to a loss before depreciation and amortization of debt expense of $7.8 million and an operating loss of $19.0 million for fiscal 1997. The improvement was largely attributable to higher income after direct operating expenses for hotels and office and industrial properties and higher other income, reduced by increased corporate expenses, a reduction in equity in earnings of unconsolidated entities, and a loss on the sale of a property in fiscal 1998 as compared to a gain in fiscal 1997.
Income after direct operating expenses from hotel properties increased $4,967,000 (23.7%) in fiscal 1998 over the level achieved in fiscal 1997. $2,208,000 (11.0%) of this increase reflected improved results from nine hotels owned throughout both fiscal years, and $2,759,000 reflected results from acquisition properties. The increase in total revenue of $11,960,000 (20.1%) exceeded the increase of $6,993,000 (18.2%) in direct operating expenses. For the nine hotels owned throughout both fiscal years, the increase in total revenue was $4,677,000 (8.1%) and the increase in direct operating expenses was $2,469,000 (6.6%). The revenue increase was attributable to improved market conditions which permitted the Real Estate Trust to raise average room rates at eight of the nine hotels. Average occupancy percentages declined slightly from those of the previous year.
Income after direct operating expenses from office and industrial properties increased $1,921,000 (14.4%) in fiscal 1998 compared to such income in fiscal 1997. Gross income increased $1,786,000 (8.5%) in fiscal 1998, while expenses decreased $135,000 (1.7%) due to refunds of property taxes. The improvement in gross income was due to higher rents obtained upon releasing space.
Other income, which includes interest income, income from other real estate properties and miscellaneous receipts, increased $277,000 (6.9%) in fiscal 1998 due to higher interest income.
Land parcels and other expense decreased $76,000 (4.5%) in fiscal 1998 as the result of lower real estate taxes and the disposition of a property in the current year.
Interest expense increased $2,290,000 (5.7%) in fiscal 1998, primarily because of the higher level of borrowings in the current period. The average balance of outstanding borrowings increased to $433.2 million for fiscal 1998 from $400.3 million for the prior year. The increase in average borrowings occurred as a result of a new issue of $200.0 million of Senior Secured Notes due 2008 and the retirement of $175.0 million of Senior Secured Notes due 2002, new mortgage loan financings and sales of new Unsecured Notes in excess of maturing Notes. The average cost of borrowings was 10.05% in fiscal 1998 and 10.30% in fiscal 1997.
Amortization of debt expense decreased $292,000 (44.0%) in fiscal 1998, primarily due to lower costs experienced in the new Senior Secured Note financing and in the renewal of lines of credit.
Depreciation increased $627,000 (5.9%) in fiscal 1998 as a result of the addition of two new income-producing properties as well as new tenant improvements and capital replacements.
Advisory, management and leasing fees paid to related parties increased $747,000 (9.3%) in fiscal 1998. The advisory fee in fiscal 1998 was $317,000 per month compared to $311,000 per month for fiscal 1997, which resulted in an aggregate increase of $75,000 (2.0%). Management and leasing fees were higher by $672,000 (15.8%) in fiscal 1998 as a result of increased gross income on which fees are based.
General and administrative expense decreased $119,000 (9.4%) in fiscal 1998 as a result of lower legal and insurance costs.
Equity in earnings of unconsolidated entities represents the Real Estate Trust's share of earnings in its partnership investments. For fiscal 1998, the Real Estate Trust recorded earnings of $1,918,000 from such investments compared to earnings of $4,150,000 in the prior year. The reduction of earnings in fiscal 1998 was due to the sales of interest rate protection agreements and the write-off of unamortized costs in excess of sales proceeds received and the write-off of unamortized loan costs when a portion of the loan portfolio was refinanced.
Loss on sale of property in fiscal 1998 reflected the termination of the Real Estate Trust's lease on a property located in Oxon Hill, Maryland. Gain on sale of property in fiscal 1997 represents the gain on the sale of a purchase-leaseback investment located in Casper, Wyoming and the gain on the condemnation of a portion of a land parcel located in Atlanta, Georgia.
Banking
The Bank's operating results historically have depended primarily on its net interest spread, which is the difference between the rates of interest earned on its loans and securities and the rates of interest paid on its deposits and borrowings. In the last three fiscal years, servicing and securitization income from credit card, home equity, automobile and home loan receivables have had a significant effect on net income. In addition to interest paid on its interest-bearing liabilities, the Bank's principal expenses are operating expenses.
On September 30, 1998, the Bank sold its credit card portfolio and related operations to First USA Bank, N.A. The credit card portfolio included approximately $4.8 billion of managed credit card loans and 3.1 million Visa and MasterCard credit card accounts. Although the credit card program has historically been a significant source of earnings for the Bank, management believes that the Bank will be able to maintain profitability by relying on its core deposit franchise as a significant source of low-cost funds, and investing those funds in assets that, although offering lower yields than credit cards, involve less credit risk and overhead costs. Nevertheless, implementation of this strategy will be a gradual process and the Bank's short term profitability may be adversely affected to the extent the immediate loss of earnings from the credit card program can not be offset by corresponding reductions in operating expenses.
Overview. The Bank recorded operating income of $184.4 million for the year ended September 30, 1998 ("fiscal 1998"), compared to operating income of $80.2 million for the year ended September 30, 1997 ("fiscal 1997"). The increase in income for fiscal 1998 was primarily attributable to a $230.8 million increase in other (non-interest) income resulting primarily from a $288.3 million gain on sale of the Bank's credit card portfolio and related operations on September 30, 1998. Offsetting this amount was an $85.7 million (or 20.5%) increase in operating (non-interest) expenses caused primarily by increased salaries and employee benefits and loan expenses.
Net Interest Income. Net interest income, before the provision for loan losses, decreased $15.2 million (or 7.1%) during fiscal 1998. The Bank would have recorded interest income of $2.3 million in fiscal 1998 if non-accrual assets and restructured loans had been current in accordance with their original terms. Interest income of $0.4 million was actually recorded on non-accrual assets and restructured loans during the fiscal year. The Bank's net interest income in future periods will continue to be adversely affected by the Bank's non-performing assets. See "Financial Condition - Asset Quality - Non-Performing Assets."
The following table sets forth, for the periods indicated, information regarding the total amount of income from interest-earning assets and the resulting yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and rates, and the net interest spread and net yield on interest-earning assets.
The following table presents certain information regarding changes in interest income and interest expense of the Bank during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); changes in rate (change in rate multiplied by old volume); and changes in rate and volume.
Interest income in fiscal 1998 decreased $16.4 million (or 3.6%) from the level in fiscal 1997 as a result of lower average balances of loans receivable, and, to a lesser extent, lower average yields on mortgage-backed securities. Higher average yields on loans receivable and higher average balances of mortgage-backed securities partially offset the negative effect on interest income of the lower average loan balances and lower average yields on mortgage-backed securities.
The Bank's net yield on interest-earning assets decreased to 3.82% in fiscal 1998 from 4.14% in fiscal 1997. The decrease in the net yield primarily reflected lower yields resulting from a shift in the composition of interest-earning assets from loans receivable to lower yielding mortgage-backed securities, as well as higher average balances of deposits. The increase in average deposits was primarily due to brokered time deposits accepted in fiscal 1997 which matured during fiscal 1998. Average demand deposits also increased during fiscal 1998 as a result of the continued expansion of the Bank's branch network. The Bank does not currently anticipate significant reliance on brokered deposits as a key source of funding in the future.
Interest income on loans, the largest category of interest-earning assets, decreased by $61.3 million (or 17.0%) from fiscal 1997 primarily because of lower average balances. Higher average yields earned on the loan portfolio partially offset the negative effect of the lower average balances.
Lower average balances of the Bank's single-family residential loans, which decreased $654.3 million (or 37.1%), resulted primarily from the $1.1 billion, $560.2 million and $598.3 million exchange of single-family residential loans held in its portfolio for mortgage-backed securities (which the Bank retained for its own portfolio) in September 1997, March 1998, and June 1998, respectively. The decrease was primarily responsible for a $34.5 million (or 29.4%) decrease in interest income from single-family residential loans. Average balances of home improvement and related loans decreased $41.8 million, largely because of securitization activity during fiscal 1998. Securitizations of credit card loans and automobile loans were the primary reasons for the $122.3 million and $35.6 million decline (or 10.5% and 14.4%), respectively, in average balances of credit card loans and automobile loans.
The average yield on the loan portfolio in fiscal 1998 increased 71 basis points (to 10.79% from 10.08%) from the average yield in fiscal 1997. Contributing to the higher net yield was an increase in the average yield on automobile loans which was largely responsible for a $6.4 million increase in interest income from such loans. In addition, an increase in the average yield on single-family residential loans (from 6.65% to 7.47%) resulted from the September 1997, March 1998, and June 1998 exchange of single-family residential loans for mortgage-backed securities discussed above. Prior to the exchange, these loans had a weighted average interest rate of 6.89%, 6.99%, and 6.84%, respectively. Offsetting these amounts was a decrease in the average yield on credit card loans, which, when coupled with the decreased average balance on such loans, resulted in a $29.7 million decline in interest income from such loans for fiscal 1998. During fiscal 1998, the Bank continued to reprice its credit card portfolio as a result of ongoing competitive pressures in the credit card industry.
Interest income on mortgage-backed securities increased $41.2 million (or 57.1%) primarily because of higher average balances. The increased mortgage-backed securities balances in the 1998 period reflected the $1.1 billion, $560.2 million and $598.3 million exchange of single-family residential loans for mortgage-backed securities in September 1997, March 1998 and June 1998, respectively. The positive effect of the higher average balances was partially offset by a decline in the average interest rates on these securities from 5.99% to 5.70%.
Interest expense decreased $1.4 million (or 0.6%) for fiscal 1998 primarily because of a $179.8 million decline in the average balances of repurchase agreement transactions and a $111.0 million decline in the average balances of Federal Home Loan Bank advances which resulted in an $11.8 million decrease in interest expense on borrowings during fiscal 1998. Excess funds generated from securitization activity during the year and additional deposits facilitated the paydown of such borrowings.
The decrease in interest expense on borrowings was offset by an increase of $10.4 million (or 6.2%) in interest expense on deposits, resulting from an increase in average deposit balances of $396.2 million (or 9.3%), which was partially offset by a decrease in the average rates on deposits (to 3.84% from 3.95%).
Provision for Loan Losses. The Bank's provision for loan losses increased to $150.8 million in fiscal 1998 from $125.1 million in fiscal 1997. The $25.7 million increase was primarily due to a $32.2 million increase in the provision for losses on consumer and other loans. The increase in the provision for loan losses was primarily due to adverse trends in delinquencies and losses in the subprime segment of the automobile portfolio. See "Financial Condition - Asset Quality - Allowances for Losses."
Other Income. Other (non-interest) income increased to $641.9 million in fiscal 1998 period from $411.1 million in fiscal 1997. The $230.8 million increase in such income was primarily attributable to an increase in gain on sales of loans which included the $288.3 million gain on the sale of the Bank's credit card portfolio and related operations on September 30, 1998. Also contributing to the increase in other income was a $10.1 million increase in deposit servicing fees. Partially offsetting these increases was a $71.9 million decrease in servicing and securitization income.
Servicing and securitization income decreased $71.9 million to $233.3 million from $305.2 million, primarily due to increases in the amortization of and unrealized losses on interest-only strips. The Bank recognized net unrealized losses on its automobile, home equity and home loan interest-only strips of $42.9 million during fiscal 1998 compared to net unrealized gains on the valuation of the Bank's credit card interest-only strips of $7.0 million during 1997. In addition, amortization of $99.0 million on interest-only strips related to prior gains on sales of loans was recorded in fiscal 1998 compared to $24.8 million in fiscal 1997. Offsetting these amounts were gains of $81.6 million, $23.1 million, $19.7 million and $3.4 million recognized on the securitization and sale of credit card loans, automobile loans, home equity and home loan receivables, respectively.
The $2.1 million (or 11.5%) decrease in loss on real estate held for investment or sale was primarily attributable to an increase of $1.5 million in the gain recorded on sales of the Bank's real estate held for sale coupled with a $0.8 million decrease in the provision for losses on such assets. See "Financial Condition - Asset Quality - Allowances for Losses."
Deposit servicing fees increased $10.1 million (or 24.1%) during fiscal 1998 primarily due to an increase in fees generated through the Bank's ATM network in addition to increases in other deposit servicing fees resulting from the expansion of the Bank's branch network.
Credit card fees, consisting of annual fees, late charges, cash advance charges, interchange income, net of rebate expenses, and overlimit fees decreased to $53.9 million in fiscal 1998 from $57.4 million in fiscal 1997. The $3.5 million (or 6.1%) decrease was primarily attributable to an $8.8 million increase in rebate expenses, the effects of which were due principally to the introduction of additional programs and products designed to encourage greater usage of the Bank's credit cards. Partially offsetting the increase in rebate expenses were increases in certain fees resulting from changes to the fee structure for the Bank's credit card programs which were implemented in fiscal 1997.
Operating Expenses. Operating expenses for fiscal 1998 increased $85.7 million (or 20.5%) from the level in fiscal 1997. The primary component of the higher operating expenses was a $38.6 million increase in salaries and employee benefits resulting primarily from the addition of staff to the Bank's consumer lending and branch operations. The $24.2 million increase in loan expenses was primarily attributable to increased credit card collection and retention costs and to increases in the valuation allowances on servicing assets. Also contributing to the increase in operating expenses was an increase of $5.1 million in marketing expenses, primarily credit card marketing expenses.
Fiscal 1997 Compared to Fiscal 1996
Real Estate
The Real Estate Trust recorded a loss before depreciation and amortization of debt expense of $7.8 million and an operating loss of $19.0 million for fiscal 1997, compared to a loss before depreciation and amortization of debt expense of $13.5 million and an operating loss of $24.2 million for fiscal 1996. The improvement was largely attributable to higher income after direct operating expenses for hotels and office and industrial properties, increased income from Saul Holdings Partnership and other partnership investments, and recognition of gains on sales of properties.
Income after direct operating expenses from hotel properties increased $2,771,000 (15.3%) in fiscal 1997 over the level achieved in fiscal 1996. In fiscal 1997, room sales increased $4,542,000 (11.7%), while food and beverage sales increased $565,000 (4.6%). The increase in total revenue of $5,219,000 (9.6%) exceeded the increase of $2,448,000 (6.8%) in direct operating expenses. The revenue increases were due to improved market conditions, which permitted management to raise average room rates while maintaining or increasing occupancy at several of the hotels. The Real Estate Trust also acquired a new hotel in fiscal 1997.
Income after direct operating expenses from commercial properties, which consists of office and industrial properties, increased $2,992,000 (28.9%) in fiscal 1997 compared to such income in fiscal 1996. Gross income increased $3,507,000 (19.9%) in fiscal 1997, while expenses increased $515,000 (7.1%). The improvement was the direct result of a higher leasing rate in fiscal 1997. Expenses in fiscal 1997 were above the prior year's principally due to higher property taxes and higher operating expenses.
Other income, which includes interest income, income from other real estate properties and miscellaneous receipts, declined by $996,000 (19.9%) in fiscal 1997 primarily due to lower cash balances on which interest was earned. Other income in fiscal 1996 also included $695,000 received as refunds of transfer taxes paid in a preceding year.
Land parcels and other expense increased $46,000 (2.8%) in fiscal 1997 as the result of higher real estate taxes.
Interest expense increased $315,000 (0.8%) in fiscal 1997, primarily because of the higher level of borrowings in the current period. The average balance of outstanding borrowings increased to $400.3 million for fiscal 1997 from $395.6 million for the prior year. The change in average borrowings occurred as a result of mortgage loan refinancings and unsecured note sales. The average cost of borrowings was 10.30% in fiscal 1997 and 10.31% in fiscal 1996.
Depreciation increased $523,000 (5.2%) in fiscal 1997 as a result of new tenant improvements, capital replacements, and the addition of a new income-producing property.
Advisory, management and leasing fees paid to related parties increased $572,000 (7.7%) in fiscal 1997. The advisory fee in fiscal 1997 was $311,000 per month, compared to $301,000 per month for the first six months of fiscal 1996 and $306,000 per month for the second six months of fiscal 1996, which resulted in an aggregate increase of $93,000 (2.6%). Management and leasing fees were higher by $479,000 (12.7%) in fiscal 1997 as a result of increased gross income on which fees are based. General and administrative expense decreased $129,000 (9.2%) in fiscal 1997, as a result of lower administrative costs.
Equity in earnings of unconsolidated entities represents the Real Estate Trust's share of earnings in its partnership investments. For fiscal 1997, the Real Estate Trust recorded earnings of $4,150,000 from such investments compared to earnings of $3,374,000 in the prior year.
Gain on sale of property in fiscal 1997 represents the gain on the sale of a purchase-leaseback investment located in Casper, Wyoming and the gain on the condemnation of a portion of a land parcel located in Atlanta, Georgia.
Banking
Overview. The Bank recorded operating income of $80.2 million for the year ended September 30, 1997 ("fiscal 1997"), compared to operating income of $46.1 million for the year ended September 30, 1996 ("fiscal 1996"). The increase in income for fiscal 1997 was primarily attributable to a $67.3 million increase in other (non-interest) income and a $13.2 million increase in net interest income before provision for loan losses, the effect of which was partially offset by a $9.4 million increase in the provision for loan losses and a $37.0 million increase in operating (non-interest) expense reflecting in part additional expenses associated with steps taken by management to improve credit quality and expand the Bank's core businesses, including the consumer loan program and deposit franchise.
Net Interest Income. Net interest income, before the provision for loan losses, increased $13.2 million (or 6.6%) in fiscal 1997. The Bank would have recorded interest income of $6.9 million in fiscal 1997 if the Bank's nonaccrual assets and restructured loans had been current in accordance with their original terms. Interest income of $0.7 million was actually recorded on non-accrual assets and restructured loans during the fiscal year. The Bank's net interest income in future periods will continue to be adversely affected by the Bank's non- performing assets. See "Financial Condition Asset Quality - Non-Performing Assets."
Interest income in fiscal 1997 increased $64.2 million from the level in fiscal 1996, primarily as a result of higher average balances of loans receivable and, to a lesser extent, mortgage-backed securities. The effect on interest income of higher average balances was offset in part by lower average yields earned by the Bank on its loan portfolio.
The Bank's net yield on interest-earning assets decreased to 4.14% in fiscal 1997 from 4.81% in fiscal 1996. The decrease in the net yield primarily reflected lower yields earned on certain of the Bank's interest-earning assets resulting from a decline in market rates as well as lower introductory and promotional rates on certain products which the Bank has offered to new and existing customers in an effort to stimulate usage.
Interest income on loans, the largest category of interest-earning assets, increased by $43.0 million (or 13.5%) from fiscal 1996 primarily because of higher average balances, which were partially offset by lower average yields on the loan portfolio.
Higher average balances on credit card loans, which increased $159.5 million (15.8%). The increase was primarily responsible for a $3.4 million (or 2.2%) increase in interest income from credit card loans. Higher average balances of automobile loans, which increased $64.2 million (or 35.1%), resulted primarily from the higher origination volume of such loans, and was largely responsible for a $16.2 million (or 75.3%) increase in interest income on automobile loans. Interest income on the Bank's single-family residential loans increased by $15.8 million (or 15.6%) primarily because of increased originations, which resulted in an increase of $355.8 million (or 25.2%) in the average balances of such loans. Average balances of home equity credit line loans increased by $60.0 million (or 74.8%) primarily because of the $119.2 million purchase of such loans in December 1996. Interest income on home equity credit line loans increased by $5.7 million (or 124.4%) in the current year.
The average yield on the loan portfolio in fiscal 1997 decreased by 73 basis points (to 10.08% from 10.81%) from the average yield in fiscal 1996. The lower net yield was primarily due to a 182 basis point decrease in the average net yield on credit card loans from 15.50% to 13.68%, the effect of which partially offset the positive effect that the higher average balances had on income. The decline in the net yield was primarily a result of marketing strategies to introduce lower introductory rates to new customers, as well as a new program offering reduced interest rates to previously risk-repriced accounts in an attempt to encourage payments from delinquent customers. Also contributing to the decreased average yield on the loan portfolio was a decrease in the average yield on single-family residential loans from 7.21% to 6.65%. An increase in the average yield on automobile loans from 11.75% to 15.24%, primarily due to higher yields earned on loans originated by one of the Bank's operating subsidiaries, partially offset the negative effect of the lower average yields discussed above.
Interest income on mortgage-backed securities increased $21.3 million (or 41.7%) primarily because of higher average balances. The increased mortgage-backed securities balances in fiscal 1997 reflected the purchase of $649.7 million of mortgage-backed securities near the end of fiscal 1996 and the $1.1 billion securitization of single-family residential loans in September 1997. The positive effect of the higher average balances was partially offset by a decrease in the average interest rates on these securities from 6.11% to 5.99%.
Interest expense increased $51.0 million (or 27.0%) for fiscal 1997 primarily because of an increase of $764.9 million (or 206.8%) in the average balances of the Bank's borrowings. The increase in the average balances of borrowings resulted in an increase of $44.6 million in interest expense for fiscal 1997 for such liabilities. The increase in interest expense on borrowings is primarily due to a $22.8 million, a $13.7 million and a $6.9 million increase in interest expense on securities sold under repurchase agreements, Federal Home Loan Bank advances and subordinated debentures, respectively, resulting primarily from higher average balances of such borrowings. The negative effect of the higher average balances was partially offset by a decrease in the average borrowing rate (to 6.25% from 7.10%), which reflected an increase in lower-yielding FHLB advances and securities sold under repurchase agreements.
An increase of $6.3 million in interest expense on deposits, the largest category of interest-bearing liabilities, also contributed to the increased interest expense. Interest expense on deposits increased primarily because of a $235.1 million increase in the average balances.
Provision for Loan Losses. The Bank's provision for loan losses increased to $125.1 million in fiscal 1997 from $115.7 million in fiscal 1996. The $9.4 million increase over the prior year was primarily attributable to a $7.8 million increase in the provision for losses on credit card loans. See "Financial Condition - Asset Quality - Allowances for Losses."
Other Income. The $67.3 million (or 19.6%) increase in other (non-interest) income to $411.1 million in fiscal 1997 from $343.8 million in fiscal 1996 was primarily attributable to increases in servicing and securitization income, credit card fees, deposit servicing fees and a decrease in loss on real estate held for investment or sale.
Servicing and securitization income increased $20.2 million to $305.2 million from $285.0 million, primarily due to gains recognized on the securitization and sale of credit card loans, automobile loans, home equity and home loan receivables of $26.2 million, $26.9 million, $11.8 million and $7.4 million, respectively. Management expects that the relative impact of gains recognized under SFAS 125 on the Bank's earnings will diminish as the gains associated with these and other transactions are amortized. In addition, in accordance with SFAS 125, the Bank recognized a $7.0 million net unrealized gain on the valuation of its interest-only strips. This gain represents the September 30, 1997 market-value adjustment on the interest-only strips related to the credit card securitized assets. Offsetting these amounts was a decrease of $36.3 million (or 13.8%) in loan servicing fees which was primarily due to a decrease of $49.0 million in excess spread income earned by the Bank for servicing its portfolios of securitized credit card loans. The decrease in such excess spread income for fiscal 1997 resulted primarily from an increase in charge-offs on securitized credit card loans which is consistent with management's expectations and generally reflects the trends that are affecting the credit card industry as a whole. See "Financial Condition - Asset Quality - Allowances for Losses."
Credit card fees, consisting of membership fees, late charges, over-the-limit fees, interchange fees and cash advance charges, increased $26.6 million (or 86.5%) in fiscal 1997 from the level in fiscal 1996. The increase was primarily attributable to the impact of changes in the fee structure for the Bank's credit card programs which were implemented in fiscal 1996 and 1997.
The $12.0 million (or 40.1%) increase in deposit servicing fees resulted primarily from the additional fees generated through the Bank's ATM network, and, to a lesser extent, an increase in the number of deposit accounts outstanding during fiscal 1997.
The $5.7 million (or 23.5%) decrease in loss on real estate held for investment or sale was primarily attributable to a decrease of $6.7 million in the provision for losses on such assets, which was partially offset by a decrease of $1.1 million in the gain recorded on sales of the Bank's real estate held for investment or sale.
Operating Expenses. Operating expenses for fiscal 1997 increased $37.0 million (9.7%) from the level in fiscal 1996. The main components of the higher operating expenses were increases in salaries and employee benefits, marketing and data processing. The $33.6 million increase in salaries and employee benefits resulted primarily from the addition of staff to the Bank's credit card, consumer lending, branch and systems operations. The $20.8 million increase in marketing expenses was primarily attributable to a $14.4 million increase in marketing expenses associated with the credit card program as the Bank continues to focus on increased originations of such loans, as well as a $5.3 million increase in marketing expenses associated with the Bank's deposit base. The $6.9 million increase in data processing expenses was principally attributable to an increase in the number of credit card accounts outstanding and the activity generated by such accounts during fiscal 1997. The $32.3 million decrease in deposit insurance premiums, which partially offset the expense increases discussed above, was primarily because of the one-time SAIF assessment recorded by the Bank in fiscal 1996. See "Business - Regulation - Deposit Insurance Premiums."
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required by this Item is included in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Trust and its consolidated subsidiaries are included in this report on the pages indicated and are incorporated herein by reference:
(a) Report of Independent Public Accountants.
(b) Consolidated Balance Sheets - As of September 30, 1998 and 1997.
(c) Consolidated Statements of Operations - For the years ended September 30, 1998, 1997 and 1996.
(d) Consolidated Statements of Shareholders' Deficit - For the years ended September 30, 1998, 1997 and 1996.
(e) Consolidated Statements of Cash Flows - For the years ended September 30, 1998, 1997 and 1996.
(f) Notes to Consolidated Financial Statements.
The selected quarterly financial data included in Note 34 of Notes to the Consolidated Financial Statements referred to above are incorporated herein by reference.
Summary financial information with respect to the Bank is also included in Part I, Item 1.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust
We have audited the accompanying consolidated balance sheets of B.F. Saul Real Estate Investment Trust (the "Trust") and subsidiaries as of September 30, 1998 and 1997, and the related consolidated statements of operations, shareholders' deficit, and cash flows for each of the three years in the period ended September 30, 1998. These financial statements are the responsibility of the Trust'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 B.F. Saul Real Estate Investment Trust and subsidiaries as of September 30, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1998, in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Washington, D.C. December 2, 1998
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
B.F. Saul Real Estate Investment Trust and its wholly owned subsidiaries (collectively, the "Real Estate Trust") operate as a Maryland real estate investment trust. The principal business activity of the Real Estate Trust is the ownership and development of income-producing properties. The properties owned by the Real Estate Trust are located predominantly in the Mid-Atlantic and Southeastern regions of the United States and consist principally of hotels, office projects, and various undeveloped land parcels.
B.F. Saul Real Estate Investment Trust also owns 80% of the outstanding common stock of Chevy Chase Bank, F.S.B. and its subsidiaries (collectively the "Bank" or the "Corporations"), whose assets accounted for approximately 95% of the consolidated assets of the B.F. Saul Real Estate Investment Trust and its consolidated subsidiaries (the "Trust") at September 30, 1998. The Bank is a federally chartered and federally insured stock savings bank. The B. F. Saul Real Estate Investment Trust is a thrift holding company by virtue of its ownership of a majority interest in the Bank and is subject to regulation by the Office of Thrift Supervision ("OTS"). The accounting and reporting practices of the Trust conform to generally accepted accounting principles and, as appropriate, predominant practices within the real estate and banking industries.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Real Estate Trust and its subsidiaries. Accordingly, the accompanying financial statements reflect the assets, liabilities, operating results, and cash flows for two business segments: Real Estate and Banking. Entities in which the Trust holds a non-controlling interest (generally 50% or less) are accounted for on the equity method. See Note 2.
USE OF ESTIMATES
The 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 and disclosure of contingent liabilities as of the date of the balance sheet and revenues and expenses for the reporting period. Actual results could differ from those estimates.
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets and certain identifiable intangibles to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, the Trust recognizes an impairment loss. Measurement of an impairment loss for long-lived assets and identifiable intangibles that the Trust expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangibles to be disposed of are generally reported at the lower of carrying amount or fair value less the cost to sell.
INCOME TAXES
The Trust files a consolidated federal income tax return which includes operations of all 80% or more owned subsidiaries. It voluntarily terminated its qualification as a real estate investment trust under the Internal Revenue Code during fiscal 1978.
The Trust uses an asset and liability approach in accounting for income taxes. Deferred income taxes are recorded using currently enacted tax laws and rates. To the extent that realization of deferred tax assets is more likely than not, such assets are recognized.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is determined by dividing net income (loss), after deducting preferred share dividend requirements, by the weighted average number of common shares outstanding during the year. For fiscal years 1998, 1997 and 1996, the weighted average number of shares used in the calculation was 4,826,910.
RECLASSIFICATIONS
Certain reclassifications have been made to the consolidated financial statements for the years ended September 30, 1997 and 1996 to conform with the presentation used for the year ended September 30, 1998.
ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED
SFAS No. 130, "Reporting Comprehensive Income" ("SFAS 130") was issued in June 1997 and establishes accounting standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 also requires an enterprise to classify items of other comprehensive income by their nature in a financial statement and to display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS 130 is effective for fiscal years beginning after December 15, 1997. The adoption of SFAS 130 will not have an impact on the Trust's financial condition or its results of operations.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"), was also issued in June 1997. SFAS 131 establishes accounting standards for the way business enterprises report information about operating segments in annual and interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS 131 requires that a business enterprise report financial and descriptive information, including profit or loss, certain specific revenue and expense items, and segment assets, about its reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by management in deciding how to allocate resources and in assessing performance. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997. Because SFAS 131 addresses only disclosure related issues, its adoption will not have an impact on the Trust's financial condition or its results of operations.
AICPA Statement of Position 98-5, "Reporting on the Costs of Start-up Activities" ("SOP 98-5"), was issued during fiscal 1998. SOP 98-5 generally requires that start-up costs be expensed as incurred. However, certain start-up costs, including the costs of acquiring or constructing long-lived assets and getting them ready for their intended use, are not covered by SOP 98-5. SOP 98-5 is effective for financial statements for fiscal years beginning after December 15, 1998. The impact of the adoption of SOP 98-5 on the Trust's financial condition and its results of operations has not been determined.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - REAL ESTATE TRUST
CASH EQUIVALENTS
The Real Estate Trust considers all highly liquid, temporary investments with an original maturity of three months or less to be cash equivalents.
PROPERTIES
Income-producing properties are stated at the lower of depreciated cost (except those which were acquired through foreclosure or equivalent proceedings, the carrying amounts of which are based on the lower of cost or fair value at the time of acquisition) or net realizable value.
Interest, real estate taxes and other carrying costs are capitalized on projects under construction. Once construction is completed and the assets are placed in service, rental income, direct operating expenses, and depreciation associated with such properties are included in current operations. The Real Estate Trust considers a project to be substantially complete and held available for occupancy upon completion of tenant improvements, but no later than one year from the cessation of major construction activity. Substantially completed portions of a project are accounted for as separate projects. Expenditures for repairs and maintenance are charged to operations as incurred.
Depreciation is calculated using the straight-line method and estimated useful lives of 31.5 to 47 years for buildings and up to 20 years for certain other improvements. Tenant improvements are amortized over the lesser of their estimated useful lives or the lives of the related leases using the straight-line method.
INCOME RECOGNITION
The Real Estate Trust derives room and other revenues from the operations of its hotel properties. The Real Estate Trust derives rental income under noncancelable long-term leases from tenants at its commercial properties.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments.
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short-term maturity of these instruments.
Liabilities
The carrying amount of mortgage notes payable and notes payable - secured approximates their fair value since most of the debt has been financed in recent periods at prevailing market interest rates. The fair value of Notes payable - unsecured is based on the rates currently offered by the Real Estate Trust for similar notes. At September 30, 1998 and 1997 the fair value of Notes payable - unsecured was $51.6 and $47.9 million, respectively.
C. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - THE BANK
Chevy Chase Bank, F.S.B. is a federally chartered and federally insured stock savings bank and, as such, is subject to comprehensive regulation, examination and supervision by the Office of Thrift Supervision ("OTS") and by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is principally engaged in the business of attracting deposits from the public and using such deposits, together with borrowings and other funds, to make loans secured by real estate, primarily residential mortgage loans, and various types of consumer loans and commercial loans. The Bank's principal deposit market is the Washington, D.C. metropolitan area.
CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits, federal funds sold and securities purchased under agreements to resell.
Regulation D pursuant to the Federal Reserve Act requires the Bank to maintain reserves in the form of cash and deposits at the Federal Reserve Bank. The total average reserve balances maintained by the Bank, which consisted primarily of cash, were $146.5, $114.6, and $105.2 million during the years ended September 30, 1998, 1997, and 1996, respectively.
LOANS HELD FOR SALE
The Bank engages in mortgage banking activities. At September 30, 1998 and 1997, loans held for sale are composed of single-family residential loans and home improvement and related loans originated or purchased for sale in the secondary market and are carried at aggregate cost which is lower than aggregate market value. Single-family residential loans held for sale will either be sold or will be exchanged for mortgage-backed securities and then sold. Gains and losses on sales of whole loans held for sale are determined using the specific identification method. See "Trading Securities."
LOANS HELD FOR SECURITIZATION AND SALE
The Bank periodically securitizes and sells certain pools of loan receivables in the public and private markets. These securitizations are recorded as sales. Gains on the sale of loans are limited to amounts related to loans existing at the date of sale and do not include amounts related to loans expected to be sold during any future reinvestment period.
Loans held for securitization and sale are the lesser of loans eligible for securitization or loans that management contemplates to securitize within six months. Such loans held for securitization and sale are reported at the lower of aggregate cost or aggregate market value for each asset type.
INVESTMENT SECURITIES AND MORTGAGE-BACKED SECURITIES
The Bank classifies its investment and mortgage-backed securities as either "held-to-maturity," "available-for-sale" or "trading" at the time such securities are acquired. Investment and mortgage-backed securities classified as "held-to-maturity" are reported at amortized cost. Investment and mortgage-backed securities classified as "available-for-sale" are reported at fair value, with unrealized gains and losses, net of the related tax effect, reported as a separate component of stockholders' equity. Investment and mortgage-backed securities classified as "trading" are reported at fair value, with unrealized gains and losses included in earnings. All investment securities and mortgage-backed securities are classified as held-to-maturity at September 30, 1998 and 1997. Premiums and discounts on investment securities and mortgage-backed securities are amortized or accreted using the level-yield method. Realized gains and losses are determined using the specific identification method.
Net unrealized holding gains, net of the related income tax effect, amounted to $58,000 as of September 30, 1998 and resulted from the transfer of investment securities and mortgage-backed securities previously classified as available-for-sale to held-to-maturity, are reported as a separate component of stockholders' equity and are being accreted over the remaining lives of the securities using the level-yield method.
TRADING SECURITIES
As part of its mortgage banking activities, the Bank exchanges loans held for sale for mortgage-backed securities and then sells the mortgage-backed securities, which are classified as trading securities, to third party investors in the month of issuance. Proceeds from sales of trading securities were $320.9, $430.9 and $363.4 million during the years ended September 30, 1998, 1997 and 1996, respectively. The Bank realized net gains of $1.0, $1.2 and $1.2 million on the sales of trading securities for the years ended September 30, 1998, 1997 and 1996, respectively. Gains and losses on sales of trading securities are determined using the specific identification method. There were no mortgage-backed securities classified as trading securities at September 30, 1998 and 1997.
At September 30, 1998 and 1997, the Bank held automobile receivables-backed securities with carrying amounts of $11.3 and $7.9 million, respectively, which were classified as trading securities. These securities were established in conjunction with two automobile loan securitization transactions and represent subordinate classes of certificates retained by the Bank. The Bank recognized net unrealized holding losses on trading securities of $1.3 million at September 30, 1998. There were no unrealized holding gains or losses on these securities during the year ended September 30, 1997. See Note 16.
LOAN ORIGINATION AND COMMITMENT FEES
Nonrefundable loan fees, such as origination and commitment fees, and incremental loan origination costs relating to loans originated or purchased are deferred. Net deferred fees (costs) related to loans held for investment are amortized over the life of the loan using the level-yield or straight-line method. Net fees (costs) related to loans held for sale are deferred until such time as the loan is sold, at which time the net deferred fees (costs) become a component of the gain or loss on sale.
CREDIT CARD FEES AND COSTS
Prior to the sale of the credit card portfolio on September 30, 1998, credit card membership fees were deferred and recognized as income on a straight-line basis over the period the fee entitled the cardholder to use the card, which was one year. Credit card origination costs were deferred and recognized as a reduction of income on a straight-line basis over the privilege period which was generally one year. See Note 8.
IMPAIRED LOANS
A loan is considered impaired when, based on all current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the agreement, including all scheduled principal and interest payments. Loans reviewed by the Bank for impairment include real estate and commercial loans and loans modified in a troubled debt restructuring. Large groups of smaller-balance homogeneous loans that have not been modified in a troubled debt restructuring are collectively evaluated for impairment, which for the Bank include residential mortgage loans and consumer loans. Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan's effective interest rate or, as a practical expedient, impairment may be measured based on the loan's observable market price, or, if the loan is collateral-dependent, the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Loans for which foreclosure is probable continue to be accounted for as loans. Prior to the sale of the credit card portfolio on September 30, 1998, certain credit card loans for which customers had agreed to modified payment terms were also classified as impaired loans. See Note 8.
Each impaired real estate or commercial loan is evaluated individually to determine the income recognition policy. Generally, payments received are applied in accordance with the contractual terms of the note or as a reduction of principal. Interest income on impaired credit card loans was recognized using the interest rate of the loan and the accrual method. Interest income continued to accrue on delinquent credit card loans until such loan was either paid or charged off.
At September 30, 1998, the Bank had one impaired real estate loan with a book value of $86,000. At September 30, 1997, the Bank had two impaired real estate loans with an aggregate book value of $1.0 million before the related allowance for losses of $545,000. At September 30, 1997, the Bank had impaired credit card loans with a carrying value of $116.9 million, before the related allowance for losses of $18.9 million. The average recorded investment in impaired credit card and real estate loans for the years ended September 30, 1998, 1997 and 1996 was $113.2, $99.0, and $49.8 million, respectively. The Bank recognized interest income of $14.4, $13.1, and $7.3 million on its impaired loans for the years ended September 30, 1998, 1997 and 1996, respectively.
ALLOWANCES FOR LOSSES
Management reviews the loan, real estate held for investment and real estate held for sale portfolios to establish allowances for estimated losses. The allowances for losses are reviewed periodically, and allowances are provided after consideration of the borrower's financial condition and/or the estimated value of collateral or real estate, including estimated selling and holding costs. Allowances are also provided by management after considering such factors as the economy in lending areas, delinquency statistics and past loss experience.
The allowances for losses are based on estimates, and ultimate losses may vary from current estimates. As adjustments to the allowances become necessary, provisions for losses are reported in operations in the periods they are determined to be necessary.
ACCRUED INTEREST RECEIVABLE ON LOANS
Loans are reviewed on a monthly basis and are placed on non-accrual status when, in the opinion of management, the full collection of principal or interest has become unlikely. Uncollectible accrued interest receivable on non-accrual loans is charged against current period interest income.
REAL ESTATE HELD FOR INVESTMENT OR SALE
Real Estate Held for Investment
At September 30, 1998 and 1997, real estate held for investment consists of developed land owned by one of the Bank's subsidiaries. Real estate held for investment is carried at the lower of cost or net realizable value. See Note 14.
Real Estate Held for Sale
Real estate held for sale consists of real estate acquired in settlement of loans ("REO") and is carried at the lower of cost or fair value (less estimated selling costs). Costs relating to the development and improvement of property, including interest, are capitalized, whereas costs relating to the holding of property are expensed. Capitalized interest amounted to $2.0, $2.2 and $3.5 million for the years ended September 30, 1998, 1997 and 1996, respectively.
Property and Equipment
Property and equipment is stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method which allocates the cost of the applicable assets over their estimated useful lives. Major improvements and alterations to office premises and leaseholds are capitalized. Leasehold improvements are amortized over the shorter of the terms of the respective leases (including renewal options that are expected to be exercised) or 20 years. Maintenance and repairs are charged to operating expenses as incurred.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill is stated net of accumulated amortization and is being amortized using the straight-line method generally over a period of 25 years. At September 30, 1998 and 1997, goodwill totaled $24.4 and $1.1 million, respectively. On November 12, 1997, the Bank purchased ASB Capital Management Inc. ("ASB"), one of the largest SEC-registered investment managers headquartered in the Washington, D.C. metropolitan area, for $27.2 million in cash. In connection with the purchase, the Bank recorded $25.3 million of goodwill. The acquisition was accounted for using the purchase method and the operating results of ASB have been included in the Trust's Consolidated Statements of Operations since the date of acquisition.
During fiscal 1998 and 1997, the Bank purchased approximately $53.2 and $137.9 million of home equity loans, respectively. The premium attributable to the value of the home equity relationships, amounting to $6.5 and $7.7 million at September 30, 1998 and 1997, respectively, is included in goodwill and other intangible assets in the Consolidated Balance Sheets. This premium is being amortized over the estimated term of the underlying relationships. Accumulated amortization of goodwill and other intangible assets was $43.6 and $37.8 million at September 30, 1998 and 1997, respectively.
SERVICING ASSETS
Effective January 1, 1997, the Bank adopted Statement of Financial Accounting Standards ("SFAS") No. 125 ("SFAS 125"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," which superseded, but generally retained, the requirements of SFAS No. 122, "Accounting for Mortgage Servicing Rights" ("SFAS 122"). Both statements require that entities that acquire servicing assets through either purchase or origination of loans and sell or securitize those loans with servicing assets retained must allocate the total cost of the loans to the servicing assets and the loans (without the servicing assets) based on their relative fair values.
Servicing assets, which are stated net of accumulated amortization, are amortized in proportion to the remaining net servicing revenues estimated to be generated by the underlying loans. Amortization of these assets amounted to $10.8, $9.0 and $7.8 million for the years ended September 30, 1998, 1997 and 1996, respectively. Accumulated amortization was $67.7 and $56.9 million at September 30, 1998 and 1997, respectively. During fiscal 1998, 1997 and 1996, the Bank recorded $8.6, $15.8 and $16.1 million respectively, of servicing assets related to the sale and/or securitization of loans.
The Bank periodically evaluates its servicing assets for impairment based upon fair value. For purposes of evaluating impairment, the Bank stratifies its servicing assets taking into consideration relevant risk characteristics including loan type, note rate and date of acquisition. To the extent the carrying value of servicing assets exceeds the fair value of such assets, a valuation allowance is recorded. The aggregate fair value of servicing assets at September 30, 1998 and 1997 was $35.3 and $46.2 million, respectively.
Activity in the valuation allowance for servicing assets is summarized as follows.
Year Ended September 30, ---------------------------------------------- (In thousands) 1998 1997 1996 - -------------------------------- -------------- -------------- -------------- Balance at beginning of year $ 1,129 $ 3,142 $ -- Additions charged / (reductions) credited to loan expenses 12,369 (2,013) 3,142 -------------- -------------- --------------
Balance at end of year $ 13,498 $ 1,129 $ 3,142 ============== ============== ==============
During fiscal 1996, the Bank sold $947,000 of rights to service mortgage loans with principal balances of $59.7 million, that were originated by the Bank in connection with its mortgage banking activities. There were no sales of rights to service mortgage loans during fiscal 1998 and 1997.
Servicing fees are included in servicing and securitization income in the Consolidated Statements of Operations.
INTEREST-ONLY STRIPS
As a result of the adoption of SFAS 125 effective January 1, 1997, the Bank recognized gains of $33.1 million during fiscal 1997 upon the securitization and sale of credit card receivables based upon the estimated fair value of the expected cash flows to be generated by the underlying receivables. Under SFAS 125, the Bank recorded a gain on the securitization and sale of credit card receivables based on the estimated fair value of assets transferred, retained, or obtained and liabilities incurred in the sale. The gain recognized at the time of the sale principally represented the estimated fair value of the interest-only strips, which represent the present value of finance charges and other ancillary income received by the trust over the sum of the return paid to certificateholders, contractual servicing fees, credit losses and other expenses of the trust. During the revolving period of each transaction, gains were recorded on the sale of new receivables to the trusts to replenish the investors' interest in trust receivables. See Note 16.
Prior to January 1, 1997, no gain or loss was recorded on the securitization and sale of credit card receivables; rather, loan servicing fees were recognized over the life of the transaction when earned.
Upon the Bank's adoption of SFAS 125, effective January 1, 1997, previously recognized excess spread assets were reclassified as interest-only strips. Interest-only strips capitalized in the year ended September 30, 1998 and in the nine months ended September 30, 1997 amounted to $124.0 and $68.2 million, respectively, and were related to the securitization and sale of credit card, home equity, automobile and home loan receivables. See Note 16.
Prior to January 1, 1997, when loans (other than credit card) were sold with the residual cash flow retained by the Bank, the net present value of such residual cash flow was recorded as an adjustment to the sales price of the loans. Estimated future losses were deducted in the computation of such residual cash flows. Excess spread assets capitalized in the three months ended December 31, 1996 and in fiscal 1996 of $9.5 and $25.7 million, respectively, were the result of the residual cash flow retained upon the securitization and sale of home equity credit line, automobile and home loan receivables.
Interest-only strips (excess spread assets prior to January 1, 1997) are amortized using the effective yield method over the estimated lives of the underlying loans. Amortization amounted to $99.0, $24.8 and $17.1 million for the years ended September 30, 1998, 1997 and 1996, respectively, and is included in servicing and securitization income in the Consolidated Statements of Operations. The Bank uses certain assumptions to calculate amortization of the interest-only strips (excess spread assets prior to January 1, 1997), mainly estimates of prepayment speeds and credit losses. To the extent actual results differ from the assumptions, additional amortization is recorded.
Effective January 1, 1997, the Bank accounts for its interest-only strips as trading securities and, accordingly, carries them at fair value. The Bank estimates the fair value of the interest-only strips on a discounted cashflow basis using appropriate discount and prepayment rates. Mark-to-market adjustments, included in servicing and securitization income, amounted to a net loss of $42.9 million in fiscal 1998 and a net gain of $7.0 million in fiscal 1997. Certain assumptions inherent in the determination of the amortization and fair value of interest-only strips are influenced by factors outside the Bank's control, and actual performance could materially differ from such assumptions.
DERIVATIVE FINANCIAL INSTRUMENTS
The Bank uses various strategies to minimize interest-rate risk, including interest-rate cap agreements and forward sale or purchase commitments. Premiums paid for interest-rate cap agreements are included in other assets in the Consolidated Balance Sheets and are amortized to expense over the terms of the interest-rate caps on a straight-line basis. Funds payable to the Bank are recognized as income in the month such funds are earned. At September 30, 1998 and 1997, unamortized premiums amounted to $0 and $3.1 million, respectively. Gains and losses on forward sale or purchase commitments are deferred and recorded as a component of the gain on sales of loans at the time the forward sale or purchase commitment matures. See Note 28. The Bank does not hold any derivative financial instruments for trading purposes.
ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued in June 1998 and establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS 133 is effective for fiscal years beginning after June 15, 1999. The impact of SFAS 133 on the Bank's financial statements has not yet been determined.
SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of FASB Statement No. 65" ("SFAS 134"), was issued in October 1998. SFAS 134 amends SFAS 65 "Accounting for Certain Mortgage Banking Activities" to require that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. SFAS 134 conforms the subsequent accounting for securities retained after the securitization of mortgage loans by a mortgage banking enterprise with the subsequent accounting for securities retained after the securitization of other types of assets by a nonmortgage banking enterprise. SFAS 134 is effective for the first fiscal quarter beginning after December 15, 1998.
1. LIQUIDITY AND CAPITAL RESOURCES - REAL ESTATE TRUST
Historically, the Real Estate Trust's total cash requirements have exceeded the cash generated by its operations. This condition is currently the case and is expected to continue to be so for the foreseeable future. The Real Estate Trust's internal sources of funds, primarily cash flow generated by its income-producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding Unsecured Notes sold to the public, the payment of interest on its Senior Secured Notes, and the payment of capital improvement costs. In the past, the Real Estate Trust funded such shortfalls through a combination of external funding sources, primarily new financings (including the sale of Unsecured Notes), refinancings of maturing mortgage debt, asset sales and tax sharing and dividend payments from the Bank.
The Real Estate Trust's ability to meet its liquidity needs, including debt service payments in fiscal 1999 and subsequent years, will depend in significant part on its receipt of dividends from the Bank and tax sharing payments from the Bank pursuant to the tax sharing agreement among the Trust, the Bank, and their subsidiaries. The availability and amount of tax sharing payments and dividends in future periods is dependent upon, among other things, the Bank's operating performance and income, regulatory restrictions on such payments, including availability of Trust collateral to support such payments, and (in the case of tax sharing payments), the continued consolidation of the Bank and the Bank's subsidiaries with the Trust for federal income tax purposes.
The Real Estate Trust believes that the financial condition and operating results of the Bank in recent periods, as well as the Bank's board resolution adopted in connection with the release of its written agreement with the OTS should enhance prospects for the Real Estate Trust to receive tax sharing payments and dividends from the Bank. During fiscal 1998, 1997 and 1996, the Bank made tax sharing payments totaling $5.6, $9.8 and $25.0 million, respectively, to the Real Estate Trust. During fiscal 1998, 1997 and 1996, the Bank made dividend payments totaling $5.2, $7.2 and $6.8 million, respectively, to the Real Estate Trust.
In recent years, the operations of the Trust have generated net operating losses while the Bank has reported net income. It is anticipated that the Trust's consolidation of the Bank's operations into the Trust's federal income tax return will result in the use of the Trust's net operating losses to reduce the federal income taxes the Bank would otherwise owe. If in any future year, the Bank has taxable losses or unused credits, the Trust would be obligated to reimburse the Bank for the greater of (i) the tax benefit to the group using such tax losses or unused tax credits in the group's consolidated federal income tax returns or (ii) the amount of the refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group.
Through September 30, 1998, the Real Estate Trust has purchased either in the open market or through dividend reinvestment 2,091,176 shares of common stock of Saul Centers, Inc. (representing 16.4% of such company's outstanding common stock). As of September 30, 1998, the market value of these unpledged shares was approximately $35.5 million.
In fiscal 1994, the Real Estate Trust refinanced a significant portion of its outstanding secured indebtedness with the proceeds of the issuance of $175.0 million aggregate principal amount of 11 5/8% Senior Secured Notes due 2002 (the "1994 Notes"). See Note 4. In March 1998, the Real Estate Trust issued $200.0 million aggregate principal amount of 9 3/4% Senior Secured Notes due 2008 (the "1998 Notes"). After providing for the retirement of the 1994 Notes, including a prepayment premium of $10.0 million and debt issuance costs of approximately $5.9 million, the Real Estate Trust realized approximately $9.1 million in net proceeds. In addition, the Real Estate Trust received about $13.2 million in cash which had been held as additional collateral by the indenture agent under the 1994 Notes. The 1998 Notes are secured by a first priority perfected security interest in 8,000 shares (80%) of the issued and outstanding common stock of the Bank, which constitute all of the Bank common stock held by the Real Estate Trust. The 1998 Notes are nonrecourse obligations of the Real Estate Trust.
The Real Estate Trust is currently selling Unsecured Notes, with a maturity ranging from one to ten years, primarily to provide funds to repay maturing Unsecured Notes. To the degree that the Real Estate Trust does not sell new Unsecured Notes in an amount sufficient to finance completely the scheduled repayment of outstanding Unsecured Notes as they mature, it will be required to finance such repayments from other sources of funds.
In fiscal 1995, the Real Estate Trust established a $15.0 million secured revolving credit line with an unrelated bank. This facility was for an initial two-year period subject to extension for one or more additional one-year terms. In fiscal 1997, the facility was increased to $20.0 million and was renewed for an additional two-year period. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $8.4 million.
In fiscal 1996, the Real Estate Trust established an $8.0 million secured revolving credit line with an unrelated bank. This facility was for a one-year term, after which any outstanding loan amount would amortize over a two-year period. During fiscal 1997, the line of credit was increased to $10.0 million and was extended for a year. During fiscal 1998, the line of credit was increased to $20.0 million and was extended for an additional year. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $4.3 million.
During fiscal 1997, the Real Estate Trust refinanced two hotel and three office properties with five-year floating rate debt. After payment of all financing costs, the Real Estate Trust received net proceeds of approximately $11.0 million.
As the owner, directly and through two wholly-owned subsidiaries, of a 21.5% limited partnership interest in Saul Holdings Partnership, the Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale of properties. The partnership agreement of Saul Holdings Partnership provides for quarterly cash distributions to the partners out of net cash flow. In fiscal 1998, the Real Estate Trust received total cash distributions of $5.5 million from Saul Holdings Partnership. Beginning in April 1998 the Real Estate Trust has reinvested its quarterly distributions and obtained additional partnership units in Saul Holdings.
During the third quarter of fiscal 1997, the Real Estate Trust commenced development of a 46,000 square foot single-story office research and development building on 3 acres of its Avenel Business Park land parcel located in Gaithersburg, Maryland ("Avenel Phase IV"). The Real Estate Trust financed the project with a construction/permanent loan. The project was substantially completed in January 1998 and was offered to Saul Holdings in accordance with the Real Estate Trust's obligations under the Right of First Refusal Agreement. An independent appraisal of the project indicated a market value of $5,600,000. The fully funded balance of the loan was $3,657,000, resulting in an equity position of $1,943,000 for the Real Estate Trust. The Board of Directors of Saul Centers, Inc., general partner of Saul Holdings, agreed to purchase the Real Estate Trust's equity position through the issuance of additional limited partnership units in Saul Holdings. Accordingly, as of April 1, 1998, Saul Holdings issued 105,922 new limited partnership units and a corresponding limited partnership interest to the Real Estate Trust in exchange for the ownership of Avenel Phase IV and the assumption of the loan.
In September 1997, the Real Estate Trust commenced development of a 95-unit extended stay hotel on a 3 acre parcel located adjacent to its Hampton Inn and Holiday Inn near Washington Dulles International Airport in Sterling, Virginia. The new hotel was franchised as a TownePlace Suites by Marriott and opened for business in August 1998. Development costs were $5.8 million and were largely financed by a construction loan of $4.5 million. The loan is for two years with two extension options for two year and one year periods, respectively. The loan covered all costs except for the land, fees to related parties, taxes and insurance.
On December 10, 1997, the Real Estate Trust purchased a 308-room Holiday Inn located in Arlington, Virginia, near Washington National Airport and the Real Estate Trust's Howard Johnson Hotel. The purchase price was $25.8 million. Also on December 10, 1997, the Real Estate Trust refinanced five other hotels in its portfolio. Funds for the two transactions were provided by a lender in the amount of $52.5 million. The new loans have a 15 year term, a fixed interest rate of 7.57%, and amortization based on a 25 year schedule.
During the quarter ended June 30, 1998, the Real Estate Trust commenced development of four new extended stay hotels:
TownePlace Suites by Marriott containing 91 units located on a 2 acre site owned by the Trust in Avenel Business Park in Gaithersburg, Maryland. Opening is scheduled for mid-April 1999.
TownePlace Suites by Marriott containing 91 units located on part of a 9 acre site owned by the Real Estate Trust in the Arvida Park of Commerce in Boca Raton, Florida. Opening is scheduled for mid-July 1999.
SpringHill Suites by Marriott containing 146 units located on part of a 9 acre site owned by the Real Estate Trust in the Arvida Park of Commerce in Boca Raton, Florida. Opening is scheduled for mid-July 1999.
TownePlace Suites by Marriott containing 95 units located on a 3 acre site owned by the Real Estate Trust in Ft. Lauderdale Commerce Center, Ft. Lauderdale, Florida. Opening is scheduled for mid-August 1999.
The projected costs for the four hotels aggregate $32 million and will largely be funded by the proceeds of a three year bank loan in the amount of $25.9 million. The loan has two one-year renewal options.
During the quarter ended June 30, 1998, the Real Estate Trust also began development of a 78,000 square foot single-story office/research and development building located on a 7 acre site owned by the Real Estate Trust in Dulles North Corporate Park, Sterling, Virginia. This project is adjacent to the Real Estate Trust's Dulles North office building and near three of the Real Estate Trust's hotel properties. The development cost is $6.6 million with bank financing of $6.5 million for a five-year term and a two-year extension option. Completion is expected in early fiscal 1999. A lease for approximately 25% of the space has been signed.
During the quarter ended September 30, 1998, the Real Estate Trust began the conversion of its two hotels located in Crystal City, Arlington, Virginia. The present 308-room Crystal City Holiday Inn will be converted into a Holiday Inn Crown Plaza, while the present 279-room Howard Johnsons will be converted into a Holiday Inn. The new brands are expected to position the hotels to generate higher room rates and revenues along with improved occupancy levels consistent with the overall market. The renovations are largely an acceleration of normal capital improvement work as well as some exterior and interior signage, new marketing materials and a facade upgrade at the Howard Johnson hotel. A restaurant, which had been operated by an unaffiliated company, will also be renovated. The incremental costs for the two conversions are expected to total $6.3 million, which will be funded by the Real Estate Trust in part from its internal resources and in part from its lines of credit.
The Real Estate Trust believes that the capital improvement costs for its income-producing properties will be in the range of $6.5 to $8.0 million per year for the next several fiscal years.
2. SAUL HOLDINGS LIMITED PARTNERSHIP - REAL ESTATE TRUST
In fiscal 1993, the Real Estate Trust entered into a series of transactions undertaken in connection with an initial public offering of common stock of a newly organized corporation, Saul Centers, Inc. ("Saul Centers"). The Real Estate Trust transferred its 22 shopping centers and one of its office properties together with the debt associated with such properties to a newly formed partnership, Saul Holdings Limited Partnership ("Saul Holdings"), in which the Real Estate Trust owns (directly or through one of its wholly owned subsidiaries) a 21.7% interest, other entities affiliated with the Real Estate Trust own a 5.3% interest, and Saul Centers owns a 73.0% interest. B. Francis Saul II, Chairman of the Board of Trustees of the Trust, is also Chairman of the Board of Directors and Chief Executive Officer of Saul Centers, which is the sole general partner of Saul Holdings. As of September 30, 1998, the Real Estate Trust had pledged 3.6% of its interest in Saul Holdings to the Bank related to payments under the Tax Sharing Agreement.
In connection with the transfer of its properties to Saul Holdings, the Real Estate Trust was relieved of approximately $196 million in mortgage debt and deferred interest. Pursuant to a reimbursement agreement among the partners of Saul Holdings and its subsidiary limited partnerships (collectively, the "Partnerships"), the Real Estate Trust and its subsidiaries that are partners in the Partnerships have agreed to reimburse Saul Centers and the other partners in the event the Partnerships fail to make payments with respect to certain portions of the Partnerships' debt obligations and Saul Centers or any such other partners personally make payments with respect to such debt obligations. At September 30, 1998, the maximum potential obligations of the Real Estate Trust and its subsidiaries under this agreement totaled approximately $115.5 million.
The fair market value of each of the properties contributed to the Partnerships by the Real Estate Trust at the date of transfer (the FMV of each such property) exceeded the tax basis of such property (with respect to each property, such excess is referred to as the FMV-Tax Difference). In the event Saul Centers, as general partner of the Partnerships, causes the Partnerships to dispose of one or more of such properties, a disproportionately large share of the total gain for federal income tax purposes would be allocated to the Real Estate Trust or its subsidiaries. In general, if the gain recognized by the Partnerships on a property disposition is less than or equal to the FMV-Tax Difference for such property (as previously reduced by the amounts of special tax allocations of depreciation deductions to the partners), a gain equal to the FMV-Tax Difference (as adjusted) will be allocated to the Real Estate Trust. To the extent the gain recognized by the Partnerships on the property disposition exceeds the FMV-Tax Difference (as adjusted), such excess generally will be allocated among all the partners in Saul Holdings based on their relative percentage interests. In general, the amount of gain allocated to the Real Estate Trust in the event of such a property disposition is likely to exceed, perhaps substantially, the amount of cash, if any, distributable to the Real Estate Trust as a result of the property disposition. In addition, future reductions in the level of the Partnerships' debt, or any release of the guarantees of such debt by the Real Estate Trust, could cause the Real Estate Trust to have taxable constructive distributions without the receipt of any corresponding amounts of cash. Currently, management does not intend to seek a release of or a reduction in the guarantees or to convert its limited partner units in Saul Holdings into shares of Saul Centers common stock.
At the date of transfer of the Real Estate Trust properties to Saul Holdings, liabilities exceeded assets transferred by approximately $104.3 million on an historical cost basis. The assets and liabilities were recorded by Saul Holdings and Saul Centers at their historical cost rather than market value because of affiliated ownership and common management and because the assets and liabilities were the subject of the business combination between Saul Centers and Saul Holdings, newly formed entities with no prior operations.
Immediately subsequent to the business combination and initial public offering of common stock by Saul Centers, Saul Centers had total owners' equity of approximately $16.4 million of which approximately $3.5 million related to the Real Estate Trust's original 21.5% ownership interest. Recognition by the Real Estate Trust of the change in its investment in the properties of approximately $107.8 million has been deferred due to the Real Estate Trust's guarantee of $115.5 million under the Saul Centers reimbursement agreement. The deferred gain of $107.8 million is included in "Deferred gains - real estate" in the financial statements. The gain will be recognized in future periods to the extent the Real Estate Trust's obligations are terminated under the reimbursement agreement.
The management of Saul Centers has adopted a strategy of maintaining a ratio of total debt to total asset value, as estimated by management, of fifty percent or less. The management of Saul Centers has concluded at September 30, 1998 that the total debt of Saul Centers remains below fifty percent of total asset value. As a result, the management of the Real Estate Trust has concluded that fundings under the reimbursement agreement are remote.
In addition to the deferred gains, as of September 30, 1998, the Real Estate Trust's investment in the consolidated entities of Saul Centers, which is accounted for under the equity method, consisted of the following.
(In thousands) ------------------------------------------------------------------- Saul Holdings: Acquisition of partnership units $ 2,892 Distributions in excess of allocated net income (10,190)
Saul Centers: Acquisition of common shares 33,836 Distributions in excess of allocated net income (6,295) -------------
Total $ 20,243 =============
The $20.2 million balance is included in "Other assets" in the financial statements.
As of September 30, 1998, the Real Estate Trust, through its partnership interest in Saul Holdings and its ownership of common shares of Saul Centers, effectively owns 33.7% of the consolidated entities of Saul Centers. Some of these shares and/or units have been deposited as collateral for the Trust's revolving lines of credit. See Note 4.
The unaudited Condensed Consolidated Balance Sheet at September 30, 1998 and 1997, and the unaudited Condensed Consolidated Statements of Operations for the twelve-month periods ended September 30, 1998, 1997 and 1996 of Saul Centers follow.
3. INVESTMENT PROPERTIES - REAL ESTATE TRUST
The following table summarizes the cost basis of income-producing properties and land parcels together with their related debt.
4. DEBT - REAL ESTATE TRUST
Mortgage notes payable are secured by various income-producing properties and land parcels. Almost all mortgage notes are payable in monthly installments, have maturity dates ranging to 2012 and accrue interest at annual rates from 7.6% to 10.0%. Certain mortgages contain a number of restrictions, including cross default provisions.
Notes payable - unsecured includes notes which have been sold by the Real Estate Trust directly to investors at varying interest rates with maturities of one to ten years. These notes do not contain any provisions for conversion, sinking fund or amortization, but are subject to a provision permitting the Real Estate Trust to call them prior to maturity. The weighted average interest rates at September 30, 1998 and 1997 were 10.3% and 10.4%, respectively. During fiscal 1998 and 1997, the Real Estate Trust sold notes amounting to approximately $11.3 and $10.0 million, respectively.
In March 1994, the Real Estate Trust issued $175.0 million aggregate principal amount of the 1994 Notes. The 1994 Notes were general obligations of the Real Estate Trust ranking pari passu with all other unsubordinated obligations of the Trust and were secured by a first priority perfected security interest in 80% (8,000 shares) of the issued and outstanding common stock of the Bank and by certain other assets of the Trust as described herein. After paying offering expenses of $8.9 million, third-party mortgage indebtedness of $74.1 million, and affiliate indebtedness of $8.9 million, the Real Estate Trust retained $83.1 million of the net proceeds of the offering for application to general corporate purposes, including a loan to an affiliate of $15.0 million. Of the remaining amount, approximately $25.8 million was deposited with the Trustee for the 1994 Notes to satisfy one of the initial collateral requirements with respect to such securities. This collateral requirement, which remained in effect while the 1994 Notes were outstanding, was recalculated each calendar quarter based on the estimated amount of one year's interest payments on then outstanding 1994 Notes and Unsecured Notes and could have been satisfied through deposits of cash or marketable securities. Concurrently with the application of the net proceeds of the offering to repay third-party mortgage indebtedness, the terms of certain of the mortgage loans repaid in part were modified to waive deferred interest, reduce interest rates and extend maturities. After the application of such net proceeds and the modification of such loans, the final maturity of loans with total balances of $111.1 million was 12 years and the final maturity of a loan with a balance of $15.1 million was 15 years. As of September 30, 1997, the Real Estate Trust was required to maintain deposits of $25.2 million and had deposited 1,535,104 shares of common stock of Saul Centers (See Note 1) with the Trustee for the 1994 Notes to satisfy in part the collateral requirements for those deposits. The common stock of Saul Centers is reflected in other assets in the accompanying balance sheets.
In March 1998, the Real Estate Trust issued $200.0 million aggregate principal amount of the 1998 Notes. After providing for the retirement of the 1994 Notes, including a prepayment premium of $10.0 million and debt issuance costs of approximately $5.9 million, the Real Estate Trust realized approximately $9.1 million in net proceeds. In addition, the Real Estate Trust received about $13.2 million in cash which had been held as additional collateral by the indenture agent under the 1994 Notes. The 1998 Notes are secured by a first priority perfected security interest in 8,000 shares (80%) of the issued and outstanding common stock of the Bank, which constitute all of the Bank common stock held by the Real Estate Trust. The 1998 Notes are nonrecourse obligations of the Real Estate Trust.
In fiscal 1995, the Real Estate Trust established a $15.0 million secured revolving credit line with an unrelated bank. This facility was for an initial two-year period subject to extension for one or more additional one-year terms. In fiscal 1997, the facility was increased to $20.0 million and was renewed for an additional two-year period. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $8.4 million.
In fiscal 1996, the Real Estate Trust established an $8.0 million secured revolving credit line with an unrelated bank. This facility was for a one-year term, after which any outstanding loan amount would amortize over a two-year period. During fiscal 1997, the line of credit was increased to $10.0 million and was extended for a year. During fiscal 1998, the line of credit was increased to $20.0 million and was extended for an additional year. Interest is computed by reference to a floating rate index. At September 30, 1998, there were no borrowings under the facility and unrestricted availability was $4.3 million.
The maturity schedule for the Real Estate Trust's outstanding debt at September 30, 1998 for the fiscal years commencing October 1, 1998 is set forth in the following table.
Debt Maturity Schedule (In thousands) -------------------------------------------------------------- Notes Notes Fiscal Mortgage Payable -- Payable -- Year Notes Secured Unsecured Total ------------- --------- ----------- ----------- -------------- 1999 $10,055 $ -- $ 16,149 $ 26,204 2000 10,193 -- 8,893 19,086 2001 12,618 -- 5,916 18,534 2002 14,367 -- 5,284 19,651 2003 12,663 -- 9,046 21,709 Thereafter 138,978 200,000 5,047 344,025 --------- ----------- ----------- -------------- Total $198,874 $200,000 $ 50,335 $ 449,209 -------------------------------------------------------------- Of the $198.9 million of mortgage debt outstanding at September 30, 1998, $169.8 million was nonrecourse to the Real Estate Trust.
5. LONG-TERM LEASE OBLIGATIONS - REAL ESTATE TRUST
The Real Estate Trust has no minimum future rental commitments. The Real Estate Trust had one long-term lease which terminated in 1998. The Real Estate Trust paid minimum ground rent expense of $69,000, $101,000 and $101,000 in fiscal 1998, 1997 and 1996, respectively.
6. INCOME FROM COMMERCIAL PROPERTIES - REAL ESTATE TRUST
Income from commercial properties consists of minimum rent arising from noncancelable commercial leases. Minimum rent for fiscal years 1998, 1997, and 1996 amounted to $21.5, $19.7 and $16.8 million, respectively. Future minimum rentals as of September 30, 1998 under noncancelable leases are as follows:
Fiscal Year (In thousands) ------------------------------------------------------------ 1999 $ 20,919 2000 17,767 2001 13,971 2002 9,258 2003 6,315 Thereafter 7,930 ----------- Total $ 76,160 ------------------------------------------------------------
7. TRANSACTIONS WITH RELATED PARTIES - REAL ESTATE TRUST
TRANSACTIONS WITH B. F. SAUL COMPANY AND ITS SUBSIDIARIES
The Real Estate Trust is managed by B. F. Saul Advisory Company (the Advisor), a wholly-owned subsidiary of B. F. Saul Company ("Saul Co."). All of the Real Estate Trust officers and three Trustees of the Trust are also officers and/or directors of Saul Co. The Advisor is paid a fixed monthly fee which is subject to annual review by the Trustees. The monthly fee was $301,000 during the period October 1995 through March 1996, $306,000 during the period April 1996 through September 1996, $311,000 during the period October 1996 through September 1997, and, $317,000 during the period October 1997 through September 1998. The advisory contract has been extended until September 30, 1999, and will continue thereafter unless canceled by either party at the end of any contract year. Certain loan agreements prohibit termination of this contract.
Saul Co. and Franklin Property Company ("Franklin"), a wholly-owned subsidiary of Saul Co., provide services to the Real Estate Trust through commercial property management and leasing, hotel management, development and construction management, and acquisitions, sales and financings of real property. Fees paid to Saul Co. and Franklin amounted to $5.2, $5.1 and $4.8 million in fiscal 1998, 1997 and 1996, respectively.
The Real Estate Trust reimburses the Advisor and Franklin for costs and expenses incurred on behalf of the Real Estate Trust, in-house legal expenses, and for all travel expenses incurred in connection with the affairs of the Real Estate Trust.
The Real Estate Trust pays the Advisor fees equal to 1% of the principal amount of the unsecured notes as they are issued to offset its costs of administering the program. These payments amounted to $113,000, $102,000 and $74,000 in fiscal 1998, 1997 and 1996, respectively.
A subsidiary of Saul Co. is a general insurance agency which receives commissions and countersignature fees in connection with the Real Estate Trust's insurance program. Such commissions and fees amounted to approximately $157,000, $158,000 and $152,000 in fiscal 1998, 1997 and 1996, respectively.
In April 1994 the Real Estate Trust made an unsecured loan to the Saul Company of $15.0 million bearing interest at 1/2 percent over prime and due on demand. In fiscal 1995 the loan balance was reduced to $12.7 million. In fiscal 1996 the Real Estate Trust made new loans aggregating $3.5 million to the Saul Company. During fiscal 1997 a curtail of $750,000 was paid by the Saul Company. At September 30, 1997 the total due the Real Estate Trust was $15.4 million. In fiscal 1998 the loan balance was reduced to $15.3 million. Interest accrued on these loans amounted to $1.3, $1.4 and $1.4 million during fiscal 1998, 1997 and 1996, respectively.
REMUNERATION OF TRUSTEES AND OFFICERS
For fiscal years 1998, 1997, and 1996, the Real Estate Trust paid the Trustees $94,000, $89,000 and $79,000, respectively, for their services. No compensation was paid to the officers of the Real Estate Trust for acting as such; however, one Trustee was paid by the Bank for his services as Chairman and Chief Executive Officer of the Bank, and four received payments for their services as directors of the Bank. Four of the Trustees and all of the officers of the Real Estate Trust receive compensation from Saul Co. as directors and/or officers.
LEGAL SERVICES
The law firm in which one of the Trustees is a partner received $0.8, $0.3 and $0.1 million, during fiscal 1998, 1997, and 1996, respectively, for legal services to the Real Estate Trust and its wholly-owned subsidiaries.
SAUL HOLDINGS LIMITED PARTNERSHIP
The Real Estate Trust accounts for this investment under the equity method. The Real Estate Trust's share of earnings for fiscal 1998, 1997 and 1996 were $2.0, $3.0 and $2.7 million, respectively. See Note 2.
OTHER TRANSACTIONS
The Real Estate Trust leases space to the Bank and Franklin at two of its income-producing properties. Minimum rents and recoveries paid by these affiliates amounted to approximately $251,000, $239,000 and $143,000, in fiscal 1998, 1997 and 1996, respectively.
8. DISPOSITION OF ASSETS - THE BANK
Pursuant to the terms of a purchase agreement, dated as of September 2, 1998 and as amended on September 30, 1998, by and between the Bank and CCB Holding Corporation (a wholly-owned subsidiary of the Bank) ("CCBH"), and First USA Bank, NA, ("FUSA"), the Bank and CCBH sold their credit card portfolio and the Bank sold its credit card operations to FUSA. This transaction was consummated on September 30, 1998. The credit card portfolio purchased by FUSA included approximately $4.8 billion of managed credit card loans and 3.1 million Visa and MasterCard credit card accounts. The Bank recognized a net gain on this sale of $288.3 million, which is included in gain on sale of loans, net in the Consolidated Statements of Operations.
All significant assets and liabilities used in or related directly to the credit card business, including those associated with credit card securitization activities, were sold to or assumed by FUSA, with the exception of the Bank's operations center which housed the majority of credit card operations (other than origination activities). Concurrently with the transaction, the Bank and FUSA entered into a lease agreement for that facility.
These financial statements include the results of operations of the credit card business for the entire fiscal year, as well as the gain on sale, which occurred on the last day of the Bank's fiscal year.
9. LOANS HELD FOR SALE - THE BANK
Loans held for sale are composed of the following:
September 30, ---------------------------- (In thousands) 1998 1997 - ------------------------------------------ ---------- ---------- Single-family residential $ 49,502 $ 102,749 Home improvement and related loans 6,785 -- ---------- ---------- Total $ 56,287 $ 102,749 ========== ==========
10. LOANS HELD FOR SECURITIZATION AND SALE - THE BANK
Loans held for securitization and sale are composed of the following:
September 30, ---------------------------- (In thousands) 1998 1997 - ------------------------------------------ ---------- ----------- Credit card $ -- $ 90,000 Automobile 125,000 80,000 Home equity -- 50,000 ---------- ----------- Total $ 125,000 $ 220,000 ========== ===========
11. INVESTMENT SECURITIES - THE BANK
At September 30, 1998 and 1997, all investment securities are classified as held-to-maturity. Gross unrealized holding gains and losses on the Bank's investment securities at September 30, 1998 and 1997 are as follows:
Unrealized Unrealized Aggregate Amortized Holding Holding Fair (In thousands) Cost Gains Losses Value - ---------------------------- --------- ----------- ----------- ---------- September 30, 1998 U.S. Government securities: Maturing after one year, but within five years $ 43,999 $ 529 $ -- $ 44,528 ========= =========== =========== ==========
September 30, 1997 U.S. Government securities: Maturing within one year $ 4,998 $ 14 $ -- $ 5,012 ========= =========== =========== ==========
There were no sales of investment securities during the years ended September 30, 1998, 1997 and 1996.
12. MORTGAGE-BACKED SECURITIES - THE BANK
At September 30, 1998 and 1997, all mortgage-backed securities are classified as held-to-maturity. Gross unrealized holding gains and losses on the Bank's mortgage-backed securities at September 30, 1998 and 1997 are as follows: Gross Gross Unrealized Unrealized Aggregate Amortized Holding Holding Fair (In thousands) Cost Gains Losses Value - --------------------------- ---------- ----------- ----------- ---------- September 30, 1998 FNMA $ 471,617 $ 3,114 $ (1,927) $ 472,804 FHLMC 408,274 1,558 (982) 408,850 Private label, AAA-rated 1,117,017 -- (12,797) 1,104,220 Private label, AA-rated 28,909 51 (15) 28,945 ---------- ----------- ----------- ---------- Total $2,025,817 $ 4,723 $ (15,721) $2,014,819 ========== =========== =========== ==========
Gross Gross Unrealized Unrealized Aggregate Amortized Holding Holding Fair (In thousands) Cost Gains Losses Value - --------------------------- ---------- ----------- ----------- ---------- September 30, 1997 FNMA $ 333,563 $ 1,425 $ (1,948) $ 333,040 FHLMC 856,522 6,480 (2,835) 860,167 Private label, AAA-rated 734,632 -- (4,828) 729,804 Private label, AA-rated 60,990 666 -- 61,656 ---------- ----------- ----------- ---------- Total $1,985,707 $ 8,571 $ (9,611) $1,984,667 ========== =========== =========== ==========
There were no sales of mortgage-backed securities from the held-to-maturity portfolio during the years ended September 30, 1998, 1997 and 1996. See Summary of Significant Accounting Policies - The Bank - "Trading Securities."
Accrued interest receivable on mortgage-backed securities totaled $12.2 and $11.9 million at September 30, 1998 and 1997, respectively, and is included in other assets in the Consolidated Balance Sheets.
At September 30, 1998, certain mortgage-backed securities were pledged as collateral for Federal Home Loan Bank of Atlanta advances, other short-term borrowings and other recourse arrangements. See Notes 20, 21 and 28. Other mortgage-backed securities with a book value of $20.9 million were pledged as collateral primarily for credit and debit card settlement obligations.
13. LOANS RECEIVABLE - THE BANK
Loans receivable is composed of the following:
September 30, -------------------------------- (In thousands) 1998 1997 - ----------------------------------------- -------------- -------------- Single-family residential $ 1,772,784 $ 747,070 Home equity 135,122 44,088 Real estate construction and ground 209,247 106,813 Commercial real estate and multifamily 75,877 53,816 Commercial 279,416 152,483 Credit card -- 987,149 Automobile 232,826 149,868 Home improvement and related loans 60,570 55,453 Overdraft lines of credit and other consumer 33,484 36,029 -------------- --------------- 2,799,326 2,332,769
Less: Undisbursed portion of loans 207,921 106,217 Unearned discounts and net deferred loan origination costs (2,709) (2,026) Allowance for losses on loans 60,157 105,679 -------------- --------------- 265,369 209,870 -------------- --------------- Total $ 2,533,957 $ 2,122,899 ============== ===============
The Bank serviced loans owned by others amounting to $5,681.2 and $9,731.8 million at September 30, 1998 and 1997, respectively.
Accrued interest receivable on loans totaled $15.2 and $19.0 million at September 30, 1998 and 1997, respectively, and is included in other assets in the Consolidated Balance Sheets.
14. REAL ESTATE HELD FOR INVESTMENT OR SALE - THE BANK
Real estate held for investment or sale is composed of the following:
September 30, -------------------------------- (In thousands) 1998 1997 - ---------------------------------------------- -------------- --------------
Real estate held for investment $ 3,819 $ 3,819 Real estate held for sale 218,972 231,407 -------------- -------------- Sub-total 222,791 235,226 -------------- -------------- Less: Allowance for losses on real estate held for investment 202 198 Allowance for losses on real estate held for sale 153,564 140,738 -------------- -------------- 153,766 140,936 -------------- -------------- Total real estate held for investment or sale $ 69,025 $ 94,290 ============== ==============
Loss on real estate held for investment or sale is composed of the following:
September 30, ---------------------------------------------- (In thousands) 1998 1997 1996 - ------------------------------ -------------- -------------- -------------- Provision for losses $ (18,860) $ (19,623) $ (26,341) Net loss from operating properties (288) (221) (350) Net gain on sales 2,609 1,156 2,278 -------------- -------------- -------------- Total $ (16,539) $ (18,688) $ (24,413) ============== ============== ==============
15. ALLOWANCES FOR LOSSES - THE BANK
Activity in the allowances for losses on loans receivable and real estate held for investment or sale is summarized as follows: Real Estate Held for Loans Investment (In thousands) Receivable or Sale - ------------------------------------------------ ---------- ------------- Balance, September 30, 1995 $ 60,496 $ 135,236 Provision for losses 115,740 26,341 Charge-offs (92,047) (34,867) Recoveries 11,334 -- ---------- ------------ Balance, September 30, 1996 95,523 126,710 Provision for losses 125,115 19,623 Increase due to acquisition of loans 118 -- Charge-offs (126,506) (5,397) Recoveries 11,429 -- ---------- ------------ Balance, September 30, 1997 105,679 140,936 Provision for losses 150,829 18,860 Reduction due to sale of credit card portfolio (87,609) -- Charge-offs (122,652) (6,030) Recoveries 13,910 -- ---------- ------------ Balance, September 30, 1998 $ 60,157 $ 153,766 ========== ============
The allowances for losses at September 30, 1998 are based on management's estimates of the amount of allowances required to reflect the losses incurred in the loan and real estate portfolios based on circumstances and conditions known at the time. As adjustments to the allowances become necessary, provisions for losses are reported in operations in the periods they are determined to be necessary.
16. ASSET-BACKED TRANSACTIONS - THE BANK
The Bank periodically sells various receivables through asset-backed securitizations, in which receivables are transferred to trusts, and certificates are sold to investors.
The Bank sold credit card receivables and received gross proceeds of $1,000.5, $1,084.5 and $919.0 million during the years ended September 30, 1998, 1997 and 1996, respectively. The Bank recognized gains of $83.4 million on credit card securitization transactions during fiscal 1998, including gains on sales of new receivables into existing trusts. During fiscal 1997, the Bank recognized gains of $33.1 million on credit card securitization transactions, including sales of new receivables into existing trusts. No gains or losses were recorded on credit card securitization transactions during fiscal 1996. See Summary of Significant Accounting Policies - The Bank. At September 30, 1997, outstanding trust certificate balances related to these and previous securitizations were $4,015.2 million and the related receivable balances contained in the trusts were $4,659.7 million. On September 30, 1998, the Bank sold its credit card portfolio and related operations, including its rights to the excess cash flows generated from such credit card securitizations. See Note 8.
The Bank sold amounts on deposit in certain spread accounts associated with certain outstanding credit card securitizations and received gross proceeds of $36.0, $144.2 and $42.1 million during fiscal 1998, 1997 and 1996, respectively. Losses of $1.8 and $7.2 million were recognized for the years ended September 30, 1998 and 1997, respectively, and are included in servicing and securitization income in the Consolidated Statements of Operations. No gains or losses were recorded for the year ended September 30, 1996. Outstanding trust certificate balances related to the securitizations were $225.9 million at September 30, 1997. On September 30, 1998, the Bank sold its credit card portfolio and related operations, including its obligations associated with such spread account securitizations. See Note 8.
The Bank sold automobile loan receivables and received gross proceeds of $534.7, $938.9 and $475.3 million during the years ended September 30, 1998, 1997 and 1996, respectively. Gains recognized on these transactions were $23.1, $26.9 and $7.3 million, respectively, for the years ended September 30, 1998, 1997 and 1996. The outstanding trust certificate balances and the related receivable balances contained in the trusts were $1,055.7 million at September 30, 1998, $12.6 million of which represents subordinate classes of certificates retained by the Bank. The outstanding trust certificate balances and the related receivable balances contained in the trusts were $1,083.0 million at September 30, 1997, $7.9 million of which represents a subordinate class of certificates retained by the Bank. These retained certificates were classified as trading securities at September 30, 1998 and 1997 and had carrying values of $11.3 and $7.9 million, respectively. See Summary of Significant Accounting Policies - The Bank. The Bank continues to service the underlying loans and is contingently liable under various credit enhancement facilities related to these transactions. See Note 28.
The Bank sold home equity credit line receivables and received gross proceeds of $181.4, $24.0 and $96.5 million during the years ended September 30, 1998, 1997 and 1996, respectively. The Bank recognized gains of $13.8, $3.4 and $4.7 million on home equity credit line transactions during the years ended September 30, 1998, 1997 and 1996, respectively, including gains on sale of new receivables into existing trusts for fiscal 1998 and 1997. The outstanding trust certificate balances and the related receivable balances contained in the trusts were $305.7 million at September 30, 1998 and $325.8 million at September 30, 1997. The Bank continues to service the underlying loans and is contingently liable under various credit enhancement facilities related to these transactions. See Note 28.
During the years ended September 30, 1998 and 1997, the Bank sold home loan and home equity receivables in asset-backed transactions to investors representing interests in the trusts. The gross proceeds received on these sales were $163.3 and $216.2 million for the years ended September 30, 1998 and 1997, respectively. The gains recognized on these transactions were $8.8 and $11.2 million for the years ended September 30, 1998 and 1997, respectively. At September 30, 1998, the outstanding trust certificate balances and the related receivable balances contained in the trust were $148.0 million and the Bank serviced the underlying loans. At September 30, 1997, the outstanding trust certificate balances and the related receivable balances contained in the trust were $133.3 million. See Note 28.
The Bank sold home loan receivables and received gross proceeds of $4.0, $154.4 and $153.5 million for the years ended September 30, 1998, 1997 and 1996, respectively. Gains recognized on these transactions were $0.4, $7.2 and $9.5 million for the years ended September 30, 1998, 1997 and 1996, respectively. The outstanding trust certificate balances and the related receivable balances contained in the trusts were $168.7 million at September 30, 1998 and $246.8 million at September 30, 1997. The Bank continues to service the underlying loans and is contingently liable under credit enhancement facilities related to these transactions. See Note 28.
17. PROPERTY AND EQUIPMENT - THE BANK
Property and equipment is composed of the following:
Estimated September 30, Useful -------------------------------- (In thousands) Lives 1998 1997 - -------------------------- ---------------- -------------- --------------- Land -- $ 51,044 $ 49,925 Construction in progress -- 8,830 1,950 Buildings and improvements 10-45 years 129,716 122,326 Leasehold improvements 5-20 years 90,967 83,526 Furniture and equipment 5-10 years 188,705 182,044 Automobiles 3-5 years 2,336 2,303 -------------- --------------- 471,598 442,074 Less: Accumulated depreciation and amortization 185,682 168,512 -------------- --------------- Total $ 285,916 $ 273,562 ============== ===============
Depreciation and amortization expense amounted to $34.0, $28.7 and $24.6 million for the years ended September 30, 1998, 1997 and 1996, respectively.
18. LEASES - THE BANK
The Bank has noncancelable, long-term leases for office premises and retail space, which have a variety of terms expiring from fiscal 1999 to 2019 and ground leases which have terms expiring from fiscal 2029 to 2080. These leases are accounted for as operating leases. Some of the leases are subject to rent adjustments in the future based upon changes in the Consumer Price Index and some also contain renewal options. The following is a schedule by years of future minimum lease payments required at September 30, 1998:
Year Ending September 30, (In thousands) ------------- ------------- 1999 $ 14,631 2000 13,832 2001 12,411 2002 10,621 2003 9,099 Thereafter 71,049 ------------- Total $ 131,643 =============
Rent expense totaled $16.6, $16.1 and $13.5 million for the years ended September 30, 1998, 1997 and 1996, respectively.
19. DEPOSIT ACCOUNTS - THE BANK
An analysis of deposit accounts and the related weighted average effective interest rates at year-end are as follows:
September 30, -------------------------------------------------- 1998 1997 ------------------------ ------------------------
Weighted Weighted Average Average (Dollars in thousands) Amount Rate Amount Rate - --------------------------- ------------ ---------- ------------ ---------- Demand accounts $ 302,529 -- $ 215,678 -- NOW accounts 1,027,310 1.32% 904,697 2.42% Money market deposit accounts 1,019,569 3.62% 983,016 3.97% Statement savings accounts 913,467 2.41% 907,141 3.48% Other deposit accounts 97,696 2.10% 79,071 2.99% Certificate accounts, less than $100 1,157,603 5.20% 1,156,724 5.50% Certificate accounts, $100 or more 370,056 5.69% 647,429 5.69% ------------ ------------ Total $ 4,888,230 3.19% $ 4,893,756 3.99% ============ ============
Interest expense on deposit accounts is composed of the following:
Year Ended September 30, ---------------------------------------- (In thousands) 1998 1997 1996 - --------------------------------- ------------ ------------ ------------ NOW accounts $ 19,796 $ 21,882 $ 23,044 Money market deposit accounts 38,756 38,644 38,317 Statement savings accounts 28,419 30,927 30,034 Certificate accounts 89,958 75,180 69,180 Other deposit accounts 2,389 2,274 1,994 ------------ ------------ ------------ Total $ 179,318 $ 168,907 $ 162,569 ============ ============ ============
Outstanding certificate accounts at September 30, 1998 mature in the years indicated as follows:
Year Ending September 30, (In thousands) ------------- -------------- 1999 $ 1,236,272 2000 190,466 2001 40,076 2002 29,257 2003 31,588 -------------- Total $ 1,527,659 ==============
At September 30, 1998, certificate accounts of $100,000 or more have contractual maturities as indicated below:
(In thousands) ----------- Three months or less $ 229,540 Over three months through six months 59,546 Over six months through 12 months 54,525 Over 12 months 26,445 ----------- Total $ 370,056 ===========
20. SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER SHORT-TERM BORROWINGS - THE BANK
Short-term borrowings are summarized as follows:
September 30, ----------------------------- (In thousands) 1998 1997 1996 - ------------------------------------------------ --------- --------- --------- Securities sold under repurchase agreements: Balance at year-end $ 387,305 $ 2,606 $ 576,823 Average amount outstanding during the year 302,564 483,076 59,687 Maximum amount outstanding at any month-end 806,393 946,090 576,823 Amount maturing within 30 days 387,305 2,606 576,576 Weighted average interest rate during the year 5.68% 5.48% 5.50% Weighted average interest rate on year-end balances 5.63% 5.35% 5.41%
Other short-term borrowings: Balance at year-end $ 104,449 $ 72,215 $ 60,318 Average amount outstanding during the year 72,826 39,126 13,641 Maximum amount outstanding at any month-end 107,845 72,241 60,318 Amount maturing within 30 days 104,449 72,215 60,318 Weighted average interest rate during the year 5.08% 5.11% 5.04% Weighted average interest rate on year-end balances 5.19% 5.34% 5.63%
The investment and mortgage-backed securities underlying the repurchase agreements were delivered to the dealers who arranged the transactions. The dealers may have loaned such securities to other parties in the normal course of their operations and agreed to resell to the Bank the identical securities at the maturities of the agreements.
At September 30, 1998, the Bank had pledged mortgage-backed securities with a book value of $162.3 million to secure certain other short-term borrowings.
21. FEDERAL HOME LOAN BANK ADVANCES - THE BANK
At September 30, 1998, advances from the Federal Home Loan Bank of Atlanta ("FHLB") totaled $352.0 million. Of the total advances at September 30, 1998, $275.0 million have a weighted average interest rate of 5.55%, adjust quarterly based on the one-month London Interbank Offered Rate ("LIBOR") and mature over varying periods between October 1998 and January 1999. The weighted average interest rate on the remaining $77.0 million is 6.14%, which is fixed for the term of the advances and which mature over varying periods between October 1998 and June 2013.
Under a Specific Collateral Agreement with the FHLB, advances are secured by all of the Bank's FHLB stock and certain mortgage-backed securities with a book value of $1,134.2 million. The FHLB requires that members maintain qualifying collateral at least equal to 100% of the member's outstanding advances at all times. The collateral held by the FHLB in excess of the September 30, 1998 advances is available to secure additional advances from the FHLB, subject to its collateralization guidelines.
22. CAPITAL NOTES - SUBORDINATED - THE BANK
Capital notes, which are subordinated to the interest of deposit account holders and other senior debt are composed of the following:
September 30, Issue ------------------- Interest (Dollars in thousands) Date 1998 1997 Rate - -------------------------------- ----------------- --------- --------- ------- Subordinated debentures due 2005 November 23, 1993 $ 150,000 $ 150,000 9 1/4% Subordinated debentures due 2008 December 3, 1996 100,000 100,000 9 1/4% --------- --------- Total $ 250,000 $ 250,000 ========= =========
The 9 1/4% Subordinated Debentures due 2008 (the "1996 Debentures") are subject to redemption at any time on or after December 1, 2001, at the option of the Bank, in whole or in part, at the following redemption prices plus accrued and unpaid interest:
If redeemed during the 12-month period Redemption beginning December 1, Price - --------------------------------------------- -------------- (In thousands) 2001 $ 104.625 2002 $ 103.700 2003 $ 102.775 2004 $ 101.850 2005 $ 100.925 2006 and thereafter $ 100.000
The 9 1/4% Subordinated Debentures due 2005 (the "1993 Debentures") are subject to redemption at any time on or after December 1, 1998, at the option of the Bank, in whole or in part, at the following redemption prices plus accrued and unpaid interest:
If redeemed during the 12-month period Redemption beginning December 1, Price - --------------------------------------------- -------------- (In thousands) 1998 $ 104.625 1999 $ 103.700 2000 $ 102.775 2001 $ 101.850 2002 $ 100.925 2003 and thereafter $ 100.000
The indenture pursuant to which the 1993 Debentures were sold (the "Indenture") provides that the Bank may not pay dividends on its capital stock unless, after giving effect to the dividend, no event of default shall have occurred and be continuing and the Bank is in compliance with its regulatory capital requirements. In addition, the amount of the proposed dividend may not exceed the sum of (i) $15.0 million, (ii) 66 2/3% of the Bank's consolidated net income (as defined in the Indenture) accrued on a cumulative basis commencing on October 1, 1993 and (iii) the aggregate net cash proceeds received by the Bank after October 1, 1993 from the sale of qualified capital stock or certain debt securities, minus the aggregate amount of any restricted payments made by the Bank. Notwithstanding the above restrictions on dividends, provided no event of default has occurred or is continuing, the Indenture does not restrict the payment of dividends on the 13% Preferred Stock (as defined below) or any payment-in-kind preferred stock issued in lieu of cash dividends on the Preferred Stock or the redemption of any such payment-in-kind preferred stock. The indenture pursuant to which the 1996 Debentures were sold provides that the proposed dividend may not exceed the sum of the restrictions discussed above for the 1993 Indenture and the aggregate liquidation preference of the new series of preferred stock of the Bank, if issued in exchange for the outstanding REIT Preferred Stock (as defined below). See Note 23.
The Bank received OTS approval to include the principal amount of the 1996 Debentures and the 1993 Debentures in the Bank's supplementary capital for regulatory capital purposes.
Deferred debt issuance costs, net of accumulated amortization, amounted to $8.6 and $9.4 million at September 30, 1998 and 1997, respectively, and are included in other assets in the Consolidated Balance Sheets.
23. real estate investment trust subsidiary - THE BANK
On December 3, 1996, a new real estate investment trust subsidiary of the Bank (the "REIT Subsidiary") sold $150.0 million of its Noncumulative Exchangeable Preferred Stock, Series A, par value $5.00 per share (the "REIT Preferred Stock"), and received net cash proceeds of $144.0 million. Cash dividends on the REIT Preferred Stock are payable quarterly in arrears at an annual rate of 10 3/8%. The liquidation value of each share of REIT Preferred Stock is $50,000 plus accrued and unpaid dividends. Except under certain limited circumstances, the holders of the REIT Preferred Stock have no voting rights. The REIT Preferred Stock is automatically exchangeable for a new series of Preferred Stock of the Bank upon the occurrence of certain events.
The REIT Preferred Stock is redeemable at the option of the REIT subsidiary at any time on or after January 15, 2007, in whole or in part, at the following per share redemption prices plus accrued and unpaid dividends:
If redeemed during the 12-month period Redemption beginning January 15, Price - --------------------------------------- -------------- (In thousands) 2007 $ 52.594 2008 $ 52.075 2009 $ 51.556 2010 $ 51.038 2011 $ 50.519 2012 and thereafter $ 50.000
The Bank received OTS approval to include the proceeds from the sale of the REIT Preferred Stock in the core capital of the Bank for regulatory capital purposes in an amount up to 25% of the Bank's core capital. The net cash proceeds from the sale of the REIT Preferred Stock is reflected in minority interest - other in the Trust's Consolidated Balance Sheets. Dividends on the REIT Preferred Stock are presented as a reduction of net income in the Consolidated Statements of Operations.
24. PREFERRED STOCK - THE BANK
Cash Dividends on the Bank's Noncumulative Perpetual Preferred Stock, Series A (the "Preferred Stock") are payable quarterly in arrears at an annual rate of 13%. If the Board of Directors does not declare the full amount of the noncumulative cash dividend accrued in respect of any quarterly dividend period, in lieu thereof the Board of Directors will be required to declare (subject to regulatory and other restrictions) a stock dividend in the form of a new series of payment-in-kind preferred stock of the Bank.
The OTS has approved the inclusion of the Preferred Stock as tier 1 or core capital and has approved the payment of dividends on the Preferred Stock, provided certain conditions are met. The holders of the Preferred Stock have no voting rights, except in certain limited circumstances.
Holders of the Preferred Stock will be entitled to receive a liquidating distribution in the amount of $25,000 per share, plus accrued and unpaid dividends for the then-current dividend period in the event of any voluntary liquidation of the Bank, after payment of the deposit accounts and other liabilities of the Bank, and out of the assets available for distribution to shareholders. The Preferred Stock ranks superior and prior to the issued and outstanding common stock of the Bank with respect to dividend and liquidation rights.
The Preferred Stock is redeemable by the Bank at its option at any time on and after May 1, 2003, in whole or in part, at the following per share redemption prices in cash, plus, in each case, an amount in cash equal to accrued and unpaid dividends for the then-current dividend period:
If redeemed during the 12-month period Redemption beginning May 1, Price - --------------------------------------- -------------- (In thousands) 2003 $ 27.250 2004 $ 27.025 2005 $ 26.800 2006 $ 26.575 2007 $ 26.350 2008 $ 26.125 2009 $ 25.900 2010 $ 25.675 2011 $ 25.450 2012 $ 25.225 2013 and thereafter $ 25.000
25. RETIREMENT PLAN - THE BANK
The Bank participates in a defined contribution profit sharing retirement plan (the "Plan") which covers those full-time employees who meet the requirements as specified in the Plan. The Plan, which can be modified or discontinued at any time, requires participating employees to contribute 2.0% of their compensation. Corporate contributions, at the discretionary amount of three times the employee contribution, were $7.3, $5.6 and $4.7 million for the years ended September 30, 1998, 1997 and 1996, respectively. There are no past service costs associated with the Plan and the Bank has no liability under the Plan other than its current contributions. The Plan owns 4.0% of the Bank's common stock.
26. REGULATORY MATTERS - THE BANK
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the Bank's regulatory capital requirements at September 30, 1998 were a 1.5% tangible capital requirement, a 3.0% core capital requirement and an 8.0% total risk-based capital requirement. Under the OTS "prompt corrective action" regulations, the Bank must maintain minimum leverage, tier 1 risk-based and total risk-based capital ratios of 4.0%, 4.0% and 8.0%, respectively, to meet the ratios established for "adequately capitalized" institutions. At September 30, 1998, the Bank was in compliance with its tangible, core and total risk-based regulatory capital requirements and exceeded the capital standards established for "well capitalized" institutions under the "prompt corrective action" regulations. The information below is based upon the Bank's understanding of the applicable FIRREA and "prompt corrective action" regulations and related interpretations.
(1) Eligible for inclusion in core capital in an amount up to 25% of the Bank's core capital pursuant to authorization from the OTS. (2) Pursuant to OTS policy, net unrealized holding gains (losses) are excluded from regulatory capital. (3) Reflects an aggregate offset of $788,000 representing the allowance for general loan losses maintained against the Bank's equity investments and non-includable subsidiaries which, pursuant to OTS guidelines, is available as a credit against the deductions from capital otherwise required for such investments. (4) Under the OTS "prompt corrective action" regulations, the standards for classification as "well capitalized" are a leverage (or "core capital") ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%.
At September 30, 1997, the Bank was in compliance with its tangible, core and total risk-based regulatory capital requirements and exceeded the capital standards established for "well capitalized" institutions under the "prompt corrective action" regulations. The information below is based upon the Bank's understanding of the applicable FIRREA and "prompt corrective action" regulations and related interpretations.
(1) Eligible for inclusion in core capital in an amount up to 25% of the Bank's core capital pursuant to authorization from the OTS. (2) Pursuant to OTS policy, net unrealized holding gains (losses) are excluded from regulatory capital. (3) Reflects an aggregate offset of $964,000 representing the allowance for general loan losses maintained against the Bank's equity investments and non-includable subsidiaries which, pursuant to OTS guidelines, is available as a credit against the deductions from capital otherwise required for such investments. (4) Under the OTS "prompt corrective action" regulations, the standards for classification as "well capitalized" are a leverage (or "core capital") ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%.
At September 30, 1998 and 1997, the Bank had $4.1 and $4.0 million, respectively, in loans to and investments in subsidiaries engaged in activities impermissible for national banks ("non-includable subsidiaries") which were fully deducted from all three capital requirements. At September 30, 1998 and 1997, the Bank also had two equity investments with an aggregate balance, after subsequent valuation allowances, of $11.7 and $15.3 million, respectively, which were fully deducted from total risk-based capital.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from total risk-based capital. In February 1998, the Bank received from the OTS an extension of the holding periods for certain of its REO properties through February 17, 1999. The following table sets forth the Bank's REO at September 30, 1998, after valuation allowances of $166.9 million, by the fiscal year in which the property was acquired through foreclosure.
Fiscal Year (In thousands) ----------- -------------- 1990 $ 19,023(1)(2) 1991 36,619(2) 1992 100(2) 1993 -- 1994 732 1995 5,907 1996 -- 1997 -- 1998 3,027 --------- Total REO $ 65,408 =========
(1) Includes REO with an aggregate net book value of $11.1 million, which the Bank treats as equity investments for regulatory capital purposes. (2) Includes REO with an aggregate net book value of $44.6 million, for which the Bank received an extension of the holding periods through February 17, 1999.
At the request of the OTS, the Board of Directors of the Bank adopted a resolution in March 1996 which, among other things, permits the Bank: (i) to make tax sharing payments without OTS approval to the Trust of up to $15.0 million relating to any single fiscal year; and (ii) to declare dividends on its stock in any quarterly period up to the lesser of (a) 50% of its after tax net income for the immediately preceding quarter or (b) 50% of the average quarterly after tax net income for the immediately preceding four quarter period, minus (in either case) dividends declared on the Bank's preferred stock during that quarterly period. The resolution also provides that the Bank will present a plan annually to the OTS detailing anticipated consumer loan securitization activity.
27. TRANSACTIONS WITH RELATED PARTIES - THE BANK
Loans Receivable
From time to time, in the normal course of business, the Bank may make loans to executive officers and directors, their immediate family members or companies with which they are affiliated. These loans are on substantially the same terms as similar loans with unrelated parties. An analysis of activity with respect to these loans for the year ended September 30, 1998 is as follows:
(In thousands) --------------- Balance, September 30, 1997 $ 2,432 Additions 3,276 Reductions (2,313) --------------- Balance, September 30, 1998 $ 3,395 ================
Services
B. F. Saul Company, which is a shareholder of the Trust, and its subsidiaries provide certain services to the Bank. These services include property management, insurance brokerage and leasing. Fees for these services were $24,000, $42,000 and $366,000 for the years ended September 30, 1998, 1997 and 1996, respectively.
The law firm in which one director of the Bank is a partner received $4.6, $4.9 and $3.2 million for legal services rendered to the Bank during the years ended September 30, 1998, 1997 and 1996 respectively.
For the years ended September 30, 1998, 1997 and 1996, one of the directors of the Bank was paid $75,000, $50,000 and $37,000, respectively, for consulting services rendered to the Bank. Another director of the Bank was paid total fees of $100,000 for each of the years ended September 30, 1998, 1997 and 1996, respectively, for consulting services. A third director of the Bank was paid $50,000 and $17,000 for consulting services rendered to the Bank for the years ended September 30, 1998 and 1997, respectively.
Tax Sharing Agreement
The Bank and the other companies in the Trust's affiliated group are parties to a tax sharing agreement dated June 28, 1990 (the "Tax Sharing Agreement"). The Tax Sharing Agreement provides for payments to be made by members of the Trust's affiliated group to the Trust based on their separate company tax liabilities. The Tax Sharing Agreement also provides that, to the extent net operating losses or tax credits of a particular member are used to reduce the overall tax liability of the Trust's affiliated group, such member will be reimbursed by the other members of the affiliated group that have taxable income in an amount equal to such tax reduction. The Bank paid $5.6, $9.8 and $25.0 million to the Trust during fiscal 1998, 1997 and 1996, respectively, under the Tax Sharing Agreement. OTS approval of the tax sharing payments during fiscal 1998, 1997 and 1996 was conditioned on a pledge by the Trust of certain assets to secure certain of its obligations under the Tax Sharing Agreement. Under the terms of the Bank's board resolution, the Bank is permitted to make tax sharing payments to the Trust of up to $15.0 million relating to any fiscal year without OTS approval. See Note 26. At September 30, 1998, the estimated tax sharing payment payable to the Trust by the Bank was $6.6 million. There was no tax sharing payment payable to the Trust by the Bank at September 30, 1997.
Other
The Bank paid $5.0, $4.9 and $4.5 million for office space leased from or managed by companies affiliated with the Bank or its directors during the years ended September 30, 1998, 1997 and 1996, respectively.
The Trust, the B. F. Saul Company, Chevy Chase Lake Corporation ("Lake") and Van Ness Square Corporation, affiliates of the Bank, from time to time maintain interest-bearing deposit accounts with the Bank. Those accounts totaled $28.0 and $26.5 million at September 30, 1998 and 1997, respectively. The Bank paid interest on the accounts amounting to $0.9, $0.6 and $1.1 million during fiscal years ended 1998, 1997 and 1996, respectively.
28. FINANCIAL INSTRUMENTS - THE BANK
The Bank, in the normal course of business, is a party to financial instruments with off-balance-sheet risk and other derivative financial instruments to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit at both fixed and variable rates, letters of credit, interest-rate cap agreements and assets sold with limited recourse. All such financial instruments are held or issued for purposes other than trading.
These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the Consolidated Balance Sheets.
The contract or notional amount of these instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. For interest-rate cap agreements, assets sold with limited recourse and forward purchase and sale commitments, the contract or notional amounts do not represent exposure to credit loss in the event of nonperformance by the other party. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The Bank is also a party to derivative financial instruments that do not have off-balance-sheet risk (e.g., interest-rate cap agreements).
Commitments to Extend Credit
The Bank had approximately $1.1 billion of commitments to extend credit at September 30, 1998. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments are subject to the Bank's normal underwriting and credit evaluation policies and procedures.
Standby Letters of Credit
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. At September 30, 1998, the Bank had written standby letters of credit in the amount of $31.4 million, which were issued to guarantee the performance of and irrevocably assure payment by customers under construction projects.
Of the total, $18.9 million will expire in fiscal 1999 and the remainder will expire over time through fiscal 2001. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan commitments to customers. Mortgage-backed securities with a book value of $3.8 million were pledged as collateral for certain of these letters of credit at September 30, 1998.
Recourse Arrangements
The Bank is obligated under various recourse provisions (primarily related to credit losses) related to the securitization and sale of receivables. As a result of these recourse provisions, the Bank maintained restricted cash accounts and overcollateralization of receivables amounting to $110.2 and $12.5 million, respectively, at September 30, 1998, and $117.7 and $8.0 million, respectively, at September 30, 1997, both of which are included in other assets in the Consolidated Balance Sheets. In addition, the Bank owned subordinated automobile receivables-backed securities with carrying values of $11.3 and $8.0 million at September 30, 1998 and 1997, respectively, which were classified as trading securities in the Consolidated Balance Sheets.
The Bank is also obligated under various recourse provisions related to the swap of single-family residential loans for mortgage-backed securities issued by the Bank. At September 30, 1998, recourse to the Bank under these arrangements was $6.5 million, consisting of restricted cash accounts amounting to $2.6 million and overcollateralization of receivables of $3.9 million.
Derivative Financial Instruments
Interest-rate cap agreements are used to limit the Bank's exposure to rising short-term interest rates related to the retained portion of certain of its asset-backed securitizations. At September 30, 1998, the Bank was a party to two interest-rate cap agreements with an aggregate notional amount of $205.6 million with maturity dates ranging from October 15, 1998 through June 30, 1999. One of the interest-rate cap agreements with a notional amount of $200.0 million entitles the Bank to receive compensatory payments from the cap provider, which is a AAA-rated (by Standard & Poor's) counterparty, equal to the product of (a) the amount by which the one-month LIBOR exceeds 7.00% and (b) the then outstanding notional principal amount for a predetermined period of time. The second interest-rate cap agreement with a notional amount of $5.6 million entitles the Bank to receive compensatory payments from the cap provider, which is a AA-rated (for long term debt as rated by Standard & Poor's) counterparty, equal to the product of (a) the amount by which the one-month LIBOR exceeds 9.00% and (b) the then outstanding notional principal amount for the predetermined period of time. The Bank has no obligation to make payments to the provider of the cap or any other party. The Bank is exposed to credit losses in the event of nonperformance by the counterparty, but does not expect the counterparty to fail to meet its obligation given its credit rating.
To manage the potentially adverse impact of interest rate movements on its held for sale fixed-rate mortgage loan pipeline, the Bank hedges its pipeline by entering into whole loan and mortgage-backed security forward sale commitments and mortgage-backed security forward purchase commitments. Forward sale commitments are used to sell specific financial instruments (whole loans or mortgage-backed securities) at a future date for a specified price.
At September 30, 1998, the Bank had mortgage-backed security forward sale commitments of $39.1 million. At September 30, 1998, the Bank had no whole loan forward sale commitments. In addition, at September 30, 1998, the Bank had $12.9 million in mortgage security forward purchase commitments related to its hedging activities. Forward commitments generally settle within 90 days. Gains and losses are deferred and recorded as a component of the gain on sales of loans at the time the forward commitment matures.
Concentrations of Credit
The Bank's principal real estate lending market is the metropolitan Washington, D.C. area. In addition, a significant portion of the Bank's consumer loan portfolio was generated by customers residing in the metropolitan Washington, D.C. area. Service industries and federal, state and local governments employ a significant portion of the Washington, D.C. area labor force. Adverse changes in economic conditions could have a direct impact on the timing and amount of payments by borrowers.
29. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - THE BANK
The majority of the Bank's assets and liabilities are financial instruments; however, certain of these financial instruments lack an available trading market. Significant estimates, assumptions and present value calculations were therefore used for the purposes of the following disclosure, resulting in a great degree of subjectivity inherent in the indicated fair value amounts. Because the fair value is estimated as of the balance sheet date, the amount which will actually be realized or paid upon settlement or maturity could be significantly different. Comparability among financial institutions may be difficult due to the wide range of permitted valuation techniques and the numerous estimates and assumptions which must be made. The estimated fair values of the Bank's financial instruments at September 30, 1998 and 1997 are as follows:
(1) Net of deferred debt issuance costs which are included in other assets in the Consolidated Balance Sheets.
The following methods and assumptions were used to estimate the fair value amounts at September 30, 1998 and 1997:
Cash, due from banks, interest-bearing deposits, federal funds sold and securities purchased under agreements to resell: Carrying amount approximates fair value.
Loans held for sale: Fair value is determined using quoted prices for loans, or securities backed by loans with similar characteristics, or outstanding commitment prices from investors.
Loans held for securitization and sale: The carrying value of loans held for securitization and sale approximates fair value because such receivables are sold at face value.
Trading securities: Fair value is equal to carrying value.
Investment securities: Fair value is based on quoted market prices.
Mortgage-backed securities: Fair value is based on quoted market prices, dealer quotes or estimates using dealer quoted market prices for similar securities.
Loans receivable, net: Fair value of certain homogeneous groups of loans (e.g. single-family residential, automobile loans, home improvement loans and fixed-rate commercial and multifamily loans) is estimated using discounted cash flow analyses based on contractual repayment schedules. The discount rates used in these analyses are based on either the interest rates paid on U.S. Treasury securities of comparable maturities adjusted for credit risk and non-interest operating costs, or the interest rates currently offered by the Bank for loans with similar terms to borrowers of similar credit quality. For loans which reprice frequently at market rates (e.g. home equity, variable-rate commercial and multifamily, real estate construction and ground loans), the carrying amount approximates fair value. Because credit card receivables were generally sold at face value through the Bank's securitization program, such face value was used as the estimated fair value of these receivables at September 30, 1997. The fair value of the Bank's loan portfolio as presented above does not include the value of established credit line customer relationships, or the value relating to estimated cash flows from future receivables and the associated fees generated from existing customers.
Other financial assets: The carrying amount of Federal Home Loan Bank stock, accrued interest receivable, interest-bearing deposits maintained pursuant to various asset securitizations and other short-term receivables approximates fair value. Interest-only strips are carried at fair value. The fair value of one of the Bank's investments is based on quoted market prices. The fair value of the Bank's interest-rate cap agreements is based on dealer quotes.
Deposit accounts with no stated maturities: Deposit liabilities payable on demand, consisting of NOW accounts, money market deposits, statement savings and other deposit accounts, are assumed to have an estimated fair value equal to carrying value. The indicated fair value does not consider the value of the Bank's established deposit customer relationships.
Deposit accounts with stated maturities: Fair value of fixed-rate certificates of deposit is estimated based on discounted cash flow analyses using the remaining maturity of the underlying accounts and interest rates currently offered on certificates of deposit with similar maturities.
Borrowings: These instruments consist of securities sold under repurchase agreements and other short-term borrowings, notes payable and Federal Home Loan Bank advances. For borrowings which either reprice frequently to market interest rates or are short-term in duration, the carrying amount approximates fair value. Fair value of the remaining amounts borrowed is estimated based on discounted cash flow analyses using interest rates currently charged by the lender for comparable borrowings with similar remaining maturities.
Capital notes-subordinated: Fair value of the 1993 Debentures and the 1996 Debentures is based on quoted market prices.
Other financial liabilities: The carrying amount of custodial accounts, amounts due to banks, accrued interest payable and other short-term payables approximates fair value.
Off-balance sheet instruments: The difference between the original fees charged by the Bank for commitments to extend credit and letters of credit and the current fees charged to enter into similar agreements is immaterial. Fair value of forward commitments is based on the estimated amount that the Bank would pay to terminate the arrangements at the reporting date, taking into account the remaining terms of the arrangements and the counterparties' credit standing, where applicable, which is immaterial.
30. LITIGATION - THE BANK
During the normal course of business, the Bank is involved in certain litigation, including litigation arising out of the collection of loans, the enforcement or defense of the priority of its security interests, the continued development and marketing of certain of its real estate properties and certain employment claims. Although the amounts claimed in some of these suits in which the Bank is a defendant are material, the Bank denies liability and, in the opinion of management, litigation which is currently pending will not have a material impact on the financial condition or future operations of the Bank.
31. COMMITMENTS AND CONTINGENCIES - THE TRUST
The Trust is involved in a number of lawsuits arising from the normal course of its business. On the basis of consultations with counsel, management does not believe that any material loss will result from the resolution of these matters.
32. INCOME TAXES - THE TRUST
The Trust voluntarily terminated its qualification as a real estate investment trust under the Internal Revenue Code during fiscal 1978.
The provisions for income taxes for the years ended September 30, 1998, 1997 and 1996, consist of the following:
The Trust's effective income tax rate varies from the statutory Federal income tax rate as a result of the following factors:
The components of the net deferred tax asset were as follows:
A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. As of September 30, 1998, management has maintained a valuation allowance in part to reduce the net deferred tax asset for net operating loss carryforwards related to state taxes. Historically, the Bank has generated taxable income while the Real Estate Trust has generated taxable losses. The net operating loss carryforwards are not expected to be realizable for state tax purposes. For federal tax purposes, there are no net operating loss carryforwards.
Management believes the existing net deductible temporary differences will reverse during periods in which the Bank generates taxable income in excess of Real Estate Trust taxable losses. Management believes that the positive consolidated earnings will continue as a result of the Bank's earnings.
TAX SHARING AGREEMENT
The Trust's affiliated group, including the Bank, entered into a tax sharing agreement dated June 28, 1990. This agreement provides that payments be made by members of the affiliated group to the Trust based on their respective allocable shares of the overall federal income tax liability of the affiliated group for taxable years and partial taxable years beginning on or after that date.
Allocable shares of the overall tax liability are prorated among the members with taxable income calculated on a separate return basis. The agreement also provides that, to the extent net operating losses or tax credits of a particular member are used to reduce overall tax liability of the Trust's affiliated group, such member will be reimbursed on a dollar-for-dollar basis by the other members of the affiliated group that have taxable income in an amount equal to such tax reduction. Under the tax sharing agreement, the Bank paid $5.6, $9.8 and $25.0 million, respectively, to the Trust during fiscal 1998, 1997 and 1996.
In recent years, the operations of the Trust have generated net operating losses while the Bank has reported net income. It is anticipated that the Trust's consolidation of the Bank's operations into the Trust's federal income tax return will result in the use of the Trust's net operating losses to reduce the federal income taxes the Bank would otherwise owe. If in any future year, the Bank has taxable losses or unused credits, the Trust would be obligated to reimburse the Bank for the greater of (i) the tax benefit to the group using such tax losses or unused tax credits in the group's consolidated Federal income tax returns or (ii) the amount of tax refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated Federal income tax return of the group.
As of September 30, 1998, there was no alternative minimum tax carryforward.
33. SHAREHOLDERS' EQUITY - THE TRUST
In June 1990, the Trust acquired from affiliated companies an additional equity interest in the Bank, which raised the Trust's ownership share of the Bank to 80%. In exchange for the interest acquired, the Trust issued 450,000 shares of a new class of $10.50 cumulative preferred shares of beneficial interest with a par value of $1 ("preferred shares"). The transaction has been accounted for at historical cost in a manner similar to the pooling of interests method because the entities are considered to be under common control. In addition, the Trust acquired two real estate properties from an affiliate in exchange for 66,000 preferred shares.
At September 30, 1998, 1997, and 1996, the amount of dividends in arrears on the preferred shares was $34.0 million ($65.98 per share), $36.2 million ($70.21 per share) and $31.6 million ($61.17 per share), respectively. Based on the dividends paid on the preferred shares during fiscal 1996, the Trust recorded a liability at September 30, 1996, equal to the total dividends in arrears on that date. The Trust paid preferred dividends of $7.6 million, $750,000 and $500,000 in fiscal 1998, 1997 and 1996, respectively.
34. QUARTERLY FINANCIAL DATA (UNAUDITED) - THE TRUST
35. INDUSTRY SEGMENT INFORMATION - TRUST
Industry segment information with regard to the Real Estate Trust is presented below. For information regarding the Bank, please refer to the "Banking" sections of the accompanying financial statements.
36. CONDENSED FINANCIAL STATEMENTS - THE TRUST
These condensed financial statements reflect the Real Estate Trust and all its consolidated subsidiaries except for the Bank which has been reflected on the equity method.
MANAGEMENT'S STATEMENT ON RESPONSIBILITY
The Consolidated Financial Statements and related financial information in this report have been prepared by the Advisor (management) in accordance with generally accepted accounting principles appropriate in the circumstances, based on best estimates and judgments, with consideration given to materiality.
The Trust maintains a system of internal accounting control supported by documentation to provide reasonable assurance that the books and records reflect authorized transactions of the Trust, and that the assets of the Trust are safeguarded.
The Board of Trustees exercises its responsibility for the Trust's financial statements through its Audit Committee, which is composed of two outside Trustees who meet periodically with the Trust's independent accountants and management. The Committee considers the audit scope, discusses financial and reporting subjects, and reviews management actions on these matters. The independent accountants have full access to the Audit Committee.
The independent accountants are recommended by the Audit Committee and confirmed by the Board of Trustees. They provide an objective assessment of the fairness and accuracy of the financial statements, consider the adequacy of the system of internal accounting controls, and perform such tests and other procedures as they deem necessary to express an opinion on the fairness of the financial statements. Management believes that the policies and procedures it has established provide reasonable assurance that its operations are conducted in conformity with law and a high standard of business conduct.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. TRUSTEES AND EXECUTIVE OFFICERS OF THE TRUST
The Declaration of Trust provides that there shall be no fewer than three nor more than twelve Trustees, as determined from time to time by the Trustees in office. The Board of Trustees has fixed its permanent membership at six Trustees divided into three classes with overlapping three-year terms. The term of each class expires at the Annual Meeting of Shareholders, which is usually held on the last Friday of January.
The following list sets forth the name, age, position with the Trust, present principal occupation or employment and material occupations, positions, offices or employments during the past five years of each Trustee and executive officer of the Trust. Unless otherwise indicated, each individual has held an office with the Trust for at least the past five years.
Class Three Trustees --Terms End at 1999 Annual Meeting
Garland J. Bloom, Jr., age 67, has served as a Trustee since 1964. He is currently a real estate consultant. He was formerly Executive Vice President and Principal of GMB Associates, Inc. (a real state finance and management firm) from 1988 to 1990 and Vice Chairman and Chief Operating Officer of Smithy-Braedon Company (a real estate finance and management firm) from 1985 to 1987.
John R. Whitmore, age 65, has served as a Trustee since 1984. He also serves as Director, President and Chief Executive Officer of The Bessemer Group, Incorporated (a financial management and banking firm) and its Bessemer Trust Company subsidiaries with which he has been an associated since 1975, and as a Director of Bessemer Securities Corporation, Chevy Chase Property Company, B. F. Saul Company and Saul Centers, Inc.
Class One Trustees --Terms End at 2000 Annual Meeting
Gilbert M. Grosvenor, age 67, has served as a Trustee since 1971. He also serves as Chairman of the Board of Trustees of the National Geographic Society and as a Director of the Bank, Saul Centers, Inc., Marriott International Corp., and Ethyl Corporation.
B. Francis Saul II, age 66, has served as Chairman and Chief Executive Officer of the Trust since 1969 and as a Trustee since 1964. He also serves as President and Chairman of the Board of Directors of B. F. Saul Company, B. F. Saul Advisory Company, Chevy Chase Property Company, Westminster Investing Corporation, and Chevy Chase Lake Corporation, as Chairman of the Board of the Bank, as Chairman of the Board and Chief Executive Officer of Saul Centers, Inc., and as a Trustee of the National Geographic Society and the Brookings Institute. Mr. Saul is the father of B. Francis Saul III.
Class Two Trustees --Terms End at 2001 Annual Meeting
George M. Rogers, Jr., age 65, has served as a Trustee since 1969. His professional corporation is a partner in the law firm of Shaw, Pittman, Potts & Trowbridge, Washington, D.C., which serves as counsel to the Trust and the Bank. Mr. Rogers serves as a Director of the Bank, B. F. Saul Company, Chevy Chase Property Company, Westminster Investing Corporation, and Chevy Chase Lake Corporation.
B. Francis Saul III, age 36, was elected a Trustee and Vice President of the Trust in 1997. He also serves as a Director and/or Officer of the Bank, B. F. Saul Company, B. F. Saul Advisory Company, Franklin Property Company, Chevy Chase Property Company, Westminster Investing Corporation, and Saul Centers, Inc. He is also a Director of the Greater Washington Boys and Girls Club and The Heights School. Mr. Saul is the son of B. Francis Saul II.
Executive Officers of the Trust Who Are Not Directors
Philip D. Caraci, age 60, serves as Senior Vice President and Secretary of the Trust, Executive Vice President of B.F. Saul Company, Senior Vice President of B. F. Saul Advisory Company, President of Franklin Property Company and a Director and President of Saul Centers, Inc.
Stephen R. Halpin, Jr., age 43, serves as Vice President and Chief Financial Officer of the Trust. He also serves as Executive Vice President and Chief Financial Officer of the Bank.
Ross E. Heasley, age 59, serves as Vice President of the Trust, B. F. Saul Company, B. F. Saul Advisory Company, Franklin Property Company and Saul Centers, Inc.
Henry Ravenel, Jr., age 64, serves as Vice President of the Trust, B. F. Saul Company, B. F. Saul Advisory Company and Saul Centers, Inc.
William K. Albright, age 67, serves as Vice President and Treasurer of the Trust, B. F. Saul Company, Franklin Property Company and B. F. Saul Advisory Company, and as Vice President of Saul Centers, Inc.
Committees of the Board of Trustees
The Board of Trustees met four times during fiscal 1998. Each member of the Board attended at least 75% of the aggregate number of meetings of the Board and of the Committees of the Board on which he served.
The Board of Trustees has three standing committees: the Audit Committee, the Executive Committee and the Nominating Committee.
The Audit Committee is composed of Messrs. Bloom and Grosvenor. Its duties include nominating the Trust's independent auditors, discussing with them the scope of their examination of the Trust, reviewing with them the Trust's financial statements and accompanying report, and reviewing their recommendations regarding internal controls and related matters. This Committee met four times during fiscal 1998.
The Executive Committee is composed of Messrs. Rogers, Saul II and Whitmore. It is empowered to oversee day-to-day actions of the Advisor and Franklin Property Company ("Franklin") in connection with the operations of the Trust, including the acquisition, administration, sale or disposition of investments. This Committee did not meet during fiscal 1998.
The Nominating Committee is composed of Messrs. Rogers and Whitmore. Its function is to screen and make recommendations to the Board of Trustees regarding potential candidates for membership on the Board and to perform such other duties as may be assigned to it from time to time. This Committee did not meet during fiscal 1998.
Trustees of the Trust are currently paid an annual retainer of $12,500 and a fee of $600 for each Board or committee meeting attended. Trustees from outside the Washington, D.C. area are also reimbursed for out-of-pocket expenses in connection with their attendance at meetings. Mr. Saul II is not paid for attending Executive Committee meetings. For the fiscal year ended September 30, 1998, the Real Estate Trust paid total fees of $94,000 to the Trustees, including $15,000 to Mr. Saul II.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Trust pays no compensation to its executive officers for their services in such capacity. Mr. Saul II receives compensation from the Bank for his services as the Bank's Chairman of the Board of Directors and Chief Executive Officer, and Mr. Halpin receives compensation from the Bank for his services as Executive Vice President and Chief Financial Officer. No other executive officers of the Trust received any compensation from the Trust or its subsidiaries with respect to any of the fiscal years ended September 30, 1998, 1997 or 1996.
The following table set forth the cash compensation paid by the Bank to Mr. Saul and Mr. Halpin for or with respect to the fiscal years ended September 30, 1998, 1997 and 1996 for all capacities in which they served during such fiscal years.
Summary Compensation Table Annual Compensation - ------------------------------------------------------------------------------ Name and Principal Other Annual All Other Position Fiscal Salary Bonus Compensation Compensation - --------------------- ------ ------------ --------- ------------ ------------
B. Francis Saul II 1998 $1,353,528 $700,000 $ -- $725,873 (1) Chairman and Chief 1997 1,230,440 600,000 -- 292,807 (2) Executive Officer 1996 1,015,054 500,000 -- 214,426 (3)
Stephen R. Halpin, Jr. 1997 $400,010 $60,000 $ -- $159,073 (1) Vice President and 1997 375,402 54,000 -- 69,167 (2) Chief Financial 1996 332,320 58,000 -- 50,295 (3) Officer - --------------------- (1) The total amounts shown in the "All Other Compensation" column for fiscal 1998 consist of the following: (i) contributions made by the Bank's Supplemental Executive Retirement Plan on behalf of Mr. Saul ($136,018) and Mr. Halpin ($20,170); (ii) the taxable benefit of premiums paid by the Bank for group term insurance on behalf of Mr. Saul ($14,724) and Mr. Halpin ($2,621); (iii) contributions to the Retirement Plan, a defined contribution plan, on behalf of Mr. Halpin ($9,600); and (iv) accrued earnings on awards previously made under the Bank's Deferred Compensation Plan on behalf of Mr. Saul ($575,131) and Mr. Halpin ($126,682).
(2) The total amounts shown in the "All Other Compensation" column for fiscal 1997 consist of the following contributions made by the Bank to the Bank's Supplemental Executive Retirement Plan on behalf of Mr. Saul ($109,616) and Mr. Halpin ($16,164); (ii) the taxable benefit of premiums paid by the Bank for group term insurance on behalf Mr. Halpin ($2,325); (iii) contributions to the Retirement Plan, a defined contribution plan, on behalf of Mr. Halpin ($9,600); and (iv) accrued earnings on awards previously made under the Bank's Deferred Compensation Plan on behalf of Mr. Saul ($183,191) and Mr. Halpin ($41,078).
(3) The total amounts shown in the "All Other Compensation" column for fiscal 1996 consist of the contributions made by the Bank to the Bank's Supplemental Executive Retirement Plan on behalf of Mr. Saul ($90,693) and Mr. Halpin ($14,373); (ii) the taxable benefit of premiums paid by the Bank for group term insurance on behalf of Mr. Halpin ($2,102); (iii) contributions to the Retirement Plan, a defined contribution plan, on behalf of Mr. Halpin ($9,000); and (iv) accrued earnings on awards previously made under the Bank's Deferred Compensation Plan on behalf of Mr. Saul ($123,733) and Mr. Halpin ($24,820).
Long-Term Incentive Plan Awards. The following table sets forth certain information concerning the principal contributions (the "Principal Contributions") credited by the Bank to the accounts (the "Accounts") of the executive officers of the Bank named above for fiscal 1998 under the Bank's Deferred Compensation Plan (the "Plan").
Long-Term Incentive Program - Awards in Last Fiscal Year
Number Performance of Shares Or Other Estimated Future Payouts Under Units Period Until Non-Stock Price-Based Plans Name and Principal Or Other Maturation ------------------------------- Position Rights(1) Or Payout Threshold Target(2) Maximum - ------------------------ --------- ------------ --------- --------- ---------- B. Francis Saul II(3)(4) N/A 2002 $550,000 $694,362 $1,140,480 Chairman and Chief Executive Officer
Stephen R. Halpin, Jr.(4) N/A 2008 $120,000 $214,902 $743,008 Vice President and Chief Financial Officer - ------------------------
(1) The estimated future payouts shown in the table are based on assumed performance rates for the Bank each year in the ten-year performance period. The actual payouts under the Plan may vary substantially from the payouts shown in the table, depending upon the Bank's actual rate of return on average assets for each fiscal year in the ten-year performance period ending September 30, 2008.
(2) The Plan does not establish any target performance levels. The payout amounts shown in this column have calculated assuming that the Bank's rate of return on average assets during each of the years in the performance period are the same as the Bank's rate of return during the fiscal year ended September 30, 1997.
(3) The payout amount shown for Mr. Saul is the estimated amount that would be payable to Mr. Saul if he continued with the Bank for the entire ten-year performance period of the Plan. Mr. Saul will attain the age of 70 in 2002 at which time he will become fully vested in the account maintained for his benefit under the plan. Under the Plan, if Mr. Saul were to retire after that date, he could elect to have the Bank pay out the Net Contribution (as defined ) in his account prior to the year 2008. Certain of the awards credited by the Bank to the Account maintained for the benefit of Mr. Saul under the Plan vested at the time Mr. Saul attained age 60 in 1992. Certain other awards credited by the Bank to the Account maintained for the benefit of Mr. Saul will vest upon the earlier of (i) five years after the date of the award, (ii) his attainment of age 70 in 2002, (iii) his death, (iv) his total or permanent disability, or a change in control of the Bank (as defined in the Plan). Accordingly, as of September 30, 1998, Mr. Saul was partially vested in the Account maintained for his benefit under the Plan. As of that date, the vested Account balance maintained for Mr. Saul's benefit under the plan was $779,446.
(4) As of September 30, 1998 the following individuals have vested Accounts that are payable within 120 days after September 30, 1998; Mr. Saul ($303,710); and Mr. Halpin ($65,081).
The Plan provides that, as of the end of each fiscal year in the ten-year period ending September 30, 2008 (or the executive officer's earlier termination of employment with the Bank), the Bank will add to or deduct from each executive officer's Account a contribution or deduction, as the case may be, which represents, the hypothetical interest (which may be positive or negative) earned on the Principal Contribution, based on the Bank's rate of return on average assets (as computed under the Plan) for the fiscal year then ended. (The Principal Contribution, plus or minus any interest credited or deducted, is referred to as the "Net Contribution").
Executive officers are entitled to receive the Net Contribution in their respective Account only upon full or partial vesting. Plan participants become fully vested in their Account under the Plan, provided that they remain continuously employed by the Bank during the vesting period, upon the earliest to occur of any of the following: (i) September 30, 2008; (ii) attainment of age 60; (iii) death; (iv) total and permanent disability; or (v) a change in control of the Bank (as defined in the Plan). Plan participants become partially vested to the extent of 50% of the Net Contribution in the Account, upon the termination of their employment by the Bank without cause (as defined in the Plan) after September 30, 2003.
Payouts are made under the Plan within 120 days after September 30, 2008, or the earlier termination of the executive officer's employment with the Bank, provided that vesting or partial vesting has occurred under the Plan.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information, as of December 4, 1998, concerning beneficial ownership of Common Shares and Preferred Shares of Beneficial Interest ("Preferred Shares") by (i) each person known by the Trust to be the beneficial owner of more than 5% of the Common Shares and the Preferred Shares, (ii) each member of the Board of Trustees, (iii) each executive officer of the Trust named in the Summary Compensation Table under "Executive Compensation" and (iv) all Trustees and executive officers of the Trust as a group.
Aggregate Number of Percent Name of Shares of Beneficial Owner Beneficially Owned (1) Class (1) - ----------------------- ---------------------- ------------------ B. Francis Saul II Preferred: 516,000 (2) 100.00% Common: 4,807,510 (3) 99.60%
Philip D. Caraci Common: 19,400 (4) 0.40%
All Trustees and Preferred: executive officers 516,000 (2) 100.00% as a group (10 persons) Common: 4,826,910 100.00% - -----------------------
(1) Beneficial owner and percent of class are calculated pursuant to rule 13d-3 under the Securities Exchange Act of 1934.
(2) Consists of Preferred Shares owned of record by B. F. Saul Company and other companies of which Mr. Saul is an officer, director and/or more than 10% shareholder (comprising 270,000 Preferred Shares owned by B. F. Saul Company, 90,000 Preferred Shares owned by Franklin Development Company, Inc., 90,000 Preferred Shares owned by The Klingle Corporation, and 66,000 Preferred Shares owned by Westminster Investing Corporation). The address of each person listed in this footnote is 8401 Connecticut Avenue, Chevy Chase, Maryland 20815. Pursuant to Rule 13d-3, the Preferred Shares described above are considered to be beneficially owned by Mr. Saul because he has or may be deemed to have sole or shared voting and/or investment power in respect thereof.
(3) Consists of Common Shares owned of record by B. F. Saul Company and other companies of which Mr. Saul is an officer and director and/or more than 10% shareholder (comprising 1,125,739 Common Shares owned by Westminster Investing Corporation, 43,673 Common Shares owned by Derwood Investment Corporation (a subsidiary of Westminster Investing Corporation), 34,400 Common Shares owned by Somerset Investment Company, Inc. (a subsidiary of Westminster Investing Corporation), 2,545,362 Common Shares owned by B. F. Saul Company, 206,300 Common Shares owned by Columbia Credit Company (a subsidiary of B. F. Saul Company), 283,400 Common Shares owned by Columbia Securities Company of Washington, D. C., 172,918 Common Shares owned by Franklin Development Company, Inc., and 395,718 Common Shares owned by The Klingle Corporation). The address of each person listed in this footnote is 8401 Connecticut Avenue, Chevy Chase, Maryland 20815. Pursuant to Rule 13d-3, the Common Shares described above are considered to be beneficially owned by Mr. Saul because he has or may be deemed to have sole or shared voting and/or investment power in respect thereof.
(4) Mr. Caraci has entered into an agreement with the Trust under which he is required to sell all Common Shares he then owns to the Trust when his employment by B. F. Saul Company and any of its affiliates ceases for any reason, including retirement, termination, death or disability. The price Mr. Caraci will receive for his Common Shares will be the greater of $28.00 per Share or the price the Trust determines at the time is the fair market value thereof.
The Preferred Shares were issued in June 1990 in connection with the transaction in which the Trust increased its equity interest in the Bank from 60% to 80%. The dividend rate on the Preferred Shares is $10.50 per share per annum. Dividends are cumulative and are payable annually or at such other times as the Trustees may determine, as and when declared by the Trustees out of any assets legally available therefor. The Preferred Shares have a liquidation preference of $100 per share. Subject to limits in certain of the Trust's loan agreements, the Preferred Shares are subject to redemption at the option of the Trust at a redemption price equal to their liquidation preference. Except as otherwise required by applicable law, the holders of Preferred Shares are entitled to vote only in certain limited situations, such as the merger of the Trust or a sale of all or substantially all of the assets of the Trust.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Real Estate
Transactions with B. F. Saul Company and its Subsidiaries. The Real Estate Trust is managed by the Advisor, a wholly owned subsidiary of the Saul Company. All of the officers of the Trust and B. Francis Saul II, George M. Rogers, Jr., B. Francis Saul III and John R. Whitmore, each of whom is a Trustee of the Trust, are also officers and/or directors of the Saul Company and/or its subsidiary corporations. The Advisor is paid a fixed monthly fee subject to annual review by the Trustees. The monthly fee was $301,000 for the period October 1995 through March 1996, $306,000 for the period April 1996 through September 1996, $311,000 for the period October 1996 through September 1997, and $317,000 for the period October 1997 through September 1998. The advisory contract has been extended until September 30, 1999, and will continue thereafter unless cancelled by either party at the end of any contract year. Certain loan agreements prohibit termination of this contract.
The Saul Company and Franklin, a wholly owned subsidiary of the Saul Company, provide services to the Real Estate Trust in the areas of commercial property management and leasing, hotel management, development and construction management, and acquisitions, sales and financings of real property. The fee schedules of the Saul Company and Franklin are reviewed and approved by the Trustees. Fees to the Saul Company and Franklin amounted to $5.2 million in fiscal 1998.
The Real Estate Trust reimburses the Advisor and Franklin for costs and expenses incurred in connection with the acquisition and development of real property on behalf of the Real Estate Trust, in-house legal expenses, and all travel expenses incurred in connection with the affairs of the Real Estate Trust.
The Real Estate Trust pays the Advisor fees equal to 1% of the principal amount of publicly offered Unsecured Notes as they are issued to offset the Advisor's costs of administering the program. The Advisor received $113,000 in such fees in fiscal 1998.
B. F. Saul Insurance Agency of Maryland, Inc., a subsidiary of the Saul Company, is a general insurance agency that receives commissions and counter-signature fees in connection with the Real Estate Trust's insurance program. Such commissions and fees amounted to approximately $157,000 in fiscal 1998.
In fiscal 1994 the Real Estate Trust made an unsecured loan to the Saul Company of $15.0 million at a floating interest rate and due on demand. In fiscal 1995 the loan balance was reduced to $12.7 million. In fiscal 1996 the Real Estate Trust made loans aggregating $3.5 million to the Saul Company. During fiscal 1997 and 1998, curtails of $750,000 and $141,000, respectively, were paid by the Saul Company. At September 30, 1998 the total due the Real Estate Trust was $15.3 million in principal and $1.7 million in deferred interest. Interest accrued on these loans amounted to $1.3 million, $1.4 million and $1.4 million during fiscal 1998, 1997 and 1996 respectively.
Remuneration of Trustees and Officers. For fiscal 1998, the Real Estate Trust paid the Trustees $94,000 in fees for their services. See "Trustees and Executive Officers of the Trust." No compensation was paid to the officers of the Real Estate Trust for acting as such; however, Mr. Saul II was paid by the Bank for his services as the Bank's Chairman and Chief Executive Officer and Mr. Halpin was paid by the Bank for his services as Executive Vice President and Chief Financial Officer of the Bank. See "Executive Compensation." Messrs. Grosvenor, Rogers, Saul II and Saul III receive compensation for their services as directors of the Bank and Messrs. Rogers, Saul II, Saul III and Whitmore and all of the officers of the Real Estate Trust receive compensation from the Saul Company and/or its affiliated corporations as directors or officers thereof.
Legal Services. For legal services to the Real Estate Trust and its subsidiaries, the law firm in which the professional corporation of George M. Rogers, Jr., a Trustee of the Trust, is a partner received approximately $ 800,000 in fiscal 1998, excluding expense reimbursements.
Other Transactions. The Real Estate Trust leases space to the Bank and Franklin at one of its income-producing properties. Amounts paid under these leases amounted to approximately $251,000 in fiscal 1998.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements
The following consolidated Financial Statements of the Trust are incorporated by reference in Part II, Item 8.
(a) Report of Independent Public Accountants.
(b) Consolidated Balance Sheets - As of September 30, 1998 and 1997.
(c) Consolidated Statements of Operations - For the years ended September 30, 1998, 1997 and 1996.
(d) Consolidated Statements of Shareholders' Deficit - For the years ended September 30, 1998, 1997 and 1996.
(e) Consolidated Statements of Cash Flows - For the years ended September 30, 1998, 1997 and 1996.
(f) Notes to Consolidated Financial Statements.
2. Financial Statement Schedules and Supplementary Data
(a) Selected Quarterly Financial Data for the Real Estate Trust are incorporated by reference in Part II, Item 8.
(b) Report of Independent Public Accountants on Financial Statement Schedules.
(c) Schedules of the Real Estate Trust:
Schedule I - Condensed Financial Information - For the years ended September 30, 1998, 1997 and 1996.
Schedule III - Consolidated Schedule of Investment Properties As of September 30, 1998.
(b) Reports on Form 8-K Form 8-K filed September 9, 1998 reporting Items 2 and 7.
(c) Exhibits
EXHIBITS DESCRIPTION - -------- ----------------------------------------------------------------- 3. ORGANIZATIONAL DOCUMENTS
(a) Amended and Restated Declaration of Trust filed with the Maryland State Department of Assessments and Taxation on June 22, 1990 as filed as Exhibit 3(a) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(b) Amendment to Amended and Restated Declaration of Trust reflected in Secretary Certificate filed with the Maryland State Department of Assessments and Taxation on June 26, 1990 as filed as Exhibit 3(b) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(c) Amended and Restated By-Laws of the Trust dated as of February 28, 1991 as filed as Exhibit T3B to the Trust's Form T-3 Application for Qualification of Indentures under the Trust Indenture Act of 1939 (File No. 22-20838) is hereby incorporated by reference.
4. INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES
(a) Indenture dated as of March 25, 1998 between the Trust and Norwest Bank Minnesota, National Association, as Trustee, with respect to the Trust's 9 3/4% Series B Senior Secured Notes due 2008, as filed as Exhibit 4(a) to Registration Statement 333-49937 is hereby incorporated by reference.
(b) Indenture with respect to the Trust's Senior Notes Due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration No. 33-19909 is hereby incorporated by reference.
(c) First Supplemental Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit T-3C to the Trust's Form T-3 Application for Qualification of Indentures under the Trust Indenture Act of 1939 (File No. 22-20838) is hereby incorporated by reference.
(d) Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration Statement No. 33-9336 is hereby incorporated by reference.
(e) Fourth Supplemental Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration Statement No. 2-95506 is hereby incorporated by reference.
(f) Third Supplemental Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration Statement No. 2-91126 is hereby incorporated by reference.
(g) Second Supplemental Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration Statement No. 2-80831 is hereby incorporated by reference.
(h) Supplemental Indenture with respect to the Trust's Senior Notes due from One Year to Ten Years from Date of Issue as filed as Exhibit 4(a) to Registration Statement No. 2-68652 is hereby incorporated by reference.
(i) Indenture with respect to the Trust's Senior Notes due from One Year to Five Years from Date of Issue as filed as Exhibit T-3C to the Trust's Form T-3 Application for Qualification of Indentures under
EXHIBITS DESCRIPTION - -------- -----------------------------------------------------------------
the Trust Indenture Act of 1939 (file No. 22-10206) is hereby incorporated by reference
(j) Indenture dated as of September 1, 1992 with respect to the Trust's Notes due from One to Ten Years form Date of Issue filed as Exhibit 4(a) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(k) First Supplemental Indenture dated as of January 16, 1997 with respect to the Trust's Notes due from One to Ten years from Date of Issue filed as Exhibit 4(b) to Registration Statement No. 33-34930 is hereby incorporated by reference.
10. MATERIAL CONTRACTS
(a) Advisory Contract with B.F. Saul Advisory Company effective October 1, 1982 filed as Exhibit 10(a) to Registration Statement No. 2-80831 is hereby incorporated by reference.
(b) Commercial Property Leasing and Management Agreement effective October 1, 1982 between the Trust and Franklin Property Company filed as Exhibit 10(b) to Registration Statement No. 2-80831 is hereby incorporated by reference.
(c) Tax sharing Agreement dated June 28,1990 among the Trust, Chevy Chase Savings Bank F.S.B. and certain of their subsidiaries filed as Exhibit 10(c) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(d) Agreement dated June 28, 1990 among the Trust B.F. Saul Company, Franklin Development Co., Inc., The Klingle Corporation and Westminster Investing Corporation relating to the transfer of certain shares of Chevy Chase Savings Bank, F.S.B. and certain real property to the Trust in exchange for preferred shares of beneficial interest of the Trust filed as Exhibit 10(d) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(e) Regulatory Capital Maintenance/Dividend Agreement dated May 17, 1988 among B.F. Saul Company, the Trust and the Federal Savings and Loan Insurance Corporation filed as Exhibit 10(e) to the Trust's Annual Report on Form 10-K (File No. 1-7184) for the fiscal year ended September 30, 1991 is hereby incorporated by reference.
(f) Written Agreement dated September 30, 1991 between the Office of Thrift Supervision and Chevy Chase Savings Bank, F.S.B. filed as Exhibit 10(f) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(g) Amendments to Commercial Property Leasing and Management Agreement between the Trust and Franklin Property Company dated as of December 31, 1992 (Amendment No. 5), July 1, 1989 (Amendment No. 4), October 1, 1986 (Amendment No. 3), January 1, 1985 (Amendment No. 2) and July 1, 1984 (Amendment No. 1) filed as Exhibit 10(o) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(h) Advisory Contract between B.F. Saul Advisory Company and Dearborn Corporation dated as of December 31, 1992 filed as Exhibit 10(p) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(i) Commercial Property Leasing and Management Agreement between Dearborn Corporation and Franklin Property Company dated as of December 31, 1992 filed as Exhibit 10(q) to Registration Statement No. 33-34930 is hereby incorporated by reference.
EXHIBITS DESCRIPTION - -------- -----------------------------------------------------------------
(j) Registration Rights and Lock-Up Agreement dated August 26, 1993 by and among Saul Centers, Inc. and the Trust, Westminster Investing Corporation, Van Ness Square Corporation, Dearborn Corporation, Franklin Property Company and Avenel Executive Park Phase II, Inc. as filed as Exhibit 10.6 to Registration Statement No. 33-64562 is hereby incorporated by reference.
(k) Exclusivity and Right of First Refusal Agreement dated August 26, 1993 among Saul Centers, Inc., the Trust, B. F. Saul Company, Westminster Investing Corporation, Franklin Property Company, Van Ness Square Corporation, and Chevy Chase Savings Bank, F.S.B. as filed as Exhibit 10.7 to Registration Statement No. 33-64562 is hereby incorporated by reference.
(l) First Amended and Restated Reimbursement Agreement dated as of August 1, 1994 by and among Saul Centers, Inc., Saul Holdings Limited Partnership, Saul Subsidiary I limited Partnership, Saul Subsidiary II Limited Partnership, Avenel Executive Park Phase II, Inc., Franklin Property Company, Westminster Investing Corporation, Van Ness Square Corporation, Dearborn Corporation and the Trust filed as Exhibit 10(l) to the Trust's Annual Report on Form 10-K (File No. 1-7184) for the fiscal year ended September 30, 1995 is hereby incorporated by reference.
(m) Amendment to Written Agreement dated October 29, 1993 between the Office of Thrift Supervision and Chevy Chase Savings Bank, F.S.B. filed as Exhibit 10(u) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(n) Registration Rights Agreement dated as of March 25, 1998 among the Trust, Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated and Friedman, Billings, Ramsey & Co., Inc. as filed as Exhibit 4(c) to Registration Statement No. 333-49937 is hereby incorporated by reference.
(o) Bank Stock Registration Rights Agreement dated as of March 25, 1998 between the Trust and Norwest Bank Minnesota, National Association, as Trustee, as filed as Exhibit 4(d) to Registration Statement No. 333-49937 is hereby incorporated by reference.
*21. List of Subsidiaries of the Trust.
*27. Financial Data Schedule.
- --------------------- * Filed herewith.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust
We have audited the consolidated financial statements of B.F. Saul Real Estate Investment Trust (the "Trust") as of September 30, 1998 and 1997 and for the years then ended in accordance with generally accepted auditing standards, and have issued our report thereon dated December 2, 1998. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Trust's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated in all material respects as to the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP
Washington, D.C. December 2, 1998
B.F. SAUL REAL ESTATE INVESTMENT TRUST CONDENSED FINANCIAL INFORMATION SCHEDULE I
(a) Required condensed financial information on the Trust is disclosed in the audited consolidated financial statements included herewith.
(b) Amounts of cash dividends paid to the Trust by consolidated subsidiaries were as follows:
Year Ended September 30 --------------------------------------- 1998 1997 1996
$5,200,000 $7,200,000 $6,800,000
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Trust has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
B.F. Saul Real Estate Investment Trust
December 28, 1998 B. Francis Saul II --------------------------------------------- B. Francis Saul II Chairman of the Board
Pursuant to the requirements of the Securities Exchanges Act of 1934. this report had been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates shown.
Signature Title Date --------- ----- ----
B. Francis Saul II - -------------------------- Trustee, Chairman of the Board B. Francis Saul II (Principal Executive Officer) December 28, 1998
Stephen R. Halpin, Jr. December 28, 1998 - -------------------------- Vice President and Chief Stephen R. Halpin, Jr. Financial Officer (Principal Financial Officer)
Ross E. Heasley December 28, 1998 - -------------------------- Vice President (Principal Ross E. Heasley Accounting Officer)
Garland J. Bloom, Jr. December 28, 1998 - -------------------------- Trustee Garland J. Bloom, Jr.
Gilbert M. Grosvenor December 28, 1998 - -------------------------- Trustee Gilbert M. Grosvenor
George M. Rogers, Jr. December 28, 1998 - -------------------------- Trustee George M. Rogers, Jr.
B. Francis Saul III December 28, 1998 - -------------------------- Trustee B. Francis Saul III
John R. Whitmore December 28, 1998 - -------------------------- Trustee John R. Whitmore