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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER 0-6835
IRWIN FINANCIAL CORPORATION
(EXACT NAME OF CORPORATION AS SPECIFIED IN ITS CHARTER)
INDIANA 35-1286807
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
500 WASHINGTON STREET COLUMBUS, INDIANA 47201
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(812) 376-1909 WWW.IRWINFINANCIAL.COM
(CORPORATION'S TELEPHONE NUMBER, INCLUDING AREA (WEB SITE)
CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
TITLE OF CLASS: COMMON STOCK*
TITLE OF CLASS: 9.25% CUMULATIVE TRUST PREFERRED SECURITIES ISSUED BY IFC
CAPITAL TRUST I AND THE GUARANTEE WITH RESPECT THERETO.
TITLE OF CLASS: 10.50% CUMULATIVE TRUST PREFERRED SECURITIES ISSUED BY IFC
CAPITAL TRUST II AND THE GUARANTEE WITH RESPECT THERETO.
TITLE OF CLASS: 8.75% CUMULATIVE CONVERTIBLE TRUST PREFERRED SECURITIES
ISSUED BY IFC CAPITAL TRUST III AND THE GUARANTEE WITH
RESPECT THERETO.
TITLE OF CLASS 8.70% CUMULATIVE TRUST PREFERRED SECURITIES ISSUED BY IFC
CAPITAL TRUST VI AND THE GUARANTEE WITH RESPECT THERETO.
Indicate by check mark whether the Corporation: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Corporation was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Corporation's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the Corporation is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant, based on the closing price for the
registrant's common stock on the New York Stock Exchange on June 30, 2002, was
approximately $332,375,690.
The aggregate market value of the voting stock held by non-affiliates of the
Corporation was $292,339,062 as of March 10, 2003. As of March 10, 2003, there
were outstanding 27,824,897 common shares of the Corporation.
* Includes associated rights.
DOCUMENTS INCORPORATED BY REFERENCE
SELECTED PORTIONS OF THE FOLLOWING DOCUMENTS PART OF FORM 10-K INTO WHICH INCORPORATED
-------------------------------------------- -----------------------------------------
DEFINITIVE PROXY STATEMENT FOR ANNUAL MEETING PART III
OF SHAREHOLDERS TO BE HELD APRIL 24, 2003
EXHIBIT INDEX ON PAGES 108 THROUGH 110
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FORM 10-K
TABLE OF CONTENTS
Part I
Item 1 -- Business.................................................... 2
Item 2 -- Properties.................................................. 15
Item 3 -- Legal Proceedings........................................... 15
Item 4 -- Submission of Matters to a Vote of Security Holders......... 18
Part II
Item 5 -- Market for Corporation's Common Equity and Related
Stockholder Matters......................................... 19
Item 6 -- Selected Financial Data..................................... 20
Item 7 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 22
Item 7A -- Quantitative and Qualitative Disclosures about Market
Risk........................................................ 70
Item 8 -- Financial Statements and Supplementary Data................. 70
Item 9 -- Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 105
Part III
Item 10 -- Directors and Executive Officers of the Corporation......... 106
Item 11 -- Executive Compensation...................................... 106
Item 12 -- Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters.................. 106
Item 13 -- Certain Relationships and Related Transactions.............. 107
Item 14 -- Controls and Procedures..................................... 107
Part IV
Item 15 -- Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 108
1
PART I
ITEM 1. BUSINESS
GENERAL
We are a diversified financial services company headquartered in Columbus,
Indiana with $4.9 billion in assets at December 31, 2002. We focus primarily on
the extension of credit to consumers and small businesses as well as providing
the ongoing servicing of those customer accounts. We currently operate five
major lines of business through our direct and indirect subsidiaries. Our major
lines of business are: mortgage banking, commercial banking, home equity
lending, commercial finance and venture capital.
We are a regulated bank holding company and we conduct our consumer and
commercial lending businesses through various operating subsidiaries. Our
banking subsidiary, Irwin Union Bank and Trust Company, was organized in 1871
and we formed the holding company in 1972. Our direct and indirect major
subsidiaries include Irwin Union Bank and Trust, a commercial bank, which
together with Irwin Union Bank, F.S.B., a federal savings bank, conduct our
commercial banking activities; Irwin Mortgage Corporation, a mortgage banking
company; Irwin Home Equity Corporation, a consumer home equity lending company;
Irwin Commercial Finance Corporation, a commercial finance subsidiary; and Irwin
Ventures LLC, a venture capital company.
At the parent level, we work actively to add value to our lines of business
by interacting with the management teams, capitalizing on interrelationships,
providing centralized services and coordinating overall organizational
decisions. Under this organizational structure, our mortgage banking, home
equity and commercial finance lines of business operate as direct and indirect
subsidiaries of Irwin Union Bank and Trust. This structure provides additional
liquidity and results in regulatory oversight of our business.
Our Internet address is http://www.irwinfinancial.com.
We make available free of charge through our Internet website our annual
report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and amendments to those reports as soon as reasonably practicable after we
electronically file the material with the Securities and Exchange Commission
(SEC). Our internet website and the information contained or incorporated in it
are not intended to be incorporated into this Annual Report on Form 10-K.
MAJOR LINES OF BUSINESS
Mortgage Banking
We established our mortgage banking line of business when we acquired our
subsidiary, Irwin Mortgage Corporation, formerly Inland Mortgage Corporation, in
1981. Irwin Mortgage became a subsidiary of Irwin Union Bank and Trust in
October, 2002. In this line of business, Irwin Mortgage originates, purchases,
sells, and services conventional and government agency-backed residential
mortgage loans throughout the United States. Most of our mortgage originations
either are insured or guaranteed by an agency of the federal government, such as
the Federal Housing Authority (FHA) or the Veterans Administration (VA) or, in
the case of conventional mortgages, meet requirements for resale to the Federal
National Mortgage Association (FNMA) or the Federal Home Loan Mortgage
Corporation (FHLMC). We originate mortgage loans through retail offices, direct
marketing and our Internet website. We also purchase mortgage loans through
mortgage brokers. Our relationships with realtors, homebuilders and brokers help
us identify potential borrowers. Irwin Mortgage also engages in the mortgage
reinsurance business through its subsidiary, Irwin Reinsurance Corporation, a
Vermont corporation. In October 2002, we began originating mortgage loans
through our new correspondent lending channel. We sell mortgage loans to
institutional and private investors but may retain servicing rights to the loans
we originate or purchase from correspondents. Irwin Mortgage collects and
accounts for the monthly payments on each loan serviced and pays the real estate
taxes and insurance necessary to protect the integrity of the mortgage lien, for
which it receives a servicing fee.
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At January 31, 2003, Irwin Mortgage operated 153 production and satellite
offices in 34 states. We discuss this line of business further in the Mortgage
Banking section of Management's Discussion and Analysis of Financial Condition
and Results of Operations (MD&A) of this report.
Commercial Banking
Our commercial banking line of business provides credit, cash management
and personal banking products primarily to small businesses and business owners.
We offer a full line of consumer, mortgage and commercial loans, as well as
personal and commercial checking accounts, savings and time deposit accounts,
personal and business loans, credit card services, money transfer services,
financial counseling, property, casualty, life and health insurance agency
services, trust services, securities brokerage and safe deposit facilities.
We offer commercial banking services through our banking subsidiaries,
Irwin Union Bank and Trust, an Indiana state-chartered commercial bank, and
Irwin Union Bank, F.S.B., a federal savings bank.
- Irwin Union Bank and Trust Company -- headquartered in Columbus, Indiana
and organized in 1871, is a full service Indiana state-chartered
commercial bank with offices currently located throughout nine counties
in central and southern Indiana, as well as in Kalamazoo, Grandville
(near Grand Rapids), Traverse City and Lansing, Michigan, and Carson
City, Nevada; and
- Irwin Union Bank, F.S.B. -- headquartered in Louisville, Kentucky, is a
full-service federal savings bank that began operations in December 2000.
Currently we have offices located in Brentwood, Missouri (near St.
Louis); Louisville, Kentucky; Salt Lake City, Utah; Las Vegas, Nevada;
and Phoenix, Arizona. We anticipate pursuing the conversion of our Las
Vegas and Salt Lake City branches of Irwin Union Bank, F.S.B. to branches
of Irwin Union Bank and Trust Company.
We discuss this line of business further in the Commercial Banking section
of the MD&A of this report.
Home Equity Lending
We established this line of business when we formed Irwin Home Equity
Corporation as our subsidiary in 1994, headquartered in San Ramon, California.
Irwin Home Equity became a subsidiary of Irwin Union Bank and Trust in 2001. In
conjunction with Irwin Union Bank and Trust, Irwin Home Equity originates,
purchases, securitizes and services home equity loans and lines of credit and
first mortgages nationwide. Our target customers are principally credit worthy,
home owning consumers who are active, unsecured credit card debt users. We
market our home equity products (with loan to value ratios up to 125%) and first
mortgage refinance programs (with loan to value ratios up to 100%) through
direct mail, telemarketing, mortgage brokers and correspondent lenders
nationwide and through the Internet. Irwin Home Equity's core competencies are
credit risk management and analysis, risk assessment, and specialized home loan
servicing, with particular expertise in test management and database analysis.
We discuss this line of business further in the Home Equity Lending section
of the MD&A of this report.
Commercial Finance
Established in 1999, our commercial finance line of business (formerly
called our equipment leasing line of business) originates small-ticket equipment
leases through an established North American network of vendors and brokers and
provides finance for franchisees of selected quick service restaurant concepts
in the United States. The majority of our leases are full payout (no residual),
small-ticket assets secured by commercial equipment. We finance a variety of
commercial and office equipment types and try to limit the industry and
geographic concentrations in our lease portfolio. Loans and leases to
franchisees sometimes involve the financing of real estate as well as equipment.
In July 2000, the commercial finance line of business acquired an ownership
of approximately 78% in Onset Capital Corporation, a Canadian small-ticket
equipment leasing company headquartered in Vancouver, British Columbia. In
December 2001, Onset Capital established Onset Alberta Ltd. as a subsidiary to
3
facilitate its leasing business. In October 2001, we formed Irwin Franchise
Capital Corporation to conduct our franchise leasing business. We established
Irwin Commercial Finance (formerly, Irwin Capital Holdings) in April 2001 as a
subsidiary of Irwin Union Bank and Trust to serve as the parent company for both
our United States and Canadian commercial finance companies.
We discuss this line of business further in the Commercial Finance section
of the MD&A of this report.
Venture Capital
We established this line of business when we formed Irwin Ventures
Incorporated in August 1999. In our venture capital line of business, we make
minority investments in early stage companies in the financial services industry
and related fields that intend to use technology as a key component of their
competitive strategy. We provide Irwin Ventures' portfolio companies the benefit
of our management experience in the financial services industry. In addition, we
expect that contacts made through venture activities may benefit management of
our other lines of business through the sharing of technologies and market
opportunities.
In August 1999, Irwin Ventures established a subsidiary, Irwin Ventures
Incorporated-SBIC, which received a small business investment company license
from the Small Business Administration. In December 2000, Irwin Ventures and
Irwin Ventures-SBIC became Delaware limited liability companies. To date, the
primary geographic focus of this line of business and each of our investments
has been on the corridors of the east and west coasts between Washington, D.C.
and Boston, and Palo Alto and Seattle.
Other Subsidiaries
Irwin Union Credit Insurance Corporation has its home office in Columbus,
Indiana and provides credit life insurance to consumer loan customers of Irwin
Union Bank.
We established Irwin Residual Holdings Corporation and Irwin Residual
Holdings Corporation II in 2002 to hold residual interests that Irwin Union Bank
and Trust Company transferred to Irwin Financial Corporation. The residual
interests were created as a result of securitizations in our home equity line of
business.
We continue to hold certain small-ticket equipment leases in our
subsidiary, Irwin Leasing Corporation (the former Affiliated Capital Corp.). The
leases were not part of the 1998 sale of substantially all of the assets of
Affiliated Capital to DVI Financial Services, Inc. Irwin Leasing and its parent,
Irwin Equipment Finance Corporation, are inactive except for the leases.
No single part of our business is dependent upon a single customer or upon
a very few customers and the loss of any one customer would not have a
materially adverse effect upon our business.
COMPETITION
In our mortgage banking business we compete for mortgage loans with other
national, and regional mortgage banking companies, as well as commercial banks,
savings banks, credit unions and savings and loan associations.
In our commercial banking business, we compete with commercial banks,
savings banks, thrifts and credit unions for deposits and loans in and around
the counties surrounding our branch offices, and with a number of nonbank
companies located throughout the United States, including insurance companies,
retailers, securities firms, companies offering money market accounts, and
national credit card companies.
In our home equity lending business, our primary competitors for our home
equity loans and lines of credit include banks, mortgage banks, large securities
firms, credit unions, thrifts, credit card issuers, finance companies, and other
home equity and mortgage lenders with operations that are either national,
regional, local or web-enabled in scope. Competition can take many forms,
including convenience in obtaining loans, customer service, marketing and
distribution channels, terms provided and interest rates charged to borrowers.
4
In our commercial finance business, our primary competitors include other
finance companies that are independent or affiliated with banks, large equipment
leasing or franchise financing companies that operate on a national or regional
basis.
In our venture capital line of business, we compete primarily with other
venture capital firms that invest in start-up companies.
Some of our competitors are not subject to the same degree of regulation as
that imposed on bank holding companies, state banking organizations and federal
saving banks. In addition, many larger banking organizations, mortgage
companies, mortgage banks, insurance companies and securities firms have
significantly greater resources than we do. As a result, some of our competitors
have advantages over us in name recognition and market penetration.
SUPERVISION AND REGULATION
GENERAL
The financial services business is highly regulated, primarily for the
protection of depositors and other customers. The following is a summary of
several applicable statutes and regulations that apply to us and to our
subsidiaries. These summaries are not complete, and you should refer to the
statutes and regulations for more information. Also, these statutes and
regulations may change in the future, and we cannot predict what effect these
changes, if made, will have on our operations.
BANK HOLDING COMPANY REGULATION
We are registered as a bank holding company with the Board of Governors of
the Federal Reserve System under the Bank Holding Company Act of 1956, as
amended and the related regulations, referred to as the BHC Act. We are subject
to regulation, supervision and examination by the Federal Reserve, and as part
of this process, we must file reports and additional information with the
Federal Reserve.
Minimum Capital Requirements
The Federal Reserve has adopted risk-based capital guidelines for assessing
bank holding company capital adequacy. These standards define capital and
establish minimum capital ratios in relation to assets, both on an aggregate
basis and as adjusted for credit risks and off-balance sheet exposures. Under
the Federal Reserve's risk-based guidelines applicable to us, capital is
classified into two categories for bank holding companies:
Tier 1 capital, or core capital, consists of:
- common stockholder's equity;
- qualifying noncumulative perpetual preferred stock;
- qualifying cumulative perpetual preferred stock (subject to some
limitations, and including our Trust Preferred securities, of which $118
million qualified as Tier 1 capital as of December 31, 2002); and
- minority interests in the common equity accounts of consolidated
subsidiaries;
less
- goodwill;
- credit-enhancing interest-only strips (certain amounts only); and
- specified intangible assets.
Tier 2 capital, or supplementary capital, consists of:
- allowance for loan and lease losses;
5
- perpetual preferred stock and related surplus;
- hybrid capital instruments;
- unrealized holding gains on equity securities;
- perpetual debt and mandatory convertible debt securities;
- term subordinated debt, including related surplus; and
- intermediate-term preferred stock, including related securities.
The Federal Reserve's capital adequacy guidelines require bank holding
companies to maintain a minimum ratio of qualifying total capital to
risk-weighted assets of 8 percent, at least 4 percent of which must be in the
form of Tier 1 capital. Risk-weighted assets include assets and credit
equivalent amounts of off-balance sheet items of bank holding companies that are
assigned to one of several risk categories, based on the obligor or the nature
of the collateral. The Federal Reserve has established a minimum ratio of Tier 1
capital (less any intangible capital items) to total assets (less any intangible
assets), or leverage ratio, of 3 percent for strong bank holding companies
(those rated a composite "1" under the Federal Reserve's rating system). For all
other bank holding companies, the minimum ratio of Tier 1 capital to total
assets is 4 percent. Also, the Federal Reserve continues to consider the Tier 1
leverage ratio in evaluating proposals for expansion or new activities.
In its capital adequacy guidelines, the Federal Reserve emphasizes that the
standards discussed above are minimums and that banking organizations generally
are expected to operate well above these minimum levels. These guidelines also
state that banking organizations experiencing growth, whether internally or
through acquisitions or other expansionary initiatives, are expected to maintain
strong capital positions substantially above the minimum levels.
As of December 31, 2002, we had regulatory capital in excess of all the
Federal Reserve's minimum levels and our internal minimum target of 11% for
risk-adjusted capital. Our ratio of total capital to risk weighted assets at
December 31, 2002 was 13.2% and our Tier 1 leverage ratio was 9.3%.
Residual Interests. On November 29, 2001, the four federal banking
agencies jointly adopted revised regulatory capital standards regarding the
treatment of certain recourse obligations, direct credit substitutes, residual
interests in assets securitizations, and other securitized transactions that
expose financial institutions primarily to credit risk. The agencies had
previously published guidelines on securitization activities in December, 1999
(the "Securitization Guidance") which dealt with the risk management and
regulatory oversight issues involved with asset securitizations and residual
interests.
Residual interests generally include any on-balance sheet asset created by
the sale of financial assets that results in the retention of any credit risks,
directly or indirectly, associated with the transfer of assets, where the
retained risk exceeds a pro rata share of the organization's claim on the
assets, whether through subordination provisions or other credit enhancement
techniques.
The revised rules (the "New Rules") became effective January 1, 2002 for
residual interests related to any transaction that settles on or after that
date. For transactions that settled prior to the effective date of the New
Rules, capital treatment prescribed by the application of the New Rules was
delayed until December 31, 2002.
Capital Treatment of Residual Interests. The New Rules imposed a
concentration limit on credit-enhancing interest-only strips (CEIOS), a subset
of residual interests, and a dollar-for-dollar capital requirement on residual
interests not deducted from Tier 1 capital.
CEIOS are, generally, assets created from the excess interest on assets
transferred (after reduction for administrative expenses, investor interest
payments, servicing fees, and credit losses on investors' interests in these
assets) that serve as credit enhancements for the investors. CEIOS are the
residual interests most often resulting from asset securitizations such as our
prior securitizations of home equity loans, in which the seller of loans
accounts for the transaction using gain-on-sale accounting treatment. Under the
New Rules, CEIOS are
6
limited to 25% of Tier 1 capital, with the excess deducted from Tier 1 capital.
At December 31, 2002, our CEIOS represented 17% of Tier 1 capital.
The New Rules reflect the policy in the existing Securitization Guidance
that imposes more frequent supervisory review, limitations on residual interest
holdings, more stringent capital requirements, or other supervisory constraints
on banking organizations found by the regulatory agencies to be lacking
effective risk management programs or engaging in practices that present safety
and soundness concerns. The Securitization Guidance provides that a bank's
failure to understand the risks inherent in the securitization activities and to
incorporate them into risk management systems and internal capital allocations
may constitute an unsafe or unsound banking practice and may result in the
down-grading of an organization's regulatory ratings.
Expansion
The BHC Act requires prior Federal Reserve approval for certain activities,
such as the acquisition by a bank holding company of control of another bank or
bank holding company. Under the BHC Act, a bank holding company may engage in
activities that the Federal Reserve has determined to be so closely related to
banking or managing or controlling banks as to be a proper incident to those
banking activities, such as operating a mortgage bank or a savings association,
conducting leasing and venture capital investment activities, performing trust
company functions, or acting as an investment or financial advisor. See the
section on "Interstate Banking and Branching Legislation" below.
Dividends
The Federal Reserve has policies on the payment of cash dividends by bank
holding companies. The Federal Reserve believes that a bank holding company
experiencing earnings weaknesses should not pay cash dividends (1) exceeding its
net income or (2) which only could be funded in ways that would weaken a bank
holding company's financial health, such as by borrowing. Also, the Federal
Reserve possesses enforcement powers over bank holding companies and their
non-bank subsidiaries to prevent or remedy unsafe or unsound practices or
violations of applicable statutes and regulations. Among these powers is the
ability to prohibit or limit the payment of dividends by banks and bank holding
companies.
The Federal Reserve expects us to act as a source of financial strength to
our banking subsidiaries and to commit resources to support them. In
implementing this policy, the Federal Reserve could require us to provide
financial support when we otherwise would not consider ourselves able to do so.
In addition to the restrictions on fundamental corporate actions such as
acquisitions and dividends imposed by the Federal Reserve, Indiana law also
places limitations on our authority with respect to such activities.
BANK AND THRIFT REGULATION
Indiana law subjects Irwin Union Bank and Trust and its subsidiaries to
supervision and examination by the Indiana Department of Financial Institutions
(DFI). Irwin Union Bank and Trust is a member of the Federal Reserve System and,
along with its subsidiaries, is also subject to regulation, examination and
supervision by the Federal Reserve. These subsidiaries include Irwin Mortgage,
Irwin Home Equity and Irwin Commercial Finance. Irwin Union Bank, F.S.B. is a
federally chartered savings bank. Accordingly, it is governed by and subject to
regulation, examination and supervision by the Office of Thrift Supervision
(OTS), and is required to comply with the rules and regulations of the OTS under
the Home Owners' Loan Act (HOLA).
The Federal Reserve also supervises Irwin Union Bank and Trust's compliance
with federal law and regulations that restrict loans by member banks to their
directors, executive officers, and other controlling persons.
The deposits of Irwin Union Bank and Trust are insured by the Bank
Insurance Fund (BIF) and the deposits of Irwin Union Bank, F.S.B. are insured by
the Savings Association Insurance Fund (SAIF) under the provisions of the
Federal Deposit Insurance Act (FDIA). As a result, Irwin Union Bank and Trust
and
7
Irwin Union Bank, F.S.B. also are subject to supervision and examination by the
Federal Deposit Insurance Corporation (FDIC). The regulatory scheme applicable
to Irwin Union Bank and Trust is comparable to that imposed on Irwin Union Bank,
F.S.B. by the OTS.
Mortgage Banking and Residential Lending Regulation
The residential lending activities of Irwin Union Bank and Trust, the
mortgage banking activities of Irwin Mortgage, and the home equity lending
business of Irwin Home Equity are regulated by the Federal Reserve. The Federal
Reserve has broad authority to oversee the banking activities of Irwin Union
Bank and Trust, as the primary federal regulator of the bank pursuant to the
FDIA, and the nonbanking subsidiaries of both Irwin Financial Corporation and
Irwin Union Bank and Trust, pursuant to the BHC Act. Federal Reserve
regulations, such as restrictions on affiliate transactions, asset quality and
earnings performance, apply to our residential lending activities. The DFI has
comparable supervisory and examination authority over Irwin Mortgage, Irwin Home
Equity and Irwin Commercial Finance due to their status as subsidiaries of Irwin
Union Bank and Trust.
Capital Requirements
The Federal Reserve has published regulations applicable to state member
banks such as Irwin Union Bank and Trust regarding the maintenance of adequate
capital. While retaining the authority to set capital ratios for individual
banks, these regulations group banks into categories based upon total risk-based
capital, Tier 1 risk-based capital and a leverage ratio (Tier 1 capital divided
by average total assets). These categories, and the applicable capital ratios,
are as follows:
The Federal Reserve requires banks to hold capital commensurate with the
level and nature of all of the risks, including the volume and severity of
problem loans, to which they are exposed. The Federal Reserve requires all state
member banks to meet a minimum ratio of qualifying total capital to weighted
risk assets of 8 percent, of which at least 4 percent should be in the form of
Tier 1 capital. For purposes of this ratio, Tier 1 capital is defined as the sum
of core capital elements less goodwill and other intangible assets.
The minimum ratio of Tier 1 capital to total assets for strong banking
institutions (rated composite "1" under the uniform rating system of banks) is 3
percent. For all other institutions, the minimum ratio of Tier 1 capital to
total assets is 4 percent. Banking institutions with supervisory, financial,
operational, or managerial weaknesses are expected to maintain capital ratios
well above the minimum levels, as are institutions with high or inordinate
levels of risk. Banks experiencing or anticipating significant growth are also
expected to maintain capital, including tangible capital positions, well above
the minimum levels. For example, most such institutions generally have operated
at capital levels ranging from 1 to 2 percent above the stated minimums. Higher
capital ratios could be required if warranted by the particular circumstances to
risk profiles of individual banks. The standards set forth above specify minimum
supervisory ratios based primarily on broad credit risk considerations. The
risk-based ratio does not take explicit account of the quality of individual
asset portfolios or the range of other types of risks to which banks may be
exposed, such as interest rate, liquidity, market or operational risks. For this
reason, banks are generally expected to operate with capital positions above the
minimum ratios.
At December 31, 2002, Irwin Union Bank and Trust had a total risk-based
capital ratio of 12.4%, a Tier 1 capital ratio of 10.4%, and a leverage ratio of
9.8% and was considered well-capitalized. See "Bank Holding Company
Regulation -- Minimum Capital Requirements -- Residual Interests" earlier in
this section for a discussion of the impact of the new regulatory capital
treatment rules. We transferred our residual assets held at Irwin Union Bank and
Trust to our holding company in the form of dividends during the fourth quarter
of 2001 and the first quarter of 2002. Because of the amount of the residuals,
we sought and received regulatory approval of these dividends as required. In
connection with our decision in the fourth quarter of 2001 to dividend these
residual assets out of Irwin Union Bank and Trust and after discussions with our
regulators as well as consideration of the risk profile of our organization, our
Board of Directors adopted resolutions regarding maintenance of capital levels
above the well-capitalized minimum requirements beginning March 31, 2002. The
benchmark levels we established are 12% total capital to risk-weighted assets at
Irwin
8
Union Bank and Trust, and 11% total capital to risk-weighted assets at Irwin
Financial. Although the dividends of the residual assets did not have a
meaningful impact on our consolidated capital ratios calculated under the New
Rules, the dividends had the effect of increasing regulatory capital ratios at
Irwin Union Bank and Trust.
The Federal Reserve, the OTS, the FDIC and other federal banking agencies
also adopted a rule modifying the risk-based capital standards to provide for
consideration of interest rate risk when assessing capital adequacy of a bank or
savings association. Under this rule, the Federal Reserve, the OTS and the FDIC
must explicitly include a bank or savings association's exposure to declines in
the economic value of their capital due to changes in interest rates as a factor
in evaluating capital adequacy of a bank or savings association. The Federal
Reserve, the OTS, the FDIC and other federal banking agencies also adopted a
joint agency policy statement providing guidance for managing interest rate
risk. The policy statement emphasizes the importance of adequate management
oversight and a sound risk management process. This assessment of interest rate
risk management made by the banks' examiners will be incorporated into the
banks' overall risk management rating and used to determine management's
effectiveness.
Insurance of Deposit Accounts
Under the Federal Deposit Insurance Corporation Improvements Act of 1991
(FDICIA), as FDIC-insured institutions, Irwin Union Bank and Trust and Irwin
Union Bank, F.S.B. are required to pay deposit insurance premiums based on the
risk they pose to BIF and SAIF, respectively. The FDIC also has authority to
raise or lower assessment rates on insured deposits to achieve the statutorily
required reserve ratios in insurance funds and to impose special additional
assessments. Each depository institution is assigned to one of three capital
groups: "well capitalized," "adequately capitalized" or "undercapitalized." An
institution is considered well capitalized if it has a total risk-based capital
ratio of 10% or greater, has a Tier 1 risk-based capital ratio of 6% or greater,
has a leverage ratio of 5% or greater and is not subject to any order or written
directive to meet and maintain a specific capital level. An "adequately
capitalized" institution has a total risk-based capital ratio of 8% or greater,
has a Tier 1 risk-based capital ratio of 4% or greater, has a leverage ratio of
4% or greater and does not meet the definition of a well capitalized bank. An
institution is considered "undercapitalized" if it does not meet the definition
of "well capitalized" or "adequately capitalized." Within each capital group,
institutions are assigned to one of three supervisory subgroups: "A"
(institutions with few minor weaknesses), "B" (institutions that demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the institution and increased risk of loss to the insurance funds), and "C"
(institutions that pose a substantial probability of loss to the insurance funds
unless effective corrective action is taken). There are nine combinations of
capital groups and supervisory subgroups to which varying assessment rates may
apply. An institution's assessment rate depends on the capital category and
supervisory category to which it is assigned.
Dividend Limitations
As a state member bank, Irwin Union Bank and Trust may not, without the
approval of the Federal Reserve, declare a dividend if the total of all
dividends declared in a calendar year, including the proposed dividend, exceeds
the total of its net income for that year, combined with its retained net income
of the preceding two years, less any required transfers to the surplus account.
Under Indiana law, certain dividends require notice to, or approval by, the DFI,
and Irwin Union Bank and Trust may not pay dividends in an amount greater than
its net profits then available, after deducting losses and bad debts. The amount
of the residual assets transferred to the holding company as a dividend from the
bank exceeded the amount that could have been dividended by the bank to the bank
holding company without regulatory approval as described above and, as a result,
we sought and obtained regulatory approval for the dividend. Due to the
limitations described above, we must now obtain prior approval from the DFI and
the Federal Reserve Bank of Chicago before Irwin Union Bank and Trust can pay
additional dividends to us until such time as net income for the year, combined
with retained net income of the preceding two years, less any required transfers
to the surplus account, exceeds the amount to be dividended.
9
In most cases, savings and loan associations, such as Irwin Union Bank,
F.S.B., are required either to apply to or to provide notice to the OTS
regarding the payment of dividends. The savings association must seek approval
if it does not qualify for expedited treatment under OTS regulations, or if the
total amount of all capital distributions for the applicable calendar year
exceeds net income for that year to date plus retained net income for the
preceding two years, or the savings association would not be adequately
capitalized following the dividend, or the proposed dividend would violate a
prohibition in any statute, regulation or agreement with the OTS. In other
circumstances, a simple notice is sufficient.
Our ability and the ability of Irwin Union Bank and Trust and Irwin Union
Bank, F.S.B. to pay dividends also may be affected by the various capital
requirements and the capital and noncapital standards established under the
FDICIA, as described above. Our rights and the rights of our shareholders and
our creditors to participate in any distribution of the assets or earnings of
our subsidiaries also is subject to the prior claims of creditors of our
subsidiaries including the depositors of a bank subsidiary.
Interstate Banking and Branching Legislation
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 (the Interstate Banking Act), banks are permitted, subject to being
adequately or better capitalized, in compliance with Community Reinvestment Act
requirements and in compliance with state law requirements (such as age-of-bank
limits and deposit caps), to merge with one another across state lines and to
create a main bank with branches in separate states. After establishing branches
in a state through an interstate merger transaction, a bank may establish and
acquire additional branches at any location in the state where any bank involved
in the interstate merger could have established or acquired branches under
applicable federal and state law.
Although Irwin Union Bank, F.S.B. has a different primary federal regulator
from Irwin Union Bank and Trust, most, if not all, of the federal statutes and
regulations applicable to Irwin Union Bank also apply to Irwin Union Bank,
F.S.B. However, as a federally chartered savings bank, Irwin Union Bank, F.S.B.
has greater flexibility in pursuing interstate branching than an Indiana state
bank. A federal savings association may establish or operate a branch in any
state outside the state of its home office if the association meets certain
statutory requirements. These requirements do not apply if the law of the state
where the branch is to be located offers reciprocal branching privileges with
the state where the savings association has its home office located. As Irwin
Union Bank and Trust does with its supervisory regulatory agencies, Irwin Union
Bank, F.S.B. must file reports with the OTS and the FDIC concerning its
activities and financial condition in addition to obtaining regulatory approvals
before establishing branches or entering into certain transactions such as
mergers with, or acquisitions of, other financial institutions.
Community Reinvestment
Under the Community Reinvestment Act (CRA), a financial institution has a
continuing and affirmative obligation, consistent with its safe and sound
operation, to help meet the credit needs of its entire community, including low-
and moderate-income neighborhoods. The CRA does not establish specific lending
requirements or programs for financial institutions, or limit an institution's
discretion to develop the types of products and services that it believes are
best suited to its particular community that are consistent with the CRA.
Institutions are rated on their performance in meeting the needs of their
communities. Performance is tested in three areas: (a) lending, which evaluates
the institution's record of making loans in its assessment areas; (b)
investment, which evaluates the institution's record of investing in community
development projects, affordable housing and programs benefiting low or moderate
income individuals and business; and (c) service, which evaluates the
institution's delivery of services through its branches, ATMs and other offices.
The CRA requires each federal banking agency, in connection with its examination
of a financial institution, to assess and assign one of four ratings to the
institution's record of meeting the credit needs of its community and to take
this record into account in evaluating certain applications by the institution,
including applications for charters, branches and other deposit facilities,
relocations, mergers, consolidations, acquisitions of assets or assumptions of
liabilities, and savings and loan holding company acquisitions. The CRA also
requires that all institutions publicly disclose their CRA ratings. Both Irwin
Union Bank and Trust and Irwin Union Bank, F.S.B. received a "satisfactory"
rating on their most recent CRA performance evaluations.
10
Brokered Deposits
Brokered deposits include funds obtained, directly or indirectly, by or
through a deposit broker for deposit into one or more deposit accounts.
Well-capitalized institutions are not subject to limitations on brokered
deposits, while an adequately capitalized institution is able to accept, renew
or rollover brokered deposits only with a waiver from the FDIC and subject to
certain restrictions on the yield paid on such deposits. Undercapitalized
institutions are not permitted to accept brokered deposits. Irwin Union Bank and
Trust and Irwin Union Bank, F.S.B. are permitted to accept brokered deposits.
Gramm-Leach-Bliley Act
On November 12, 1999, the Gramm-Leach-Bliley Act (the GLB Act) was enacted,
which amended or repealed certain provisions of the Glass-Steagall Act and other
legislation that restricted the ability of bank holding companies, securities
firms and insurance companies to affiliate with one another. The GLB Act
established a comprehensive framework to permit affiliations among commercial
banks, insurance companies and securities firms. The GLB Act contains provisions
intended to safeguard consumer financial information in the hands of financial
service providers by, among other things, requiring these entities to share
their privacy policies to their customers and allowing customers to "opt out" of
having their financial service providers disclose their confidential financial
information with non-affiliated third parties, subject to certain exceptions.
Financial privacy regulations implementing the GLB provisions became effective
during 2001. Similar to most other consumer-oriented laws, the regulations
contain some specific prohibitions and require timely disclosure of certain
information. We do not anticipate that the GLB Act will have a material adverse
effect on our operations or prospects or those of our subsidiaries. However, to
the extent the GLB Act permits banks, securities firms and insurance companies
to affiliate, the financial services industry may experience further
consolidation. This consolidation could result in a growing number of larger
financial institutions that offer a wider variety of financial services than we
currently offer and that can aggressively compete in the markets we currently
serve.
COMPLIANCE WITH CONSUMER PROTECTION LAWS
Our subsidiaries also are subject to many federal and state consumer
protection statutes and regulations including the Equal Credit Opportunity Act,
the Fair Housing Act, the Truth in Lending Act, the Truth in Savings Act, the
Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act.
Among other things, these acts:
- require lenders to disclose credit terms in meaningful and consistent
ways;
- prohibit discrimination against an applicant in any consumer or business
credit transaction;
- prohibit discrimination in housing-related lending activities;
- require certain lenders to collect and report applicant and borrower data
regarding loans for home purchases or improvement projects;
- require lenders to provide borrowers with information regarding the
nature and cost of real estate settlements;
- prohibit certain lending practices and limit escrow account amounts with
respect to real estate transactions; and
- prescribe possible penalties for violations of the requirements of
consumer protection statutes and regulations.
Equal Credit Opportunity Act
The federal Equal Credit Opportunity Act prohibits discrimination against
an applicant in any credit transaction, whether for consumer or business
purposes, on the basis of race, color, religion, national origin, sex, marital
status, age (except in limited circumstances), receipt of income from public
assistance programs
11
or good faith exercise of any rights under the Consumer Credit Protection Act.
In addition to prohibiting outright discrimination on any of the impermissible
bases listed above, an effects test has been applied to determine whether a
violation of the act has occurred. This means that if a creditor's actions have
had the effect of discriminating, the creditor may be held liable, even when
there is no intent to discriminate. In addition to actual damages, the Equal
Credit Opportunity Act permits regulatory agencies to take enforcement action
and provides for punitive damages. Successful complainants also may be entitled
to an award of court costs and attorneys' fees.
Fair Housing Act
The federal Fair Housing Act regulates many lending practices, including
prohibiting discrimination in a lender's housing-related lending activities
against any person because of race, color, religion, national origin, sex,
handicap or familial status. The Fair Housing Act is broadly written and has
been broadly interpreted by the courts. A number of lending practices have been
found to be, or may be considered, illegal under the Fair Housing Act, including
some that are not specifically mentioned in the act itself. Among those
practices that have been found to be, or may be considered, illegal under the
Fair Housing Act are declining a loan for the purposes of racial discrimination,
making excessively low appraisals of property based on racial considerations and
pressuring, discouraging, or denying applications for credit on a prohibited
basis.
The Fair Housing Act allows a person who believes that he or she has been
discriminated against to file a complaint with the Department of Housing and
Urban Development (HUD). Aggrieved persons also may initiate a civil action. The
Fair Housing Act also permits the Attorney General of the United States to
commence a civil action if there is reasonable cause to believe that a person
has been discriminated against in violation of the Fair Housing Act. Penalties
for violation of the Fair Housing Act include actual damages suffered by the
aggrieved person and injunctive or other equitable relief. The courts also may
assess civil penalties.
Home Mortgage Disclosure Act
The federal Home Mortgage Disclosure Act grew out of public concern over
credit shortages in certain urban neighborhoods. One purpose of the Home
Mortgage Disclosure Act is to provide public information that will help show
whether financial institutions are serving the housing credit needs of the
neighborhoods and communities in which they are located. The Home Mortgage
Disclosure Act also includes a "fair lending" aspect that requires the
collection and disclosure of data about applicant and borrower characteristics
as a way of identifying possible discriminatory lending patterns and enforcing
anti-discrimination statutes. The Home Mortgage Disclosure Act requires
institutions to report data regarding applications for loans for the purchase or
improvement of one-to-four family and multifamily dwellings, as well as
information concerning originations and purchases of such loans. Federal bank
regulators rely, in part, upon data provided under the Home Mortgage Disclosure
Act to determine whether depository institutions engage in discriminatory
lending practices.
The appropriate federal banking agency (that is, the Federal Reserve for
Irwin Union Bank and Trust and the OTS for Irwin Union Bank, F.S.B.), or in some
cases, HUD, enforces compliance with the Home Mortgage Disclosure Act and
implements its regulations. Administrative sanctions, including civil money
penalties, may be imposed by supervisory agencies for violations of this act.
Real Estate Settlement Procedures Act
The federal Real Estate Settlement Procedures Act (RESPA), requires lenders
to provide borrowers with disclosures regarding the nature and cost of real
estate settlements. RESPA also prohibits certain abusive practices, such as
kickbacks, and places limitations on the amount of escrow accounts. Violations
of RESPA may result in imposition of penalties, including: (1) civil liability
equal to three times the amount of any charge paid for the settlement services
or civil liability of up to $1,000 per claimant, depending on the violation; (2)
awards of court costs and attorneys' fees; and (3) fines of not more than
$10,000 or imprisonment for not more than one year, or both. A significant
number of individual claims and purported
12
consumer class action claims have been commenced against financial institutions
and other mortgage lending companies, including Irwin Mortgage, alleging
violations of the prohibition against kickbacks and seeking civil damages, court
costs and attorneys' fees. See the "Legal Proceedings" section of this report.
Truth in Lending Act
The federal Truth in Lending Act is designed to ensure that credit terms
are disclosed in a meaningful way so that consumers may compare credit terms
more readily and knowledgeably. As a result of the act, all creditors must use
the same credit terminology and expressions of rates, the annual percentage
rate, the finance charge, the amount financed, the total of payments and the
payment schedule.
Violations of the Truth in Lending Act may result in regulatory sanctions
and in the imposition of both civil and, in the case of willful violations,
criminal penalties. Under certain circumstances, the Truth in Lending Act and
Federal Reserve Regulation Z also provide a consumer with a right of rescission,
which relieves the consumer of the obligation to pay amounts to the creditor or
to a third party in connection with the offending transaction, including finance
charges, application fee, commitment fees, title search fees and appraisal fees.
Consumers may also seek actual and punitive damages for violations in the Truth
in Lending Act. See the "Legal Proceedings" section of this report.
State Consumer Protection Laws
In addition to the federal consumer protection laws discussed above, our
subsidiaries are also subject to state consumer protection laws that regulate
the mortgage origination and lending businesses of these subsidiaries. As part
of the home equity line of business in conjunction with its subsidiary, Irwin
Home Equity, Irwin Union Bank and Trust originates home equity loans through its
branch in Nevada. Irwin Union Bank and Trust uses interest rates and loan terms
in its home equity loans and lines of credit that are authorized by Nevada law,
but might not be authorized by the laws of the states in which the borrowers are
located. As a FDIC-insured, state member bank, Irwin Union Bank and Trust is
authorized by Section 27 of the FDIA to charge interest at rates allowed by the
laws of the state where the bank is located regardless of any inconsistent state
law, and to apply these rates to loans to borrowers in other states. The FDIC
has opined that a state bank with branches outside of the state in which it is
chartered may also be located in a state in which it maintains an interstate
branch. Irwin Union Bank and Trust relies on Section 27 of the FDIA and the FDIC
opinion in conducting its home equity lending business described above. From
time to time, state regulators have questioned the application of Section 27 of
the FDIA to credit practices affecting citizens of their states. Any change in
Section 27 of the FDIA or in the FDIC's interpretation of this provision, or any
successful challenge as to the permissibility of these activities, could require
that we change the terms of some of our loans or the manner in which we conduct
our home equity line of business.
EMPLOYEES AND LABOR RELATIONS
At January 31, 2003, we and our subsidiaries had a total of 3,288
employees, including full-time and part-time employees. We continue a commitment
of equal employment opportunity for all job applicants and staff members, and
management regards its relations with its employees as satisfactory.
EXECUTIVE OFFICERS
Our executive officers are elected annually by the Board of Directors and
serve for a term of one year or until their successors are elected and
qualified. In addition to our Chairman, Mr. Miller, and President, Mr. Nash,
both of whom also serve as directors, our executive officers are listed below.
Claude E. Davis (42) has been President of Irwin Union Bank and Trust since
January 1996. He has been an officer since 1988.
Elena Delgado (47) has been President and Chief Executive Officer of Irwin
Home Equity since September 1994.
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Gregory F. Ehlinger (40) has been our Senior Vice President and Chief
Financial Officer since August of 1999. He has been one of our officers since
August 1992.
Paul D. Freudenthaler (38) joined us as Vice President -- Financial Risk
Management in December 2001. From September 2000 through November 2001, he was
Corporate Controller for America Online Latin America, an Internet service
provider. From July 2000 to August 2000 he served as Senior Vice President --
Treasurer of Telscape International, Inc., a development stage
telecommunications company. Prior thereto, he held the position of Chief
Accounting Officer of Telscape from July 1999 until June 2000. Subsequent to his
departure from Telscape, Telscape filed a voluntary petition for relief under
Chapter 11 of the U.S. Bankruptcy Code on April 27, 2001. From February 1999
through June 1999, he was Director -- International of Bank United, F.S.B. From
January 1994 through January 1999, he was Director -- International of Irwin
Mortgage Corporation, our subsidiary.
Jose M. Gonzalez (44) has been our Vice President -- Internal Audit since
October 1995. In 2001, he was also appointed as Vice President -- Operational
Risk Management.
Robert H. Griffith (45) has been President and Chief Executive Officer of
Irwin Mortgage since January 2001. He has been an officer of Irwin Mortgage
since 1993.
Theresa L. Hall (50) has been our Vice President -- Human Resources since
1988 and has been one of our officers since 1980.
Bradley J. Kime (42) has been President of Irwin Union Bank F.S.B. since
December 2000, and is also Chief Operating Officer and Executive Vice President
of Irwin Union Bank and Trust. He has been an officer of Irwin Union Bank and
Trust since 1987, and one of our officers since 1986.
Joseph R. LaLeggia (41) has been our President of Irwin Commercial Finance
Corporation since July of 2002. From April 1998 to July of 2002 he was president
and chief executive officer of Onset Capital Corporation. From January 1997
until April of 1998 he was President of AT&T Capital Canada Inc. He held various
executive positions with AT&T Capital Canada since 1992, including Chief
Financial Officer.
Jody A. Littrell (35) has been our Vice President and Controller since
March 2000. He was employed with Arthur Andersen LLP from September 1990 to
March 2000.
Ellen Z. Mufson (54) has been our Vice President -- Legal and Assistant
Secretary since September 1997. She was Vice President -- Legal Counsel of Irwin
Union Bank and Trust from July 1996 through August 1997, and our Corporate
Counsel from January 1995 through June 1996.
Nancy Roth (46) has been our Vice President -- Assistant General Auditor
since May of 2002. She was employed by Bank One Corp. from May of 1995 through
May of 2002, becoming a Vice President and Accounting Manager with them in
February of 1996.
Steven R. Schultz (37) joined us as Vice President -- Legal in January
2002. From August 1999 through December 2001 he was an attorney in the London
office of Fried, Frank, Harris, Shriver & Jacobson, focusing primarily on
mergers and acquisitions, capital markets financings and private equity
transactions. From August 1993 until July 1999 he practiced corporate and
securities law at Barnes & Thornburg in Indianapolis, Indiana.
Matthew F. Souza (46) has been our Senior Vice President -- Ethics since
August 1999 and our Secretary since 1986. He has been one of our officers since
1986.
Thomas D. Washburn (56) has been our Executive Vice President since August
1999 and has been one of our officers since 1976. From 1981 to August 1999 he
served as our Senior Vice President and Chief Financial Officer.
Brett R. Vanderkolk (37) has been our Vice President -- Treasurer since
September 2000. From August 1996, to September 2000, he served as Manager,
Corporate Finance for Arvin Industries, Inc. (manufacturer of automotive
products).
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ITEM 2. PROPERTIES
Our main office and the main offices of Irwin Ventures LLC and Irwin Union
Credit Insurance Corporation are located at 500 Washington Street, Columbus,
Indiana, in space leased from Irwin Union Bank and Trust. The location and
general character of our other materially important physical properties as of
January 31, 2003 are as follows:
IRWIN MORTGAGE
The main office, where administrative and servicing activities are
centered, is located at 10500 Kincaid Drive, Fishers, Indiana, and is leased.
Loan production and satellite offices, which are leased, are operated from
approximately 153 locations in 34 states.
IRWIN UNION BANK AND TRUST
The main office is located in four connected buildings at 500, 520 and 526
Washington Street, Columbus, Indiana. Irwin Union Realty Corporation, a
wholly-owned subsidiary of Irwin Union Bank and Trust, owns these buildings in
fee and leases them to Irwin Union Bank and Trust. One or the other of Irwin
Union Bank and Trust or Irwin Union Realty owns the branch properties in fee at
5 locations in Columbus and Southern Indiana. These properties have no major
encumbrances. Irwin Union Bank and Trust leases 11 other branch offices in
Central and Southern Indiana, 4 offices in Michigan and 1 office in Nevada.
IRWIN UNION BANK, F.S.B.
The main office is located at 9300 Shelbyville Road, Louisville, Kentucky.
Irwin Union Bank, F.S.B. leases 4 branch offices located in Arizona, Missouri,
Nevada and Utah.
IRWIN HOME EQUITY
The main office is located at 12677 Alcosta Boulevard, Suite 500, San
Ramon, California. Irwin Home Equity also occupies two other offices in San
Ramon, California and a processing center in Carson City, Nevada. Irwin Home
Equity leases all of its offices.
IRWIN COMMERCIAL FINANCE CORPORATION
The main office of Irwin Commercial Finance Corporation is located at 500
Washington Street, Columbus, Indiana. The office location is leased. The office
of our United States commercial finance subsidiary, Irwin Business Finance, is
located in Bellevue, Washington and is leased. Our Canadian commercial finance
subsidiary, Onset Capital Corporation, has its main office in Vancouver, British
Columbia, Canada, and operates 8 other offices, including a subsidiary, in 4
Canadian provinces. All of these offices are leased. The main office of our
franchise leasing subsidiary, Irwin Franchise Capital Corporation, is located in
Purchase, New York and is leased. Irwin Franchise Capital owns the building that
houses its telemarketing center in Columbus, Nebraska, and has 8 other locations
in 6 states, all of which are leased.
ITEM 3. LEGAL PROCEEDINGS
Culpepper and related cases.
Irwin Mortgage (formerly, Inland Mortgage), our indirect subsidiary, is a
defendant in Culpepper v. Inland Mortgage Corporation, filed in April 1996, in
the United States District Court for the Northern District of Alabama by
borrowers purporting to represent a nationwide class. The lawsuit alleges that
Irwin Mortgage violated the federal Real Estate Settlement Procedures Act
(RESPA) in connection with certain payments made to mortgage brokers. A second
lawsuit alleging similar violations was consolidated with Culpepper. In June
2001, the Court of Appeals for the 11th Circuit upheld the district court's
certification of a plaintiff class and the case was remanded for further
proceedings in the federal district court.
15
In September, 2001, Irwin Mortgage received notice that it was named as a
defendant in Beggs v. Irwin Mortgage Corporation, also filed in the United
States District Court for the Northern District of Alabama. The plaintiff,
purporting to represent a nationwide class of borrowers, filed allegations
similar to those in Culpepper but seeks inclusion of borrowers not covered in
Culpepper (those with mortgage loans since early 1999 through the date of class
certification, if a class is certified). The plaintiff is asking the court to
certify a class and to consolidate the case with Culpepper.
On October 18, 2001, the Department of Housing and Urban Development (HUD),
the agency responsible for interpreting and implementing RESPA, issued a
clarifying Policy Statement that explicitly disagreed with the ruling of the
Court of Appeals for the 11(th) Circuit in Culpepper and with the court's
interpretation of RESPA in connection with the types of payments at issue in
Culpepper.
In response to the district court's order, the parties in Culpepper filed
supplemental briefs analyzing the import of the new HUD policy statement on
November 14, 2001. In addition to responding to the district court's order,
Irwin Mortgage filed a petition for certiorari with the United States Supreme
Court seeking review of the 11(th) Circuit's ruling, and on December 28, 2001,
also filed a motion in the district court seeking a stay of further proceedings
until the 11(th) Circuit rendered decisions in the other three RESPA cases
pending in that court. On January 22, 2002, the Supreme Court denied Irwin
Mortgage's petition for certiorari. On March 8, 2002, the district court granted
Irwin Mortgage's motion to stay proceedings in Culpepper until the 11(th)
Circuit decided the other RESPA cases pending in that court. The Beggs case was
similarly stayed.
The 11(th) Circuit has now rendered decisions in all three of the RESPA
cases originally argued before it with Culpepper. On September 18, 2002, the
11(th) Circuit issued the first of these decisions in Heimmermann v. First Union
Mortgage Corp., ruling that the trial court abused its discretion in certifying
a class action under RESPA. In Heimmermann, the court expressly recognized that
it was, in effect, overruling its previous decision in Culpepper. On January 24,
2003, the 11(th) Circuit affirmed the denial of class certification by the
district courts in the remaining two RESPA cases.
On February 20, 2003, the parties in Culpepper filed a joint motion for a
proposed scheduling order with the district court, which contemplates that Irwin
Mortgage will file a motion to decertify the class and the plaintiffs will file
a renewed motion for summary judgment.
If the class is not decertified and the district court finds that Irwin
Mortgage violated RESPA, Irwin Mortgage could be liable for damages equal to
three times the amount of that portion of payments made to the mortgage brokers
that is ruled unlawful. Based on notices sent by the Culpepper plaintiffs to
date to potential class members and additional notices that might be sent, we
believe the Culpepper class is not likely to exceed 32,000 borrowers who meet
the class specifications.
In addition to Culpepper and Beggs, there are three lawsuits, filed against
Irwin Mortgage in 2002 in the Circuit Court of Calhoun County, Alabama (Cook v
Irwin Mortgage, Ford v. Irwin Mortgage, and Hill v. Irwin Mortgage). These cases
seek class action status and allege claims based on payments similar to those at
issue in Culpepper. Another case, Gorman v. Irwin Mortgage, filed in 2002 in the
United States District Court for the Northern District of Alabama, alleges RESPA
violations both similar to and different from those in Culpepper in connection
with payments made to mortgage brokers. Before Irwin Mortgage filed an answer in
Gorman, the District Court granted plaintiff's motion to intervene in the Beggs
case.
Irwin Mortgage intends to defend these lawsuits vigorously and believes it
has numerous defenses to the alleged RESPA and similar violations. Irwin
Mortgage further believes that the 11(th) Circuit's recent RESPA decisions
provide grounds for reversal of the class certification by the district court in
Culpepper. We have no assurance, however, that Irwin Mortgage will be successful
in defeating class certification in Culpepper or ultimately prevailing on the
merits in that case or the others. We have not established a reserve for this or
the related cases. We are unable at this stage of the litigation to determine a
reasonable estimate of potential loss Irwin Mortgage could suffer, but an
adverse outcome in Culpepper or the other lawsuits could subject Irwin Mortgage
to substantial monetary damages that could be material to our financial
position.
16
United States ex rel. Paranich v. Sorgnard et al.
In January, 2001, we, Irwin Leasing Corporation (formerly Affiliated
Capital Corp.), our indirect subsidiary, and Irwin Equipment Finance
Corporation, our direct subsidiary (the Irwin companies) were served as
defendants in an action filed in the United States District Court for the Middle
District of Pennsylvania. The suit alleges that a manufacturer/importer of
certain medical devices (Matrix Biokinetics, Inc., and others) made
misrepresentations to health care professionals and to government officials to
improperly obtain Medicare reimbursement for treatments using the devices, and
that the Irwin companies, through Affiliated Capital's financing activities,
aided in making the alleged misrepresentations. The Irwin companies filed a
motion to dismiss on February 12, 2001. On August 10, 2001, the court granted in
part the motion of the Irwin companies by dismissing Irwin Financial and Irwin
Equipment Finance as defendants in the suit. Irwin Leasing remains a defendant.
We have not established any reserves for this case. Because the case is in the
early stages of litigation, management is unable at this time to form a
reasonable estimate of the amount of potential loss, if any, that Irwin Leasing
could suffer. The company intends to defend this lawsuit vigorously.
McIntosh v. Irwin Home Equity Corporation.
Our subsidiary, Irwin Union Bank and Trust Company, is a defendant in a
purported class action lawsuit filed in the U.S. District Court in Massachusetts
in July 2001. The case involves loans purchased by Irwin Union Bank from
FirstPlus, an unaffiliated third-party lender, and alleges a failure to comply
with certain truth in lending disclosure requirements in making second mortgage
home equity loans to the plaintiff borrowers. The complaint seeks rescission of
the loans and other damages.
On September 30, 2002, the court granted plaintiffs' motion for
certification of a class, subject to certain limitations. On October 15, 2002,
we filed a motion for reconsideration with the district court and a petition for
permission to appeal the class certification decision with the Court of Appeals
for the 1st Circuit. The court of appeals has deferred taking action on the
class certification issue until the district court rules on the motion for
reconsideration.
If the class is ultimately upheld, the actual number of plaintiff borrowers
will be determined only after a review of loan files. As specified, the
plaintiff class is limited to those borrowers who obtained a mortgage loan
originated with prepayment penalty provisions by FirstPlus during the three-year
period prior to the filing of the suit. Only high-rate loans that are subject to
the provisions of the Home Ownership and Equity Protection Act of 1994 would be
included in the class. Although discovery has not yet commenced, we believe that
out of approximately 200 loans acquired directly from FirstPlus through our
correspondent lending channel and approximately 7,800 loans acquired from other
parties in certain bulk acquisitions that may include FirstPlus originations,
only a portion of these loans will satisfy all of the criteria for inclusion in
the class.
We believe we have available numerous defenses to the allegations and
intend to vigorously defend this lawsuit. Because this case is in the early
stages of litigation, we are unable to form a reasonable estimate of potential
loss, if any, and have not established any reserves related to this case.
Stamper v. A Home of Your Own, Inc.
On January 25, 2002, a jury in this case awarded the plaintiffs damages of
$1.434 million, jointly and severally, against defendants, including our
indirect subsidiary, Irwin Mortgage Corporation. The case was filed in August,
1998 in the Baltimore, Maryland, City Circuit Court. The nine plaintiff
borrowers alleged that A Home of Your Own, Inc. and its principal, Robert
Beeman, defrauded the plaintiffs by selling them defective homes at inflated
prices and that Irwin Mortgage participated in the fraud. We have reserved for
this case based upon advice of our legal counsel. Irwin Mortgage filed an appeal
with the Maryland Court of Special Appeals, and oral argument was held on
January 7, 2003. Although we believe Irwin Mortgage has justifiable grounds for
appeal, we cannot predict at this time whether the appeal will ultimately be
successful.
We and our subsidiaries are from time to time engaged in various matters of
litigation including the matters described above, other assertions of improper
or fraudulent loan practices or lending violations, and
17
other matters, and we have a number of unresolved claims pending. In addition,
as part of the ordinary course of business, we and our subsidiaries are parties
to litigation involving claims to the ownership of funds in particular accounts,
the collection of delinquent accounts, challenges to security interests in
collateral, and foreclosure interests, that is incidental to our regular
business activities. While the ultimate liability with respect to these other
litigation matters and claims cannot be determined at this time, we believe that
damages, if any, and other amounts relating to pending matters are not likely to
be material to our consolidated financial position or results of operations,
except as described above. Reserves have been established for these various
matters of litigation, when appropriate, based upon the advice of legal counsel.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 2002, no matters were submitted to a vote of
our security holders, through the solicitation of proxies or otherwise.
18
PART II
ITEM 5. MARKET FOR CORPORATION'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Until September 20, 2001, our common shares were quoted on the Nasdaq
National Market under the symbol "IRWN." Our common shares were approved for
listing on the New York Stock Exchange on September 5, 2001, and began trading
under the symbol "IFC" on September 21, 2001. The following table sets forth
certain information regarding trading in, and cash dividends paid with respect
to, the shares of our common stock in each quarter of the two most recent
calendar years. The approximate number of shareholders of record on March 10,
2003, was 1,856.
STOCK PRICES AND DIVIDENDS:
PRICE RANGE TOTAL
--------------- QUARTER CASH DIVIDENDS
HIGH LOW END DIVIDENDS FOR YEAR
------ ------ ------- --------- ---------
2001
First quarter................................... $24.88 $19.31 $21.13 $0.065
Second quarter.................................. 25.25 18.69 25.15 0.065
Third quarter................................... 27.70 16.00 20.90 0.065
Fourth quarter.................................. 22.08 14.49 17.00 0.065 $0.26
2002
First quarter................................... $19.15 $14.40 $16.49 $0.0675
Second quarter.................................. 20.66 17.65 20.10 0.0675
Third quarter................................... 20.05 14.50 17.00 0.0675
Fourth quarter.................................. 17.80 13.20 16.50 0.0675 $0.27
We expect to continue our policy of paying regular cash dividends, although
there is no assurance as to future dividends because they are dependent on
future earnings, capital requirements, and financial condition. On February 26,
2003, our Board of Directors approved an increase in the first quarter dividend
to $0.07 per share, payable in March 2003. Dividends paid by Irwin Union Bank
and Irwin Union Bank, F.S.B. to the Corporation are restricted by banking law.
SALES OF UNREGISTERED SECURITIES:
In 2002, we issued 6,360 shares of common stock pursuant to elections made
by six of our outside directors to receive board compensation under the 1999
Outside Director Restricted Stock Compensation Plan in lieu of cash fees. All of
these shares were issued in reliance on the private placement exemption from
registration provided in Section 4(2) of the Securities Act.
19
ITEM 6. SELECTED FINANCIAL DATA
FIVE-YEAR SELECTED FINANCIAL DATA
AT OR FOR YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
(IN THOUSANDS EXCEPT PER SHARE DATA)
FOR THE YEAR:
Net revenues................... $ 427,084 $ 400,937 $ 297,507 $ 266,748 $ 272,063
Noninterest expense............ 340,853 326,737 237,976 214,111 221,206
----------- ----------- ----------- ----------- -----------
Income before income taxes..... 86,231 74,200 59,531 52,637 50,857
Provision for income taxes..... 33,398 28,859 23,865 19,481 20,354
Income before cumulative effect
of change in accounting
principle................... 52,833 45,341 35,666 33,156 30,503
Cumulative effect of change in
accounting principle, net of
tax......................... 495 175 -- -- --
----------- ----------- ----------- ----------- -----------
Net income..................... $ 53,328 $ 45,516 $ 35,666 $ 33,156 $ 30,503
=========== =========== =========== =========== ===========
Mortgage loan originations..... $11,411,875 $ 9,225,991 $ 4,091,573 $ 5,876,750 $ 8,944,615
Home equity loan
originations................ 1,067,227 1,149,410 1,225,955 439,507 389,673
COMMON SHARE DATA:
Earnings per share:(1)
Basic....................... $ 1.99 $ 2.15 $ 1.70 $ 1.54 $ 1.40
Diluted..................... 1.89 2.00 1.67 1.51 1.38
Cash dividends per share....... 0.27 0.26 0.24 0.20 0.16
Book value per share........... 12.98 10.81 8.92 7.55 6.70
Dividend payout ratio.......... 14.01% 12.13% 14.13% 12.93% 11.39%
Weighted average
shares -- basic............. 26,829 21,175 20,973 21,530 21,732
Weighted average
shares -- diluted........... 29,675 24,173 21,593 21,886 22,139
Shares outstanding -- end of
period...................... 27,771 21,305 21,026 21,105 21,673
AT YEAR END:
Assets......................... $ 4,884,722 $ 3,446,602 $ 2,425,690 $ 1,682,992 $ 1,948,180
Trading assets................. 157,514 199,071 152,614 59,025 32,148
Loans held for sale............ 1,314,849 502,086 579,788 508,997 936,788
Loans and leases............... 2,815,276 2,137,822 1,234,922 733,424 556,991
Allowance for loan and lease
losses...................... 50,936 22,283 13,129 8,555 9,888
Servicing assets............... 174,935 228,624 130,627 138,500 117,129
Deposits....................... 2,694,344 2,308,962 1,442,589 870,318 1,009,211
Short-term borrowings.......... 993,124 487,963 476,928 473,103 644,861
Long-term and collateralized
debt........................ 421,495 30,000 30,000 30,000 2,839
Trust preferred securities..... 233,000 198,500 153,500 50,000 50,000
Shareholders' equity........... 360,555 231,665 188,870 159,296 145,233
Managed first mortgage
servicing portfolio......... 16,792,669 12,875,532 9,196,513 10,488,112 11,242,470
Managed home equity
portfolio................... 1,830,339 2,064,542 1,625,719 777,934 581,241
SELECTED FINANCIAL RATIOS:
Performance Ratios:
Return on average assets....... 1.33% 1.45% 1.76% 2.01% 1.85%
Return on average equity....... 16.66 21.82 20.83 21.51 22.84
Net interest margin(2)(3)...... 6.02 5.36 5.38 5.03 4.33
20
AT OR FOR YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
(IN THOUSANDS EXCEPT PER SHARE DATA)
Noninterest income to
revenues(4)................. 54.7% 64.8% 69.9% 75.3% 78.7%
Efficiency ratio(5)............ 72.4 78.1 78.6 79.0 79.6
Loans and leases to
deposits(6)................. 89.9 79.1 85.6 84.3 55.2
Average interest-earning assets
to average interest-bearing
liabilities................. 121.7 117.2 113.5 127.4 121.0
Asset Quality Ratios:
Allowance for loan and lease
losses to:
Total loans and leases...... 1.8% 1.0% 1.1% 1.1% 1.8%
Non-performing loans and
leases.................... 163.6 116.3 181.8 189.9 82.4
Net charge-offs to average
loans and leases............ 0.7 0.7 0.3 0.3 0.3
Net home equity charge-offs to
managed home equity
portfolio................... 2.9 1.6 0.6 0.4 0.4
Non-performing assets to total
assets...................... 0.8 0.7 0.4 0.5 0.8
Non-performing assets to total
loans and leases and other
real estate owned........... 1.3 1.1 0.8 1.1 2.8
Ratio of Earnings to Fixed
Charges:
Including deposit interest..... 1.9x 1.6x 1.6x 1.9x 1.8x
Excluding deposit interest..... 3.0 2.5 2.5 2.5 2.3
Capital Ratios:
Average shareholders' equity to
average assets.............. 8.0% 6.7% 8.5% 9.4% 8.1%
Tier 1 capital ratio........... 9.3 6.8 8.9 11.4 11.6
Tier 1 leverage ratio.......... 9.7 9.4 12.4 12.8 10.5
Total risk-based capital
ratio....................... 13.2 10.8 13.6 13.5 12.3
---------------
(1) Earnings per share of common stock before cumulative effect of change in
accounting principle related to SFAS 142, "Goodwill and Other Intangible
Assets," for the year ended December 31, 2002 was $1.97 basic and $1.87
diluted. Earnings per share of common stock before cumulative effect of
change in accounting principle related to SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," for the year ended December
31, 2001 was $2.14 basic and $1.99 diluted.
(2) Net interest income divided by average interest-earning assets.
(3) Calculated on a tax-equivalent basis.
(4) Revenues consist of net interest income plus noninterest income.
(5) Noninterest expense divided by net interest income plus noninterest income.
(6) Excludes loans to be sold or securitized.
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
ABOUT FORWARD-LOOKING STATEMENTS
You should read the following discussion in conjunction with our
consolidated financial statements, footnotes, and tables. This discussion and
other sections of this report contain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. We intend such forward-looking statements to be
covered by the safe harbor provisions for forward-looking statements contained
in the Private Securities Litigation Reform Act of 1995, and are including this
statement for purposes of invoking these safe harbor provisions. Words such as
"anticipate," "approximation," "assume," "assumptions," "attempt," "believe,"
"continue," "continuing," "could," "estimate," "expect," "expectation,"
"forecast," "future," "intend," "judgment," "likely," "may," "plan,"
"possibility," "probable," "project," "projections," "seek," "strategy,"
"resume," "unlikely," "will," "would," and similar expressions are intended to
identify forward-looking statements, which may include, among other things:
- statements and assumptions relating to projected growth, earnings,
earnings per share, and other financial performance measures as well as
management's short-term and long-term performance goals;
- statements relating to the anticipated effects on results of operations
or financial condition from recent and expected developments or events;
- statements relating to our business and growth strategies, including
potential acquisitions; and
- any other statements, projections or assumptions that are not historical
facts.
Forward-looking statements involve known and unknown risks, uncertainties
and other important factors that could cause our actual results, performance or
achievements, or industry results, to differ materially from our expectations of
future results, performance or achievements expressed or implied by these
forward-looking statements. In addition, our past results of operations do not
necessarily indicate our future results. Actual future results may differ
materially from what is projected due to a variety of factors, including, but
not limited to, potential changes in interest rates, which may affect consumer
demand for our products and the valuation of our servicing portfolio; staffing
fluctuations in response to product demand; the relative profitability of our
lending operations, including our correspondent mortgage loan originations;
management of our servicing portfolios, including short-term swings in valuation
of such portfolios due to quarter-end secondary market interest rates, which are
inherently volatile; borrowers' refinancing opportunities, which may affect the
prepayment assumptions used in our valuation estimates; unanticipated
deterioration in the credit quality of our assets; difficulties in delivering
products to the secondary market as planned or in securitizing our products as
planned; difficulties in expanding our businesses or raising capital and other
funding sources as needed; competition from other financial service providers
for experienced managers as well as for customers; changes in the value of
companies in which we invest; changes in variable compensation plans related to
the performance and valuation of lines of business where we tie compensation
systems to line-of-business performance; legislative or regulatory changes,
including changes in the interpretation of regulatory capital rules; disclosure
or consumer lending rules or rules affecting corporate governance; changes in
applicable accounting policies or principles or their application to our
business; or governmental changes in monetary or fiscal policies. Further,
geopolitical uncertainty may negatively impact the financial services industry
or cause changes in or exaggerate the effects of the factors described above. We
undertake no obligation to update publicly any of these statements in light of
future events, except as required in subsequent periodic reports we file with
the Securities and Exchange Commission (SEC).
22
CONSOLIDATED OVERVIEW
2002 % CHANGE 2001 % CHANGE 2000
------ -------- ------ -------- ------
Net income (millions).......................... $ 53.3 17.2% $ 45.5 27.6% $ 35.7
Basic earnings per share(1).................... 1.99 (7.4) 2.15 26.5 1.70
Diluted earnings per share(1).................. 1.89 (5.5) 2.00 19.8 1.67
Return on average equity....................... 16.66% -- 21.82% -- 20.83%
Return on average assets....................... 1.33 -- 1.45 -- 1.76
---------------
(1) Earnings per share of common stock before cumulative effect of change in
accounting principle related to SFAS 142, "Goodwill and Other Intangible
Assets," for the year ended December 31, 2002 was $1.97 basic and $1.87
diluted. Earnings per share of common stock before cumulative effect of
change in accounting principle related to SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," for the year ended December
31, 2001 was $2.14 basic and $1.99 diluted.
We recorded net income of $53.3 million for the year ended December 31,
2002, up 17.2% from the $45.5 million for the year ended in 2001. Net income per
share (diluted) was $1.89 for the year ended December 31, 2002, down from $2.00
per share in 2001 and up from $1.67 per share in 2000. Return on equity was
16.66% for the year ended December 31, 2002, 21.82% in 2001 and 20.83% in 2000.
Strategy
Our strategy is to maintain a diverse and balanced revenue stream by
focusing on niches in financial services where we believe we can optimize the
productivity of our capital and where our experience and expertise can provide a
competitive advantage. Our operational objectives are premised on simultaneously
achieving three goals: creditworthiness, profitability and growth. We believe we
must continually balance these goals in order to deliver long-term value to all
of our stakeholders. We have developed a four-part business plan to meet these
goals:
- Identify underserved niches. We focus on product or market niches in
financial services that we believe are underserved and where we believe
customers are willing to pay a premium for value-added services. We don't
believe it is necessary to be the largest or leading market share company
in any of our product lines, but we do believe it is important that we
are viewed as a preferred provider in niche segments of those product
offerings.
- Hire exceptional management with niche expertise. We enter niches only
when we have attracted senior managers who have proven track records in
the niche for which they are responsible. Each line of our five lines of
business has a separate management team that operates its niche as a
separate business unit responsible for performance goals specific to that
particular line of business. Our structure allows the senior managers of
each line of business to focus their efforts on understanding their
customers and meeting the needs of the markets they serve. This structure
also promotes accountability among managers of each enterprise. The
senior managers at each of our lines of business and at the parent
company have significant experience with us and in their respective
industries. We attempt to create a mix of short-term and long-term
incentives (including, in some instances, minority interests in the line
of business) that provide these managers with the incentive to achieve
creditworthy, profitable growth over the long term.
- Diversify capital and earnings risk. We diversify our revenues and
allocate our capital across complementary lines of business as a key part
of our risk management. Our lines of business are cyclical, but when
combined in an appropriate mix, we believe they provide sources of
diversification and opportunities for growth in a variety of economic
conditions. For example, both the origination and servicing of
residential mortgage loans are very cyclical businesses, tied to changes
in interest rates. We believe our participation in these markets has been
profitable over time due to our dedication to participating in both
segments of the mortgage banking business, rather than one or the other,
which would otherwise leave us more susceptible to swings in interest
rates.
23
- Reinvest in new opportunities. We reinvest on an ongoing basis in the
development of new and existing opportunities. As a result of our
attention to long-term value creation, we believe it is important at
times to limit short-term growth by investing for future return. We are
biased toward seeking new growth through organic expansion of existing
lines of business or the initiation of a new line through a start-up,
with highly qualified managers we select to focus on a single line of
business. Over the past ten years, we have made only a few acquisitions
and those have typically been in non-competitive bidding situations.
We believe our historical growth and profitability is the result of our
endeavors to pursue complementary consumer and commercial lending niches through
our bank holding company structure, our experienced management, our diverse
product and geographic markets, and our willingness and ability to align the
compensation structure of each of our lines of business with the interests of
our stakeholders. Through various economic environments and cycles, we have had
a relatively stable revenue and earnings stream on a consolidated basis
generated primarily through internal growth rather than acquisitions.
CONSOLIDATED INCOME STATEMENT ANALYSIS
Net Income
We recorded net income of $53.3 million for the year ended December 31,
2002, up 17.2% from net income of $45.5 million for the year ended December 31,
2001, and compared to $35.7 million in 2000. Net income per share (diluted) was
$1.89 for the year ended December 31, 2002, down from $2.00 per share in 2001
and up from $1.67 per share in 2000. Return on equity was 16.66% for the year
ended December 31, 2002, 21.82% in 2001 and 20.83% in 2000. The effective income
tax rate for 2002 was 39%, compared to 39% and 40% in 2001 and 2000,
respectively. Net income per share reflects dilution from our February 2002
common stock offering.
24
Net Interest Income
Net interest income for the year ended December 31, 2002 totaled $213.6
million, up 45.1% from 2001 net interest income of $147.2 million and up 134.1%
from 2000. Net interest margin for the year ended December 31, 2002 was 6.02%
compared to 5.36% in 2001 and 5.38% in 2000. The improvement in margin from 2001
to 2002 was primarily due to lower rate funding sources. The following tables
show our daily average consolidated balance sheet, interest rates and interest
differential at the dates indicated:
DECEMBER 31,
--------------------------------------------------------------------------------------------------
2002 2001 2000
-------------------------------- ------------------------------ ------------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
------------ -------- ------ ---------- -------- ------ ---------- -------- ------
(DOLLARS IN THOUSANDS)
ASSETS
Interest-earning
assets:
Interest-bearing
deposits with
banks.............. $ 25,859 $ 311 1.20% $ 64,290 $ 2,230 3.47% $ 31,654 $ 1,522 4.81%
Federal funds sold... 12,582 104 0.83 17,973 257 1.43 2,265 143 6.31
Trading assets....... 186,947 34,164 18.27 188,166 32,029 17.02 91,334 15,898 17.41
Taxable investment
securities......... 35,479 2,583 7.28 30,523 2,678 8.77 32,068 2,594 8.09
Tax-exempt investment
securities(1)...... 4,444 342 7.70 4,794 374 7.80 4,974 378 7.60
Loans held for
sale............... 668,522 55,336 8.28 911,949 102,383 11.23 578,758 71,141 12.29
Loans and leases, net
of unearned
income(1)(2)....... 2,620,428 218,805 8.35 1,533,261 128,557 8.38 960,848 93,349 9.72
---------- -------- ----- ---------- -------- ----- ---------- -------- -----
Total interest-
earning
assets......... $3,554,261 $311,645 8.77% $2,750,956 $268,508 9.76% $1,701,901 $185,025 10.87%
---------- -------- ----- ---------- -------- ----- ---------- -------- -----
Noninterest-earning
assets:
Cash and due from
banks.............. $ 100,259 $ 85,242 $ 47,752
Premises and
equipment, net..... 34,041 32,727 27,412
Other assets......... 354,296 281,904 256,807
Less allowance for
loan and lease
losses............. (37,054) (15,587) (10,892)
---------- ---------- ----------
Total assets..... $4,005,803 $3,135,242 $2,022,980
========== ========== ==========
LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest-bearing
liabilities:
Money market
checking........... $ 132,351 $ 664 0.50% $ 105,564 $ 1,283 1.22% $ 96,028 $ 1,334 1.39%
Money market
savings............ 648,706 10,253 1.58 388,432 13,209 3.40 6,428 201 3.13
Regular savings...... 58,204 1,586 2.72 52,650 1,996 3.79 207,823 10,665 5.13
Time deposits........ 1,027,045 41,858 4.08 1,015,105 56,852 5.60 629,179 40,620 6.46
Short-term
borrowings......... 600,821 15,003 2.50 594,831 29,656 4.99 465,353 31,528 6.78
Long-term and
collateralized
debt............... 247,113 8,631 3.49 25,517 2,320 9.09 29,629 3,430 11.58
Trust preferred
securities
distribution....... 205,400 19,800 9.64 165,500 15,767 9.53 64,885 5,761 8.88
---------- -------- ----- ---------- -------- ----- ---------- -------- -----
Total interest-
bearing
liabilities.... $2,919,640 $ 97,795 3.35% $2,347,599 $121,083 5.16% $1,499,325 $ 93,539 6.24%
---------- -------- ----- ---------- -------- ----- ---------- -------- -----
25
DECEMBER 31,
--------------------------------------------------------------------------------------------------
2002 2001 2000
-------------------------------- ------------------------------ ------------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
------------ -------- ------ ---------- -------- ------ ---------- -------- ------
(DOLLARS IN THOUSANDS)
Noninterest-bearing
liabilities:
Demand deposits...... $ 577,409 $ 419,512 $ 260,348
Other liabilities.... 188,738 159,553 92,111
Shareholders' equity... 320,016 208,578 171,196
---------- ---------- ----------
Total liabilities
and
shareholders'
equity......... $4,005,803 $3,135,242 $2,022,980
========== ========== ==========
Net interest
income............. $213,850 $147,425 $ 91,486
======== ======== ========
Net interest income
to average
interest-earning
assets............. 6.02% 5.36% 5.38%
===== ===== =====
---------------
(1) Interest is reported on a fully taxable equivalent basis using a federal
income tax rate of 35%.
(2) For purposes of these computations, nonaccrual loans are included in daily
average loan amounts outstanding.
The following table sets forth, for the periods indicated, a summary of the
changes in interest earned and interest paid resulting from changes in volume
and rates for the major components of interest-earning assets and
interest-bearing liabilities on a fully taxable equivalent basis:
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
2002 OVER 2001 2001 OVER 2000
-------------------------------- -------------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
-------- -------- -------- -------- -------- -------
(IN THOUSANDS)
INTEREST INCOME
Loans and leases........ $ 91,154 $ (906) $ 90,248 $ 55,611 $(20,403) $35,208
Mortgage loans held for
sale................. (27,329) (19,718) (47,047) 40,956 (9,714) 31,242
Taxable investment
securities........... 435 (530) (95) (125) 209 84
Tax-exempt securities... (27) (5) (32) (14) 10 (4)
Trading assets.......... (207) 2,342 2,135 16,855 (724) 16,131
Interest-bearing
deposits with
financial
institutions......... (1,333) (586) (1,919) 1,569 (861) 708
Federal funds sold...... (77) (76) (153) 992 (878) 114
-------- -------- -------- -------- -------- -------
Total................ 62,616 (19,479) 43,137 115,844 (32,361) 83,483
-------- -------- -------- -------- -------- -------
INTEREST EXPENSE
Money market checking... 326 (945) (619) 132 (183) (51)
Money market savings.... 8,851 (11,807) (2,956) 11,945 1,063 13,008
Regular savings......... 211 (621) (410) (7,963) (706) (8,669)
Time deposits........... 669 (15,663) (14,994) 24,916 (8,684) 16,232
Short-term borrowings... 299 (14,952) (14,653) 8,772 (10,644) (1,872)
Long-term debt.......... 20,147 (13,836) 6,311 (476) (634) (1,110)
26
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
2002 OVER 2001 2001 OVER 2000
-------------------------------- -------------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
-------- -------- -------- -------- -------- -------
(IN THOUSANDS)
Trust preferred
securities
distribution......... 3,801 232 4,033 8,933 1,073 10,006
-------- -------- -------- -------- -------- -------
Total................ 34,304 (57,592) (23,288) 46,259 (18,715) 27,544
-------- -------- -------- -------- -------- -------
Net interest income..... $ 28,312 $ 38,113 $ 66,425 $ 69,585 $(13,646) $55,939
======== ======== ======== ======== ======== =======
The variance not due solely to rate or volume has been allocated on the
basis of the absolute relationship between volume and rate variances.
Provision for Loan and Lease Losses
The consolidated provision for loan and lease losses for the year 2002 was
$44.0 million, compared to $17.5 million and $5.4 million in 2001 and 2000,
respectively. More information on this subject is contained in the section on
credit risk.
Noninterest Income
Noninterest income during the year 2002 totaled $257.4 million, compared to
$271.2 million for 2001 and $211.6 million in 2000. The decrease in 2002 versus
2001 was primarily a result of decreased gain from sale of loans at the home
equity lending line of business related to the transition away from
securitization structures accounted for using gain-on-sale accounting treatment
under SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities." Also contributing to the decrease is the higher
amortization and impairment expense related to mortgage servicing rights as a
result of declining interest rates.
Noninterest Expense
Noninterest expenses for the year ended December 31, 2002 totaled $340.9
million, compared to $326.7 million and $238.0 million in 2001 and 2000,
respectively. The increase in consolidated other expense in 2002 and 2001 is
primarily related to our mortgage banking line of business.
CONSOLIDATED BALANCE SHEET ANALYSIS
Total assets at December 31, 2002 were $4.9 billion, up 41.7% from December
31, 2001. However, we believe that changes in the average balance sheet are a
more accurate reflection of the actual changes in the level of activity on the
balance sheet. Average assets for 2002 were $4.0 billion up 27.8% from December
31, 2001, and up 98.0% from December 31, 2000. The growth in the consolidated
balance sheet reflects increases in portfolio loans and leases at the commercial
banking, home equity lending and commercial finance lines of business. Also,
there was significant growth in loans held for sale at the mortgage banking line
of business at December 31, 2002.
Loans
Our commercial loans are extended primarily to Midwest and Rocky Mountain
regional businesses and our leases are originated throughout the United States
and Canada. We also extend credit to consumers nationally through mortgages,
installment loans and revolving credit arrangements. The majority of the
remaining portfolio consists of residential mortgage loans (1-4 family
dwellings) and mortgage loans on commercial property. As of December 31, 2001,
$342.6 million of loans held for sale at the home equity lending line of
business were reclassified to loans held for investment. These loans are
included in the real estate mortgage category in the tables below. This
reclassification was the result of a management decision
27
during 2001 to eliminate securitization structures that require gain on sale
accounting treatment under SFAS No. 140. Loans by major category for the periods
presented were as follows:
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- -------- --------
(IN THOUSANDS)
Commercial, financial
and agricultural...... $1,347,962 $1,055,307 $ 677,066 $443,985 $278,834
Real estate
construction.......... 314,851 287,228 220,485 121,803 97,253
Real estate mortgage.... 777,865 490,186 122,301 115,265 123,980
Consumer................ 27,857 38,489 56,785 48,936 51,730
Direct lease financing:
Domestic.............. 291,711 232,527 116,867 3,890 6,375
Canadian.............. 133,784 91,816 72,864 -- --
Unearned income:
Domestic.............. (59,287) (44,183) (21,570) (455) (1,181)
Canadian.............. (19,467) (13,548) (9,876) -- --
---------- ---------- ---------- -------- --------
Total.............. $2,815,276 $2,137,822 $1,234,922 $733,424 $556,991
========== ========== ========== ======== ========
The following table shows our contractual maturity distribution of loans at
December 31, 2002. Actual principal payments may differ depending on customer
prepayments:
AFTER ONE
WITHIN BUT WITHIN AFTER FIVE
ONE YEAR FIVE YEARS YEARS TOTAL
-------- ---------- ---------- ----------
(IN THOUSANDS)
Commercial, financial and
agricultural...................... $394,945 $564,015 $ 389,002 $1,347,962
Real estate construction............ 220,793 65,382 28,676 314,851
Real estate mortgage................ 15,670 35,676 726,519 777,865
Consumer loans...................... 2,519 17,119 8,219 27,857
Direct lease financing:
Domestic.......................... 10,829 168,842 112,040 291,711
Canadian.......................... 4,481 117,516 11,787 133,784
-------- -------- ---------- ----------
Total.......................... $649,237 $968,550 $1,276,243 $2,894,030
======== ======== ========== ==========
Loans due after one year with:
Fixed interest rates.............. 888,710
Variable interest rates........... 1,356,083
----------
Total.......................... $2,244,793
==========
Investment Securities
The following table shows the composition of our investment securities at
the dates indicated:
DECEMBER 31,
-----------------------------
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
U.S. Treasury and government obligations.............. $60,868 $29,329 $25,999
Obligations of states and political subdivisions...... 4,210 4,425 4,586
Mortgage-backed securities............................ 1,738 4,224 5,152
Other................................................. 1,132 818 1,358
------- ------- -------
Total............................................... $67,948 $38,796 $37,095
======= ======= =======
28
The following table shows maturity distribution of our investment
securities at December 31, 2002:
AFTER ONE
WITHIN ONE BUT WITHIN FIVE TO AFTER TEN
YEAR FIVE YEARS TEN YEARS YEARS TOTAL
---------- ---------- --------- --------- -------
(DOLLARS IN THOUSANDS)
U.S. Treasury and government
obligations................ $14,992 $ -- $ -- $45,876 $60,868
Obligations of states and
political subdivisions..... 335 890 1,305 1,680 4,210
Mortgage-backed securities... 297 866 566 9 1,738
Other........................ 1,132 -- -- -- 1,132
------- ------ ------ ------- -------
Total................... $16,756 $1,756 $1,871 $47,565 $67,948
======= ====== ====== ======= =======
Weighted average yield:
Held-to-maturity........... 1.49% 8.57% 8.88% 9.57%
Available-for-sale......... -- 5.50% -- --
Average yield represents the weighted average yield to maturity computed
based on average historical cost balances. The yield information on
available-for-sale securities does not give effect to changes in fair value that
are reflected as a component of shareholders' equity. The yield on state and
municipal obligations has been calculated on a fully taxable equivalent basis,
assuming a 35% tax rate. Expected maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties.
Deposits
Total deposits as of December 31, 2002 averaged $2.4 billion compared to
average deposits in 2001 of $2.0 billion, and average deposits in 2000 of $1.2
billion. Demand deposits at December 31, 2002 averaged $577.4 million, a 37.6%
increase over the December 31, 2001 balance. Demand deposits in 2001 were up
61.1% on average, or $159.2 million, from 2000. A significant portion of demand
deposits is related to deposits at Irwin Union Bank and Trust, which are
associated with escrow accounts held on loans in the servicing portfolio at the
mortgage banking line of business. During 2002, these escrow accounts averaged
$409.4 million compared to a 2001 average of $294.8 million, and a 2000 average
of $175.8 million. Irwin Union Bank and Trust utilizes institutional
broker-sourced deposits as funding from time to time to supplement deposits
solicited through branches and other wholesale funding sources. At December 31,
2002, institutional broker-sourced deposits totaled $337.4 million compared to a
balance of $577.3 million at December 31, 2001. The decline in brokered deposits
in 2002 reflects our reduced reliance on these higher-rate funding sources.
The following table shows maturities of certificates of deposit of $100,000
or more, and brokered deposits and core deposits at the dates indicated:
DECEMBER 31,
------------------------------------
2002 2001 2000
---------- ---------- --------
(IN THOUSANDS)
Under 3 months.................................. $ 241,722 $ 335,420 $133,804
3 to 6 months................................... 116,119 151,924 164,904
6 to 12 months.................................. 63,742 260,184 120,476
After 12 months................................. 280,287 138,059 243,860
---------- ---------- --------
Total CDs..................................... $ 701,870 $ 885,587 $663,044
========== ========== ========
Brokered deposits............................... $ 337,431 $ 577,297 $494,316
========== ========== ========
Core Deposits................................... $1,516,812 $1,135,870 $688,110
========== ========== ========
29
SHORT-TERM BORROWINGS
Short-term borrowings during 2002 averaged $600.8 million compared to an
average of $594.8 million in 2001, and $465.4 million in 2000. The increase in
2001 relates to the growth at the home equity lending line of business and the
increased production at the mortgage banking line of business. In 2002, average
short-term borrowings rose slightly as a result of increased production at the
mortgage line of business that was partially offset by whole loan sales and
securitized borrowings at the home equity lending line of business. The
securitized borrowings are treated as long-term debt on our balance sheet.
The following table shows the distribution of our short-term borrowings and
the weighted average rates at the dates shown. Also provided are the maximum
amount of borrowings and the average amounts of borrowings as well as weighted
average interest rates.
2002 2001 2000
---------------- ---------------- ----------------
AMOUNT RATE AMOUNT RATE AMOUNT RATE
-------- ---- -------- ---- -------- ----
(DOLLARS IN THOUSANDS)
Lines of Credit and other Borrowings:
At December 31..................... $221,302 2.36% $ 75,483 2.95% $226,599 7.19%
Weighted average during the year... 133,382 2.95 130,901 5.30 227,564 6.95
Maximum month-end balance during
the year........................ 333,927 335,223 293,100
Federal Home Loan Bank Borrowings:
At December 31..................... $527,000 1.49% $212,000 2.15% $153,000 6.27%
Weighted average during the year... 238,629 1.95 205,657 4.07 130,037 6.51
Maximum month-end balance during
the year........................ 692,000 409,000 230,000
Federal Funds:
At December 31..................... $ 30,000 1.99% $ 35,200 3.40% $ 20,000 6.32%
Weighted average during the year... 38,885 2.31 25,462 3.86 18,938 6.95
Maximum month-end balance during
the year........................ 56,000 46,400 20,000
Drafts Payable Related to Mortgage
Loan Closings:
At December 31..................... $200,701 n/a $154,157 n/a $ 64,557 n/a
Weighted average during the year... 173,708 n/a 216,442 n/a 68,028 n/a
Maximum month-end balance during
the year........................ 258,911 497,655 95,094
Commercial Paper:
At December 31..................... $ 14,121 1.59% $ 11,123 2.59% $ 11,346 6.85%
Weighted average during the year... 16,217 2.00 17,609 4.65 20,786 6.60
Maximum month-end balance during
the year........................ 18,972 27,965 31,774
LONG-TERM DEBT AND COLLATERALIZED BORROWINGS
Long-term debt totaled $30.1 million at December 31, 2002 compared to $30.0
million at December 31, 2001. Collateralized borrowings totaled $391.4 million
at December 31, 2002 relating to the change we made in 2002 at the home equity
lending line of business away from securitization structures requiring
gain-on-sale accounting. The new securitization structures result in loans
remaining as assets and collateralized borrowings being recorded as long-term
debt on the balance sheet. This securitization debt represents match-term
funding for our home equity loans.
30
CAPITAL
Shareholders' equity averaged $320.0 million during 2002, up 53.4% compared
to 2001, and up 86.9% from 2000. Shareholders' equity balance of $360.6 million
at December 31, 2002 represented $12.98 per common share, compared to $10.81 per
common share at December 31, 2001, and compared to $8.92 per common share at
year-end 2000. We paid an aggregate of $7.5 million in dividends during 2002,
compared to $5.5 million during 2001 and $5.0 million during 2000.
The following table sets forth our capital and capital ratios at the dates
indicated:
DECEMBER 31,
--------------------------------------
2002 2001 2000
---------- ---------- ----------
(IN THOUSANDS)
Tier 1 capital................................. $ 462,064 $ 295,021 $ 250,825
Tier 2 capital................................. 196,092 173,316 133,319
---------- ---------- ----------
Total risk-based capital.................. $ 658,156 $ 468,337 $ 384,144
========== ========== ==========
Risk-weighted assets........................... $4,996,891 $4,329,973 $2,979,376
Risk-based ratios:
Tier 1 capital............................... 9.2% 6.8% 8.4%
Total capital............................. 13.2 10.8 12.9
Tier 1 leverage ratio.......................... 9.7 9.4 12.4
Ending shareholders' equity to assets.......... 7.4 6.7 7.8
Average shareholders' equity to assets......... 8.0 6.7 8.5
At December 31, 2002, our total risk-adjusted capital ratio was 13.2%
compared to the 10.0% required to be considered "well-capitalized" by the
regulators and our internal minimum target of 11.0%. At year-end 2001, our total
risk-adjusted capital ratio was 10.8%. We were below the 11.0% target at
year-end 2001, just prior to our issuance of common stock in early 2002. Our
ending equity to assets ratio at December 31, 2002 was 7.4% compared to 6.7% at
December 31, 2001. However, as previously discussed, temporary conditions that
existed at year end make the average balance sheet ratio a more accurate measure
of capital. Our average equity to assets for the year ended December 31, 2002
was 8.0% compared to 6.7% for the year 2001. Our Tier 1 capital totaled $462.1
million as of December 31, 2002, or 9.2% of risk-weighted assets. The increased
equity and capital ratios are reflective of our February 2002 public offering
that raised $82.0 million, net of expenses, on the sale of 6,210,000 shares of
common stock.
We have issued $233.0 million in trust preferred securities through six IFC
Capital Trusts as of December 31, 2002. All securities are callable at par after
five years. These funds are all Tier 1 qualifying capital. The sole assets of
these trusts are our subordinated debentures. Highlights about these trusts are
listed below:
ORIGINATION $ AMOUNT IN COUPON MATURITY CUMULATIVE
NAME DATE THOUSANDS RATE DATE DIVIDEND OTHER
---- ----------- ----------- ------ -------- ---------- -----
IFC Capital Trust I...... Jan 1997 $ 50,000 9.25% Jan 2027 quarterly We have a 19 year
extension option
beyond the stated
maturity.
IFC Capital Trust II..... Nov 2000 51,750 10.50 Nov 2030 quarterly
IFC Capital Trust III.... Nov 2000 51,750 8.75 Nov 2030 quarterly Initial conversion
ratio of 1.261 shares
of common stock to 1
convertible security.
IFC Capital Trust IV..... Jul 2001 15,000 10.25 Jul 2031 semiannual
IFC Capital Trust V...... Nov 2001 30,000 9.95 Nov 2031 semiannual
IFC Capital Trust VI..... Oct 2002 34,500 8.70 Oct 2032 quarterly
--------
$233,000
========
31
In July 1999, we raised $30 million of 7.58%, 15-year subordinated debt that is
callable in 2009 at par. The debt was privately placed. These funds qualify as
Tier 2 capital. The securities are not convertible into our common shares.
Earnings Outlook
Given the current economic climate of a gradual recovery, tempered with
geopolitical concern, we expect at the time of this writing, consolidated
earnings per share (diluted) in 2003 to be in the range of $1.90 to $2.10 per
share. This estimate is based on various factors and current assumptions
management believes are reasonable, including current industry forecasts of a
variety of economic and competitive factors. However, projections are inherently
uncertain, and our actual earnings may differ significantly from this estimate
due to uncertainties and risks related to our business. Our transition off
securitization gain-on-sale accounting in our home equity line of business will
have had a two-year history at the end of 2003. We assume that this transition,
coupled with the continued growth of our other lines of business, will enable us
over time to produce earnings growth and return on equity aligned with our
long-term targets of 12% or better growth in earnings per share and 15% return
on equity.
A meaningful amount of our earnings comes from activities and
mark-to-market accounting requirements tied directly or indirectly to market
activities, particularly movements in the bond market (e.g., the valuation of
our mortgage servicing portfolio). We attempt to manage the impact of short-term
movements in interest rates on the valuation of our mortgage servicing rights
through a combination of financial derivatives and the changes in income from
production of new mortgages likely to be driven by those same movements in
interest rates. However, the correlation within short periods of time (such as a
single quarter) between interest rate movements that impact the reported value
of our mortgage servicing rights at quarter end and the production effects of
those interest rate movements -- which may not be reflected until the following
quarter -- can be low. It is possible, therefore, that our balanced revenue
strategy may be successful as measured over several quarters or years, but may
have market-based variances if measured over short periods. We also have a large
amount of income that is subject to assumptions and pricing for credit risks. We
use a variety of methods for estimating the effects of and accounting for credit
losses, but ultimately, we need to make estimates based on imperfect knowledge
of future events. For example, if the pace of economic recovery in the U.S. is
slower in 2003 than currently anticipated by consensus estimates, our credit
related costs may increase beyond our current estimates.
CRITICAL ACCOUNTING POLICIES/MANAGEMENT JUDGMENTS AND ACCOUNTING ESTIMATES
Accounting estimates are an integral part of our financial statements and
are based upon our current judgments. Certain accounting estimates are
particularly sensitive because of their significance to the financial statements
and because of the possibility that future events affecting them may differ from
our current judgments or that our use of different assumptions could result in
materially different estimates. The following is a description of the critical
accounting policies we apply to material financial statement items, all of which
require the use of accounting estimates and/or judgment:
Valuation of Mortgage Servicing Rights
Mortgage servicing rights are recorded at the lower of their cost basis or
fair value and a valuation allowance is recorded for any stratum that is
impaired. We estimate the fair value of the servicing assets each month using a
cash flow model to project future expected cash flows based upon a set of
valuation assumptions we believe market participants would use for similar
assets. We review these assumptions on a regular basis to ensure that they
remain consistent with current market conditions. Additionally, we periodically
receive third party estimates of the portfolio value from an independent
valuation firm. Inaccurate assumptions in valuing mortgage servicing rights
could result in additional impairment and adversely affect our results of
operations. See footnote 7 for further discussion.
32
Allowance for Loan and Lease Losses
The allowance for loan and lease losses (ALLL) reflects our estimate of the
adequacy of reserves needed to cover probable loan and lease losses and certain
risks inherent in our loan portfolio. The ALLL is an estimate based on our
judgement applying the principles of SFAS 5, "Accounting for Contingencies,"
SFAS 114, "Accounting by Creditors for Impairment of a Loan," and SFAS 118,
"Accounting by Creditors for Impairment of a Loan -- Income Recognition and
Disclosures." In determining a proper level of loss reserves, management
periodically evaluates the adequacy of the allowance based on our past loan loss
experience, known and inherent risks in the loan portfolio, levels of
delinquencies, adverse situations that may affect a borrower's ability to repay,
trends in volume and terms of loans and leases, estimated value of any
underlying collateral, changes in underwriting standards, changes in credit
concentrations, and current economic and industry conditions. In addition,
various regulatory agencies, as an integral part of their examination process,
periodically review our allowance for loan and lease losses. Such agencies may
require us to recognize additions to the allowance for loan and lease losses
based on their judgments of information available to them at the time of their
examination.
We compute the allowance based on an analysis that incorporates both a
quantitative and qualitative element. The quantitative component of the
allowance reflects expected losses resulting from analysis developed through
specific credit allocations for individual loans and historical loss experience
for each loan category. The specific credit allocations are based on a regular
analysis of all loans over a fixed-dollar amount where the internal credit
rating is at or below a predetermined classification. The historical loan loss
component is applied to all loans that do not have a specific reserve allocated
to them. Loans are segregated by major product type, and in some instances, by
aging, with an estimated loss ratio applied against each product type and aging
category. The loss ratio is generally based upon the previous three years' loss
experience for each loan type. The qualitative portion of the allowance reflects
management's estimate of probable inherent but undetected losses within the
portfolio. This assessment is performed via the evaluation of eight specific
qualitative factors as outlined in regulatory guidance. We perform the
quantitative and qualitative assessments on a quarterly basis. Loans and leases
that are determined by management to be uncollectible are charged against the
allowance. The allowance is increased by provisions against income and
recoveries of loans and leases previously charged off. See Credit Risk section
and footnote 6 for further discussion.
Valuation of Residual Interests
Residual interests from past securitizations are classified as trading
assets and as such, we record them at fair value on the balance sheet. We record
the changes in fair value of these residuals as trading gains or losses in
results of operations in the period of change. We use a discounted cash flow
analysis to determine the fair value of these residuals. Cash flows are
projected over the lives of the residuals using prepayment, default, and
interest rate assumptions that we believe market participants would use for
similar financial instruments. See footnote 3 for further discussion.
Accounting for Private Equity Investments
It is our accounting policy to account for private equity investments held
by our venture capital line of business at fair value, with unrealized and
realized gains and losses included in noninterest income as investment
securities gains and losses. The fair value of private equity investments (which
by their nature are not publicly traded) is estimated based on the investees'
financial results, conditions and prospects, values of comparable public
companies, market liquidity and sales restrictions. We assume that cost
approximates fair value, unless there is evidence suggesting a revaluation is
appropriate. Potential reasons for revaluation include: 1) an anticipated
pricing of a company's future equity financing that would be lower than the
previous funding round (although the reverse would not necessarily require an
upward adjustment) 2) a significant deterioration in the company's performance
3) a significant reduction in the company's potential realizable value -- for
example, if market conditions have caused a meaningful change in the value of
peer companies. We may increase the valuation of a private equity investment
only if the investee has completed a new equity financing in which a
professional investor is investing for the first time at a higher valuation. We
believe the
33
values derived from the application of our policy represent a close
approximation of fair value for non-marketable securities.
Accounting for Deferred Taxes
Deferred tax assets and liabilities are determined based on temporary
differences between the time income or expense items are recognized for book
purposes and in our tax return. We make this measurement using the enacted tax
rates and laws that are expected to be in effect when the differences are
expected to reverse. We recognize deferred tax assets based on estimates of
future taxable income. Events may occur in the future that could cause the
realizability of these deferred tax assets to be in doubt, requiring the need
for a valuation allowance.
SUMMARY OF QUARTERLY FINANCIAL DATA
2002
------------------------------------------
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
--------- -------- -------- --------
(DOLLARS IN THOUSANDS)
SUMMARY INCOME STATEMENT INFORMATION
Interest income................................. $ 88,975 $ 83,645 $ 71,176 $ 67,646
Interest expense................................ (24,940) (26,164) (23,460) (23,231)
Provision for loan and lease losses............. (8,587) (15,577) (9,500) (10,332)
Noninterest income.............................. 95,961 54,483 51,091 55,898
Noninterest expense............................. (106,921) (83,178) (76,248) (74,506)
Income taxes.................................... (17,285) (5,016) (5,073) (6,024)
--------- -------- -------- --------
Net income before cumulative effect of change in
accounting principle......................... 27,203 8,193 7,986 9,451
Cumulative effect of change in accounting
principle.................................... -- -- -- 495
--------- -------- -------- --------
Net Income...................................... $ 27,203 $ 8,193 $ 7,986 $ 9,946
========= ======== ======== ========
Earnings per share:
Basic(1)..................................... $ 0.98 $ 0.30 $ 0.29 $ 0.41(1)
Diluted(1)................................... 0.92 0.29 0.28 0.39(1)
34
2001
-----------------------------------------
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
-------- -------- -------- --------
(DOLLARS IN THOUSANDS)
SUMMARY INCOME STATEMENT INFORMATION
Interest income.................................. $ 69,492 $ 72,954 $ 65,174 $ 60,662
Interest expense................................. (26,452) (31,909) (31,235) (31,488)
Provision for loan and lease losses.............. (8,142) (5,006) (2,804) (1,553)
Noninterest income............................... 82,850 58,464 68,101 61,828
Noninterest expense.............................. (98,707) (75,545) (77,812) (74,673)
Income taxes..................................... (6,971) (7,491) (8,616) (5,780)
-------- -------- -------- --------
Net income before cumulative effect of change in
accounting principle.......................... 12,070 11,467 12,808 8,996
Cumulative effect of change in accounting
principle..................................... -- -- -- 175
-------- -------- -------- --------
$ 12,070 $ 11,467 $ 12,808 $ 9,171
======== ======== ======== ========
Earnings per share:
Basic(2)...................................... $ 0.57 $ 0.54 $ 0.61 $ 0.44(2)
Diluted(2).................................... 0.53 0.50 0.56 0.41(2)
---------------
(1) Earnings per share of common stock before cumulative effect of change in
accounting principle for the three-month period ended March 31, 2002 was
$0.39 basic and $0.37 diluted.
(2) Earnings per share of common stock before cumulative effect of change in
accounting principle for the three-month period ended March 31, 2001 was
$0.43 basic and $0.40 diluted.
EARNINGS BY LINE OF BUSINESS
Irwin Financial Corporation is composed of five principal lines of
business:
- Mortgage Banking
- Commercial Banking
- Home Equity Lending
- Commercial Finance
- Venture Capital
The following table summarizes our net income (loss) by line of business
for the periods indicated:
YEAR ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
Net income (loss):
Mortgage Banking...................................... $44,543 $38,100 $13,006
Commercial Banking.................................... 16,085 8,918 7,090
Home Equity Lending................................... 1,005 16,248 18,494
Commercial Finance.................................... (58) (2,878) (1,618)
Venture Capital....................................... (2,483) (6,506) 2,723
Other (including consolidating entries)............... (5,764) (8,366) (4,029)
------- ------- -------
$53,328 $45,516 $35,666
======= ======= =======
35
MORTGAGE BANKING
The following table shows selected financial information for our mortgage
banking line of business:
YEAR ENDED DECEMBER 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ---------- ----------- -----------
(IN THOUSANDS)
SELECTED INCOME STATEMENT DATA:
Net interest income...................... $ 41,545 $ 30,261 $ 15,401 $ 21,745 $ 26,244
(Provision for) recovery of loan
losses................................. (354) 31 357 (1,998) (1,721)
Loan origination fees.................... 74,970 61,917 34,688 46,311 59,328
Gain on sales of loans................... 147,647 113,140 45,601 72,395 97,724
Loan servicing fees...................... 58,316 52,837 50,309 54,247 52,217
Amortization of servicing assets......... (55,097) (34,660) (23,712) (25,078) (23,002)
(Impairment) recovery of servicing
assets................................. (143,376) (11,321) (13,802) 11,320 (11,121)
Gain (loss) on derivatives............... 125,586 3,846 24 (10,808) 4,318
Gain on sales of mortgage servicing
assets................................. 14,842 8,394 27,528 9,005 829
Other income............................. 6,727 5,016 4,538 3,628 2,276
----------- ----------- ---------- ----------- -----------
Total net revenue...................... 270,806 229,461 140,932 180,767 207,092
Operating expense.......................... 197,715 167,624 119,387 144,915 159,046
----------- ----------- ---------- ----------- -----------
Income before taxes........................ 73,091 61,837 21,545 35,852 48,046
Income taxes............................... 28,548 23,912 8,539 12,789 19,193
----------- ----------- ---------- ----------- -----------
Net income before cumulative effect of
change in accounting principle........... 44,543 37,925 13,006 23,063 28,853
Cumulative effect of change in accounting
principle................................ -- 175 -- -- --
----------- ----------- ---------- ----------- -----------
Net income................................. $ 44,543 $ 38,100 $ 13,006 $ 23,063 $ 28,853
=========== =========== ========== =========== ===========
SELECTED BALANCE SHEET DATA AT END OF
PERIOD:
Total assets............................. $ 1,605,202 $ 926,946 $ 522,349 $ 549,966 $ 1,020,249
Mortgage loans held for sale............. 1,239,309 502,086 249,580 277,614 697,542
Mortgage servicing assets................ 146,398 211,201 121,555 132,648 113,131
Short-term debt.......................... 809,921 385,640 215,826 217,691 430,859
Long-term debt........................... -- -- 3,951 223 2,839
Shareholder's equity..................... 100,069 63,150 47,828 98,556 104,696
SELECTED OPERATING DATA:
Mortgage loan originations............... $11,411,875 $ 9,225,991 $4,091,573 $ 5,876,750 $ 8,944,615
Servicing portfolio:
Balance at end of period................. 16,792,669 12,875,532 9,196,513 10,448,112 11,242,470
Weighted average coupon rate........... 6.59% 7.23% 7.76% 7.51% 7.56%
Weighted average servicing fee......... 0.37 0.45 0.43 0.44 0.43
Servicing sold as a % of originations.... 31.1 29.9 108.0 85.4 61.4
Overview
In our mortgage banking line of business, we originate, purchase, sell and
service conventional and government agency-backed residential mortgage loans
throughout the United States. We also engage in the business of mortgage
reinsurance. Because most of our mortgage originations either are insured by an
agency of the federal government, such as the FHA or the VA, or, in the case of
conventional mortgages, meet requirements for sale to FNMA or the FHLMC, we are
able to remove substantially all of the credit risk of these loans from our
balance sheet. We securitize and sell mortgage loans to institutional and
private investors but may retain the servicing rights. Loan origination demand
and servicing values react in opposite directions to interest rate change as
explained below. We believe this balance between mortgage loan originations and
36
mortgage loan servicing assists in managing the risk from interest rate changes,
which has helped stabilize our revenue stream.
Our mortgage banking line of business is currently our largest contributor
to revenue, comprising 63.4% of our total revenues in 2002, compared to 57.2% in
2001 and 47.4% in 2000. Our mortgage banking line of business contributed 83.5%
of our net income for 2002, compared to 83.7% and 36.5% in 2001 and 2000,
respectively.
Our channels for originating loans consist primarily of retail, wholesale,
and correspondent lending. The retail channel originates loans through retail
branches, and, to a limited degree, through our internet website. This channel
identifies potential borrowers mainly through relationships maintained with
housing intermediaries, such as realtors, homebuilders and brokers. Our
wholesale and correspondent divisions purchase loans from third party sources.
The wholesale division purchases primarily from mortgage loan brokers through
table-funded transactions. During the fourth quarter of 2002 we launched our
correspondent lending division. This division purchases closed mortgage loans
primarily from small mortgage banks and banks. It is expected that this division
will be a significant contributor to our originations in 2003 and will add
meaningfully to our earnings. We fund our mortgage loan originations using
internal funding sources and through credit facilities provided by third
parties. Generally within a 30-day period after funding, we sell our mortgage
loan originations into the secondary mortgage market by either direct loan sales
or by securitization. Our secondary market sources include government-sponsored
mortgage entities, nationally sponsored mortgage conduits, and institutional and
private investors. Our mortgage banking line of business may retain servicing
rights to the loans that it sells or securitizes.
As mentioned, we believe there is a balance between mortgage loan
originations and mortgage loan servicing that assists in managing the risk from
interest rate changes and the impact of rate changes on each part of the
business. In rising interest rate environments, originations typically decline,
while the unrealized value of our mortgage servicing portfolio generally
increases as prepayment expectations decline. In declining interest rate
environments, unrealized servicing values typically decrease as prepayment
expectations increase, while the value of our mortgage production franchise
generally increases. However, the offsetting impact of changes in production
income and servicing values may not always be recognized in the same quarter
under generally accepted accounting principles, causing greater volatility in
short-term results than is apparent in longer-term measurements such as annual
income. We sell servicing rights periodically for many reasons, including income
recognition, cash flow, and servicing portfolio management. Servicing rights
sales occur at the time the underlying loans are sold to an investor (in flow
sales) or in pools from our seasoned servicing portfolio (in bulk sales).
Strategy
Our mortgage banking line of business focuses primarily on first-time
homeowners, which we believe will increase in number in coming years due to
certain national demographic trends that are favorable to housing formation in
our target markets. The mortgage banking business is cyclical, following changes
in interest rates. In our mortgage banking line of business we do not try to
anticipate the timing of changes in interest rates, but instead we have
developed a strategy intended to maintain profitability across interest rate
cycles. Our strategy has three components:
- We manage our loan production activities through the expansion or
contraction of existing channels in geographic markets and demographic
groups that support our strategy, and channels (such as correspondent and
credit unions) that are thought to be underserved by the mortgage
industry and that value our mortgage bank's service-oriented approach to
lending.
- We are continuing our process improvement initiative to increase profit
margins by significantly reducing fixed costs associated with processing
and securitizing mortgage loans. This initiative includes re-designing
our processes so that we process, underwrite, and close loans in more
centralized environments.
37
- We are more likely to retain servicing rights in periods of low interest
rates and more likely to sell these servicing rights during periods of
high interest rates. This strategy gives us the flexibility to invest in
servicing rights during periods of relatively high production when
servicing values tend to be low and sell the servicing during periods of
lower production when servicing values tend to be high.
Net Income
Net income from mortgage banking for the year ended December 31, 2002 was
$44.5 million, compared to $38.1 million during 2001, an increase of 16.9% and
an increase of 242.5% over 2000 results of $13.0 million. These increases in
2001 and 2002 primarily relate to increased production as a result of a
declining interest rate environment. The relatively lower net income in 2000 was
the result of rising interest rates, which slowed production activity throughout
the mortgage banking industry in that year, and decisions we made on the
retention of mortgage servicing rights.
The following table shows the composition of our originations by loan
categories for the periods indicated:
YEAR ENDED DECEMBER 31,
-------------------------------------
2002 2001 2000
----------- ---------- ----------
(DOLLARS IN THOUSANDS)
Total originations...................................... $11,411,875 $9,225,991 $4,091,573
Percent retail loans.................................... 34.2% 35.7% 35.7%
Percent wholesale loans................................. 59.1 59.7 55.7
Percent brokered(1)..................................... 5.5 4.6 8.6
Percent correspondent................................... 1.2 -- --
Percent refinances...................................... 61.1 54.1 16.4
---------------
(1) Brokered loans are loans we originate for which we receive loan origination
fees, but which are funded, closed and owned by unrelated third parties.
Mortgage loan originations for the year ended December 31, 2002 totaled
$11.4 billion, up 23.7% from the same period in 2001 as a result of the
declining interest rate environment. Refinanced loans accounted for 61.1% of
loan production for 2002 compared to 54.1% in 2001. Higher production volume
caused mortgage loan origination fees to increase 21.1% in 2002 to $75.0
million. The declining rate environment and resulting higher loan production in
2002 resulted in gains on the sale of loans during this period increasing 30.5%
to $147.6 million compared to 2001. This compares to $113.1 million for the year
2001, and $45.6 million for the year 2000.
As a result of declining interest rates during most of 2001, our mortgage
banking line of business experienced an increase in loan originations in 2001
compared to 2000. Loan originations in 2001 were $9.2 billion, up 125.5% from
2000. Income from mortgage loan originations in 2001 totaled $61.9 million,
78.5% higher than 2000. Refinances accounted for 54.1% of 2001 originations, as
compared to 16.4% in 2000. Because certain fees are not collected for loan
refinancings, loan origination fees, which are fees we charge the borrower to
initiate the loan application and/or to secure an interest rate, did not
increase at the same rate as loan production in 2002 and 2001.
38
Net Revenue
Net revenue for the year ended December 31, 2002 totaled $270.8 million,
compared to $229.5 million for the year ended December 31, 2001, and $140.9
million in 2000. The following table sets forth certain information regarding
net revenue for the periods indicated:
YEAR ENDED DECEMBER 31,
-------------------------------
2002 2001 2000
--------- -------- --------
(IN THOUSANDS)
Net interest income......................................... $ 41,545 $ 30,261 $ 15,401
(Provision for) recovery of loan losses..................... (354) 31 357
Loan origination fees....................................... 74,970 61,917 34,688
Gain on sales of loans...................................... 147,647 113,140 45,601
Servicing fees.............................................. 58,316 52,837 50,309
Amortization expense........................................ (55,097) (34,660) (23,712)
Impairment expense.......................................... (143,376) (11,321) (13,802)
Gain on derivatives......................................... 125,586 3,846 24
Gain on sales of mortgage servicing assets.................. 14,842 8,394 27,528
Other income................................................ 6,727 5,016 4,538
--------- -------- --------
Total net revenue........................................... $ 270,806 $229,461 $140,932
========= ======== ========
Net interest income is generated from the interest earned on mortgage loans
before they are sold to investors, less the interest expense incurred on
borrowings to fund the loans. Net interest income for the year 2002 totaled
$41.5 million, compared to $30.3 million in 2001, and $15.4 million in 2000. The
increases in net interest income in 2002 and 2001 are a result of increased
production related to the declining interest rate environment as well as an
increase in spread between short-term warehouse interest rates we pay and
longer-term interest rates paid to us by our borrowers while the mortgage loans
are on our balance sheet. We anticipate that the relative contribution of net
interest income to total revenues will increase as a result of the development
of our correspondent channel where the bulk of net revenues come from the
warehousing process and where production fees are of lesser importance to
profitability as compared to the retail and wholesale channels.
Loan origination fees are recognized when loans are sold. Origination fees
for the year ended December 31, 2002 totaled $75.0 million, compared to $61.9
million for 2001, and $34.7 million in 2000, an increase of 21.1% and 116.1%,
respectively. These increases are a result of higher secondary market deliveries
during these periods. As mentioned earlier, the percentage increase in loan
origination fees is not necessarily proportionate to loan origination growth due
to product mix and the high percentage of refinances that have occurred in 2001
and 2002.
Gain on sale of loans includes the valuation of newly created mortgage
servicing rights and is recognized when loans are pooled and sold into the
secondary mortgage market. Gain on sale of loans for the year ended 2002 totaled
$147.6 million, compared to $113.1 million in 2001, an increase of 30.5%. Gain
on sale of loans for the year ended December 31, 2000 totaled $45.6 million. The
increases in 2001 and 2002 are a result of increased originations and secondary
market activity during these years.
Servicing fee income is recognized by collecting fees, which normally range
between 25 and 44 basis points annually on the principal amount of the
underlying mortgages. Servicing fee income totaled $58.3 million for the year of
2002, an increase of 10.4% from 2001 and an increase of 15.9% from 2000,
primarily reflecting the growth in the servicing portfolio over the last two
years.
Amortization expense relates to mortgage servicing rights and is based on
the estimated lives of the underlying loans. Amortization expense totaled $55.1
million for the year ended December 31, 2002, compared to $34.7 million during
2001 and $23.7 million during 2000. This increase in 2002 and 2001 relates
39
to the increase in the underlying servicing portfolio and to the shortening of
estimated lives due to decrease in interest rates.
Impairment expense is recorded when the book value of the mortgage
servicing rights exceeds the fair market value on a strata by strata basis.
Impairment expense totaled $143.4 million during 2002, compared to $11.3 million
during 2001 and $13.8 million in 2000. The significant increase in impairment
expense in 2002 was a result of higher prepayment trends from declining interest
rates throughout the year. The impairment expense recorded in 2002 was largely
offset by derivative gains of $125.6 million during the same period. Derivative
gains of $3.8 million were recorded during 2001. At December 31, 2002, the
mortgage line of business held $8.0 billion notional amount of Eurodollar future
contracts and $2.0 billion notional amount in interest rate swaptions to manage
the risk of our servicing assets. The current risk management activities of the
mortgage bank related to servicing assets do not satisfy the criteria for "hedge
accounting" under SFAS 133. As a result, these derivatives are accounted for as
other assets, and changes in fair value are adjusted through earnings as
derivative gains, while the underlying servicing asset is accounted for on a
strata-by-strata basis at the lower of cost or market.
Our mortgage banking business maintains the flexibility either to sell
servicing for current cash flow through bulk sale or to retain servicing for
future cash flow through the retention of ongoing servicing fees. Total
servicing sales represented 31.1% of loan originations in 2002, compared to
29.9% in 2001, and 108.0% in 2000. The decision to sell or retain servicing is
based on current market conditions for servicing assets, loan origination levels
and production expenses, and the general level of risk tolerance of the mortgage
banking line of business and the Corporation. We sold $2.9 billion of servicing
in 2002, generating a $14.8 million pre-tax gain. This compares to servicing
sales of $2.3 billion in 2001, producing an $8.4 million pre-tax gain. In 2000,
servicing sales totaled $4.1 billion producing a $27.5 million pre-tax gain.
Operating Expenses
The following table sets forth operating expenses for our mortgage banking
line of business for the periods indicated:
YEAR ENDED DECEMBER 31,
------------------------------
2002 2001 2000
-------- -------- --------
(DOLLARS IN THOUSANDS)
Salaries and employee benefits.............................. $ 62,010 $ 52,266 $ 45,550
Incentive and commission pay................................ 69,836 58,673 27,729
Other expenses.............................................. 65,869 56,685 46,108
-------- -------- --------
Total operating expenses.................................... $197,715 $167,624 $119,387
======== ======== ========
Number of employees(1)...................................... 1,858 1,533 1,297
---------------
(1) On a full time equivalent basis.
Operating expenses for the year ended December 31, 2002 totaled $197.7
million, an 18.0% increase over the year 2001, and a 65.6% increase over 2000.
Salaries and employee benefits including incentive and commission pay increased
18.8% in 2002 over 2001 and 79.9% over 2000. These fluctuations reflect the
decreased production activities throughout 2000, followed by a significant
increase in production activities in 2001 and 2002.
40
Mortgage Servicing
The following table shows information about our managed mortgage servicing
portfolio, including mortgage loans held for sale, for the periods indicated:
YEAR ENDED DECEMBER 31,
------------------------------
2002 2001 2000
-------- -------- --------
(PORTFOLIO IN BILLIONS)
Beginning servicing portfolio............................... $ 12.9 $ 9.2 $ 10.5
Mortgage loan closings.................................... 10.8 8.8 3.7
Sales of servicing rights................................. (2.9) (2.3) (4.1)
Run-off(1)................................................ (4.0) (2.8) (0.9)
-------- -------- --------
Ending servicing portfolio.................................. $ 16.8 $ 12.9 $ 9.2
======== ======== ========
Number of loans (end of period)............................. 137,738 123,291 103,069
Average loan size........................................... $121,917 $104,432 $ 89,200
Percent GNMA and state housing programs..................... 37% 60% 75%
Percent conventional and other.............................. 55 33 21
Percent warehouse........................................... 8 7 4
Delinquency ratio........................................... 5.3 7.8 9.6
Mortgage servicing assets to related servicing
portfolio(2).............................................. 0.9 1.8 1.7
---------------
(1) Run-off is the reduction in principal balance of the servicing portfolio due
to regular principal payments made by mortgagees and early repayments of
entire loans.
(2) Excludes loans held for sale (warehouse) and any deferred service release
premium on warehouse as well as pre-1995 servicing rights and related
servicing portfolio.
Our mortgage servicing portfolio, including mortgage loans held for sale,
totaled $16.8 billion at December 31, 2002, a 30.4% increase from the December
31, 2001 balance of $12.9 billion, and up 82.6% from the same date in 2000.
These increases in 2001 and 2002 reflect the strong mortgage production we have
experienced along with greater retention of servicing on loans sold over the
past year. We believe that the relative growth of the conventional portion of
the portfolio is the result of heavy refinance activity in 2001 and 2002 where
conventional loans made up a higher than normal portion of our originations. We
believe that over time our production strategy would favor a servicing portfolio
with a heavier weighting in GNMA and state housing programs than we had at the
end of 2002.
We record originated mortgage servicing assets at allocated cost basis when
the loans are sold and purchased servicing assets at fair value. Thereafter
servicing rights are accounted for at the lower of their cost or fair value. We
record a valuation allowance for any impairment on a strata-by-strata basis. We
determine fair value on a monthly basis based on a discounted cash flow
analysis. These cash flows are projected over the life of the servicing using
prepayment, default, discount rate and cost to service assumptions that we
believe market participants would use to value similar assets. We also
periodically have independent valuations performed on the portfolio. We last had
the portfolio valued in such an independent process as of December 31, 2002. At
December 31, 2002, we estimated the fair value of these assets to be $150.8
million in the aggregate, or $4.4 million greater than the carrying value on the
balance sheet. At December 31, 2001, we estimated the fair value of these assets
to be $239.7 million in the aggregate, or $28.5 million greater than the
carrying value on the balance sheet. Fair value declined relative to carrying
value as a result of the higher prepayment trends from declining interest rates
and erosion of cushion in a number of valuation strata.
41
COMMERCIAL BANKING
The following table shows selected financial information for our commercial
banking line of business:
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- -------- --------
(DOLLARS IN THOUSANDS)
SELECTED INCOME STATEMENT DATA:
Interest income..................... $ 110,107 $ 104,514 $ 82,680 $ 54,452 $ 46,056
Interest expense.................... 40,253 53,515 44,268 23,525 20,957
---------- ---------- ---------- -------- --------
Net interest income................. 69,854 50,999 38,412 30,927 25,099
Provision for loan and lease
losses............................ 9,812 7,900 2,933 1,813 1,820
Noninterest income.................. 16,081 14,981 12,006 11,797 11,712
Operating expense................... 50,029 43,482 35,805 29,080 24,515
---------- ---------- ---------- -------- --------
Income before taxes................. 26,094 14,598 11,680 11,831 10,476
Income taxes........................ 10,009 5,680 4,590 4,486 3,967
---------- ---------- ---------- -------- --------
Net income.......................... $ 16,085 $ 8,918 $ 7,090 $ 7,345 $ 6,509
========== ========== ========== ======== ========
SELECTED BALANCE SHEET DATA AT END
OF PERIOD:
Total assets........................ $1,969,956 $1,648,294 $1,167,559 $789,560 $607,992
Loans............................... 1,823,304 1,514,957 1,067,980 720,493 514,950
Allowance for loan and lease
losses............................ 20,725 14,644 9,228 7,375 6,680
Deposits............................ 1,733,864 1,456,376 998,855 710,899 567,526
Shareholders' equity................ 154,423 129,179 68,539 63,678 46,990
DAILY AVERAGES:
Assets.............................. $1,802,896 $1,402,589 $ 956,744 $682,632 $567,116
Loans............................... 1,693,426 1,276,003 879,875 600,877 462,319
Allowance for loan and lease
losses............................ 17,823 11,038 8,133 7,317 6,308
Deposits............................ 1,583,926 1,253,725 851,386 619,308 514,694
Shareholders' equity................ 140,249 85,312 57,214 52,867 42,026
Shareholders' equity to assets...... 7.78% 6.08% 5.98% 7.74% 7.41%
OVERVIEW
Our commercial banking line of business focuses on providing credit, cash
management and personal banking products to small businesses and business
owners. We offer commercial banking services through our banking subsidiaries,
Irwin Union Bank and Trust, an Indiana state-chartered commercial bank, and
Irwin Union Bank, F.S.B., a federal savings bank.
STRATEGY
Our strategy is to expand our commercial banking line of business into
selected new markets. We target metropolitan markets with strong economies where
we believe recent bank consolidation has negatively impacted customers. We
believe this consolidation has led to disenchantment with the delivery of
financial services to the small business community among both the owners of
those small businesses and the senior banking officers who had been providing
services to them. In markets that management identifies as attractive
opportunities, the bank seeks to hire senior commercial loan officers and cash
management personnel who have strong local ties and who can focus on providing
personalized services to small businesses in that market. We currently have no
specific near-term expansion plans, but our strategy is to expand only in
markets that satisfy the following criteria:
- the market is a metropolitan area with attractive business demographics
displaying evidence of sustainable growth;
42
- recent banking merger and acquisition activity has occurred in the market
where management believes that the acquiror is viewed by customers as an
outsider and/or not responsive to local small business needs; and
- we are able to attract experienced, senior banking staff to manage the
new market.
We expect consolidation to continue in the banking and financial services
industry and plan to capitalize on the opportunities brought about in this
environment by continuing the bank's growth strategy for small business banking
in new markets throughout the United States. Our focus will be to provide
personalized banking services to small businesses, using experienced staff with
a strong presence in cities affected by the industry-wide consolidations. In
addition to its market expansion, our commercial bank continues to develop its
banking, insurance, and investment products to provide a full range of financial
services to its small business customers.
On average, we anticipate our new banking offices will break even
approximately 18 months after they are opened, and we estimate that a banking
office will achieve targeted levels of profitability in approximately five
years, in an average market. Some markets will experience growth and
profitability at greater or lesser rates than we currently expect because of
many factors, including execution of our strategy, accuracy in assessing market
potential, and success in recruiting senior lenders and other staff. Over time,
we may choose to leave certain markets if these factors limit profitability. Our
expansion into new markets is subject to regulatory approval.
The following tables show the geographic composition of our commercial
banking loans and our core deposits:
DECEMBER 31,
------------------------------------------------------------------------
2002 2001 2000
---------------------- ---------------------- ----------------------
LOANS PERCENT LOANS PERCENT LOANS PERCENT
OUTSTANDING OF TOTAL OUTSTANDING OF TOTAL OUTSTANDING OF TOTAL
----------- -------- ----------- -------- ----------- --------
(DOLLARS IN THOUSANDS)
Southern Indiana............... $ 553,592 30.4% $ 566,601 37.4% $ 519,863 48.7%
Indianapolis MSA............... 267,508 14.7 232,576 15.4 263,047 24.6
Markets entered since
1999(1)...................... 1,002,204 54.9 715,780 47.2 285,070 26.7
---------- ----- ---------- ----- ---------- -----
Total........................ $1,823,304 100.0% $1,514,957 100.0% $1,067,980 100.0%
========== ===== ========== ===== ========== =====
CORE PERCENT CORE PERCENT CORE PERCENT
DEPOSITS OF TOTAL DEPOSITS OF TOTAL DEPOSITS OF TOTAL
---------- -------- ---------- -------- -------- --------
Southern Indiana................ $ 918,528 60.5% $ 795,117 70.0% $575,317 83.6%
Indianapolis MSA................ 140,712 9.3 67,003 5.9 61,401 8.9
Markets entered since 1999(1)... 457,572 30.2 273,750 24.1 51,392 7.5
---------- ----- ---------- ----- -------- -----
Total......................... $1,516,812 100.0% $1,135,870 100.0% $688,110 100.0%
========== ===== ========== ===== ======== =====
---------------
(1) Includes offices in Kalamazoo, Grandville, Traverse City and Lansing,
Michigan; Brentwood, Missouri; Louisville, Kentucky; Salt Lake City, Utah;
Las Vegas, Nevada; and Phoenix, Arizona.
Net Income
Commercial banking net income increased to $16.1 million during 2002,
compared to $8.9 million in 2001, and 2000 net income of $7.1 million. Results
in 2002 reflect growth of $18.9 million in net interest income over 2001. Net
interest income in 2001 increased 32.8% over 2000.
43
Net Interest Income
The following table shows information about net interest income for our
commercial banking line of business:
YEAR ENDED DECEMBER 31,
----------------------------------
2002 2001 2000
---------- ---------- --------
Net interest income on a taxable equivalent basis(1)...... $ 70,059 $ 51,224 $ 38,620
Average interest earning assets........................... 1,745,816 1,347,327 908,739
Net interest margin....................................... 4.01% 3.80% 4.25%
---------------
(1) Reflects what net interest income would be if all interest income were
subject to federal and state income taxes.
Net interest income on a taxable equivalent basis was $70.1 million, an
increase of 36.8% over 2001, and an increase of 81.4% from 2000. The 2002 and
2001 improvement in net interest income resulted from an increase in our
commercial banking loan portfolio as a result of growth and expansion efforts.
Net interest margin is computed by dividing net interest income by average
interest earning assets. Net interest margin during 2002 was 4.01%, compared to
3.80% in 2001, and 4.25% in 2000. The improved margin in 2002 reflects reduced
reliance on higher-rate wholesale funding sources. The line of business
increased its core deposits to $1.5 billion, an annual increase of 33.5%,
reflecting success in deposit gathering initiatives. The reduction in net
interest margin in 2001 was due primarily to the fact that the commercial bank
was negatively impacted by repricing a significant portion of its commercial
loan portfolio, which is tied to the prime rate, in advance of corresponding
declines in its funding base, which is more closely tied to London InterBank
Offering Rate, or LIBOR, and similar market driven rate indices.
Noninterest Income
The following table shows the components of noninterest income for our
commercial banking line of business:
YEAR ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- ------- -------
(DOLLARS IN THOUSANDS)
Trust fees.................................................. $ 1,933 $ 2,212 $ 2,285
Service charges on deposit accounts......................... 4,775 3,565 2,156
Insurance commissions, fees and premiums.................... 1,705 1,776 1,877
Gain from sales of loans.................................... 5,167 2,728 589
Loan servicing fees......................................... 945 708 707
Amortization and impairment of servicing assets............. (3,183) (936) (456)
Brokerage fees.............................................. 1,236 1,554 1,991
Other....................................................... 3,503 3,374 2,857
------- ------- -------
Total noninterest income.................................... $16,081 $14,981 $12,006
======= ======= =======
Total noninterest income to total net revenues.............. 21.1% 25.8% 25.3%
Noninterest income during 2002 increased 7.3% over 2001 and 33.9% over
2000. This increase was due primarily to higher gains from sales of loans
related to increased mortgage production and increased fee income on deposit
accounts related to new fee structures put into place in mid-2001. These
increases were partially offset by increased impairment charges recorded against
mortgage servicing assets in this line of business. The commercial banking line
of business has a first mortgage servicing portfolio that has increased to
$355.3 million, principally a result of mortgage loan production in its
south-central Indiana markets. Those servicing rights are carried on the balance
sheet at the lower of cost or market, estimated at December 31, 2002, to be $2.1
million.
44
Operating Expenses
The following table shows the components of operating expenses for our
commercial banking line of business:
YEAR ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- ------- -------
(DOLLARS IN THOUSANDS)
Salaries and employee benefits.............................. $29,896 $25,411 $21,507
Other expenses.............................................. 20,133 18,071 14,298
------- ------- -------
Total operating expenses.................................... $50,029 $43,482 $35,805
======= ======= =======
Number of employees at period end(1)........................ 454 470 432
---------------
(1) On a full time equivalent basis.
Operating expenses during 2002 totaled $50.0 million, an increase of 15.1%
over 2001, and an increase of 39.7% from 2000. Net revenues increased 31.1% in
2002 compared to 2001, indicative of improved operating efficiency.
Balance Sheet
Total assets for the year ended December 31, 2002 averaged $1.8 billion
compared to $1.4 billion in 2001, and $1.0 billion in 2000. Average earning
assets for the year ended December 31, 2002 were $1.7 billion compared to $1.3
billion in 2001, and $0.9 billion in 2000. The most significant component of the
increase in 2002 and 2001 was an increase in commercial loans as a result of the
commercial bank's continued growth and expansion efforts into new markets.
Average core deposits for the year totaled $1.5 billion, an increase of 42.7%
over average core deposits in 2001 of $1.0 billion, and an increase of 133.3%
from 2000.
Credit Quality
Nonperforming loans, the allowance for loan losses and provision for loan
losses have increased in 2002 over 2001 reflecting general economic conditions,
portfolio growth and increased charge-offs. The recessionary economic conditions
were exacerbated by the events of September 11th, 2001 which negatively impacted
consumer confidence and deferred recovery from weakened business conditions.
Nonperforming loans are not significantly concentrated in any industry category.
The following table shows information about our nonperforming assets in this
line of business and our allowance for loan losses:
DECEMBER 31,
--------------------------
2002 2001 2000
------- ------- ------
(DOLLARS IN THOUSANDS)
Nonperforming loans......................................... $14,970 $ 7,077 $2,469
Other real estate owned..................................... 96 100 230
------- ------- ------
Total nonperforming assets.................................. $15,066 $ 7,177 $2,699
======= ======= ======
Nonperforming assets to total assets........................ 0.76% 0.44% 0.23%
Allowance for loan losses................................... $20,725 $14,644 $9,228
Allowance for loan losses to total loans.................... 1.14% 0.97% 0.86%
FOR THE PERIOD ENDED:
Provision for loan losses................................... $ 9,812 $ 7,900 $2,933
Net charge-offs............................................. $ 3,731 $ 2,484 $1,080
Net charge-offs to average loans............................ 0.22% 0.19% 0.12%
45
HOME EQUITY LENDING
The following table shows selected financial information for the home
equity lending line of business:
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- -------- --------
(DOLLARS IN THOUSANDS)
SELECTED INCOME STATEMENT DATA:
Net interest income................. $ 94,068 $ 61,803 $ 35,864 $ 18,852 $ 5,495
Provision for loan losses........... (25,596) (2,320) (461) -- (513)
Gain on sales of loans.............. 28,942 91,406 46,970 23,725 18,610
Loan servicing fees................. 13,528 13,355 7,559 4,907 3,323
Amortization and impairment of
servicing assets.................. (6,905) (3,217) (1,583) (1,445) (842)
Trading (losses) gains.............. (26,032) (38,407) 14,399 2,512 (2,952)
Other income........................ 2,258 1,649 699 2,015 820
---------- ---------- ---------- -------- --------
Total net revenues............. 80,263 124,269 103,447 50,566 23,941
Operating expenses.................. 78,588 97,189 72,623 35,557 30,609
---------- ---------- ---------- -------- --------
Income before taxes................. 1,675 27,080 30,824 15,009 (6,668)
Income taxes...................... 670 10,832 12,330 2,403 --
---------- ---------- ---------- -------- --------
Net income (loss)................... $ 1,005 $ 16,248 $ 18,494 $ 12,606 $ (6,668)
========== ========== ========== ======== ========
SELECTED BALANCE SHEET DATA:
Total assets........................ $ 939,494 $ 602,226 $ 550,526 $339,640 $311,974
Home equity loans, net of allowance
for loan losses................... 604,666(1) 343,972 4,010 1,904 7,832
Home equity loans held for sale..... 75,540 -- 330,208 231,382 242,702
Residual assets -- trading.......... 157,065(2) 199,071 152,614 57,833 32,321
Short-term debt..................... 201,328 138,527 163,732 260,184 226,998
Collateralized borrowings........... 391,425 -- -- -- --
Shareholders' equity................ 155,831 135,493 99,586 58,733 40,272
SELECTED OPERATING DATA:
Loan volume:
Lines of credit................... 443,323 317,579 629,906 93,185 98,855
Loans............................. 623,903 831,830 596,049 346,322 290,818
Total managed portfolio balance at
end of period..................... 1,830,339 2,064,542 1,625,719 777,934 581,241
Delinquency ratio................... 6.0% 5.1% 4.4% 2.1% 1.3%
Total managed portfolio including
credit risk sold balance at end of
period............................ $2,502,685 $2,317,975 $1,825,527 $842,403 $581,241
Weighted average coupon rate:
Lines of credit................... 10.79% 11.11% 14.04% 12.72% 11.89%
Loans............................. 13.50 13.38 13.09 12.33 11.86
Gain on sale of loans to loans
sold.............................. 4.70 8.47 6.06 5.57 6.32
Net home equity charge-offs to
average managed portfolio......... 2.91 1.82 0.57 0.36 0.37
46
---------------
(1) Includes $392.4 million of collateralized loans at December 31, 2002, as
part of securitized financings.
(2) Includes $82.5 million of residual assets at December 31, 2002 that would be
considered credit-enhancing interest-only strips (CEIOS) under new federal
banking regulations.
Overview
Our home equity lending line of business originates, purchases,
securitizes, sells and services a variety of home equity lines of credit and
fixed-rate home equity loan products nationwide. We market our home equity
products through a combination of direct mail, Internet, and wholesale channels.
We target creditworthy, homeowners who are active credit users. Customers are
underwritten using proprietary models based on several criteria, including the
customers' previous use of credit. Generally we either sell the loans through
whole loan sales or we securitize them as financings. We normally retain the
servicing rights for the loans we sell. To address the new capital rules
discussed later in this section, in 2002 we began using securitizations
accounted for as on-balance sheet financing and whole loan sales, while
eliminating our use of securitization structures requiring gain-on-sale
accounting and the creation of residual interests.
We offer home equity loans with combined loan-to-value (CLTV) ratios of up
to 125% of their collateral value. Home equity loans are priced taking into
account, among other factors, the relative loan-to-value (LTV) ratio of the loan
at origination. For example, everything being equal, those loans with
loan-to-value ratios greater than 100% (high LTV or HLTVs) are priced with
higher coupons than home equity loans with loan-to-value ratios less than 100%
to compensate for increased loss through default. For the year ended December
31, 2002, HLTV home equity loans made up 60.1% of our loan originations and
62.4% of our managed portfolio. In an effort to reduce portfolio concentration
risk and to comply with existing banking regulations, we have in place policies
governing the size of our investment in loans secured by real estate where the
LTV is greater than 90%.
For most of our home equity product offerings, we offer customers the
choice to accept an early repayment fee in exchange for a lower interest rate. A
typical early repayment option provides for a fee equal to up to six months'
interest that is payable if the borrower chooses to repay the loan during the
first three to five years of its term. Approximately 79.1%, or $1.4 billion, of
our home equity managed portfolio at December 31, 2002 has early repayment
provisions.
Strategy
Beginning in 2002, as part of our strategic response to changes in capital
regulations regarding residuals, our home equity lending line of business ceased
using securitization structures for loans that involve gain-on-sale accounting
treatment and create residuals under SFAS 140. Subsequent securitizations have
used financing treatment structures. We also developed whole loan sale
opportunities for our products.
In response to economic weakness and rising consumer delinquencies and
defaults, we began implementing a new strategy in late 2002 by changing our loan
origination focus toward identifying customers whose credit history would
suggest lower risk of default on loans we extend. While these customers likely
will require more competitively priced loans, we believe our loss rates on new
production will decline and our overall risk-adjusted profitability will
improve.
We believe that our decisions to move away from securitization gain-on-sale
accounting, expand whole loan sale opportunities, and to transform the higher
risk, more volatile segments of our business into lower risk, sounder segments
will result in a more stable and robust business with increased growth
opportunities.
Portfolio Mix
Our home equity lending line of business blends aspects of the credit card
and mortgage banking industries. The home equity products are designed to appeal
to homeowners who have high levels of unsecured (credit card) debt, who through
the use of a debt consolidating mortgage loan can meaningfully reduce their
after-tax monthly cash outflows. We underwrite our loans as if the credit is
unsecured, but we believe that the
47
mortgage lien associated with the loan has a meaningful, positive influence on
the payment priority of our customers. We lend nationally in our home equity
lending line of business. The following table shows the geographic composition
of our home equity lending managed portfolio on a percentage basis as of
December 31, 2002 and December 31, 2001:
DECEMBER 31, DECEMBER 31,
STATE 2002 2001
----- ------------ ------------
California.................................................. 20.1% 22.9%
Florida..................................................... 7.4 7.2
Virginia.................................................... 5.5 5.8
Ohio........................................................ 5.3 5.1
Maryland.................................................... 5.2 4.4
All other states............................................ 56.5 54.6
---------- ----------
Total..................................................... 100.0% 100.0%
========== ==========
Total managed (in thousands)................................ $1,830,339 $2,064,542
The following table provides a breakdown of our home equity lending managed
portfolio by product type, outstanding principal balance and weighted average
coupon as of December 31, 2002:
WEIGHTED
AVERAGE
AMOUNT % OF TOTAL COUPON
---------- ---------- --------
(IN THOUSANDS)
Home equity loans < = 100% CLTV............................. $ 247,302 13.51% 11.63%
Home equity lines of credit < = 100% CLTV................... 398,106 21.75 9.61
---------- ----- -----
Total < = 100% CLTV......................................... 645,408 35.26 10.38
Home equity loans > 100% CLTV............................... 704,514 38.49 14.63
Home equity lines of credit > 100% CLTV..................... 387,010 21.14 12.32
---------- ----- -----
Total > 100% CLTV........................................... 1,091,524 59.63 13.81
First mortgages............................................. 42,045 2.30 8.31
Other (immediate credit).................................... 51,362 2.81 13.92
---------- ----- -----
Total..................................................... $1,830,339 100% 12.48%
========== ===== =====
Securitizations
Under our past securitization program, home equity loans were sold to
limited purpose, bankruptcy-remote fully owned subsidiaries. In turn, these
subsidiaries established separate trusts to which they transferred the home
equity loans in exchange for the proceeds from the sale of asset-backed
securities issued by the trust. The trusts' activities are generally limited to
acquiring the home equity loans, issuing asset-backed securities and making
payments on the securities. Due to the nature of the assets held by the trusts
and the limited nature of each trust's activities, they are classified as QSPEs
under SFAS No. 140. "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities."
These securitization structures we used prior to 2002 involved "sales" of
the loans, transferring them off of our balance sheet, and have been accounted
for using gain-on-sale treatment in accordance with SFAS 140 or its predecessor
SFAS 125. Although we recognized gains on the sale of loans in the period in
which such loans were sold, we expect to receive cash (representing the excess
spread, overcollateralization if applicable, and servicing fees) over the lives
of the loans. Concurrent with recognizing such gains on sale, we recorded the
future expected receipt of discounted cash flow as a residual interest, which is
currently indicated on our consolidated balance sheet as part of "trading
assets." We recognized gains on the sale of loans in an amount equal to the
difference between proceeds and allocated cost basis of the loans sold. Residual
interests are recorded at fair value with the subsequent changes in fair value
recorded as unrealized gain or loss in our results of operations in the period
of the change. We determine fair value on a monthly basis based on a
48
discounted cash flow analysis. These cash flows are projected over the lives of
the residuals using prepayment, default, and discount rate assumptions that we
believe market participants would use for similar financial instruments.
Based on changes to our funding practices to adjust to new regulatory
capital rules discussed later in this section, we began using securitization
structures that are not accounted for using gain-on-sale treatment under
generally accepted accounting principles, but rather as secured borrowings. For
these assets funded on-balance sheet, we are now recording interest income over
the life of the loan as it is earned, net of interest expense over the life of
the bonds and a provision for credit losses inherent in the portfolio. We do not
expect this different accounting treatment to affect cash flows related to the
loans, nor do we expect that the ultimate total receipt of revenues and
profitability derived from our home equity loans will change materially by these
different financing structures.
49
SECURITIZATION TRANSACTIONS AND ASSUMPTIONS
The table below details information with respect to pool sizes and age for
the portfolio we have securitized, including product for which we no longer
retain credit risk.
ORIGINAL AGE OF
BALANCE CURRENT MONTH DEAL
SOLD BALANCE CLOSED (MONTHS)
---------- ---------- ------ --------
(IN THOUSANDS)
CORE HELOCS (< = 100% CLTV)
1995-2 HELOCs...................... $ 51,584 $ -- Nov-95 NA
1996-1 HELOCs...................... 75,999 -- Oct-96 NA
1997-1 HELOCs...................... 54,997 -- Jun-97 NA
1997-2 HELOCs...................... 69,998 6,514 Nov-97 62
1998-1 HELOCs...................... 122,591 21,194 Jun-98 55
2000-1 HELOCs...................... 66,803 23,132 Sep-00 28
2001-1 HELOCs...................... 27,719 14,260 Mar-01 22
2001-2 HELOCs...................... 64,018 39,721 Sep-01 16
2002-1 HELOCs...................... 127,110 106,297 Jun-02 7
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $ 660,819 $ 211,118 32
========== ========== ==
CORE HELS (< = 100% CLTV)
1996-1 HELs........................ $ 63,997 $ -- Oct-96 NA
1997-1 HELs........................ 44,999 -- Jun-97 NA
1997-2 HELs........................ 60,000 -- Nov-97 NA
1998-1 HELs........................ 71,490 6,901 Jun-98 55
1999-1 HELs........................ 89,999 12,512 Feb-99 47
1999-2 HELs........................ 45,000 8,409 May-99 44
1999-3 HELs........................ 107,657 24,998 Nov-99 38
2000-1 HELs........................ 123,971 39,537 Sep-00 28
2001-1 HELs........................ 124,951 46,633 Mar-01 22
2001-2 HELs........................ 227,760 138,291 Sep-01 16
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $ 959,824 $ 277,281 28
========== ========== ==
FIRST MORTGAGES (< = 100% CLTV)
1998-1 First....................... $ 7,495 $ 1,682 Jun-98 55
1999-1 First....................... 60,001 20,615 Feb-99 47
1999-2 First....................... 15,021 5,715 May-99 44
1999-3 First....................... 25,246 12,446 Nov-99 38
2001-1 First....................... 4,058 2,242 Mar-01 22
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $ 111,821 $ 42,700 44
========== ========== ==
125 HELOCS
1998-1 HELOC125s................... $ 7,420 $ 1,677 Jun-98 55
1999-3 HELOC125s................... 38,320 17,084 Nov-99 38
2000-LB1 HELOC125s................. 29,919 16,412 Jun-00 31
2001-1 HELOC 125s.................. 30,812 19,624 Mar-01 22
2001-2 HELOC 125s.................. 70,295 54,992 Sep-01 16
2002-1 HELOC 125s.................. 161,031 148,467 Jun-02 7
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $ 337,797 $ 258,256 17
========== ========== ==
125 HELS
1999-2 HEL125s..................... $ 119,978 $ 36,337 May-99 44
1999-3 HEL125s..................... 70,658 25,639 Nov-99 38
2000-A1 HEL125s.................... 123,698 47,362 Jun-00 31
2000-1 HEL125s..................... 166,330 80,486 Sep-00 28
2001-1 HEL125s..................... 219,765 126,113 Mar-01 22
2001-2 HEL125s..................... 313,368 239,485 Sep-01 16
2002-1 HEL125s..................... 150,976 139,012 Jun-02 7
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $1,164,773 $ 694,434 23
========== ========== ==
PNB 99-1 HELOCS (< = 100% CLTV)
ACQUIRED OCTOBER 2000
PNB 1999-1 HELOC................... $ 500,000 $ 115,143 May-99 44
========== ========== ==
IMMEDIATE CREDIT (Program
discontinued)
1999-3 HEL ImmedCredit............. $ 524 $ 121 Nov-99 38
1999-3 HELOC ImmedCredit........... 13,903 3,596 Nov-99 38
2000-LB1 HELOC ImmedCredit......... 69,267 25,987 Jun-00 31
---------- ---------- --
TOTAL/WEIGHTED AVERAGE............. $ 83,694 $ 29,704 32
========== ========== ==
GRAND TOTAL/WEIGHTED AVERAGE....... $3,818,728 $1,628,636 30
========== ========== ==
PROJECTED PROJECTED PROJECTED
ACTUAL ACTUAL CUMULATIVE LIFETIME REMAINING WEIGHTED
ANNUALIZED CUMULATIVE LOSSES TO CUMULATIVE CUMULATIVE AVERAGE
LOSS RATE LOSSES AS DATE AS A LOSSES AS LOSSES AS FUTURE
AS A % OF A % OF % OF A % OF A % OF PREPAYMENT WEIGHTED
ORIGINAL ORIGINAL ORIGINAL ORIGINAL ORIGINAL SPEED AVERAGE
BALANCE BALANCE BALANCE(1) BALANCE(2) BALANCE(3) ASSUMPTION COUPON
---------- ---------- ---------- ---------- ---------- ---------- --------
CORE HELOCS (< = 100% CLTV)
1995-2 HELOCs...................... 0.41% 2.30% 1.35% 1.35% 0.00% NA NA
1996-1 HELOCs...................... 0.26 1.36 1.36 1.36 0.00 NA NA
1997-1 HELOCs...................... 0.26 1.34 1.30 1.30 0.00 NA NA
1997-2 HELOCs...................... 0.26 1.36 1.44 1.44 0.00 36% 11.29%
1998-1 HELOCs...................... 0.35 1.62 1.55 1.91 0.35 41 9.57
2000-1 HELOCs...................... 0.72 1.68 1.43 2.46 1.03 43 9.81
2001-1 HELOCs...................... 0.73 1.35 0.85 2.82 1.97 37 9.51
2001-2 HELOCs...................... 0.31 0.41 1.04 3.34 2.30 35 9.24
2002-1 HELOCs...................... 0.06 0.03 0.16 4.99 4.83 24 8.77
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 0.32% 1.17% 1.12% 2.53% 1.94% 31% 9.18%
==== ===== ===== ===== ===== == =====
CORE HELS (< = 100% CLTV)
1996-1 HELs........................ 0.14% 0.69% 1.29% 1.29% 0.00% NA NA
1997-1 HELs........................ 0.20 0.93 1.27 1.27 0.00 NA NA
1997-2 HELs........................ 0.24 1.20 1.26 1.26 0.00 NA NA
1998-1 HELs........................ 0.17 0.79 1.27 1.38 0.11 52% 12.54%
1999-1 HELs........................ 0.29 1.12 1.39 1.59 0.20 45 11.79
1999-2 HELs........................ 0.61 2.22 1.52 1.95 0.44 46 11.41
1999-3 HELs........................ 0.61 1.93 1.50 2.05 0.55 46 12.56
2000-1 HELs........................ 0.61 1.43 1.24 2.13 0.89 48 12.61
2001-1 HELs........................ 0.55 1.02 0.94 1.92 0.98 50 12.42
2001-2 HELs........................ 0.30 0.41 0.40 2.12 1.72 43 11.27
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 0.39% 1.06% 1.06% 1.83% 0.92% 46% 11.83%
==== ===== ===== ===== ===== == =====
FIRST MORTGAGES (< = 100% CLTV)
1998-1 First....................... 0.00% 0.00% 0.81% 0.98% 0.17% 35% 8.92%
1999-1 First....................... 0.09 0.35 0.85 1.04 0.19 40 8.55
1999-2 First....................... 0.29 1.05 0.69 0.95 0.26 30 8.54
1999-3 First....................... 0.51 1.63 0.63 0.97 0.34 31 9.18
2001-1 First....................... 0.00 0.00 0.32 0.51 0.19 50 9.32
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 0.20% 0.70% 0.76% 0.99% 0.23% 36% 8.78%
==== ===== ===== ===== ===== == =====
125 HELOCS
1998-1 HELOC125s................... 1.41% 6.47% 6.80% 9.73% 2.93% 20% 12.29%
1999-3 HELOC125s................... 2.79 8.83 6.63 11.79 5.16 23 11.94
2000-LB1 HELOC125s................. 2.88 7.43 6.02 12.88 6.86 23 12.79
2001-1 HELOC 125s.................. 3.68 6.74 3.36 11.29 7.93 26 13.35
2001-2 HELOC 125s.................. 1.57 2.09 1.97 14.35 12.37 21 11.66
2002-1 HELOC 125s.................. 0.06 0.03 0.34 12.09 11.76 24 12.00
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 1.29% 2.87% 2.31% 12.47% 10.16% 23% 12.08%
==== ===== ===== ===== ===== == =====
125 HELS
1999-2 HEL125s..................... 2.03% 7.44% 6.17% 8.15% 1.97% 37% 13.74%
1999-3 HEL125s..................... 2.40 7.59 6.08 8.76 2.68 34 15.00
2000-A1 HEL125s.................... 1.45 3.74 4.08 5.76 1.69 37 13.70
2000-1 HEL125s..................... 2.58 6.02 5.17 9.34 4.17 35 15.27
2001-1 HEL125s..................... 2.36 4.33 4.43 9.82 5.39 31 15.03
2001-2 HEL125s..................... 1.40 1.86 1.44 11.26 9.82 23 14.98
2002-1 HEL125s..................... 0.70 0.41 0.26 13.54 13.29 16 14.46
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 1.79% 3.85% 3.43% 9.96% 6.52% 27% 14.77%
==== ===== ===== ===== ===== == =====
PNB 99-1 HELOCS (< = 100% CLTV)
ACQUIRED OCTOBER 2000
PNB 1999-1 HELOC................... 0.90% 3.31% 3.71% 4.47% 0.76% 28% 10.60%
==== ===== ===== ===== ===== == =====
IMMEDIATE CREDIT (Program
discontinued)
1999-3 HEL ImmedCredit............. 7.68% 24.33% 16.50% 22.39% 5.89% 34% 14.90%
1999-3 HELOC ImmedCredit........... 7.55 23.92 16.22 24.05 7.83 30 13.24
2000-LB1 HELOC ImmedCredit......... 7.13 18.41 16.81 30.44 13.63 23 13.71
---- ----- ----- ----- ----- -- -----
TOTAL/WEIGHTED AVERAGE............. 7.20% 19.36% 16.71% 29.33% 12.62% 24% 13.66%
==== ===== ===== ===== ===== == =====
GRAND TOTAL/WEIGHTED AVERAGE....... 1.10% 2.78% 2.59% 6.29% 4.08% 30% 12.63%
==== ===== ===== ===== ===== == =====
---------------
(1) Sum of previous quarterly loss projections, updated quarterly, as a percent
of original balance.
(2) Sum of Projected Cumulative Losses to Date and Projected Remaining
Cumulative Losses, as a percent of original balance.
(3) Sum of Projected Future Losses to call date from current quarter's model, as
a percent of original balance.
50
Home Equity Servicing
Our home equity lending business continues to service a majority of the
loans it has securitized and sold. We earn a servicing fee of approximately 50
to 100 basis points of the outstanding principal balance of the loans treated as
sales under generally accepted accounting principles. For loans treated as
secured financings, the servicing fee is implicit in the yield of the underlying
loans and therefore is not capitalized. For whole loans sold with servicing
retained, we capitalize servicing fees including rights to future early
repayment fees. These loans are included below in managed portfolio including
credit risk sold. In addition, where applicable, we have the opportunity to earn
additional future servicing incentive fees, although we are not currently
recognizing any revenue or balance sheet asset to reflect this potential given
the uncertainty surrounding our ability to earn and estimate such incentive
fees. The following table shows certain information about our home equity
portfolio, which includes loans held on the balance sheet as well as securitized
loans:
2002 2001 2000
---------- ---------- ----------
(IN THOUSANDS)
Managed portfolio including credit risk sold............. $2,502,685 $2,317,975 $1,825,527
Managed portfolio........................................ 1,830,339 2,064,542 1,625,719
Delinquency ratio on managed portfolio (30+ days
including nonaccruals)................................. 6.0% 5.1% 4.4%
In our home equity lending business, we generally retain credit risk on
loans we originate, whether funded on- or off-balance sheet. The managed
portfolio amounts listed above include those loans we service with credit risk
retained. Delinquency rates and losses on our managed portfolio result from a
variety of factors, including loan seasoning, portfolio mix and general economic
conditions. The 30-day and greater delinquency ratio was 6.0% at December 31,
2002, and 5.1% at December 31, 2001. The credit quality of the home equity loans
underlying previous securitizations continues to perform within the range of
management's long-term expectations, although the current economic conditions
make it difficult for us to predict with perfect clarity what short-term losses
are expected to be. The increase in delinquencies at December 31, 2002, is a
result of continued seasoning of the portfolio as well as the effect of selling
a large percentage of current production near year end, all of which had no
delinquencies. This increase in delinquencies may result in an elevated level of
charge-offs later in 2003.
Net Income
Our home equity lending business recorded net income of $1.0 million during
the year ended December 31, 2002, compared to net income in 2001 of $16.2
million, and $18.5 million in 2000. Our financial results in 2002 reflect
changes we made to address new regulatory capital rules associated with residual
interests on sold loans. Beginning in 2002, we eliminated our use of
securitization structures that require gain-on-sale accounting treatment under
SFAS 140.
Net Revenue
Net revenue for the year ended December 31, 2002 totaled $80.3 million,
compared to net revenue for the year ended December 31, 2001 of $124.3 million,
and $103.4 million in 2000. The reduction in revenues is a result of increased
provision for loan losses as the line of business begins to build an on-balance
sheet loan portfolio and reduced gain-on-sale revenues related to the transition
away from gain-on-sale accounting for our securitizations. Provision for loan
losses totaled $25.6 million in 2002 compared to $2.3 million in 2001 and $0.5
million in 2000.
During 2002, our home equity lending business produced $1.1 billion of home
equity loans, relatively unchanged from the $1.1 billion of production in 2001.
The 2001 loan production was down 6.2% from 2000 volume of $1.2 billion.
Included in the 2000 total is a fourth quarter acquisition of the residual
interest, servicing rights and related whole loans of an approximately $400
million pool of previously securitized home equity lines of credit. The
collateral supporting the pool is comprised of seasoned lines of credit,
predominantly up to 100% combined loan-to-value and similar in credit quality
and yield to lines of credit originated by our business. Our home equity lending
business had $680.2 million of net loans and loans held for sale at
51
December 31, 2002, compared to $344.0 million at December 31, 2001, and $334.2
million at the same date in 2000. The increase in 2002 relates to the buildup of
the on-balance sheet loan portfolio as part of the transition away from
gain-on-sale accounting in our securitizations. Included in the loan balance at
December 31, 2002 were $392.4 million of collateralized loans as part of a
secured financing.
The following table sets forth certain information regarding net revenue
for the periods indicated:
YEAR ENDED DECEMBER 31,
------------------------------
2002 2001 2000
-------- -------- --------
(DOLLARS IN THOUSANDS)
Net interest income......................................... $ 94,068 $ 61,803 $ 35,864
Provision for loan losses................................... (25,596) (2,320) (461)
Gain on sales of loans...................................... 28,942 91,406 46,970
Loan servicing fees......................................... 13,528 13,355 7,559
Amortization and impairment of servicing assets............. (6,905) (3,217) (1,583)
Trading (losses) gains...................................... (26,032) (38,407) 14,399
Other income................................................ 2,258 1,649 699
-------- -------- --------
Total net revenue........................................... $ 80,263 $124,269 $103,447
======== ======== ========
Net interest income increased to $94.1 million for the year ended December
31, 2002, compared to 2001 net interest income of $61.8 million, and $35.9
million in 2000. This line of business earns interest income on loans held on
the balance sheet and the accretion of the discount applied to its residual
interests, which accretion totaled $34.2 million during 2002 versus $32.0
million in 2001, and $15.9 million in 2000.
Gains on sales of loans for the year ended December 31, 2002 totaled $28.9
million, compared to $91.4 million and $47.0 million during the same period in
2001 and 2000, respectively. The significant decline in gains in 2002 relates to
the transition away from securitization structures requiring gain-on-sale
accounting. We reported gains during the first quarter of 2002 as a result of
making a final delivery of $31.7 million of loans to complete a 2001
securitization transaction that involved gain-on-sale accounting. We had a
securitization of $439.1 million of loans during the second quarter that we
accounted for as a secured financing. See further discussion of this subject in
the section titled, "Securitizations." We completed whole loan sales during 2002
of $583.8 million resulting in a gain of $26.6 million. We do not record a
residual interest as a result of these whole loan sales. These are cash sales
for which we receive a premium, record a servicing asset, and monetize any
points and fees at the time of sale. We securitized $1.1 billion of loans in
2001 compared to $774.6 million in 2000, all using gain-on-sale accounting. The
gain on sales of loans relative to the principal balance of loans sold increased
during 2001 due to improvement in net funding costs. These improvements included
a higher mix of loans originated with fees for early repayment, a higher
risk-adjusted interest rate on the underlying collateral, a lower relative
acquisition cost structure due to continued expansion of new distribution
channels, an ability to sell a portion of the residual interest at inception of
the securitization transaction, and otherwise improved excess spread that we
were able to realize on the basis of our consistent performance history to date.
Amortization and impairment of servicing assets includes amortization
expenses and valuation adjustments relating to the carrying value of servicing
assets. Our home equity lending business determines fair value of its servicing
asset using discounted cash flows and assumptions as to estimated future
servicing income and cost that we believe market participants would use to value
similar assets. At December 31, 2002, net servicing assets totaled $26.4
million, compared to a balance of $15.3 million at December 31, 2001, and $7.7
million at December 31, 2000. Servicing asset amortization and impairment
expense totaled $6.9 million during 2002, compared to $3.2 million for the year
ended December 31, 2001, and $1.6 million in 2000.
Trading gains (losses) represent unrealized gains (losses) as a result of
adjustments to the carrying values of our residual interests. Trading losses
totaled $26.0 million in 2002 compared to $38.4 million in 2001. In 2000, we had
trading gains related to our residual interests totaling $14.4 million. Residual
interests had a balance of $157.1 million at December 31, 2002 and $199.1
million at December 31, 2001, compared to $152.6 million at the same date in
2000. Included in the valuation are assumptions for estimated prepayments,
52
expected losses, and discount rates that we believe market participants would
use to value similar assets. Management continually evaluates these assumptions
to determine the proper carrying values of these items on the balance sheet. To
the extent our expectations of future loss rates, prepayment speeds and other
factors change as we gather additional data over time, these residual valuations
may be subject to additional adjustments in the future, up or down. These
adjustments could have a material effect on our earnings. The increased
unrealized trading losses in 2002 principally reflect higher expected loss rates
and prepayment speeds. The increased unrealized trading losses in 2001 also
reflect higher expected loss rates and prepayment speeds as well as an increase
in the discount rate. These higher expected loss rates are reflective of the
continued weakness in the economy and a slower rate of recovery in the
delinquency of the portfolio than we had anticipated. Our forward loss
assumptions are reevaluated monthly and, as such, our residual asset valuations
will be adjusted continuously to reflect changes in actual and expected loss
rates in our portfolio.
On November 29, 2001, we sold $12.3 million of residual interests on
previously sold loans representing approximately $108.9 million of principal
balance. This was approximately 40% of our residual interest in home equity
loans securitized in September 2000. Consistent with our three previous residual
sales, we sold these residual interests for a price equal to the carrying value
on our balance sheet.
Operating Expenses
The following table shows operating expenses for our home equity lending
line of business for the periods indicated:
YEAR ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- ------- -------
(DOLLARS IN THOUSANDS)
Salaries and employee benefits.............................. $46,548 $59,007 $39,180
Other....................................................... 32,040 38,182 33,443
------- ------- -------
Total operating expenses............................... $78,588 $97,189 $72,623
======= ======= =======
Number of employees at period end........................... 692 773 614
Operating expenses were $78.6 million for the year ended December 31, 2002,
compared to $97.2 for the year 2001, and an increase of 8.2% from 2000.
Operating expenses in 2001 included $5.5 million of compensation expense related
to minority ownership interests at the home equity line of business. The 2002
operating expenses reflect the reversal of $5.1 million of this expense due to
the decline in the value of the minority ownership interest during the most
recent year.
Impact of Recent Change to Regulatory Capital Rules
The federal banking regulators, including the Federal Reserve, our
principal regulator, adopted revised regulatory capital standards regarding the
treatment of certain recourse obligations, direct credit substitutes, residual
interests in asset securitizations, and other securitized transactions. In
general, the new rules require a banking institution that has certain
credit-enhancing interest-only strips (CEIOS) in an amount that exceeds 25% of
its Tier 1 capital, to deduct the after-tax excess amount of these CEIOS from
Tier 1 capital for purposes of computing risk-based capital ratios.
The new capital standards became effective on January 1, 2002, for new
residual interests related to any transaction covered by the revised rules that
settles after December 31, 2001. For transactions settled before January 1,
2002, application of the new capital treatment to the residuals created was
delayed until December 31, 2002.
We believe these new rules apply to many, if not all, of the securitization
transactions done by our home equity line of business prior to 2002 to fund loan
production. The residual assets we now own do not exceed the 25% concentration
limit in the new capital treatment rules. The CEIOS included in our residual
assets as of December 31, 2002, comprised 17% of our consolidated Tier 1
capital. Therefore, we have not been subject to any deductions from capital
under these new rules.
53
We financed the significant growth in our home equity lending line of
business through the first quarter of 2002 using securitization transaction
structures that create residual interests through gain-on-sale
accounting -- transactions accounted for as sales under SFAS 140. To mitigate
the impact of the new capital rules, beginning in 2002 we eliminated our use of
securitization structures that require gain-on-sale accounting. We believe using
securitization structures that require on-balance sheet financing treatment or
whole loan sale transactions rather than using securitization structures that
require off-balance sheet gain-on-sale treatment under SFAS 140 will allow
continued access to the capital markets for cost-effective, matched funding of
our loan assets in a capital-efficient manner, while not meaningfully affecting
or changing our cash flows, nor changing the longer term economic profitability
of our home equity lending operation.
Changing our securitization practices has significantly affected the
reported financial results of our home equity line of business in 2002. The key
financial impacts have included:
- By using on-balance sheet financing structures to fund our home equity
loan originations, we are required to change the timing of revenue
recognition on these assets under generally accepted accounting
principles. For assets funded on-balance sheet, we record interest income
over the life of the loans, as it is earned, net of interest expense over
the life of the bonds and a provision for credit losses inherent in the
portfolio. For assets funded through securitization transactions
accounted for as a sale under SFAS 140, we have recorded revenue as
gain-on-sale at the time of loan sale based on the difference between
proceeds and allocated cost basis of the loans sold. We have also
recognized residual interests based on the discounted present value of
anticipated revenue streams over the expected lives of the loans. This
different accounting treatment does not, however, affect cash flows
related to the loans, and management expects that the ultimate total
receipt of revenues and profitability derived from our home equity loans
will be relatively unchanged by the change in funding structures.
- Due to the extension of the period during which revenue is recognized
under the new financing structures we are using, we have reduced the rate
of growth in production and related expenses in the home equity lending
line of business to more closely align anticipated revenue recognition
and expenses under this new model.
- After the initial transition period, as the portfolio of on-balance sheet
home equity loans continues to grow, we will record increased levels of
net interest income sufficient to cover ongoing expenses and credit
losses. We would then expect to be in a position to resume profitable
growth in this line of business. We will continue to pursue selective
opportunities to sell whole loans in cash sale transactions if attractive
terms can be negotiated. We completed four such transactions during 2002.
54
COMMERCIAL FINANCE
The following table shows selected financial information for our commercial
finance line of business for the periods indicated:
YEAR ENDED DECEMBER 31,
------------------------------
2002 2001 2000
-------- -------- --------
(DOLLARS IN THOUSANDS)
SELECTED INCOME STATEMENT DATA:
Net interest income......................................... $ 15,140 $ 9,481 $ 3,196
Provision for loan and lease losses......................... (8,481) (6,939) (1,513)
Noninterest income.......................................... 4,397 1,695 799
-------- -------- --------
Total net revenues........................................ 11,056 4,237 2,482
Salaries, pension, and other employee expense............... 9,482 6,481 3,298
Other expense............................................... 2,640 1,943 1,747
-------- -------- --------
Loss before taxes and cumulative effect of change in
accounting principle...................................... (1,066) (4,187) (2,563)
Income taxes................................................ 513 1,309 945
-------- -------- --------
Loss before cumulative effect of change in accounting
principle................................................. (553) (2,878) (1,618)
Cumulative effect of change in accounting principle......... 495 -- --
-------- -------- --------
Net loss.................................................... $ (58) $ (2,878) $ (1,618)
======== ======== ========
SELECTED BALANCE SHEET DATA AT END OF PERIOD:
Total assets................................................ $343,384 $266,670 $159,773
Loans and leases............................................ 345,844 264,827 154,934
Allowance for loan and lease losses......................... (7,657) (4,587) (2,441)
Shareholders' equity........................................ 29,236 18,741 21,346
Net charge-offs............................................. 5,401 4,653 961
Net interest margin......................................... 5.07% 4.64% 4.50%
Total fundings of loans and leases.......................... $207,087 $190,716 $113,323
Overview
In our commercial finance line of business, we originate transactions
through established U.S. and Canadian relationships with vendors and
manufacturers, some select brokers, and direct relationships with franchisees.
The majority of our loans and leases are full payout, small-ticket loans and
leases secured by commercial equipment. Within the franchise channel, the
majority of our contracts are loans, and our leases are full payout with higher
transaction sizes than in our small-ticket channel. The Franchise channel also
finances real estate for select franchise systems. We finance a variety of
commercial and office equipment and try to limit the industry and geographic
concentrations in our loan and lease portfolio.
We established this line of business in 1999 when we formed Irwin Business
Finance, our United States commercial leasing company, headquartered in
Bellevue, Washington. On July 14, 2000, this line of business completed an
acquisition of an ownership position of approximately 78% in Onset Capital
Corporation, a Canadian small-ticket equipment leasing company headquartered in
Vancouver, British Columbia. Principals of Onset own the remaining approximately
22%. The Onset acquisition added approximately $60 million in leases to our
commercial finance portfolio. To begin our franchise finance operations, we
acquired a portfolio of approximately $22 million in leases and loans in August
2001, and in October 2001 we established Irwin Franchise Capital Corporation. We
established Irwin Commercial Finance in April 2001 (originally named Irwin
Capital Holdings) as a subsidiary of Irwin Union Bank and Trust to serve as the
parent company for both our United States and Canadian commercial finance
companies.
During the year ended December 31, 2002, the commercial finance line of
business incurred a loss of $58 thousand, compared to a loss of $2.9 million for
the year 2001 and a loss of $1.6 million in 2000. The 2002
55
results include a $0.5 million benefit from a cumulative effect of an accounting
change related to the reversal of unamortized negative goodwill related to the
acquisition of Onset. The increased loss in 2001 relates primarily to higher
loss provisions taken during the year. These losses also reflect expenses
related to staffing, systems development and portfolio growth initiatives in
excess of portfolio revenues. This line of business originated $207.1 million in
loans and leases during 2002, compared to $190.7 million during 2001 and $113.3
million in 2000. The 2001 period includes an acquisition of loans and leases of
approximately $22.0 million related to the formation of Irwin Franchise Capital
Corporation in October 2001. The line of business portfolio at December 31, 2002
was $345.8 million compared to $264.8 million at December 31, 2001.
We had nonperforming loans and leases at December 31, 2002 totaling $4.9
million, compared to non-performing loans and leases at December 31, 2001
totaling $3.9 million. Allowance for loan and lease losses at December 31, 2002
was $7.7 million, representing 2.21% of total loans and leases, compared to a
balance at December 31, 2001 of $4.6 million, representing 1.73% of total
leases. Net charge-offs recorded by this line of business totaled $5.4 million
in 2002 compared to $4.7 million in 2001. The increased nonperformings,
allowance and charge-offs were principally the result of deterioration in the
credit quality of the broker-based, small ticket portion of our domestic
portfolio. We have taken steps to reduce our concentration in this portion of
our portfolio and we have made substantial underwriting changes in this
portfolio over the past year. In the future, we expect our concentration in
vendor-based small ticket products (both domestically and Canadian) and
franchise finance to grow as a proportion of the line of business' portfolio.
Despite delays in reaching sustainable profitability in this line of
business largely as a result of unanticipated credit losses in our U.S.-based
leasing portfolio, we continue to believe that our strategy is appropriate for
serving the commercial finance niches we address. It is our expectation that
this line of business will be modestly profitable in 2003 and begin to approach
our long-term return targets in 2004 or 2005, depending on growth rates.
The following table provides certain information about the loan and lease
portfolio of our commercial finance line of business at the dates shown:
DECEMBER 31,
-----------------------
2002 2001
--------- ---------
(DOLLARS IN THOUSANDS)
Franchise loans............................................. $ 95,753 $ 35,950
Weighted average yield.................................... 9.01% 10.05%
Delinquency ratio......................................... 0.30 0.00
Domestic leases............................................. $135,775 $150,610
Weighted average yield.................................... 10.37% 10.73%
Delinquency ratio......................................... 1.41 2.68
Canadian leases(1).......................................... $114,316 $ 78,267
Weighted average yield.................................... 10.95% 11.17%
Delinquency ratio......................................... 1.03 1.69
---------------
(1) In U.S. dollars.
56
VENTURE CAPITAL
The following table shows selected financial information for our venture
capital line of business for the periods indicated:
YEAR ENDED DECEMBER 31,
----------------------------
2002 2001 2000
------- -------- -------
(IN THOUSANDS)
SELECTED INCOME STATEMENT DATA:
Net interest income (expense)............................... $ 43 $ (404) $ (598)
Mark-to-market adjustment on investments.................... (4,187) (10,444) 5,202
Noninterest income.......................................... 501 592 364
------- -------- -------
Total net revenues........................................ (3,643) (10,256) 4,968
Operating expense........................................... 495 590 431
------- -------- -------
Income (loss) before taxes.................................. (4,138) (10,846) 4,537
Income taxes (benefit)...................................... (1,655) (4,340) 1,814
------- -------- -------
Net income (loss)........................................... $(2,483) $ (6,506) $ 2,723
======= ======== =======
SELECTED BALANCE SHEET DATA AT END OF PERIOD:
Investment in portfolio companies (cost).................... $12,620 $ 10,696 $ 5,206
Mark-to-market adjustment................................... (8,123) (3,936) 6,508
------- -------- -------
Carrying value of portfolio companies....................... $ 4,497 $ 6,760 $11,714
======= ======== =======
OVERVIEW
In our venture capital line of business, we make minority investments in
early stage companies in the financial services industry and related fields that
intend to use technology as a key component of their competitive strategy. We
provide Irwin Ventures' portfolio companies the benefit of our management
experience in the financial services industry. In addition, we expect that
contacts made through venture activities may benefit management of our other
lines of business through the sharing of technologies and market opportunities.
Our venture capital line of business had investments in six private companies as
of December 31, 2002, with an aggregate investment cost of $12.6 million and a
carrying value of $4.5 million.
In August 1999, Irwin Ventures established a subsidiary, Irwin Ventures
Incorporated-SBIC, which received a small business investment company license
from the Small Business Administration. In December 2000, Irwin Ventures and
Irwin Ventures-SBIC became Delaware limited liability companies. To date, the
primary geographic focus of this line of business and each of our investments
has been on the corridors of the east and west coasts between Washington, D.C.
and Boston, and Palo Alto and Seattle.
In 1999, our Board of Directors approved an allocation of up to $20 million
to support this subsidiary. We carry venture capital investments held by Irwin
Ventures at fair value, with changes in market value recognized in other income.
The investment committee of Irwin Ventures determines the value of the
investments at the end of each reporting period. We adjust the values based upon
review of the investee's financial results, condition, and prospects. Changes in
estimated market values can also be made when an event such as a new funding
round from other private equity investors would cause a change in estimated
market value. In the future, should Irwin Ventures have investments in
publicly-traded securities, it would look to the traded market value of the
investments as the basis of its mark-to-market.
Despite the recent sharp reduction in values of technology companies, Irwin
Ventures continues to see opportunities in emerging technologies applied to the
financial services industry. Irwin Ventures believes this will continue as
improvements in technology and entrepreneurial innovation continue to change the
manner in which financial services are delivered to businesses and consumers.
Over the last two to three years, we have determined that the pace of
technological change (or the pace of adoption of new technologies by individuals
57
and corporations) has been slower than anticipated. However, the relevance of
technology as a great facilitator of change and innovation in financial services
remains.
Therefore, our strategic rationale for continuing to make venture capital
investments has evolved. We believe that technology has the power to reduce the
attractiveness of some banking niches while creating new ones. We are attempting
to position Irwin Ventures to make multiple small investments across a variety
of technology-based financial services niches in order to capitalize on the new
market opportunities enabled by technology. We also believe this presents an
opportunity to enhance our ability to identify and evaluate corporate
development opportunities as our continued involvement in venture capital
enables us to stay close to innovations that could affect the landscape of
financial services in the future.
During the year ended December 31, 2002, the venture capital line of
business recorded a net loss of $2.5 million, compared to a net loss of $6.5
million in 2001, and net income of $2.7 million in 2000. The fluctuation in
results in the venture capital line of business is primarily due to valuation
adjustments to reflect the company's portfolio investments at market value.
PARENT AND OTHER
Results at the parent company and other businesses totaled a net loss of
$5.8 million for the year ended December 31, 2002, compared to a loss of $8.4
million during the same period in 2001 and $4.0 million in 2000. The components
of these other results net of tax are as follows:
YEAR ENDED DECEMBER 31,
---------------------------
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
Parent company results...................................... $(7,533) $(6,924) $(4,295)
Home equity lending line of business compensation expense
related to key employee retention initiatives............. 1,211 (1,948) --
Other, net.................................................. 558 506 266
------- ------- -------
Total Parent and Other net losses......................... $(5,764) $(8,366) $(4,029)
======= ======= =======
Net losses at Parent and Other increased significantly in 2001 compared to
2000 primarily because of increased operating expenses at the parent. These
expenses include interest expense associated with a portion of the trust
preferred securities issued during 2001 relating to capital not yet allocated to
our lines of business. Also included in the increased net losses is a pre-tax
compensation charge of $3.2 million related to the estimated future cost of key
employee retention initiatives at our home equity lending line of business. In
2002, $2.0 million of this expense was reversed as the valuation of this line of
business declined. As mentioned above, included in the parent company operating
results are allocations to our subsidiaries of interest expense related to our
interest-bearing capital obligations. During the year ended December 31, 2002,
we allocated $13.5 million of these expenses to our subsidiaries, compared to
$9.2 million and $5.4 million during 2001 and 2000, respectively. Before 2000,
we did not allocate these expenses to our subsidiaries. Included in 2000 was a
$2.7 million compensation expense reflecting the increase in minority ownership
interests at the home equity lending line of business. There are currently
minority interests in our home equity lending, venture capital, and commercial
finance lines of business.
Each subsidiary pays taxes to us at the statutory rate. Subsidiaries also
pay fees to us to cover direct and indirect services. In addition, certain
services are provided from one subsidiary to another. Intercompany income and
expenses are calculated on an arm's-length, external market basis and are
eliminated in consolidation.
Inflation
Since substantially all of our assets and liabilities are monetary in
nature, such as cash, securities, loans and deposits, their values are less
sensitive to the effects of inflation than to changes in interest rates. We
attempt to control the impact of interest rate fluctuations by managing the
relationship between interest rate
58
sensitive assets and liabilities and by hedging certain interest sensitive
assets with financial derivatives or forward commitments.
RISK MANAGEMENT
We are engaged in businesses that involve the assumption of financial risks
including:
- Credit risk
- Liquidity risk
- Interest rate risk
- Operational risk
Each line of business that assumes financial risk uses a formal process to
manage this risk. In all cases, the objectives are to ensure that risk is
contained within prudent levels and that we are adequately compensated for the
level of risk assumed.
Our Chairman, President, Executive Vice President, Chief Financial Officer,
Vice President Financial Risk Management, Vice President Operational Risk
Management, and the President of Irwin Union Bank meet on a monthly basis (or
more frequently as appropriate) as an Enterprise Risk Management Committee
(ERMC), reporting to the Board of Director's Audit and Risk Management
Committee. The ERMC and its subcommittees oversee all aspects of our financial,
credit, and operational risks, although these risks are typically managed at the
line of business level. The ERMC provides independent review and enhancement of
those lines of business' risk management processes and establishes independent
oversight of our risk reporting, surveillance and model parameter changes.
Credit Risk. The assumption of credit risk is a key source of earnings for
the home equity lending, commercial banking and commercial finance lines of
business. In addition, the mortgage banking line of business assumes some credit
risk although its mortgages typically are insured.
The credit risk in the loan portfolios of the home equity lending,
commercial finance and commercial banking lines of business have the most
potential to have a significant effect on our consolidated financial
performance. These lines of business manage credit risk through the use of
lending policies, credit analysis and approval procedures, periodic loan
reviews, and personal contact with borrowers. Loans over a certain size are
reviewed by a loan committee prior to approval.
The allowance for loan and lease losses is an estimate based on our
judgement applying the principles of SFAS 5, "Accounting for Contingencies,"
SFAS 114, "Accounting by Creditors for Impairment of a Loan," and SFAS 118,
"Accounting by Creditors for Impairment of a Loan -- Income Recognition and
Disclosures." The allowance is maintained at a level we believe is adequate to
absorb probable losses inherent in the loan and lease portfolio. We compute the
allowance based on an analysis that incorporates both a quantitative and
qualitative element. The quantitative component of the allowance reflects
expected losses resulting from analysis developed through specific credit
allocations for individual loans and historical loss experience for each loan
category. The specific credit allocations are based on a regular analysis of all
loans over a fixed-dollar amount where the internal credit rating is at or below
a predetermined classification. The historical loan loss component is applied to
all loans that do not have a specific reserve allocated to them. Loans are
segregated by major product type, and in some instances, by aging, with an
estimated loss ratio applied against each product type and aging category. The
loss ratio is generally based upon historic loss experience for each loan type.
Loans are segregated by major product type, with an estimated loss ratio applied
against each. The loss ratio is generally based upon the previous three years'
loss experience for each loan type, adjusted for changes in the composition of
the portfolio.
The qualitative portion of the allowance reflects management's estimate of
probable inherent but undetected losses within the portfolio. This assessment is
performed via the evaluation of eight specific qualitative factors as outlined
in regulatory guidance. We perform the quantitative and qualitative assessments
on a quarterly basis. Loans and leases that are determined by management to be
uncollectible are charged
59
against the allowance. The allowance is increased by provisions against income
and recoveries of loans and leases previously charged off. Qualitative reserves
are allocated to individual loan categories in the following table.
Net charge-offs for the year ended December 31, 2002 were $19.3 million, or
0.74% of average loans, compared to $10.5 million, or 0.69% of average loans
during 2001. Net charge-offs in 2000 were $2.7 million or 0.28% of average
loans. At December 31, 2002, the allowance for loan and lease losses was 1.81%
of outstanding loans and leases, compared to 1.04% at year-end 2001, and 1.06%
at year-end 2000. The increase in charge-offs and allowance is a result of loan
growth, deteriorating credit quality, as well as the new balance sheet retention
of home equity loans. As mentioned earlier, the home equity business began
recognizing charge-offs and recording an allowance for loan losses in late 2001
as the line of business moved away from gain-on-sale accounting and recorded its
loans on the balance sheet both before and after they have been securitized.
Included in the 2002 and 2001 charge-offs were approximately $3.9 million and
$2.3 million, respectively, of charge-offs at the home equity lending line of
business not charged against the allowance for loan and lease losses account.
Instead, these charge-offs were previously taken through a lower of cost or
market valuation allowance that was established in late 2001 as required under
generally accepted accounting principles when we transferred approximately $38
million of home equity loans held for sale to the held for investment category
at fair value. This valuation allowance account was depleted during the third
quarter of this year. We now reserve for these same loans through our provision
for loan and lease losses.
Total nonperforming loans and leases at December 31, 2002, were $31.1
million, compared to $19.2 million at December 31, 2001, and $7.2 million at
December 31, 2000. Nonperforming loans and leases as a percent of total loans
and leases at December 31, 2002 were 1.11%, compared to 0.90% at December 31,
2001, and 0.58% in 2000. The 2002 increase occurred primarily at the commercial
banking line of business where nonperforming loans increased to $15.1 million at
December 31, 2002, compared to $7.1 million at the end of 2001. The 2001
increase occurred primarily at our home equity lending line of business in
connection with a change in the classification of nonperforming loans from the
"loans held for sale" category to "loans held for investment" to reflect the
change in management's intent regarding ultimate disposition of these assets.
Prior to this reclassification in 2001, these loans were segregated from
performing loans and carried at the lower of their cost or market value. Any
impairment provision was recorded through the markdown of the loans to their
market value.
Other real estate we owned totaled $5.3 million at December 31, 2002, up
from $4.4 million at December 31, 2001, which was up from $2.8 million at the
same date in 2000. The increase in 2002 and 2001 was primarily attributable to
both the home equity lending and mortgage banking lines of business. Total
nonperforming assets at December 31, 2002 were $36.4 million, or 0.75% of total
assets. Nonperforming assets at December 31, 2001, totaled $23.5 million, or
0.68% of total assets, compared to $10.1 million, or 0.42%, in 2000.
60
The following table shows an analysis of our consolidated allowance for
loan and lease losses:
AT OR FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- -------- --------
(IN THOUSANDS)
Loans and leases outstanding at end
of period, net of unearned
income............................ $2,815,276 $2,137,822 $1,234,922 $733,424 $556,991
========== ========== ========== ======== ========
Average loans and leases for the
period, net of unearned income.... $2,620,428 $1,533,261 $ 960,848 $642,435 $585,025
========== ========== ========== ======== ========
ALLOWANCE FOR LOAN AND LEASE LOSSES:
Balance beginning of period......... $ 22,283 $ 13,129 $ 8,555 $ 9,888 $ 8,812
CHARGE-OFFS:
Commercial, financial and
agricultural loans............. 3,666 1,638 1,210 646 246
Real estate mortgage loans........ 7,130 600 -- -- 232
Consumer loans.................... 800 1,489 818 813 761
Lease financing:
Domestic....................... 5,158 3,624 363 772 1,263
Canadian....................... 1,476 2,402 777 -- --
---------- ---------- ---------- -------- --------
Total charge-offs............ 18,230 9,753 3,168 2,231 2,502
---------- ---------- ---------- -------- --------
RECOVERIES:
Commercial, financial and
agricultural loans............. 435 144 76 32 14
Real estate mortgage loans........ 1,002 -- -- -- --
Consumer loans.................... 252 193 221 307 362
Lease financing:
Domestic....................... 523 334 84 164 183
Canadian....................... 658 877 85 -- --
---------- ---------- ---------- -------- --------
Total recoveries............. 2,870 1,548 466 503 559
---------- ---------- ---------- -------- --------
Net charge-offs..................... (15,360) (8,205) (2,702) (1,728) (1,943)
Acquisition of Onset Capital........ -- -- 1,908 -- --
Reduction due to sale of loans...... -- (6) -- (3,126) (2,976)
Reduction due to reclassification of
loans............................. -- -- (16) (922) --
Foreign currency adjustment......... 17 (140) (19) -- --
Provision charged to expense........ 43,996 17,505 5,403 4,443 5,995
---------- ---------- ---------- -------- --------
Balance end of period............... $ 50,936 $ 22,283 $ 13,129 $ 8,555 $ 9,888
========== ========== ========== ======== ========
ALLOWANCE FOR LOAN AND LEASE LOSSES
BY CATEGORY:
Commercial, financial and
agricultural loans............. $ 17,942 $ 11,198 $ 4,370 $ 5,634 $ 4,240
Real estate mortgage loans........ 23,150 2,872 2,462 1,194 3,299
Consumer loans.................... 2,067 2,309 2,226 1,270 1,747
Lease financing:
Domestic....................... 5,953 4,527 2,325 457 602
Canadian....................... 1,824 1,377 1,746 -- --
---------- ---------- ---------- -------- --------
Totals....................... $ 50,936 $ 22,283 $ 13,129 $ 8,555 $ 9,888
========== ========== ========== ======== ========
61
AT OR FOR THE YEAR ENDED DECEMBER 31,
----------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- -------- --------
(IN THOUSANDS)
ALLOWANCE FOR LOAN AND LEASE LOSSES
BY CATEGORY TO TOTAL:
Commercial, financial and
agricultural loans............. 35% 50% 33% 66% 43%
Real estate mortgage loans........ 45 13 19 14 33
Consumer loans.................... 4 11 17 15 18
Lease financing:
Domestic....................... 12 20 18 5 6
Canadian....................... 4 6 13 -- --
---------- ---------- ---------- -------- --------
Totals....................... 100% 100% 100% 100% 100%
========== ========== ========== ======== ========
RATIOS:
Net charge-offs to average loans and
leases(1)......................... 0.74% 0.69% 0.28% 0.27% 0.33%
Allowance for loan losses to loans
and leases outstanding............ 1.81% 1.04% 1.06% 1.17% 1.78%
---------------
(1) Included in 2002 and 2001 charge-offs were $3.9 million and $2.3 million,
respectively, of charge-offs at the home equity lending line of business not
charged against the allowance for loan and lease losses.
The following table shows information about our nonperforming assets at the
dates shown:
DECEMBER 31,
----------------------------------------------
2002 2001 2000 1999 1998
------- ------- ------- ------ -------
(IN THOUSANDS)
ACCRUING LOANS PAST DUE 90 DAYS OR MORE:
Commercial, financial and agricultural
loans....................................... $ 30 $ 1,146 $ 324 $ 58 $ 252
Real estate mortgages......................... -- -- -- -- 291
Consumer loans................................ 688 157 510 89 89
Lease financing:
Domestic.................................... 220 1,624 627 -- --
Canadian.................................... 143 68 -- -- --
------- ------- ------- ------ -------
1,081 2,995 1,461 147 632
------- ------- ------- ------ -------
NONACCRUAL LOANS AND LEASES:
Commercial, financial and agricultural
loans....................................... 13,798 5,066 752 748 1,052
Real estate mortgages......................... 11,308 8,115 1,922 3,250 9,710
Consumer loans................................ 454 708 918 273 174
Lease financing:
Domestic.................................... 3,415 1,180 960 88 426
Canadian.................................... 1,077 1,088 1,209 -- --
------- ------- ------- ------ -------
30,052 16,157 5,761 4,359 11,362
------- ------- ------- ------ -------
Total nonperforming loans and leases..... 31,133 19,152 7,222 4,506 11,994
------- ------- ------- ------ -------
OTHER REAL ESTATE OWNED:
Other real estate owned....................... 5,272 4,388 2,833 3,752 3,506
------- ------- ------- ------ -------
Total nonperforming assets............... $36,405 $23,540 $10,055 $8,258 $15,500
======= ======= ======= ====== =======
Nonperforming loans and leases to total loans
and leases.................................. 1.11% 0.90% 0.58% 0.59% 2.15%
======= ======= ======= ====== =======
Nonperforming assets to total assets.......... 0.75% 0.68% 0.42% 0.49% 0.80%
======= ======= ======= ====== =======
62
Loans that are past due 90 days or more are placed on nonaccrual status
unless, in management's opinion, there is sufficient collateral value to offset
both principal and interest. The $36.4 million of nonperforming assets at
December 31, 2002, were concentrated at our lines of business as follows:
- Mortgage banking $ 4.1
- Commercial banking 15.1
- Home equity lending 12.4
- Commercial finance 4.8
For the periods presented, the year-end balances of any restructured loans
are reflected in the table above either in the amounts shown for "accruing loans
past due 90 days or more" or in the amounts shown for "nonaccrual loans and
leases."
Interest income of approximately $2.1 million would have been recorded
during 2002 on nonaccrual and renegotiated loans if such loans had been accruing
interest throughout the year in accordance with their original terms. The amount
of interest income actually recorded during the year of 2002 on nonaccrual and
restructured loans was approximately $1.7 million.
No loan concentrations existed of more than 10% of total loans to borrowers
engaged in similar activities that would be similarly affected by economic or
other conditions. Our credit exposure to loans to individuals and businesses in
California represents less than 15% of our loan portfolio (from our home equity
lending and commercial finance portfolios).
Generally, the accrual of income is discontinued when the full collection
of principal or interest is in doubt, or when the payment of principal or
interest has become contractually 90 days past due unless the obligation is both
well secured and in the process of collection.
An asset/liability management committee (ALMC) at each of our lines of
business monitors the repricing structure of assets, liabilities and off-balance
sheet items and uses a financial simulation model to measure interest rate risk
over multiple interest rate scenarios. Our parent company ALMC oversees the
interest rate risk profile of all of our lines of business as a whole and is
represented on each of the line of business ALMC. We incorporate many factors
into the financial model, including prepayment speeds, net interest margin, fee
income and a comprehensive mark-to-market valuation process. We reevaluate risk
measures and assumptions regularly and enhance modeling tools as needed.
Liquidity Risk. Liquidity is the availability of funds to meet the daily
requirements of our business. For financial institutions, demand for funds
results principally from extensions of credit and withdrawal of deposits.
Liquidity is provided through deposits and short-term and long-term borrowings,
by asset maturities or sales, and through equity capital.
The objectives of liquidity management are to ensure that funds will be
available to meet current and future demands and that funds are available at a
reasonable cost. We manage liquidity via daily interaction with the lines of
business and periodic liquidity planning sessions. Since loans are less
marketable than securities, the ratio of total loans to total deposits is a
traditional measure of liquidity for banks and bank holding companies. At
December 31, 2002, the ratio of loans and loans held for sale to total deposits
was 153.3%. We are comfortable with this relatively high level due to our
position in first mortgage loans held for sale ($1.3 billion) and second
mortgage loans financed through matched-term secured financing ($0.4 billion).
The first mortgage loans carry an interest rate at or near current market rates
for first mortgage loans and are generally sold within a short period. Excluding
these two items, our loans to deposit ratio at December 31, 2002 was 89.9%.
63
As disclosed in the footnotes to the Consolidated Financial Statements, we
have certain obligations to make future payments under contracts. At December
31, 2002, the aggregate contractual obligations are:
PAYMENTS DUE BY PERIOD
---------------------------------------------------------
CONTRACTUAL OBLIGATIONS TOTAL LESS THAN 1 YEAR 1-5 YEARS AFTER 5 YEARS
----------------------- ---------- ---------------- --------- -------------
(IN THOUSANDS)
Deposits with contractual maturity.......... $ 926,732 $ 571,224 $340,280 $ 15,228
Other deposits.............................. 1,767,612 1,767,612 -- --
Short-term borrowings....................... 993,124 992,448 676 --
Long-term debt.............................. 30,070 70 -- 30,000
Collateralized borrowing.................... 391,425 98,831 188,887 103,707
Trust preferred securities.................. 233,000 -- -- 233,000
Operating leases............................ 64,175 17,211 37,384 9,580
---------- ---------- -------- --------
Total..................................... $4,406,138 $3,447,396 $567,227 $391,515
========== ========== ======== ========
The table above describes our on-balance sheet contractual obligations. As
described in the line of business sections, both mortgage banking and home
equity lending fund a high percentage of their loan production via whole loan
sales and/or asset securitization. It is, therefore, important to note that loan
sales/securitizations that occur frequently in our first mortgage loan and home
equity loan businesses have proven reliable (even in unstable market
environments such as September 11th) and are an important element in our
liquidity management.
The mortgage banking line of business sells virtually all of its mortgage
loan originations within 30 days of funding, taking them off our balance sheet.
Therefore, the on-balance sheet funding of first mortgage loans is for the brief
period of time from origination to sale/securitization. During 2002, the home
equity line of business sold or securitized home equity loans at least once each
quarter. In 2002, home equity loan originations totaled $1.1 billion and the sum
of home equity loan sales and securitizations also totaled $1.1 billion.
Beginning in 2002, home equity loan securitizations were retained
on-balance sheet, moving away from gain-on-sale treatment. From a liquidity
perspective, the securitizations in 2002 provided matched funding for the life
of the loans making up the securitizations. Both the securitized assets and the
funding from the securitizations are now reflected on the balance sheet and
require no additional funding. The Collateralized borrowing figure in the table
above includes $391 million related to this securitization. Bond principal
payments are dependent upon principal collections on the underlying loans.
Prepayment speeds can affect the timing and amount of loan principal payments.
The table above reflects our current estimate of the principal collection on
these loans.
Deposits consist of three primary types: non-maturity transaction account
deposits, certificates of deposit and escrow account deposits. Non-maturity
transaction account deposits are generated by our commercial banking line of
business and include deposits made into checking, savings, money market and
other types of deposit accounts by our customers. These types of deposits have
no contractual maturity date and may be withdrawn at any time. While these
balances fluctuate daily, a large percentage typically remain for much longer.
At December 31, 2002, these deposit types totaled $1.2 billion, which was an
increase of $0.3 billion from December 31, 2001.
Certificates of deposit (CDs) differ from non-contractual maturity accounts
in that they do have contractual maturity dates. We issue CDs both directly to
customers and through brokers. As of December 31, 2002, CDs issued directly to
customers totaled $0.6 billion, which was an increase of $0.1 billion from
December 31, 2001. Brokered CDs are typically considered to have higher
liquidity risk than CDs issued directly to customers since they are often done
in large blocks and since a direct relationship does not exist with the
depositor. In recognition of this, we manage the size and maturity structure of
brokered CDs closely.
64
The average remaining life of our brokered CD portfolio as of year end was 22
months. CDs issued through brokers totaled $0.3 billion at December 31, 2002,
which was a $0.2 billion decrease from December 31, 2001.
Escrow account deposits are related to the servicing of our originated
first mortgage loans. When a first mortgage borrower makes a monthly mortgage
payment, consisting of interest and principal due on the loan and often a real
estate tax portion, we hold the payment in a non-interest bearing account until
the payment is remitted to the current owner of the loan or the proper tax
authority. At December 31, 2002, these balances totaled $0.6 billion, which was
a $0.2 billion increase from December 31, 2001.
Short-term borrowings consists of borrowings from several sources. Our
largest borrowing source is the Federal Home Loan Bank of Indianapolis (FHLBI),
of which we are an active member. We utilize their collateralized borrowing
programs to help fund qualifying first mortgage, home equity and commercial real
estate loans. As of December 31, 2002, FHLBI borrowings outstanding totaled $0.5
billion, a $0.3 billion increase from December 31, 2001. We had sufficient
collateral pledged to FHLBI at December 31, 2002 to borrow an additional $0.4
billion, if needed, and a total facility with FHLBI of $1.3 billion.
In addition to borrowings from FHLBI, we use other lines of credit as
needed. At December 31, 2002, the amount of short-term borrowings outstanding on
our major credit lines and the total amount of the borrowing lines were as
follows:
- Warehouse line of credit to fund home equity loans: $135 million
outstanding on a $300 million borrowing facility
- Warehouse borrowing facilities to fund first mortgage loans: $298 million
outstanding out of $600 million borrowing facilities
- Line of credit collateralized by mortgage servicing rights: $60 million
outstanding on a $60 million borrowing facility
- Uncollateralized lines with various correspondent banks, including fed
fund lines: $30 million outstanding out of $165 million available
Interest Rate Risk. Because all of our assets are not perfectly match
funded with like-term liabilities, our earnings are affected by interest rate
changes. Interest rate risk is measured by the sensitivity of both net interest
income and fair market value of net interest sensitive assets to changes in
interest rates.
Our commercial banking, home equity lending, and commercial finance lines
of business assume interest rate risk in the pricing structure of their loans
and leases, and manage this risk by adjusting the duration of their interest
sensitive liabilities and through the use of hedging.
Our mortgage banking line of business assumes interest rate risk by
entering into commitments to extend loans to borrowers at a fixed rate for a
limited period of time. We hold closed loans only temporarily until a pool is
formed and sold in a securitization or under a flow sale arrangement. To
mitigate the risk that interest rates will rise between loan origination and
sale, the mortgage bank buys commitments to deliver loans at a fixed price.
Our mortgage, commercial banking and home equity lending lines of business
also are exposed to the risk that interest rates will decline, increasing
prepayment speeds on loans and decreasing the value of servicing assets and
residual interests. Some offsets to these exposures exist in the form of strong
production operations, selective sales of servicing rights, match-funded
asset-backed securities sales and the use of financial instruments to manage the
economic performance of the assets. Since there are accounting timing
differences between the recognition of gains or losses on financial derivatives
and the realization of economic gains or losses on certain offsetting exposures
(e.g., strong production operations), our decisions on the degree to which we
manage risk with derivative instruments to insulate against short-term price
volatility depends on a variety of factors, including:
- the type of risk we are trying to mitigate;
- offsetting factors elsewhere in the Corporation;
65
- the level of current capital above our target minimums;
- time remaining in the quarter (i.e., days until quarter-end);
- current level of derivative gain or loss relative to accounting and
economic basis;
- basis risk: the degree to which the interest rates underlying our
derivative instruments might not move parallel to the interest rate
driving our asset valuation; and
- convexity: the degree to which asset values, or risk management
derivative instrument values, do not change in a linear fashion as
interest rates change.
This strategy may, at times, result in variability in inter-quarter results
that are not reflective of underlying trends for the Corporation.
The following tables reflect our estimate of the present value of interest
sensitive assets, liabilities, and off-balance sheet items at December 31, 2002.
In addition to showing the estimated fair market value at current rates, they
also provide estimates of the fair market values of interest sensitive items
based upon a hypothetical instantaneous move both up and down 100 and 200 basis
points in the entire yield curve.
The first table is an economic analysis showing the present value impact of
changes in interest rates, assuming a comprehensive mark-to-market environment.
The second table is an accounting analysis showing the same net present value
impact, adjusted for expected GAAP treatment. Neither analysis takes into
account the book values of the noninterest sensitive assets and liabilities
(such as cash, accounts receivable, and fixed assets), the values of which are
not directly determined by interest rates.
The analyses are based on discounted cash flows over the remaining
estimated lives of the financial instruments. The interest rate sensitivities
apply only to transactions booked as of December 31, 2002, although certain
accounts such as "Official Checks and Due From" are normalized whereby the
three- or six-month average balance is included rather than the quarter-end
balance in order to avoid having the analysis skewed by a significant increase
or decrease to an account balance at quarter-end.
The net asset value sensitivities do not necessarily represent the changes
in the lines of business' net asset value that would actually occur under the
given interest rate scenarios, as sensitivities do not reflect changes in value
of the companies as a going concern, nor consider potential rebalancing or other
hedging actions that might be taken in the future under asset/liability
management.
Specifically, the volume of derivative contracts entered into to manage the
risk of MSRs fluctuates from quarter to quarter, depending upon market
conditions, the size of our MSR portfolio and various additional factors. We
monitor derivative positions frequently and rebalance them as needed. It is
unlikely that the volume of derivative positions would remain constant over
large fluctuations in interest rates, although the tables below assume they do.
MSR risk management derivative contracts appear under the category "Interest
Sensitive Financial Derivatives" in the tables below.
A categorization change occurred between December 31, 2001 and 2002 whereby
all non-interest bearing escrow deposits related to our first mortgage business
are now being classified under the category "Deposits" in the Economic Value
table below. For December 31, 2001 information below, some of these deposits
were excluded from the table since they are non-interest bearing. While escrow
deposits remain non-interest bearing, we believe the reclassification is more
consistent with our overall approach. The interest sensitivity of these deposits
has been, and will continue to be, reported under the category "Mortgage
Servicing Rights." For the December 31, 2002 Economic Value table, approximately
$582.6 million of such escrow deposits are included under the category
"Deposits." The change has no impact on the GAAP-Based Value table below.
66
ECONOMIC VALUE CHANGE METHOD
PRESENT VALUE AT DECEMBER 31, 2002,
CHANGE IN INTEREST RATES OF:
-------------------------------------------------------------------
-2% -1% CURRENT +1% +2%
----------- ----------- ----------- ----------- -----------
(IN THOUSANDS)
INTEREST SENSITIVE ASSETS
Loans and other assets.......... $ 3,360,601 $ 3,325,485 $ 3,283,074 $ 3,241,047 $ 3,199,072
Loans held for sale............. 1,321,670 1,320,506 1,317,708 1,314,791 1,311,778
Mortgage servicing rights....... 111,634 128,849 174,935 268,837 346,272
Residual interests.............. 128,798 142,630 157,514 173,142 188,179
Interest sensitive financial
derivatives................... 58,988 38,986 9,163 (20,690) (80,214)
----------- ----------- ----------- ----------- -----------
Total interest sensitive
assets........................ 4,981,691 4,956,456 4,942,394 4,977,127 4,965,087
----------- ----------- ----------- ----------- -----------
INTEREST SENSITIVE LIABILITIES
Deposits........................ (2,714,072) (2,706,307) (2,694,393) (2,682,753) (2,671,322)
Short-term borrowings........... (1,120,546) (1,120,451) (1,119,693) (1,118,940) (1,118,190)
Long-term debt.................. (697,580) (685,639) (671,798) (657,174) (641,468)
----------- ----------- ----------- ----------- -----------
Total interest sensitive
liabilities................... (4,532,198) (4,512,397) (4,485,884) (4,458,867) (4,430,980)
----------- ----------- ----------- ----------- -----------
Net market value as of December
31, 2002...................... $ 449,493 $ 444,059 $ 456,510 $ 518,260 $ 534,107
=========== =========== =========== =========== ===========
Change from current............. $ (7,017) $ (12,451) $ -- $ 61,750 $ 77,597
=========== =========== =========== =========== ===========
Net market value as of December
31, 2001...................... $ 363,161 $ 371,850 $ 431,775 $ 490,274 $ 528,499
=========== =========== =========== =========== ===========
Potential change................ $ (68,614) $ (59,925) $ -- $ 58,499 $ 96,724
=========== =========== =========== =========== ===========
67
GAAP-BASED VALUE CHANGE METHOD
PRESENT VALUE AT DECEMBER 31, 2002,
CHANGE IN INTEREST RATES OF:
--------------------------------------------------------------
-2% -1% CURRENT +1% +2%
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
INTEREST SENSITIVE ASSETS
Loans and other assets(1)........ $ -- $ -- $ -- $ -- $ --
Loans held for sale.............. 1,314,849 1,314,849 1,314,849 1,311,932 1,308,919
Mortgage servicing rights........ 115,825 133,041 174,935 257,642 298,128
Residual interests............... 128,798 142,630 157,514 173,142 188,179
Interest sensitive financial
derivatives.................... 58,988 38,986 9,163 (20,690) (80,214)
---------- ---------- ---------- ---------- ----------
Total interest sensitive
assets......................... 1,618,460 1,629,506 1,656,461 1,722,026 1,715,012
---------- ---------- ---------- ---------- ----------
INTEREST SENSITIVE LIABILITIES
Deposits(1)...................... -- -- -- -- --
Short-term borrowings(1)......... -- -- -- -- --
Long-term debt(1)................ -- -- -- -- --
---------- ---------- ---------- ---------- ----------
Total interest sensitive
liabilities(1)................. -- -- -- -- --
---------- ---------- ---------- ---------- ----------
Net market value as of December
31, 2002....................... $1,618,460 $1,629,506 $1,656,461 $1,722,027 $1,715,012
========== ========== ========== ========== ==========
Potential change................. $ (38,001) $ (26,955) $ -- $ 65,565 $ 58,551
========== ========== ========== ========== ==========
Net market value as of December
31, 2001....................... $1,085,076 $1,101,062 $1,145,978 $1,149,916 $1,160,674
========== ========== ========== ========== ==========
Potential change................. $ (60,902) $ (44,915) $ -- $ 3,938 $ 14,697
========== ========== ========== ========== ==========
---------------
(1) Value does not change in GAAP presentation.
Operational risk. Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external
events. Irwin Financial, like other financial services organizations, is exposed
to a variety of operational risks. These risks include regulatory, reputational
and legal risks as well as the potential for processing errors, internal or
external fraud, failure of computer systems, and external events that are beyond
the control of the corporation, such as natural disasters.
Our Board of Directors has ultimate accountability for the level of
operational risk assumed by us. The Board guides management by approving our
business strategy and significant policies. Our management and Board have also
established a control environment that encourages a high degree of awareness and
proactivity in alerting senior management and the Board to potential control
issues on a timely basis.
The Board has directed that primary responsibility for the management of
operational risk rests with the managers of our business units, who are
responsible for establishing and maintaining internal control procedures that
are appropriate for their operations. In 2002, we started implementing a
multi-year program to provide a more integrated firm-wide approach for the
identification, measurement, monitoring and mitigation of operational risk. The
new enterprise-wide operational risk oversight function reports to the Audit and
Risk Management Committee of our Board of Directors and to our Executive Risk
Management Committee, which is led by the Chairman of the Board of Directors.
The financial services business is highly regulated. Statutes and
regulations may change in the future, and we cannot predict what effect these
changes, if made, will have on our operations. It should be noted that the
supervision, regulation and examination of banks, thrifts and mortgage companies
by regulatory agencies are
68
intended primarily for the protection of depositors and other customers rather
than shareholders of these institutions.
We are registered as a bank holding company with the Board of Governors of
the Federal Reserve System under the Bank Holding Company Act of 1956, as
amended and the related regulations, referred to as the BHC act. We are subject
to regulation, supervision and examination by the Federal Reserve and as part of
this process we must file reports and additional information with the Federal
Reserve. The regulation, supervision and examinations occur at the local, state
and federal levels and involve, but are not limited to minimum capital
requirements, consumer protection, community reinvestment, and deposit
insurance.
As a result of the movement of residuals from Irwin Union Bank and Trust to
the Corporation in 2001 and 2002, our subsidiary, Irwin Union Bank and Trust,
has certain restrictions on paying dividends to us. See Dividends Limitations in
the Supervision and Regulation section of Part I.
Derivative Financial Instruments
Financial derivatives are used as part of the overall asset/liability risk
management process. We use certain derivative instruments that do not qualify
for hedge accounting treatment under SFAS No. 133. These derivatives are
classified as other assets and marked to market on the income statement. While
we do not seek GAAP hedge accounting treatment for the assets that these
instruments are hedging, the economic purpose of these instruments is to manage
the risk inherent in existing exposures to either interest rate risk or foreign
currency risk.
We enter into forward contracts to protect against interest rate
fluctuations from the date of mortgage loan commitment until the loans are sold.
At December 31, 2002, we designated the portion of these transactions hedging
the closed mortgage loans as hedges that qualify for hedge accounting treatment
under SFAS 133. The notional amount of our forward contracts (which does not
represent the amount at risk) totaled $2.2 billion and $0.6 billion at December
31, 2002 and 2001, respectively. The basis of the hedged closed loans is
adjusted for change in value associated with the risk being hedged. We value
closed loan contracts at period end based upon the current secondary market
value of securities with similar characteristics. The unrealized loss of our
forward contracts at December 31, 2002 was $26.2 million. The effect of these
hedging activities was recorded through earnings as gain from sale of loans.
We enter into commitments to originate loans whereby the interest rate on
the loan is determined prior to funding (rate lock commitments). Rate lock
commitments on loans intended to be sold are considered to be derivatives and
are recorded at fair value. We value these commitments at period end based upon
the current secondary market value of securities with similar characteristics.
At December 31, 2002, we had a notional amount of rate lock commitments
outstanding totaling $1.6 billion with a fair value of $36.3 million. Changes in
fair value of these derivatives are recorded in earnings. Hedge ineffectiveness
recorded in gain on sale of loans, net for the year ended December 31, 2002,
relating to fair value hedges of mortgage loans held for sale was a loss of $2.5
million. Hedge ineffectiveness was not material for 2001.
Certain of our fixed rate residual interests are funded with floating rate
liabilities. To hedge such mismatches, we own three interest rate caps, which
had a fair value of $0.5 million and a notional amount of $60.1 million at
December 31, 2002. We classify interest rate caps as other assets on the balance
sheet and carry them at their fair values. Two of the interest rate caps qualify
for cash flow hedge accounting treatment under SFAS 133. As a result,
adjustments to fair value for these derivatives are recorded through accumulated
other comprehensive income. We record adjustments to fair value for the third
interest rate cap as other income on the income statement. For the year ended
December 31, 2002, we recorded an $85 thousand loss in other income and $172
thousand loss in accumulated other comprehensive income related to these
derivative products.
We manage the interest rate risk associated with our mortgage servicing
rights through the use of Eurodollar futures contracts and interest rate
options. For the year ended December 31, 2002, we recorded gains of $125.6
million on these derivatives. Both the futures contracts and options were
marked-to-market and included in other assets with changes in value recorded in
the income statement as other income. At
69
December 31, 2002, we held $8.0 billion in notional amount of Eurodollar
contracts, with expirations ranging from the first quarter of 2003 to the first
quarter of 2009. The indices underlying these Eurodollar futures contracts are
the three-month LIBOR rates. We also held open swaption positions with a
notional value totaling $2.0 billion at December 31, 2002, with a final maturity
of January 2, 2003. These positions change during the quarter so period-end
positions may or may not be indicative of our net risk exposure throughout the
quarter.
Onset Capital Corporation uses two interest rate swaps to reduce repricing
risk associated with one of its funding sources. The interest rate risk is
created due to a repricing mismatch between the fixed-rate payment stream from
leasing assets and floating rate funding. The notional amounts of the swaps were
$5.2 million and $3.6 million as of December 31, 2002. The notional values of
both interest rate swaps amortize on a schedule designed to approximate the
principal pay down of the lease portfolio, and have an average remaining
maturity of approximately six months.
We own foreign currency forward contracts to protect the U.S. dollar value
of intercompany loans made to Onset Capital Corporation that are denominated in
Canadian dollars. We had a notional amount of $84.7 million in forward contracts
outstanding as of December 31, 2002. For the year ended December 31, 2002, we
recognized losses on these contracts of $0.9 million. These contracts are
marked-to-market with gains and losses included in other expense on the income
statement. The foreign currency transaction gain was $0.5 million during the
year ended December 31, 2002.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The quantitative and qualitative disclosures about market risk are reported
in the Interest Rate Risk section of Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations found on pages 65
through 69.
ITEM 8. FINANCIAL STATEMENTS
Management Report on Responsibility for Financial Reporting
The management of Irwin Financial Corporation and its subsidiaries has the
responsibility of preparing the accompanying financial statements and for their
integrity and objectivity. The statements were prepared in conformity with
generally accepted accounting principles and are not misstated due to fraud or
material error. The financial statements include amounts that are based on
management's best estimates and judgments. Management also prepared the other
information in the annual report and is responsible for its accuracy and
consistency with the financial statements.
Our financial statements have been audited by PricewaterhouseCoopers LLP,
independent certified public accountants. Management has made available to
PricewaterhouseCoopers all of Irwin Financial's financial records and related
data, as well as the minutes of stockholders' and directors' meetings.
Furthermore, management believes that all representations made to
PricewaterhouseCoopers during its audit were valid and appropriate.
Our management has established and maintains a system of internal control
that provides reasonable, but not absolute, assurance as to the integrity and
reliability of the financial statements, the protection of assets from
unauthorized use or disposition, and the prevention and detection of fraudulent
financial reporting. Assessments of the system of internal control are based on
criteria for effective internal control over financial reporting described in
"Internal Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Management continually monitors the
system of internal control for compliance. Irwin Financial maintains a strong
internal auditing program that independently assesses the effectiveness of the
internal controls and recommends possible improvements. In addition, as part of
its audit of our financial statements, PricewaterhouseCoopers completed an
assessment of selected internal accounting controls to establish a basis for
reliance on these controls in determining the nature, timing, and extent of
audit-tests to be applied. Management has considered the internal auditor's and
PricewaterhouseCoopers' recommendations concerning our system of internal
control and has taken actions to respond appropriately to
70
these recommendations that we believe are cost effective in the circumstances.
Management believes that our system of internal control is adequate to
accomplish the objectives discussed herein.
Management also recognized its responsibility for fostering a strong
ethical climate so that our affairs are conducted according to the highest
standards of personal and corporate conduct. This responsibility is articulated
in our Guiding Philosophy, a condensed version of which has been published in
our annual report since 1995. Employees at all levels of the Corporation are
trained in our Guiding Philosophy. This responsibility is also reflected in our
Code of Conduct. The Code of Conduct addresses, among other things, the
necessity of ensuring open communication within Irwin Financial; potential
conflicts of interest; compliance with all domestic and foreign laws, including
those related to financial disclosures; and confidentiality of proprietary
information. We maintain a systematic program to assess compliance with these
policies.
/s/William K. Miller /s/ Gregory F. Ehlinger
71
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors
Irwin Financial Corporation
Columbus, Indiana
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of income, of changes in shareholders' equity
and of cash flows present fairly, in all material respects, the financial
position of Irwin Financial Corporation and its subsidiaries at December 31,
2002 and 2001, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
-s- PricewaterhouseCoopers LLP
Chicago, Illinois
January 24, 2003
72
IRWIN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
2002 2001
------------ ------------
(IN THOUSANDS,
EXCEPT FOR SHARES)
ASSETS:
Cash and cash equivalents................................... $ 157,771 $ 158,223
Interest-bearing deposits with financial institutions....... 34,951 14,261
Trading assets -- Note 3.................................... 157,514 199,071
Investment securities -- held-to-maturity (Market value:
$5,644 in 2002 and $6,206 in 2001) -- Note 4................ 5,349 6,065
Investment securities -- available-for-sale -- Note 4....... 62,599 32,731
Loans held for sale......................................... 1,314,849 502,086
Loans and leases, net of unearned income -- Note 5.......... 2,815,276 2,137,822
Less: Allowance for loan and lease losses -- Note 6......... (50,936) (22,283)
---------- ----------
2,764,340 2,115,539
Servicing assets -- Note 7.................................. 174,935 228,624
Accounts receivable......................................... 55,928 41,828
Accrued interest receivable................................. 15,263 13,121
Premises and equipment -- Note 8............................ 32,398 34,988
Other assets................................................ 108,825 100,065
---------- ----------
Total assets......................................... $4,884,722 $3,446,602
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY:
Deposits
Noninterest-bearing....................................... $ 821,814 $ 533,927
Interest-bearing.......................................... 1,170,660 889,448
Certificates of deposit over $100,000..................... 701,870 885,587
---------- ----------
2,694,344 2,308,962
Short-term borrowings -- Note 10............................ 993,124 487,963
Long-term debt -- Note 11................................... 30,070 30,000
Collateralized borrowings -- Note 12........................ 391,425 0
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts -- Note 13................ 233,000 198,500
Other liabilities........................................... 181,348 188,854
---------- ----------
Total liabilities.................................. 4,523,311 3,214,279
---------- ----------
Commitments and contingencies -- Note 14
Minority interest......................................... 856 658
Shareholders' equity
Preferred stock, no par value -- authorized 4,000,000
shares; none issued as of December 31, 2002 and 96,336
shares as of December 31, 2001.......................... -- 1,386
Common stock, no par value -- authorized 40,000,000
shares; issued 29,612,080 shares and 23,402,080 shares
as of December 31,2002 and December 31, 2001,
respectively; including 1,840,623 and 2,096,947 shares
in treasury as of December 31, 2002 and December 31,
2001, respectively...................................... 112,000 29,965
Additional paid-in capital................................ 3,606 4,426
Deferred compensation..................................... (240) (449)
Accumulated other comprehensive loss, net of deferred
income tax benefit of $336 and $216 in 2002 and 2001,
respectively............................................ (1,142) (325)
Retained earnings......................................... 287,662 241,725
---------- ----------
401,886 276,728
Less treasury stock, at cost....................... (41,331) (45,063)
---------- ----------
Total shareholders' equity......................... 360,555 231,665
---------- ----------
Total liabilities and shareholders' equity......... $4,884,722 $3,446,602
========== ==========
The accompanying notes are an integral part of the consolidated financial
statements.
73
IRWIN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------
2002 2001 2000
---------- --------- --------
(IN THOUSANDS, EXCEPT FOR PER SHARE)
INTEREST INCOME:
Loans and leases............................................ $ 218,350 $128,458 $93,258
Loans held for sale......................................... 55,336 102,383 71,141
Trading account............................................. 34,164 32,029 15,898
Investment securities:
Taxable................................................... 3,262 4,908 4,116
Tax-exempt................................................ 226 247 250
Federal funds sold.......................................... 104 257 143
--------- -------- -------
Total interest income............................... 311,442 268,282 184,806
--------- -------- -------
INTEREST EXPENSE:
Deposits.................................................... 54,361 73,340 52,820
Short-term borrowings....................................... 15,003 29,656 31,528
Long-term debt.............................................. 8,631 2,320 3,430
Preferred securities distribution........................... 19,800 15,767 5,761
--------- -------- -------
Total interest expense.............................. 97,795 121,083 93,539
--------- -------- -------
Net interest income......................................... 213,647 147,199 91,267
Provision for loan and lease losses......................... 43,996 17,505 5,403
--------- -------- -------
Net interest income after provision for loan and lease
Losses.................................................... 169,651 129,694 85,864
--------- -------- -------
OTHER INCOME:
Loan servicing fees......................................... 73,505 67,362 58,641
Amortization and impairment of servicing assets............. (208,561) (50,134) (39,553)
--------- -------- -------
Net loan administration income/(loss)..................... (135,056) 17,228 19,088
--------- -------- -------
Loan origination fees....................................... 76,766 64,303 52,696
Gain from sales of loans.................................... 183,258 207,370 76,553
Gain on sale of mortgage servicing assets................... 14,842 8,394 27,528
Trading (losses)/gains...................................... (26,032) (38,420) 14,399
Derivative gains, net....................................... 125,476 5,959 --
Other....................................................... 18,179 6,409 21,379
--------- -------- -------
257,433 271,243 211,643
--------- -------- -------
OTHER EXPENSE:
Salaries.................................................... 188,263 184,293 124,509
Pension and other employee benefits......................... 33,928 26,870 20,601
Office expense.............................................. 18,225 14,698 12,420
Premises and equipment...................................... 34,392 31,420 26,932
Marketing and development................................... 12,296 13,618 22,881
Professional Fees........................................... 9,611 10,371 7,027
Other....................................................... 44,138 45,467 23,606
--------- -------- -------
340,853 326,737 237,976
--------- -------- -------
Income before income taxes.................................. 86,231 74,200 59,531
Provision for income taxes.................................. 33,398 28,859 23,865
--------- -------- -------
Income before cumulative effect of change in accounting
principle................................................. 52,833 45,341 35,666
Cumulative effect of change in accounting principle, net of
tax....................................................... 495 175 --
--------- -------- -------
Net income.................................................. $ 53,328 $ 45,516 $35,666
========= ======== =======
Earnings per share before cumulative effect of change in
accounting principle: Note 21
Basic..................................................... $ 1.97 $ 2.14 $ 1.70
========= ======== =======
Diluted................................................... $ 1.87 $ 1.99 $ 1.67
========= ======== =======
Earnings per share: Note 21
Basic..................................................... $ 1.99 $ 2.15 $ 1.70
========= ======== =======
Diluted................................................... $ 1.89 $ 2.00 $ 1.67
========= ======== =======
Dividends per share......................................... $ 0.27 $ 0.26 $ 0.24
========= ======== =======
The accompanying notes are an integral part of the consolidated financial
statements.
74
IRWIN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
ACCUMULATED
OTHER
COMPREHENSIVE ADDITIONAL
RETAINED INCOME DEFERRED PAID IN COMMON PREFERRED TREASURY
TOTAL EARNINGS (LOSS) COMPENSATION CAPITAL STOCK STOCK STOCK
-------- -------- ------------- ------------ ---------- -------- --------- --------
(IN THOUSANDS, EXCEPT SHARES)
Balance at January 1, 2000.... $159,296 $171,101 $ (70) -- $4,250 $ 29,965 $ -- $(45,950)
======== ======== ======= ===== ====== ======== ====== ========
Net income.................. 35,666 35,666
Unrealized gain on
investment securities net
of $43 tax liability...... 64 64
Foreign currency adjustment
net of $43 tax benefit.... (66) (66)
Minimum pension liability
net of $257 tax benefit... (387) (387)
--------
Total comprehensive
income.............. 35,277
Deferred compensation......... (503) (503)
Cash dividends................ (5,038) (5,038)
Tax benefit on stock option
exercises................... 136 136
Treasury stock:
Purchase of 220,948
shares.................... (3,414) (3,414)
Sales of 142,132 shares..... 1,730 (55) 1,785
Issuance of 96,336 shares of
preferred stock............. 1,386 1,386
-------- -------- ------- ----- ------ -------- ------ --------
Balance December 31, 2000..... $188,870 $201,729 $ (459) $(503) $4,331 $ 29,965 $1,386 $(47,579)
======== ======== ======= ===== ====== ======== ====== ========
Net income.................. 45,516 45,516
Unrealized gain on
investment securities net
of $53 tax liability...... 80 80
Foreign currency adjustment
net of $221 tax benefit... (333) (333)
Minimum pension liability
net of $257 tax
liability................. 387 387
--------
Total comprehensive
income.............. 45,650
Deferred compensation......... 54 54
Cash dividends................ (5,520) (5,520)
Tax benefit on stock option
exercises................... 2,451 2,451
Treasury stock:
Purchase of 136,089
shares.................... (3,223) (3,223)
Sales of 415,261 shares..... 3,383 (2,356) 5,739
-------- -------- ------- ----- ------ -------- ------ --------
Balance December 31, 2001..... $231,665 $241,725 $ (325) $(449) $4,426 $ 29,965 $1,386 $(45,063)
======== ======== ======= ===== ====== ======== ====== ========
Net income.................. 53,328 53,328
Unrealized loss on
derivatives net of $115
tax benefit............... (172) (172)
Unrealized loss on
investment securities net
of $49 tax benefit........ (73) (73)
Foreign currency adjustment
net of $45 tax
liability................. 67 67
Minimum SERP liability...... (639) (639)
--------
Total comprehensive
Income.............. 52,511
Other adjustments............. 287 78 209
Cash dividends................ (7,469) (7,469)
Sales of 6,210,000 shares of
common stock................ 82,035 82,035
Conversion of preferred stock
to 120,441 shares common.... -- (1,386) 1,386
Tax benefit on stock option
Exercises................... 516 516
Treasury stock:
Purchase of 58,635 shares... (1,176) (1,176)
Sales of 194,518 shares..... 2,186 (1,336) 3,522
-------- -------- ------- ----- ------ -------- ------ --------
Balance December 31, 2002..... $360,555 $287,662 $(1,142) $(240) $3,606 $112,000 $ -- $(41,331)
======== ======== ======= ===== ====== ======== ====== ========
The accompanying notes are an integral part of the consolidated financial
statements.
75
IRWIN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------------
2002 2001 2000
------------ ------------ -----------
(IN THOUSANDS)
NET INCOME.................................................. $ 53,328 $ 45,516 $ 35,666
ADJUSTMENTS TO RECONCILE NET INCOME TO CASH PROVIDED (USED)
BY OPERATING ACTIVITIES:
Depreciation, amortization, and accretion, net.............. 11,451 9,097 9,114
Amortization and impairment of servicing assets............. 208,561 50,134 39,050
Provision for loan and lease losses......................... 43,996 17,505 5,403
Deferred income tax......................................... (52,507) 26,245 21,702
Gain on sale of mortgage servicing assets................... (14,842) (8,394) (27,528)
Gain from sale of loans..................................... (183,258) (207,273) (76,050)
Originated and purchased mortgage servicing assets.......... (180,627) (151,821) (57,165)
Originations of loans held for sale......................... (12,226,408) (10,375,401) (5,317,528)
Proceeds from sale of mortgage servicing assets............. 40,597 11,979 53,142
Proceeds from the sale of loans held for sale............... 11,595,401 10,331,270 5,323,784
Net decrease (increase) in trading assets................... 41,557 (61,763) (95,896)
(Increase) decrease in accounts receivable.................. (14,100) 27,228 (49,415)
Other, net.................................................. 29,994 14,092 23,639
------------ ------------ -----------
Net cash used by operating activities..................... (646,857) (271,586) (112,082)
------------ ------------ -----------
LENDING AND INVESTING ACTIVITIES:
Proceeds from maturities/calls of investment securities:
Held-to-maturity.......................................... 716 4,114 1,286
Available-for-sale........................................ 5,665 2,441 26
Purchase of investment securities:
Held-to-maturity.......................................... -- (437) (781)
Available-for-sale........................................ (35,660) (7,692) --
Net increase (decrease) in interest-bearing deposits with
financial institutions.................................... (20,690) 22,153 (9,615)
Net increase in loans, excluding sales...................... (718,319) (733,698) (534,845)
Sales of loans.............................................. 27,024 149,957 31,521
Acquisition of Onset Capital Corporation, net of cash
acquired.................................................. -- -- (837)
Other, net.................................................. (4,931) (10,760) (11,922)
------------ ------------ -----------
Net cash used by lending and investing activities......... (746,195) (573,922) (525,167)
------------ ------------ -----------
FINANCING ACTIVITIES:
Net increase in deposits.................................... 385,382 865,688 573,012
Net increase in short-term borrowings....................... 505,161 12,461 2,399
Proceeds from issuance (repayments) of long-term debt....... 70 -- (176)
Net proceeds from issuance of collateralized borrowings..... 391,425 -- --
Proceeds from issuance of trust preferred securities........ 34,500 45,000 103,500
Proceeds from sale of stock for equity offering............. 82,035 -- --
Proceeds from issuance of preferred stock................... -- -- 1,386
Purchase of treasury stock for employee benefit plans....... (1,176) (3,223) (3,414)
Proceeds from sale of stock for employee benefit plans...... 2,702 5,834 1,866
Dividends paid.............................................. (7,469) (5,520) (5,038)
------------ ------------ -----------
Net cash provided by financing activities................. 1,392,630 920,240 673,535
------------ ------------ -----------
Effect of exchange rate changes on cash..................... (30) (2) (8)
------------ ------------ -----------
Net (decrease) increase in cash and cash equivalents........ (452) 74,730 36,278
Cash and cash equivalents at beginning of period............ 158,223 83,493 47,215
------------ ------------ -----------
Cash and cash equivalents at end of period.................. $ 157,771 $ 158,223 $ 83,493
============ ============ ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period:
Interest.................................................. $ 104,461 $ 123,058 $ 81,989
============ ============ ===========
Income taxes.............................................. $ 49,185 $ 7,357 $ 13,864
============ ============ ===========
Non-cash Transactions:
Conversion of preferred stock to common stock............. $ 1,386 $ -- $ --
============ ============ ===========
Mortgage loans held for sale transferred to loans and
leases.................................................. $ -- $ 327,700 $ --
============ ============ ===========
The accompanying notes are an integral part of the consolidated financial
statements.
76
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation: Irwin Financial Corporation and its subsidiaries provide
financial services throughout the United States and Canada. We are engaged in
the mortgage banking, commercial banking, home equity lending, commercial
finance, and venture capital lines of business. Intercompany balances and
transactions have been eliminated in consolidation.
Use of Estimates: The preparation of financial statements in conformity
with generally accepted accounting principles requires us to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Foreign Currency: Assets and liabilities denominated in Canadian dollars
are translated into U.S. dollars at rates prevailing on the balance sheet date;
income and expenses are translated at average rates of exchange for the year.
Unrealized foreign currency translation gains and losses are recorded in
accumulated other comprehensive income in shareholders' equity.
Securities: Those securities that we have the positive intent and ability
to hold until maturity are classified as "held-to-maturity" and are stated at
cost adjusted for amortization of premium and accretion of discount (adjusted
cost). Securities that might be sold prior to maturity are classified as
"available-for-sale" and are stated at fair value. Unrealized gains and losses
on available for sale investments, net of the future tax impact, are reported as
a separate component of shareholders' equity until realized. Investment gains
and losses are based on the adjusted cost of the specific security determined on
a specific identification basis.
Trading Assets: Trading assets are stated at fair value. Unrealized gains
and losses are included in earnings. Included in trading assets are residual
interests. In the past, when we sold receivables in securitizations of home
equity loans and lines of credit, we retained residual interests, a servicing
asset, one or more subordinated tranches, and in some cases a cash reserve
account, all of which are retained interests in the securitized receivables.
Gain or loss on the sale of the receivables depends in part on the previous
carrying amount of the financial assets involved in the transfer, allocated
between the assets sold and the retained interests based on their relative fair
value at the date of transfer.
To obtain fair value of residual interests, quoted market prices are used
if available. However, quotes are generally not available for residual
interests, so we generally estimate fair value based on the present value of
expected cash flows using estimates of the key assumptions -- prepayment speeds,
credit losses, forward yield curves, and discount rates commensurate with the
risks involved -- that management believes market participants would use to
value similar assets. Adjustments to carrying values are recorded as trading
gains or losses.
Loans Held For Sale: Loans held for sale are carried at the lower of cost
or market, determined on an aggregate basis for both performing and
nonperforming loans. Cost basis includes deferred origination fees and costs.
Loans held for sale that qualify for hedge accounting are carried at fair value.
Fair value is determined based on the contract price at which the mortgage loans
will be sold.
Loans: Loans are carried at cost. Loan origination fees and costs are
deferred and the net amounts are amortized as an adjustment to yield. When loans
are sold, deferred fees and costs are included with outstanding principal
balances to determine gains or losses. Interest income on loans is computed
daily based on the principal amount of loans outstanding. The accrual of
interest income is generally discontinued when a loan becomes 90 days past due
as to principal or interest. Management may elect to continue the accrual of
interest when the estimated net realizable value of collateral is sufficient to
cover the principal balance and accrued interest.
Direct Financing Leases: Interest and service charges, net of initial
direct costs, are deferred and reported as income in decreasing amounts over the
life of the lease, which averages three to four years, so as to provide an
approximate constant yield on the outstanding principal balance.
77
Allowance for Loan and Lease Losses: The allowance for loan and lease
losses is maintained at a level considered adequate to provide for loan and
lease losses and is based on management's evaluation of inherent losses in the
portfolio. Loans are considered impaired if it is probable that we will be
unable to collect the scheduled payments of principal or interest when due
according to the contractual terms of the loan agreement. The measurement of
impaired loans is generally based on the present value of expected future cash
flows discounted at the historical effective interest rate, except that all
collateral-dependent loans are measured for impairment based on the fair value
of the collateral.
Servicing Assets: When we securitize or sell loans, we generally retain
the right to service the underlying loans sold. A portion of the cost basis of
loans sold is allocated to this servicing asset based on its fair value relative
to the loans sold and the servicing asset combined. We use the market prices
under comparable servicing sale contracts, when available, or alternatively use
valuation models that calculate the present value of future cash flows to
determine the fair value of the servicing assets. In using this valuation
method, we incorporate assumptions that we believe market participants would use
in estimating future net servicing income, which include estimates of the cost
of servicing per loan, the discount rate, float value, an inflation rate,
ancillary income per loan, prepayment speeds, and default rates. Servicing
assets are amortized over the estimated lives of the related loans in proportion
to estimated net servicing income.
In determining servicing value impairment, the servicing portfolio is
stratified into its predominant risk characteristics, principally by interest
rate and product type. These segments of the portfolio are valued, using market
prices under comparable servicing sale contracts, when available, or
alternatively, using the same model as was used to originally determine the fair
value at origination, using current market assumptions. The calculated value is
then compared with the book value of each stratum to determine the required
reserve for impairment. The impairment reserve fluctuates as interest rates
change and, therefore, no reasonable estimate can be made as to future increases
or declines in valuation allowance levels. We also test actual cash collection
to projected cash collections and adjust our models as appropriate. In addition,
we periodically have independent valuations performed on the portfolio.
Derivative Instruments: All derivative instruments have been recorded at
fair value and are classified as other assets in the consolidated balance sheet.
The adoption of SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities," on January 1, 2001 resulted in a cumulative change in accounting
principle, increasing net income by $175 thousand in 2001.
Derivative instruments that are used in our risk management strategy may
qualify for hedge accounting if the derivatives are designated as cash flow or
fair value hedges and applicable hedge criteria are met. Changes in the fair
value of a derivative that is highly effective (as defined by SFAS No. 133) and
qualifies as a fair value hedge, along with changes in the fair value of the
underlying hedged item, are recorded in current period earnings. Changes in the
fair value of a derivative that is highly effective (as defined by SFAS No. 133)
and qualifies as a cash flow hedge, to the extent that the hedge is effective,
are recorded in other comprehensive income only until earnings are recognized
from the underlying hedged item. Net gains or losses resulting from hedge
ineffectiveness are recorded in current period earnings.
We use certain derivative instruments that do not qualify for hedge
accounting treatment under SFAS No. 133. These derivatives are classified as
other assets and marked to market in the income statement. While we do not seek
GAAP hedge accounting treatment for these instruments, their economic purpose is
to manage the risk of existing exposures to either interest rate risk or foreign
currency risk.
Premises and Equipment: Premises and equipment are recorded at cost.
Depreciation is determined by the straight-line method.
Venture Capital Investments: Venture capital investments held by Irwin
Ventures, LLC are carried at fair value with changes in fair value recognized in
other income. The investment committee of Irwin Ventures determines the value of
these nonpublicly traded investments at the end of each reporting period based
upon review of the investee's financial results, condition, and prospects.
Changes in estimated fair values can also be made when an event such as a new
round of funding from other private equity investors would cause a change
78
in estimated market value. In the future, should the company have investments in
publicly-traded securities, it would look to the traded market value of the
investments as the basis of its mark-to-market.
Other Assets: Included in other assets at December 31, 2002 and 2001 are
$5.3 million and $4.4 million of real estate properties acquired as a result of
foreclosure. Other real estate owned is carried at the lower of the recorded
investment in the related loan or fair value of the property less estimated
costs to sell.
Income Taxes: A consolidated tax return is filed for all eligible
entities. Deferred income taxes are computed using the liability method, which
establishes a deferred tax asset or liability based on temporary differences
between the tax basis of an asset or liability and the basis recorded in the
financial statements.
Cash and Cash Equivalents Defined: For purposes of the statement of cash
flows, we consider cash and due from banks to be cash equivalents.
Stock-Based Employee Compensation: At December 31, 2002, we have two
stock-based employee compensation plans, which are described more fully in Note
18. We use the intrinsic value method to account for our plans under the
recognition and measurement principles of APB Opinion No. 25, "Accounting for
Stock Issued to Employees," and related Interpretations. No stock-based employee
compensation cost is reflected in net income for any of the periods presented,
as all options granted under these plans had an exercise price equal to the
market value of the underlying common stock on the date of grant. The Board of
Directors has not chosen to expense stock options. The Board wishes to analyze
new guidance from the FASB, SEC or other relevant authority regarding the
standardization of valuation methods, should such guidance be forthcoming. In
the absence of a uniform valuation method for public companies, we will continue
to disclose the impact of expensing stock options, using our valuation method,
in this footnote. The following table illustrates the effect on net income and
earnings per share if we had applied the fair value recognition provisions of
FASB Statement No. 123, "Accounting for Stock-Based Compensation," to
stock-based employee compensation:
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
Net income as reported...................................... $53,328 $45,516 $35,666
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects................................ (2,639) (1,887) (1,301)
------- ------- -------
Proforma net income......................................... $50,689 $43,629 $34,365
======= ======= =======
Basic earnings per share
As reported............................................... $ 1.99 $ 2.15 $ 1.70
Pro forma................................................. $ 1.89 $ 2.06 $ 1.64
Diluted earnings per share
As reported............................................... $ 1.89 $ 2.00 $ 1.67
Pro forma................................................. $ 1.80 $ 1.92 $ 1.59
In determining compensation expense above, the fair value of each option
was estimated to be $6.99, $11.43, and $9.32 on the date of the grant using the
binomial option-pricing model with the following assumptions for 2002, 2001, and
2000, respectively: risk free interest rates of 4.54%, 5.26%, and 6.13%;
dividend yield of 1.00% for 2002, 2001 and 2000; volatility of 40% for 2002,
2001 and 2000; and a weighted average expected life of seven years in 2002 and
ten years in 2001 and 2000.
Recent Accounting Developments: In June 2001 the FASB approved SFAS No.
142, "Goodwill and Other Intangible Assets." Under the provisions of SFAS No.
142, goodwill is no longer amortized against earnings. Instead, goodwill and
intangible assets deemed to have an indefinite life are reviewed for impairment
at least annually. The amortization period of intangible assets with finite
lives is no longer limited to forty years. This standard became effective
January 1, 2002. We discontinued the amortization of goodwill with a net
carrying value of $1.8 million on the date of adoption and annual amortization
of $0.2 million that resulted from business combinations prior to the adoption
of SFAS No. 141. In addition, as required by the standard,
79
we wrote off, as a cumulative effect of a change in accounting principle,
unamortized negative goodwill totaling $0.5 million net of tax at the date of
adoption arising from a prior business combination at our commercial finance
line of business.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections" and SFAS No. 147, "Acquisition of Certain Financial Institutions."
These Statements rescind the Statements concerning gains and losses from
extinguishment of debt and accounting for intangible assets of motor carriers.
They also amend the rules for sale-leaseback accounting, require the
acquisitions of financial institutions to be accounted for in accordance with
business combinations and goodwill and other intangible assets, and make various
technical corrections to existing pronouncements. These Statements had no
material impact on our earnings or financial position.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." This Statement improves financial
reporting by requiring that a liability for a cost associated with an exit or
disposal activity be recognized and measured initially at fair value only when
the liability is incurred rather than at the date of an entity's commitment to
an exit plan. The provisions of this Statement are effective for exit or
disposal activities that are initiated after December 31, 2002. Management does
not believe the implementation of SFAS 146 will have a material effect on our
earnings or financial position.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others," which elaborates on the disclosures about
certain guarantees that are issued. A guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. They are also required to disclose (a) the
nature of the guarantee, including the approximate term, how it arose, and the
events that would require performance under the guarantee; (b) the maximum
potential amount of future payments under the guarantee; (c) the carrying amount
of the liability; and (d) the nature and extent of any recourse provisions or
available collateral that would enable recovery of any amounts paid under the
guarantee. The initial recognition and measurement provisions are applicable on
a prospective basis to guarantees issued or modified after December 31, 2002.
The disclosure requirement became effective on December 15, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" which requires existing unconsolidated variable
interest entities to be consolidated by their primary beneficiaries if the
entities do not effectively disperse risks among parties involved. The primary
beneficiary is the party that absorbs a majority of expected losses, receives a
majority of expected residual returns, or both, as a result of holding variable
interests, which are the ownership, contractual, or other pecuniary interests in
the entity. They are required to disclose the (a) nature, purpose, size, and
activities of the variable interest entity, (b) the carrying amount and
classification of assets that are collateral, and (c) any lack of recourse by
creditors to the primary beneficiary. If a primary interest is not held, but a
significant variable interest is held, disclosure requirements include (1) the
nature, purpose, size and activities of the variable interest entity, (2)
exposure to loss, (3) the date and nature of involvement with the entity. This
interpretation applies immediately to variable interests created or obtained
after January 31, 2003 for interim periods beginning after June 15, 2003.
Management does not believe the implementation of Interpretation No. 46 will
have a material effect on our earnings or financial position.
Reclassifications: Certain amounts in the 2001 and 2000 consolidated
financial statements have been reclassified to conform to the 2002 presentation.
These changes had no impact on previously reported net income or shareholders'
equity.
NOTE 2 -- RESTRICTIONS ON CASH AND INTEREST-BEARING DEPOSITS WITH FINANCIAL
INSTITUTIONS
Irwin Union Bank and Trust Company and Irwin Union Bank, F.S.B. are
required to maintain reserve balances with the Federal Reserve Bank. The total
reserve balance at December 31, 2002 was $19.2 million. Additionally, we are
required to maintain reserve funds in connection with our loan securitization
activities. Included in accounts receivable at December 31, 2002 is $0.2 million
of these reserve funds.
80
NOTE 3 -- SALES OF RECEIVABLES
Under our past securitization program, home equity loans were sold to
limited purpose, bankruptcy-remote fully owned subsidiaries. In turn, these
subsidiaries established separate trusts to which they transferred the home
equity loans in exchange for the proceeds from the sale of asset-backed
securities issued by the trust. The trusts' activities are generally limited to
acquiring the home equity loans, issuing asset-backed securities and making
payments on the securities. Due to the nature of the assets held by the trusts
and the limited nature of each trust's activities, they are classified as
qualified special purpose entities (QSPEs) under SFAS No. 140. "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."
In accordance with SFAS No. 140, assets and liabilities of the QSPEs are not
consolidated in our Financial Statements.
We agree to service the loans transferred to the QSPEs for a fee and may
earn other related operating income. We also retain the residual interests in
the QSPEs and these interests are reported as trading assets in our balance
sheets.
During 2002 and 2001, we sold home equity loans and lines of credit in
securitization transactions resulting in the creation of residual interests.
Residual interests totaling $157.1 million and $199.1 million, respectively, are
included in trading assets at December 31, 2002 and 2001, respectively. We
receive annual servicing fees of approximately 0.5% to 1.0% of the outstanding
balance and rights to future cash flows arising after the investors in the
securitization trust have received the return for which they contracted. The
investors and the securitization trusts have no recourse to our other assets for
failure of debtors to pay when due. Our residual interests are subordinate to
investor's interests. The value of the residual interests are subject to
prepayment, credit, and interest rate risks in the transferred financial assets.
We recognized pretax gains of $2.5 million, $91.4 million, and $47.0
million on the securitization of home equity loans and lines of credit at our
home equity line of business during 2002, 2001, and 2000, respectively.
In accounting for the residual assets, we analyze interests on a tranche by
tranche basis and perform analysis at the loan level. Key economic assumptions
used in measuring the fair value of residual interests at the date of
securitization resulting from the one securitization completed during the year
2002 were as follows:
Prepayment speed (annual rate)................ 22.00%
Weighted-average remaining life (in years).... 2.83
Expected credit losses (annual rate).......... 1.14%
Residual cash flows discounted at............. 18.00
Interest rates on adjustable notes............ LIBOR plus contractual spread ranging from 22
to 200 basis points
81
At December 31, 2002, key economic assumptions and the sensitivity of the
current fair value of all residual cash flows to immediate 10 percent and 25
percent adverse changes in those assumptions are as follows:
HOME EQUITY LOANS AND LINES OF CREDIT
-------------------------------------
($ IN THOUSANDS)
Balance Sheet Carrying Value of residual interests -- Fair
Value..................................................... $157,065
Weighted-average life (in years)............................ 1.91
Prepayment Speed Assumptions (annual rate).................. 32.37%
Impact on fair value of 10% adverse change (35.61%)......... $ (1,823)
Impact on fair value of 25% adverse change (40.46%)......... (4,189)
Expected Credit Losses (annual rate)........................ 3.57%
Impact on fair value of 10% adverse change (3.93%).......... $ (6,200)
Impact on fair value of 25% adverse change (4.46%).......... (14,658)
Residual cash flows discount rate (annual).................. 18.69%
Impact on fair value of 10% adverse change (20.56%)......... $ (4,450)
Impact on fair value of 25% adverse change (23.36%)......... (10,701)
These sensitivities are hypothetical and should be used with caution.
Changes in fair value based on a 10 percent and 25 percent variation in
assumptions generally cannot be extrapolated because the relationship of the
change in assumption to the change in fair value may not be linear. Also, in
this table, the effect of a variation in a particular assumption on the fair
value of the retained interest is calculated without changing any other
assumption; in reality, changes in one factor may result in changes in another
(for example, increases in market interest rates may result in lower prepayments
and increased credit losses), which might magnify or counteract the
sensitivities.
Static pool credit losses are calculated by summing the actual and
projected future credit losses and dividing them by the original balance of each
pool of assets. The amount shown here for each year is calculated based on all
securitizations occurring in that year accounted for using gain-on-sale
methodology.
Actual and projected credit losses (%) as of:
HOME EQUITY LOANS AND LINES OF CREDIT SECURITIZED IN
------------------------------------------------------------------
1997 1998 1999 2000 2001 2002
-------- -------- -------- ---------- ---------- -------
DECEMBER 31, 2002 (DOLLARS IN THOUSANDS)
Actual to date................... 1.23% 1.45% 3.49% 4.61% 2.05% 1.26%
Projected future cumulative...... 0.01 0.35 0.89 2.57 4.87 5.72
-------- -------- -------- ---------- ---------- -------
Total losses..................... 1.24 1.80 4.38 7.18 6.92 6.98
Original balance securitized..... $229,994 $160,470 $433,606 $1,128,398 $1,042,462 $31,708
The table below summarizes the cash flows received from (paid to)
securitization trusts during the year ended December 31, 2002 where gain on sale
accounting has been applied:
(IN THOUSANDS)
Proceeds from new securitizations........................... $ 31,708
Servicing fees received..................................... 14,479
Cash flows received on residual interests*.................. 53,626
Cash received upon release from reserve accounts............ 271
Purchases of delinquent or foreclosed assets................ (75)
Servicing advances.......................................... (13,458)
Reimbursements of servicing advances........................ 15,234
Prepayment interest shortfalls paid out as compensating
interest.................................................. (2,664)
82
---------------
* Cash flows received on residual interests are net of $4.8 million used to
over-collateralize the trusts. During 2002, $48 thousand was paid to
over-collateralize the trusts at the time of securitization.
Historical loss and delinquency amounts for the managed portfolio:
DELINQUENT PRINCIPAL OVER
TOTAL PRINCIPAL AMOUNT OF 30 DAYS** FOR THE YEAR
LOANS AT DECEMBER 31, 2002 ENDED DECEMBER 31, 2002
-------------------------- -------------------------
(DOLLARS IN THOUSANDS)
Managed loans comprised of:
Loans held for investment........................ $ 631,358 $ 21,282
Loans held for sale.............................. 75,541 --
Loans securitized, servicing and residual
retained*...................................... 1,123,440 88,666
---------- --------
Total managed portfolio.......................... $1,830,339 $109,948
========== ========
---------------
* Represents the principal amount of the loan. Residual interests held for
securitized assets are excluded from this table because they are recognized
separately.
** Includes bankruptcies, foreclosures and other real estate owned.
Actual credit losses, net of recoveries, on the managed portfolio during
the year ended December 31, 2002 were $57.9 million. Of this amount, $10.1
million related to loans held for investment while $47.8 million related to
sold, securitized loans.
NOTE 4 -- INVESTMENT SECURITIES
The amortized cost, fair value, and carrying value of investments held at
December 31, 2002 are as follows:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR CARRYING
COST GAINS LOSSES VALUE VALUE
--------- ---------- ---------- ------- --------
(IN THOUSANDS)
Held-to-Maturity:
Obligations of states and political
subdivisions................................. $ 4,210 $299 $ -- $ 4,509 $ 4,210
Mortgage-backed securities..................... 1,006 -- (4) 1,002 1,006
Other.......................................... 133 -- -- 133 133
------- ---- ---- ------- -------
Total held-to-maturity....................... 5,349 299 (4) 5,644 5,349
------- ---- ---- ------- -------
Available-for-Sale:
U.S. Treasury and Government Obligations....... 60,868 -- -- 60,868 60,868
Mortgage-backed securities..................... 722 10 -- 732 732
Other.......................................... 1,007 -- (8) 999 999
------- ---- ---- ------- -------
Total available-for-sale..................... 62,597 10 (8) 62,599 62,599
------- ---- ---- ------- -------
Total investments............................ $67,946 $309 $(12) $68,243 $67,948
======= ==== ==== ======= =======
83
The amortized cost, fair value, and carrying value of investments held at
December 31, 2001 are as follows:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR CARRYING
COST GAINS LOSSES VALUE VALUE
--------- ---------- ---------- ------- --------
(IN THOUSANDS)
Held-to-Maturity:
Obligations of states and political
subdivisions................................. $ 4,425 $113 $ -- $ 4,538 $ 4,425
Mortgage-backed securities..................... 1,507 28 -- 1,535 1,507
Other.......................................... 133 -- -- 133 133
------- ---- ---- ------- -------
Total held-to-maturity....................... 6,065 141 -- 6,206 6,065
------- ---- ---- ------- -------
Available-for-Sale:
U.S. Treasury and Government Obligations....... 29,251 78 -- 29,329 29,329
Mortgage-backed securities..................... 2,671 46 -- 2,717 2,717
Other.......................................... 685 -- -- 685 685
------- ---- ---- ------- -------
Total available-for-sale..................... 32,607 124 -- 32,731 32,731
------- ---- ---- ------- -------
Total investments............................ $38,672 $265 $ -- $38,937 $38,796
======= ==== ==== ======= =======
The amortized cost and estimated value of debt securities at December 31,
2002, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.
AMORTIZED FAIR
COST VALUE
--------- -------
(IN THOUSANDS)
Held-to-Maturity:
Due in one year or less................................... $ 468 $ 468
Due after one year through five years..................... 890 941
Due after five years through ten years.................... 1,305 1,426
Due after ten years....................................... 1,680 1,807
------- -------
4,343 4,642
Mortgage-backed securities.................................. 1,006 1,002
------- -------
$ 5,349 $ 5,644
------- -------
Available-for-Sale:
Due in one year or less................................... $15,999 $15,991
Due after ten years....................................... 45,876 45,876
------- -------
61,875 61,867
Mortgage-backed securities.................................. 722 732
------- -------
62,597 62,599
------- -------
Total investments......................................... $67,946 $68,243
======= =======
Investment securities amounting to $1.2 million were pledged and cannot be
repledged by holder, as collateral for borrowings and for other purposes on
December 31, 2002. During 2002 there were no sales or calls on investments. In
2001 and 2000 there were no sales of "available for sale" investments.
Additionally in 2001 and 2000, "held-to-maturity" investments totaling $0.3
million and $2.9 million, respectively, were called resulting in immaterial
losses.
84
NOTE 5 -- LOANS AND LEASES
Loans and leases are summarized as follows:
DECEMBER 31,
-----------------------
2002 2001
---------- ----------
(IN THOUSANDS)
Commercial, financial and agricultural...................... $1,347,962 $1,055,307
Real estate-construction.................................... 314,851 287,228
Real estate-mortgage........................................ 777,865 490,186
Consumer.................................................... 27,857 38,489
Direct financing leases
Domestic............................................... 291,711 232,527
Foreign................................................ 133,784 91,816
Unearned income
Domestic............................................... (59,287) (44,183)
Foreign................................................ (19,467) (13,548)
---------- ----------
Total..................................................... $2,815,276 $2,137,822
========== ==========
At December 31, 2002, we pledged mortgage loans held for investment with a
carrying value of $0.4 billion as collateral for debt securities to bondholders
(Note 12).
Commercial loans are extended primarily to local regional businesses in the
market areas of Irwin Union Bank. We also provide consumer loans to the
customers in those markets. Real estate loans and direct financing leases are
extended throughout the United States and Canada.
Our commercial banking line of business makes loans to our directors and
officers and to organizations and individuals with which our directors and
officers are associated. All outstanding loans and commitments included in such
transactions were made in the normal course of business and on substantially the
same terms, including interest rates and collateral, as those prevailing at the
time for comparable transactions with other persons and did not involve more
than the normal risk of collectibility or present other unfavorable features.
Such loans amounted to $289 thousand and $145 thousand at December 31, 2002 and
2001, respectively. During 2002, $608 thousand of new loans were made and
repayments totaled $465 thousand.
NOTE 6 -- ALLOWANCE FOR LOAN AND LEASE LOSSES
Changes in the allowance for loan and lease losses are summarized below:
DECEMBER 31,
----------------------------
2002 2001 2000
-------- ------- -------
(IN THOUSANDS)
Balance at beginning of year........................... $ 22,283 $13,129 $ 8,555
Acquisition of Onset Capital........................... -- -- 1,908
Provision for loan and lease losses.................... 43,996 17,505 5,403
Reduction due to sale of loans and leases.............. -- (6) --
Reduction due to reclassification of loans............. -- -- (16)
Foreign currency adjustment............................ 17 (140) (19)
Recoveries............................................. 2,870 1,548 466
Charge-offs............................................ (18,230) (9,753) (3,168)
-------- ------- -------
Balance at end of year................................. $ 50,936 $22,283 $13,129
======== ======= =======
At December 31, 2002, the recorded investment in loans for which impairment
has been recognized in accordance with SFAS Nos. 114 and 118 was $14.1 million
with no related allowance and $36.4 million with
85
$7.0 million of related allowance. At December 31, 2001 the recorded investment
in loans for which impairment has been recognized in accordance with SFAS Nos.
114 and 118 was $33.1 million with $4.2 million of related allowance and none
with no related allowance.
For the year ended December 31, 2002, the average balance of impaired loans
was $42.4 million, for which $0.5 million of interest was recorded. For the
years ended December 31, 2001 and 2000, respectively, $2.3 million and $521
thousand of interest income was recorded on average balances of $16.6 million
and $3.5 million.
NOTE 7 -- SERVICING ASSETS
Included on the consolidated balance sheet at December 31, 2002 and 2001
are $174.9 million and $228.6 million, respectively, of capitalized servicing
assets. These amounts relate to the principal balances of loans serviced by us
for investors.
MORTGAGE SERVICING ASSET:
DECEMBER 31,
---------------------
2002 2001
--------- --------
(IN THOUSANDS)
Beginning balance........................................... $ 228,624 $130,522
Additions................................................... 180,627 151,821
Amortization................................................ (62,191) (50,843)
Impairment.................................................. (146,370) 709
Reduction for servicing sales............................... (25,755) (3,585)
--------- --------
$ 174,935 $228,624
========= ========
We have established a valuation allowance to record servicing assets at
their fair value. Changes in the allowance are summarized below:
DECEMBER 31,
-------------------------------
2002 2001 2000
-------- -------- -------
(IN THOUSANDS)
Balance at beginning of year................................ $ 13,495 $ 14,204 $ 401
Provision for impairment.................................... 146,370 11,321 13,803
Permanent impairment*....................................... -- (12,030) --
-------- -------- -------
Balance at end of year...................................... $159,865 $ 13,495 $14,204
======== ======== =======
---------------
* Permanent impairment was recorded in conjunction with a portfolio
restratification change made when we updated predominant risk characteristics
inherent in the portfolio of servicing rights.
At December 31 2002, key economic assumptions and the sensitivity of the
current carrying value of mortgage servicing rights to immediate 10% and 20%
adverse changes in those assumptions are as follows ($ in thousands):
Carrying amount of mortgage servicing rights................ 174,935
Constant prepayment speed................................... 16.78%
Impact on fair value of 10% adverse change(18.46)%.......... (8,962)
Impact on fair value of 20% adverse change(20.14)%.......... (16,660)
Discount Rate............................................... 9.98%
Impact on fair value of 10% adverse change(10.98)%.......... (3,046)
Impact on fair value of 20% adverse change(11.98)%.......... (5,959)
86
These sensitivities are hypothetical and should be used with caution. As
the figures indicate, changes in value based on a 10% and 20% variation in
assumptions generally cannot be extrapolated because the relationship of the
change in assumption to the change in value may not be linear. Also, in this
table, the effect of a variation in a particular assumption on the value of the
residual interest is calculated without changing any other assumption; in
reality, changes in one factor may result in changes in another (for example,
increases in market interest rates may result in lower prepayments and increased
credit losses), which might magnify or counteract the sensitivities.
Included in the servicing assets are $146.4 million and $211.2 million of
servicing assets related to our mortgage banking line of business at December
31, 2002 and 2001, respectively. The servicing assets at our mortgage banking
line of business in the aggregate had a fair value of $150.8 million and $239.7
million at December 31, 2002 and 2001, respectively.
At the mortgage banking line of business, the servicing portfolio
underlying the portion of our servicing assets carried on our balance sheet was
$15.5 billion and $11.6 billion at December 31, 2002 and 2001, respectively. We
sold servicing assets with a notional amount of underlying loans totaling $2.9
billion and $2.3 billion in 2002 and 2001, respectively. Key economic
assumptions used in measuring the carrying value of mortgage servicing rights at
the mortgage banking line of business at December 31, 2002 were as follows:
Weighted average prepayment rate (annual rate).............. 14.64%
Weighted average discount rate.............................. 9.6%
Weighted average remaining life (in years).................. 3.0
NOTE 8 -- PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
DECEMBER 31,
----------------------------------
USEFUL
2002 2001 LIVES
-------- -------- ----------
(IN THOUSANDS)
Land...................................................... $ 2,293 $ 2,263 n/a
Building and leasehold improvements....................... 20,115 19,742 7-40 years
Furniture and equipment................................... 52,003 49,001 3-10 years
-------- --------
74,411 71,006
Less accumulated depreciation............................. (42,013) (36,018)
-------- --------
Total........................................... $ 32,398 $ 34,988
======== ========
Amounts charged to non-interest expense for depreciation amounted to $7.5
million, $5.2 million, and $5.9 million in 2002, 2001, and 2000, respectively.
NOTE 9 -- LEASE OBLIGATIONS
At December 31, 2002, we leased certain branch locations and office
equipment used in our operations.
Operating lease rental expense was $21.6 million in 2002, $19.8 million in
2001, and $17.8 million in 2000.
87
The future minimum rental payments required under noncancellable operating
leases with initial or remaining terms of one year or more are summarized as
follows:
(IN THOUSANDS)
Year ended December 31:
2003...................................................... $17,211
2004...................................................... 13,859
2005...................................................... 10,796
2006...................................................... 8,337
2007...................................................... 4,392
Thereafter................................................ 9,580
-------
Total minimum rental payments..................... $64,175
=======
NOTE 10 -- SHORT-TERM BORROWINGS
Short-term borrowings are summarized as follows:
DECEMBER 31,
--------------------
2002 2001
-------- --------
(IN THOUSANDS)
Drafts payable related to mortgage loan closings............ $200,701 $154,157
Commercial paper............................................ 14,121 11,123
Federal Home Loan Bank borrowings........................... 527,000 212,000
Federal funds............................................... 30,000 35,200
Lines of credit and other borrowings........................ 221,302 75,483
-------- --------
$993,124 $487,963
======== ========
Weighted average interest rate.............................. 2.30% 4.64%
Drafts payable related to mortgage loan closings are related to mortgage
closings at the end of December which have not been presented to the banks for
payment. When presented for payment, these borrowings will be funded internally
or by borrowing from the lines of credit.
The majority of our commercial paper is payable to a company controlled by
a significant shareholder and director of the Corporation.
Federal Home Loan Bank borrowings are collateralized by $1.7 billion in
loans and loans held for sale.
We also have lines of credit available of $1.2 billion to fund loan
originations and operations. Interest on the lines of credit is payable monthly
or quarterly with variable rates ranging from 1.94% to 2.62% at December 31,
2002.
NOTE 11 -- LONG-TERM DEBT
At December 31, 2002 and 2001 we had $30 million of subordinated debt on
our balance sheet with an interest rate of 7.58% and a maturity date of July
2014. In addition, at December 31, 2002 there was a mortgage note outstanding
for $70 thousand with an interest rate of 8.50% and a maturity date of April,
2008.
NOTE 12 -- COLLATERALIZED BORROWINGS
In the normal course of business, we have originated and purchased home
equity loans with the intent to earn interest income, origination fees and
servicing income. Through 2001, the majority of such loans originated and
purchased have historically been considered held for sale and usually sold to
third party investors directly or through a variety of QSPEs in order to achieve
more efficient execution and provide funds for the continued origination and
purchase of loans. In 2002, management determined that we had the intent and
ability to structure and maintain our home equity securitizations as financing
transactions.
88
Beginning in the second quarter of 2002, we commenced securitization of
loans structured as secured financings. Sale treatment was precluded on these
transactions as we maintained effective control over the loans transferred to
our securitization trusts through a call option on the transferred loans and the
retention of servicer discretion. This type of securitization structure results
in cash being received and debt being recorded. In connection with these
transactions, the 2002-1 notes are collateralized by $0.4 billion in home equity
loans and home equity lines of credit classified on the balance sheet as loans
held for investment (Note 5). The principal and interest on these debt
securities are paid using the cash flows from the underlying loans. Accordingly,
the timing of the principal payments on these debt securities is dependent on
the payments received on the underlying collateral. The interest rate on the
bonds floats at a spread to LIBOR.
Collateralized borrowings are summarized as follows:
CONTRACTUAL DECEMBER 31,
MATURITY INTEREST RATE 2002
----------- ------------- ------------
(IN THOUSANDS)
2002-1 asset backed notes:
Variable rate senior note.............................. 7/25/2023 1.65 110,920
Variable rate senior note.............................. 6/25/2029 1.67 202,077
Variable rate subordinate note......................... 2/25/2029 2.28 24,964
Variable rate subordinate note......................... 2/25/2029 2.88 21,063
Variable rate subordinate note......................... 2/25/2029 3.63 26,524
Unamortized premium...................................... 5,877
--------
Total.................................................... $391,425
========
NOTE 13 -- COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF
SUBSIDIARY TRUSTS
We have issued $233 million in trust preferred securities through six IFC
Capital Trusts as of December 31, 2002. All securities are callable at par after
five years from origination date. These funds are all Tier 1 qualifying capital.
The sole assets of these trusts are our subordinated debentures. Highlights
about these trusts are listed below:
ORIGINATION COUPON MATURITY
NAME DATE AMOUNT RATE DATE DIVIDEND OTHER
---- ----------- -------- ------ -------- ---------- --------------------------
IN THOUSANDS
IFC Capital Trust I...... Jan 1997 $ 50,000 9.25% Jan 2027 quarterly have a 19 year extension
option beyond maturity
IFC Capital Trust II..... Nov 2000 51,750 10.50 Nov 2030 quarterly
IFC Capital Trust III.... Nov 2000 51,750 8.75 Nov 2030 quarterly initial conversion ratio
of 1.261 shares of common
stock to 1 convertible
preferred security
IFC Capital Trust IV..... Jul 2001 15,000 10.25 Jul 2031 semiannual
IFC Capital Trust V...... Nov 2001 30,000 9.95 Nov 2031 semiannual
IFC Capital Trust VI..... Oct 2002 34,500 8.70 Oct 2032 quarterly
--------
$233,000
========
NOTE 14 -- COMMITMENTS AND CONTINGENCIES
Our indirect subsidiary, Irwin Mortgage Corporation, is a defendant in a
class action lawsuit in the United States District Court for the Northern
District of Alabama alleging that Irwin Mortgage violated the federal Real
Estate Settlement Procedures Act (RESPA) relating to Irwin Mortgage's payment of
broker fees
89
to mortgage brokers. In June 2001, the Court of Appeals for the 11th Circuit
upheld the district court's certification of a plaintiff class and the case was
remanded for further proceedings in the federal district court. In September
2001, a second suit sought class status and consolidation with this suit.
In November, 2001, by order of the district court, the parties filed
supplemental briefs analyzing the impact of a new policy statement from the
Department of Housing and Urban Development (HUD) that explicitly disagrees with
the judicial interpretation of RESPA by the Court of Appeals for the 11th
Circuit in its ruling upholding class certification in this case. In response to
a motion from Irwin Mortgage, in March, 2002, the district court granted Irwin
Mortgage's motion to stay proceedings in this case until the 11th Circuit
decided the three other RESPA cases originally argued before it with this case.
The second suit seeking consolidation with this one was similarly stayed.
The 11th Circuit has now decided all of the RESPA cases pending in that
court. In one of those cases, the 11th Circuit concluded that the trial court
had abused its discretion in certifying a class action under RESPA. Further, in
that decision, the 11th Circuit expressly recognized it was, in effect,
overruling its previous decision upholding class certification in this case. In
February, 2003, the parties filed a joint motion for a proposed scheduling order
with the district court, which contemplates that Irwin Mortgage will file a
motion to decertify the class and the plaintiffs will file a renewed motion for
summary judgment.
If the class is not decertified and the district court finds that Irwin
Mortgage violated RESPA, Irwin Mortgage could be liable for damages equal to
three times the amount of that portion of payments made to the mortgage brokers
that is ruled unlawful. Based on notices sent by the plaintiffs to date to
potential class members and additional notices that might be sent in this case,
we believe the class is not likely to exceed 32,000 borrowers who meet the class
specifications.
In addition to this case and the case seeking consolidation with it, three
other lawsuits were filed against Irwin Mortgage in 2002 in the Circuit Court of
Calhoun County. These cases seek class action status and allege claims based on
payments similar to those at issue in this case. Another case filed in 2002 in
the United States District Court for the Northern District of Alabama alleges
RESPA violations both similar to and different from those in this case in
connection with payments made to mortgage brokers.
Irwin Mortgage intends to defend this and the related lawsuits vigorously
and believes it has numerous defenses to the alleged RESPA and similar
violations. Irwin Mortgage further believes that the 11th Circuit's recent RESPA
decisions provide grounds for reversal of the class certification in this case.
We have no assurance, however, that Irwin Mortgage will be successful in
defeating class certification in this case or will ultimately prevail on the
merits in this or the other cases. However, we expect that an adverse outcome in
this or the related cases could result in substantial monetary damages that
could be material to our financial position. We have not established any
reserves for this or the related cases and are unable at this stage of the
litigation to form a reasonable estimate of potential loss that we could suffer.
In January, 2001, we and Irwin Leasing Corporation (formerly Affiliated
Capital Corp.), our indirect subsidiary, and Irwin Equipment Finance
Corporation, our direct subsidiary (together, the Irwin companies), were served
as defendants in an action filed in the United States District Court for the
Middle District of Pennsylvania. The suit alleges that a manufacturer/importer
of certain medical devices made misrepresentations to health care professionals
and to government officials to improperly obtain Medicare reimbursement for
treatments using the devices, and that the Irwin companies, through Affiliated
Capital's financing activities, aided in making the alleged misrepresentations.
The Irwin companies filed a motion to dismiss on February 12, 2001. On August
10, 2001, the court granted our motion in part by dismissing Irwin Financial and
Irwin Equipment Finance as defendants in the suit. Irwin Leasing remains a
defendant. We have not established any reserves for this case. Because the case
is in the early stages of litigation, management is unable at this time to form
a reasonable estimate of the amount of potential loss, if any, that Irwin
Leasing could suffer. The company intends to defend this lawsuit vigorously.
Our subsidiary, Irwin Union Bank and Trust Company, is a defendant in a
purported class action lawsuit, filed in the U.S. District Court in
Massachusetts in July 2001. The case involves loans purchased by Irwin Union
Bank and Trust from an unaffiliated third-party originator. The plaintiffs
allege that the loan documents
90
did not comply with certain provisions of the Truth in Lending Act relating to
high rate loans. The complaint seeks rescission of the loans and other damages.
On September 30, 2002, the court granted plaintiffs' motion for certification of
a class, subject to certain limitations. We filed a motion for reconsideration
with the district court and a petition for permission to appeal the class
certification decision with the Court of Appeals for the 1st Circuit. Discovery
has not yet commenced. If the class is ultimately upheld, the actual number of
plaintiff borrowers will be determined only after a review of loan files. We
believe that out of approximately 200 loans acquired directly from the
third-party originator and approximately 7,800 loans acquired from others
through bulk acquisitions, only a portion of these loans will qualify for
inclusion in the class. Because this case is in the early stages of litigation,
we are unable to form a reasonable estimate of potential loss, if any, and have
not established any reserves related to this case.
Our indirect subsidiary, Irwin Mortgage Corporation, is a defendant in a
case filed in August, 1998 in the Baltimore, Maryland, City Circuit. On January
25, 2002, a jury in this case awarded the plaintiffs damages of $1.434 million
jointly and severally against defendants, including Irwin Mortgage. The nine
plaintiff borrowers alleged that a home rehabilitation company defrauded the
plaintiffs by selling them defective homes at inflated prices and that Irwin
Mortgage, which provided the plaintiff borrowers mortgage loans on the home
purchases, participated in the fraud. Irwin Mortgage filed an appeal with the
Maryland Court of Special Appeals. Oral argument was held on January 7, 2003. We
have reserved for this case based upon advice of our legal counsel. Although we
believe Irwin Mortgage has justifiable grounds for appeal, we cannot predict at
this time whether the appeal will ultimately be successful.
We and our subsidiaries are from time to time engaged in various matters of
litigation including the matters described above, other assertions of improper
or fraudulent loan practices or lending violations, and other matters, and we
have a number of unresolved claims pending. In addition, as part of the ordinary
course of business, we and our subsidiaries are parties to litigation involving
claims to the ownership of funds in particular accounts, the collection of
delinquent accounts, challenges to security interests in collateral, and
foreclosure interests, that is incidental to our regular business activities.
While the ultimate liability with respect to these other litigation matters and
claims cannot be determined at this time, we believe that damages, if any, and
other amounts relating to pending matters are not likely to be material to our
consolidated financial position or results of operations, except as described
above. Reserves have been established for these various matters of litigation,
when appropriate, based upon the advice of legal counsel.
NOTE 15 -- FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
In the normal course of business we are party to certain financial
instruments with off-balance sheet risk to meet the financial needs of our
customers. These financial instruments include loan commitments and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amounts recognized on the
consolidated balance sheet.
Our exposure to credit loss, in the form of nonperformance by the
counterparty on commitments to extend credit and standby letters of credit, is
represented by the contractual amount of those instruments. Collateral pledged
for standby letters of credit and commitments varies but may include accounts
receivable; inventory; property, plant, and equipment; and residential real
estate. Total outstanding commitments to extend credit at December 31, 2002,
were $495.6 million. These loan commitments include $134.0 million of floating
rate loan commitments and $361.6 million of fixed rate loan commitments. We had
approximately $24.6 million and $26.1 million in irrevocable standby letters of
credit outstanding at December 31, 2002 and 2001, respectively.
NOTE 16 -- DERIVATIVE FINANCIAL INSTRUMENTS
Financial derivatives are used as part of the overall asset/liability
management process. These instruments are used to manage risk related to changes
in interest and foreign currency fluctuations. Our portfolio of derivative
financial instruments generally consists of forward contracts and interest rate
lock commitments relating to mortgage banking activities, financial futures
contracts, interest rate caps, forward foreign exchange contracts, and interest
rate swaps. Certain derivative instruments have been designated as hedges as all
91
documentation requirements have been satisfied and the hedges have been highly
effective in offsetting changes in the fair value of the hedged items. Other
derivative instruments that are used to hedge certain assets have not been
designated as hedges as they did not qualify for hedge accounting treatment.
We enter into forward contracts to protect against interest rate
fluctuations from the date of first mortgage loan commitment until the loans are
sold. At December 31, 2002, we designated the portion of these transactions
hedging the closed mortgage loans as hedges that qualify for hedge accounting
treatment under SFAS 133. The notional amount of our forward contracts (which
does not represent the amount at risk) totaled $2.2 billion and $0.6 billion at
December 31, 2002 and 2001, respectively. The basis of the hedged closed loans
is adjusted for change in value associated with the risk being hedged. We value
closed loan contracts at period end based upon the current secondary market
value of securities with similar characteristics. The unrealized loss of our
forward contracts at December 31, 2002 was $26.2 million. The effect of these
hedging activities was recorded through earnings as gain from sale of loans.
We enter into commitments to originate loans whereby the interest rate on
the loan is determined prior to funding (rate lock commitments). Rate lock
commitments on loans intended to be sold are considered to be derivatives and
are recorded at fair value. We value these commitments at period end based upon
the current secondary market value of securities with similar characteristics.
At December 31, 2002, we had a notional amount of rate lock commitments
outstanding totaling $1.6 billion with a fair value of $36.3 million. Changes in
fair value of these derivatives are recorded in earnings. Hedge ineffectiveness
recorded in gain on sale of loans, net for the year ended December 31, 2002,
relating to fair value hedges of mortgage loans held for sale was a loss of $2.5
million. Hedge ineffectiveness was not material for 2001.
We manage the interest rate risk inherent in our mortgage servicing rights
through the use of Eurodollar futures contracts and interest rate options. We do
not seek to attain hedge accounting under SFAS 133 for these instruments. For
the year ended December 31, 2002, we recorded gains of $125.6 million on these
derivatives. Both the futures contracts and options were marked-to-market and
included in other assets with changes in value recorded in the income statement
as derivatives gains. At December 31, 2002, we held $8.0 billion in notional
amount of Eurodollar contracts, with expirations ranging from the first quarter
of 2003 to the first quarter of 2009. The indices underlying these Eurodollar
futures contracts are three-month LIBOR rates. We also held open swaption
positions with a notional value totaling $2.0 billion at December 31, 2002, with
a final maturity of January 2, 2003. These positions change during the quarter
so period-end positions may or may not be indicative of our net risk exposure
throughout the quarter.
Certain of our fixed rate residual interests are funded with floating rate
liabilities. To hedge such mismatches, we own three interest rate caps, which
had a fair value of $0.5 million and a notional amount of $60.1 million at
December 31, 2002. We classify interest rate caps as other assets on the balance
sheet and carry them at their fair values. Two of the interest rate caps qualify
for hedge accounting treatment under SFAS 133 as cash flow hedges of the funding
for these residual interests. As a result, a loss adjustment to fair value of
$172 thousand, net of tax, on these cash flow derivatives was recorded through
accumulated other comprehensive income for the year ended December 31, 2002. We
record adjustments to fair value for the third interest rate cap as other income
on the income statement. For the year ended December 31, 2002, we recorded an
$85 thousand loss related to this derivative product.
We enter into foreign currency contracts to protect the value of
intercompany loans made to Onset, our Canadian leasing company, against changes
in the exchange rate. Included in other assets at December 31, 2002, is $483
thousand related to these contracts. These contracts are short term in nature
and their value is based upon closing forward foreign exchange rates at period
end. We had a notional amount of $84.7 million in forward contracts outstanding
as of December 31, 2002.
The Canadian leasing company uses interest rate swaps to neutralize
repricing risk associated with one of its funding sources. At December 31, 2002,
we had two interest rate swaps with a notional value of $5.2 million and $3.6
million. The interest rate swaps amortize on a schedule that is designed to
match the principal pay down of the loan portfolio and have an average remaining
maturity of approximately six months. The fair values of these derivative
instruments are not material.
92
NOTE 17 -- GUARANTEES
Upon the occurrence of certain events under financial guarantees, we have
performance obligations provided in certain contractual arrangements. These
various agreements are summarized below.
We sell loans and commercial loan participation interests to: (i) private
investors; (ii) agency investors including, but not limited to, FNMA, FHLMC and
GNMA; and (iii) other financial institutions. Each loan sale is subject to
certain terms and conditions, which generally require us to indemnify and hold
the investor harmless against any loss arising from errors and omissions in the
origination, processing and/or underwriting of the loans. We are subject to this
risk for loans that we originate as well as loans we acquire from brokers and
correspondents. At December 31, 2002 we had approximately $10.8 million recorded
as an estimate for losses that may occur as a result of the guarantees described
above based on trends in repurchase and indemnification requests, actual loss
experience, known and inherent risks in the loans, and current economic
conditions. The length of the indemnification period, which varies by investor,
and the nature of the alleged defect may extend to the life of the loan. For the
past two years, loans sold for which these guarantees apply totaled
approximately $11.0 billion in 2002 and $9.2 billion in 2001.
We also sell home equity loans to private investors. We have agreed to
repurchase loans that do not perform at agreed-upon levels. The repurchase
period generally ranges from 60-120 days after the settlement date. In addition,
a repurchase obligation may be triggered if a loan does not meet specified
representations related to credit information, loan documentation and
collateral. At December 31, 2002 we had approximately $0.7 million recorded as
an estimate for losses that may occur as a result of the guarantees described
above based on trends in repurchase and indemnification requests, actual loss
experience, known and inherent risks in the loans, and current economic
conditions. Total home equity loans sold for which these guarantees apply were
$0.6 billion in 2002.
In the normal course of our servicing duties, we are often required to
advance payments to investors, taxing authorities and insurance companies that
are due and have not been received from borrowers as of specified cut-off dates.
These servicing advances, totaled $34.5 million at December 31, 2002. Servicing
advances, including contractual interest, are considered a priority cash flow in
the event of foreclosure or liquidation, thus making their collection more
likely. At December 31, 2002, we had $2.2 million recorded as an estimate for
possible losses on these advances.
We also service loans on behalf of private and agency investors and
occasionally sell the servicing rights on these loans to third-party servicers.
The typical servicing contract requires us to indemnify and hold the investor
harmless against any loss arising from our failure to abide by the servicing
guidelines adopted by the investor. The typical servicing sale agreement
requires us to indemnify and hold the purchaser harmless against any loss
arising from our breach of any representation or warranty made in connection
with the sale. Some of the more common servicing sale representations and
warranties include: (i) each loan is in full compliance with investor
requirements; insurer requirements; and federal, state and local laws and
regulations; (ii) seller and all prior servicers have serviced and maintained
the loans in accordance with investor requirements; (iii) each custodial file
and all documents related thereto is true, correct and complete in all material
respects. The loss estimate recorded for these guarantees at December 31, 2002
was $0.6 million.
We provide guarantees to third parties on behalf of one of our subsidiaries
related to operating lease payments with maturity dates extending through 2007.
The maximum potential future payments guaranteed by us under these arrangements
is $28.1 million at December 31, 2002.
We provide Merchant processing services for certain of our commercial
customers. These services entail accepting merchant deposits of credit card
transactions. Under credit card chargeback rules we are contingently liable for
any billing disputes between the card company and its customer. As these
disputes arise, the card company charges us and credits its customer. We then
pass the "charge-back" on to the depositing merchant. If for any reason the
merchant is unwilling or unable to reimburse us for its payment to the credit
card company, we must bear the loss.
We have policies and procedures in place to evaluate customer
creditworthiness prior to offering merchant processing services to the customer.
During 2002 we accepted approximately $53.3 million in
93
merchant deposits and received an estimated $0.3 million in charge-backs. We
incurred no losses on these charge-backs. Any future losses are expected to be
immaterial and as such, no loss accrual has been established.
NOTE 18 -- REGULATORY MATTERS
The Corporation and its bank subsidiaries, Irwin Union Bank and Trust
Company and Irwin Union Bank, F.S.B., are subject to various regulatory capital
requirements administered by the federal and state banking agencies. Under
capital adequacy guidelines, the Corporation, Irwin Union Bank and Trust, and
Irwin Union Bank, F.S.B. must meet specific capital guidelines that involve
quantitative measures of their assets, liabilities, and certain off-balance
sheet items as calculated under regulatory accounting practices. Capital amounts
and classification are also subject to qualitative judgments by the regulators
about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require minimum amounts and ratios (set forth in the following table) of total
and Tier I capital (as defined in the regulations) to risk-weighted assets (as
defined), and Tier I capital to average assets (as defined). We believe, as of
December 31, 2002, that we have met all capital adequacy requirements to which
we are subject. In addition, our board of directors has established minimum
total capital standards for the Corporation and Irwin Union Bank and Trust of
11% and 12%, respectively.
As of December 31, 2002, we were categorized as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized the Corporation, Irwin Union Bank and Trust, and Irwin Union Bank,
F.S.B. must exceed minimum total risk-based, Tier I risk-based, and Tier I
capital to average assets ratios. There have been no conditions or events that
we believe have changed this category.
The following table presents actual capital amounts and ratios for the
Corporation, Irwin Union Bank and Trust and Irwin Union Bank, F.S.B. as compared
to amounts and ratios under the regulatory framework:
ADEQUATELY WELL
ACTUAL CAPITALIZED CAPITALIZED
----------------- ----------------- -----------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------- ----- -------- ----- -------- -----
(DOLLARS IN THOUSANDS)
AS OF DECEMBER 31, 2002:
Total Capital (to Risk-Weighted
Assets):
Irwin Financial Corporation....... $658,156 13.2% $399,673 8.0% $499,592 10.0%
Irwin Union Bank and Trust........ 498,978 12.4 322,303 8.0 402,879 10.0
Irwin Union Bank, F.S.B........... 28,970 21.2 10,928 8.0 13,659 10.0
Tier I Capital (to Risk-Weighted
Assets):
Irwin Financial Corporation....... 462,064 9.2 199,837 4.0 299,755 6.0
Irwin Union Bank and Trust........ 418,676 10.4 161,152 4.0 241,727 6.0
Irwin Union Bank, F.S.B........... 28,440 20.8 N/A 8,196 6.0
Tier I Capital (to Average Assets):
Irwin Financial Corporation....... 462,064 9.7 191,237 4.0 239,046 5.0
Irwin Union Bank and Trust........ 418,676 9.8 170,877 4.0 213,597 5.0
Core Capital (to Adjusted Tangible
Assets)
Irwin Union Bank, F.S.B........... 28,440 9.0 12,598 4.0 15,748 5.0
Tangible Capital (to Tangible
Assets)
Irwin Union Bank, F.S.B........... 28,440 9.0 4,724 1.5 N/A
94
ADEQUATELY WELL
ACTUAL CAPITALIZED CAPITALIZED
----------------- ----------------- -----------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------- ----- -------- ----- -------- -----
(DOLLARS IN THOUSANDS)
AS OF DECEMBER 31, 2001:
Total Capital (to Risk-Weighted
Assets):
Irwin Financial Corporation....... $468,337 10.8% $346,408 8.0% $433,010 10.0%
Irwin Union Bank and Trust........ 363,735 10.8 268,663 8.0 335,829 10.0
Irwin Union Bank, F.S.B........... 17,135 34.8 3,939 8.0 4,923 10.0
Tier I Capital (to Risk-Weighted
Assets):
Irwin Financial Corporation....... 295,021 6.8 173,204 4.0 259,806 6.0
Irwin Union Bank and Trust........ 342,153 10.2 134,332 4.0 201,497 6.0
Irwin Union Bank, F.S.B........... 17,074 34.7 N/A 2,954 6.0
Tier I Capital (to Average Assets):
Irwin Financial Corporation....... 295,021 9.4 126,091 4.0 157,613 5.0
Irwin Union Bank and Trust........ 342,153 10.9 125,344 4.0 156,680 5.0
Core Capital (to Adjusted Tangible
Assets)
Irwin Union Bank, F.S.B........... 17,074 9.4 7,293 4.0 9,117 5.0
Tangible Capital (to Tangible
Assets)
Irwin Union Bank, F.S.B........... 17,074 9.4 2,735 1.5 N/A
NOTE 19 -- FAIR VALUES OF FINANCIAL INSTRUMENTS
Fair value estimates, methods and assumptions are set forth below for our
financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance
sheet for cash and cash equivalents approximate those assets' fair values.
Interest-bearing deposits with financial institutions, loans, loans held
for sale, deposit liabilities, short-term borrowings, long-term debt, and
company-obligated mandatorily redeemable preferred securities of subsidiary
trust: The fair values were estimated using discounted cash flow analyses,
using interest rates currently being offered for like assets with similar terms,
to borrowers with similar credit quality, and for the same remaining maturities.
Trading assets and servicing assets: The carrying amounts reported in the
balance sheet for trading assets approximate those assets' fair values. Fair
value is calculated using the methodologies specified in note 1.
Investment securities: Fair values for investment securities were based on
quoted market prices when available. For securities which had no quoted market
prices, fair values were estimated by discounting future cash flows using
current rates on similar securities.
Derivative instruments: The carrying amounts reported in the balance sheet
for derivative instruments approximate those assets' fair values. The estimated
fair values of derivative instruments are determined using methodologies
discussed in Note 15.
Off-balance sheet loan commitments and standby letters of credit had an
immaterial estimated fair value at December 31, 2002 and 2001. As of December
31, 2002 and 2001, our loan commitments had a notional amount of $495.6 million
and $157.6 million, respectively. Our standby letters of credit had a notional
amount of $24.6 million and $26.1 million at December 31, 2002 and 2001,
respectively.
95
The estimated fair values of our financial instruments at December 31, are
as follows:
2002 2001
--------------------------- ---------------------------
CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR
AMOUNT VALUE AMOUNT VALUE
---------- -------------- ---------- --------------
(IN THOUSANDS)
FINANCIAL ASSETS:
Cash and cash equivalents................. $ 157,771 $ 157,771 $ 158,223 $ 158,223
Interest-bearing deposits with financial
institutions............................ 34,951 35,005 14,261 14,271
Trading assets............................ 157,514 157,514 199,071 199,071
Investment securities..................... 67,948 68,243 38,796 38,937
Loans held for sale....................... 1,314,849 1,317,708 502,086 503,405
Loans, net of unearned discount........... 2,468,535 2,651,037 1,871,135 1,919,336
Servicing asset........................... 174,935 180,478 228,624 257,770
Derivatives............................... 23,796 23,796 20,148 20,148
FINANCIAL LIABILITIES:
Deposits.................................. 2,694,344 2,695,326 2,308,962 2,296,873
Short-term borrowings..................... 993,124 1,003,652 487,963 488,361
Long-term and collateralized debt......... 421,495 424,378 30,000 30,680
Company-obligated mandatorily redeemable
preferred securities of subsidiary
trust................................... 233,000 236,619 198,500 215,654
The fair value estimates consider relevant market information when
available. Because no market exists for a significant portion of our financial
instruments, fair value estimates are determined based on present value of
estimated cash flows and consider various factors, including current economic
conditions and risk characteristics of certain financial instruments. Changes in
factors, or the weight assumed for the various factors, could significantly
affect the estimated values.
The fair value estimates are presented for existing on- and off-balance
sheet financial instruments without attempting to estimate the value of our
long-term relationships with depositors and the benefit that results from the
low cost funding provided by deposit liabilities. In addition, significant
assets which were not considered financial instruments and were therefore not a
part of the fair value estimates include lease receivables, accounts receivable
and premises and equipment.
NOTE 20 -- SHAREHOLDERS' EQUITY
We have a stock plan that provides up to 300,000 shares to be used to
compensate Business Development Board members. As of December 31, 2002 and 2001,
11,099 shares and 8,071 shares were issued at a weighted average price of $18.48
and $22.13, respectively.
We also have a stock plan to compensate our Directors with our common
stock, if so elected, in lieu of cash for their annual retainer and meeting
fees. The number of shares issued under the plan is based on the current market
value of our common stock. In 2002 and 2001, respectively, we granted 6,360 and
5,466 shares under the 1999 plan at a weighted average fair value of $17.73 and
$21.89, respectively. In addition, we have an employee stock purchase plan for
all qualified employees. The plan provides for employees to purchase common
stock through payroll deduction at approximately 85% of the current market
value.
We have two stock option plans (established in 1997 and 1992) which provide
for the issuance of 2,840,000 shares of non-qualified and incentive stock
options. In addition, the 2001 stock plan provides for the issuance of 2,000,000
of non-qualified and incentive stock options, stock appreciation rights,
restricted stock, and phantom stock units. An additional 2,000,000 of stock
appreciation rights may be granted under this plan. For all plans, the exercise
price of each option, which has a ten-year life and a vesting period of four
years beginning the year granted, is equal to the market price of our stock on
the grant date. Vested outstanding
96
stock options have been considered as common stock equivalents in the
computation of diluted earnings per share. In 2001, we awarded 3,952 shares of
common stock in restricted stock grants at a weighted average fair value of
$25.30 through this plan. We did not issue any restricted stock grants in 2002.
Activity in the above plans for 2002, 2001, and 2000 is summarized as
follows:
2002 2001 2000
-------------------------- -------------------------- ---------------------------------
WEIGHTED WEIGHTED WEIGHTED
NUMBER OF AVERAGE NUMBER OF AVERAGE NUMBER OF AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
--------- -------------- --------- -------------- ---------------- --------------
Outstanding at the
beginning of the
year................. 1,673,908 $17.02 1,616,259 $13.37 1,328,090 $12.50
Granted.............. 532,180 16.10 416,197 22.13 351,934 16.67
Exercised............ (100,701) 7.19 (329,053) 5.25 (32,400) 5.56
Forfeited and
expired........... (22,231) 20.91 (29,495) 20.55 (31,365) 21.60
--------- --------- ---------
Outstanding at the of
the year............. 2,083,156 17.22 1,673,908 17.02 1,616,259 13.37
========= ========= =========
Exercisable at the end
of the year.......... 1,410,766 $16.89 1,162,817 $15.46 1,210,356 $11.30
========= ========= =========
The table below show options outstanding and exercisable by price range as
of December 31, 2002:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------------- ----------------------------------------
WEIGHTED
NUMBER AVERAGE WEIGHTED NUMBER WEIGHTED
RANGE OF OUTSTANDING REMAINING AVERAGE EXERCISABLE AVERAGE
EXERCISE PRICES AS OF DECEMBER 31, 2002 CONTRACTUAL LIFE EXERCISE PRICE AS OF DECEMBER 31, 2002 EXERCISE PRICE
--------------------- ----------------------- ---------------- -------------- ----------------------- --------------
$ 5.53 - $10.66...... 358,543 2.50 $ 8.65 358,543 $ 8.65
13.69 - 15.65...... 662,362 7.84 15.12 308,543 14.54
15.81 - 18.69...... 343,336 7.63 17.21 232,527 17.05
19.75 - 21.38...... 313,899 8.35 21.27 156,484 21.28
21.97 - 28.56...... 405,516 6.58 25.10 354,919 25.22
--------- ---- ------ --------- ------
$ 5.53 - $28.56...... 2,083,656 6.72 $17.22 1,411,016 $16.89
On June 30, 2002 our 96,336 of preferred shares met the conversion
requirements and converted at 1.25 to common shares.
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NOTE 21 -- EARNINGS PER SHARE
Earnings per share calculations are summarized as follow:
BASIC EFFECT OF EFFECT OF EFFECT OF DILUTED
EARNINGS STOCK PREFERRED CONVERTIBLE EARNINGS
PER SHARE OPTIONS SHARES SHARES PER SHARE
--------- --------- --------- ----------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
2002
Net income before cumulative effect of change in
accounting principle........................... $52,833 $ -- $ -- $2,801 $55,634
Shares............................................ 26,829 164 72 2,610 29,675
------- ------ ------ ------ -------
Per-Share Amount.................................. 1.97 (0.01) (0.01) (0.08) 1.87
------- ====== ====== ====== -------
Cumulative effect of change in accounting
principle...................................... 495 495
------- -------
Per-Share Amount.................................. 0.02 0.02
------- -------
Net income........................................ 53,328 56,129
------- -------
Per-Share Amount.................................. $ 1.99 $ 1.89
======= =======
2001
Net income before cumulative effect of change in
accounting principle........................... $45,341 $ -- $ -- $2,801 $48,142
Shares............................................ 21,175 292 96 2,610 24,173
------- ------ ------ ------ -------
Per-Share Amount.................................. 2.14 (0.03) (0.01) (0.11) 1.99
------- ====== ====== ====== -------
Cumulative effect of change in accounting
principle...................................... 175 175
------- -------
Per-Share Amount.................................. 0.01 0.01
------- -------
Net income........................................ 45,516 48,317
------- -------
Per-Share Amount.................................. $ 2.15 $ 2.00
======= =======
2000
Net income........................................ $35,666 $ -- $ -- $ 295 $35,961
Shares............................................ 20,973 281 78 261 21,593
------- ------ ------ ------ -------
Per-Share Amount.................................. $ 1.70 (0.02) (0.01) 0.00 $ 1.67
======= ====== ====== ====== =======
In 2002 and 2001, 758,030 and 562,764 shares, respectively, related to
stock options that were not included in the dilutive earnings per share
calculation because they were antidilutive.
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NOTE 22 -- INCOME TAXES
Income tax expense is summarized as follows:
2002 2001 2000
-------- ------- -------
(IN THOUSANDS)
CURRENT:
Federal................................................... $ 71,309 $ 2,580 $ 1,374
State..................................................... 17,260 34 600
-------- ------- -------
88,569 2,614 1,974
-------- ------- -------
DEFERRED:
Federal................................................... (44,551) 22,876 18,000
State..................................................... (10,620) 3,369 3,702
-------- ------- -------
(55,171) 26,245 21,702
-------- ------- -------
INCOME TAX EXPENSE:
Federal................................................... 26,758 25,456 19,374
State..................................................... 6,640 3,403 4,302
-------- ------- -------
$ 33,398 $28,859 $23,676
======== ======= =======
Our net deferred tax liability, which is included in other liabilities on
the consolidated balance sheet, consisted of the following:
DECEMBER 31,
-------------------
2002 2001
-------- --------
(IN THOUSANDS)
Mortgage servicing.......................................... $(55,898) $(83,974)
Deferred securitization income.............................. (22,181) (43,023)
Loan and lease loss reserve................................. 26,836 13,499
Deferred origination fees and costs......................... 4,495 2,090
Deferred compensation....................................... 5,857 7,779
Retirement benefits......................................... (1,078) 310
Fixed assets................................................ (4,397) (3,096)
Net operating loss carryforwards............................ -- 6,001
Other, net.................................................. 3,198 2,075
-------- --------
Net deferred tax liability.................................. $(43,168) $(98,339)
======== ========
At December 31, 2001, we had a deferred tax asset of $6.0 million relating
to net operating loss carry forwards. These loss carryforwards were all utilized
in 2002.
A reconciliation of income tax expense to the amount computed by applying
the statutory income tax rate to income before income taxes is summarized as
follows:
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
Income taxes computed at the statutory rate................. $30,181 $25,969 $20,770
Increase (decrease) resulting from:
Nontaxable interest from investment securities and
loans.................................................. (127) (141) (136)
State franchise tax, net of federal benefit............... 4,316 2,212 2,796
Other items -- net........................................ (972) 819 246
------- ------- -------
$33,398 $28,859 $23,676
======= ======= =======
99
NOTE 23 -- EMPLOYEE RETIREMENT PLANS
We have a contributory retirement and savings plan which covers all
employees and meets requirements of Section 401(k) of the Internal Revenue Code.
Employees may contribute up to 14% of their compensation to the plan which is
matched by 60% by us up to 5% of the employee's compensation.
The matching vests 20% after one year, 40% after two years, 60% after three
years, 80% after four years, and 100% after 5 years. The expense to match
employee contributions for the years ended December 31, 2002, 2001 and 2000 was
approximately $2.0 million, $1.5 million and $1.1 million, respectively.
We have a defined benefit plan covering eligible employees of adopting
subsidiaries. The benefits are based on years of service and the employees'
compensation during their employment. Contributions are intended to provide not
only for benefits attributed to service to date but also for those expected to
be earned in the future.
Plan assets are 80-85% invested in equities 15-20% in corporate and U.S.
bonds, and 0-5% in cash equivalents.
DECEMBER 31,
-----------------
2002 2001
------- -------
(IN THOUSANDS)
Funded status............................................... $(3,354) $(2,140)
Unrecognized prior service cost............................. 384 131
Unrecognized net actuarial loss............................. 9,641 5,287
------- -------
Prepaid pension cost........................................ $ 6,671 $ 3,278
======= =======
Weighted average assumptions:
Discount rate............................................. 6.75% 7.00%
Return on plan assets..................................... 8.50% 8.50%
Rate of compensation increase:
Bank Employees......................................... 3.75% 3.75%
All Other Employees.................................... 4.00% 4.00%
A reconciliation of the change in projected benefit obligation and plan
assets is presented below:
2002 2001
------- -------
(IN THOUSANDS)
Change in benefit obligations:
Benefit obligation at January 1,............................ $15,501 $13,441
Service cost................................................ 1,122 750
Interest cost............................................... 1,149 971
Amendments.................................................. 305 --
Actuarial loss.............................................. 1,604 669
Benefits paid............................................... (364) (330)
------- -------
Benefit obligation at December 31,.......................... $19,317 $15,501
======= =======
Change in plan assets:
Fair value plan assets at January 1,........................ $13,361 $10,666
Actual return on plan assets................................ (2,034) (1,275)
Benefits paid............................................... (364) (330)
Employer contributions...................................... 5,000 4,300
------- -------
Fair value plan assets at December 31,...................... $15,963 $13,361
======= =======
100
The net pension cost for 2002, 2001 and 2000 included the following
components:
2002 2001 2000
------- ----- -------
(IN THOUSANDS)
Service cost................................................ $ 1,122 $ 750 $ 650
Interest cost............................................... 1,149 971 819
Expected return on plan assets.............................. (1,112) (888) (1,040)
Amortization of prior service cost.......................... 52 25 25
Amortization of actuarial loss.............................. 396 123 --
------- ----- -------
Net pension cost............................................ $ 1,607 $ 981 $ 454
======= ===== =======
NOTE 24 -- INDUSTRY SEGMENT INFORMATION
We have five principal segments that provide a broad range of financial
services throughout the United States and Canada. The Mortgage Banking line of
business originates, sells, and services residential first mortgage loans. The
Commercial Banking line of business provides commercial banking services. The
Home Equity Lending line of business originates and services home equity loans.
The Commercial Finance line of business leases and loans against commercial
equipment and real estate. The Venture Capital line of business invests in
early-stage technology companies focusing on financial services. Our other
segment primarily includes the parent company and eliminations.
The accounting policies of each segment are the same as those described in
the "Summary of Significant Accounting Policies." Below is a summary of each
segment's revenues, net income, and assets for 2002, 2001, and 2000:
MORTGAGE COMMERCIAL HOME EQUITY COMMERCIAL VENTURE
BANKING BANKING LENDING FINANCE CAPITAL OTHER CONSOLIDATED
---------- ---------- ----------- ---------- -------- -------- ------------
(IN THOUSANDS)
2002
Net interest income.... $ 41,330 $ 61,348 $ 68,472 $ 6,661 $ 43 $ (8,203) $ 169,651
Intersegment
interest............. (139) (1,306) -- (2) -- 1,447 --
Other revenue.......... 229,615 16,081 11,791 4,397 (4,220) (231) 257,433
Intersegment
revenues............. -- -- -- -- 534 (534) --
---------- ---------- -------- -------- -------- -------- ----------
Total net revenues... 270,806 76,123 80,263 11,056 (3,643) (7,521) 427,084
Other expense.......... 195,600 48,699 76,224 12,122 495 7,713 340,853
Intersegment
expenses............. 2,115 1,330 2,364 -- -- (5,809) --
---------- ---------- -------- -------- -------- -------- ----------
Net income before
taxes.............. 73,091 26,094 1,675 (1,066) (4,138) (9,425) 86,231
Income taxes........... 28,548 10,009 670 (513) (1,655) (3,661) 33,398
---------- ---------- -------- -------- -------- -------- ----------
Income before
cumulative effect
of change in
accounting
principle.......... 44,543 16,085 1,005 (553) (2,483) (5,764) 52,833
Cumulative effect of
change in accounting
principle............ -- 495 495
---------- ---------- -------- -------- -------- -------- ----------
Net income (loss)...... $ 44,543 $ 16,085 $ 1,005 $ (58) $ (2,483) $ (5,764) $ 53,328
========== ========== ======== ======== ======== ======== ==========
Assets at December
31,.................. $1,605,202 $1,969,956 $939,494 $343,384 $ 4,782 $ 21,904 $4,884,722
========== ========== ======== ======== ======== ======== ==========
101
MORTGAGE COMMERCIAL HOME EQUITY COMMERCIAL VENTURE
BANKING BANKING LENDING FINANCE CAPITAL OTHER CONSOLIDATED
---------- ---------- ----------- ---------- -------- -------- ------------
(IN THOUSANDS)
2001
Net interest income.... $ 30,959 $ 43,293 $ 60,756 $ 2,584 $ (404) $ (7,494) $ 129,694
Intersegment
interest............. (667) (194) (1,272) (42) -- 2,175 --
Other revenue.......... 199,169 14,771 64,626 1,695 (10,482) 1,464 271,243
Intersegment
revenues............. -- 210 -- -- 630 (840) --
---------- ---------- -------- -------- -------- -------- ----------
Total net revenues... 229,461 58,080 124,110 4,237 (10,256) (4,695) 400,937
Other expense.......... 166,233 40,905 96,468 8,424 590 14,117 326,737
Intersegment
expenses............. 1,391 2,577 562 -- -- (4,530) --
---------- ---------- -------- -------- -------- -------- ----------
Net income before
taxes.............. 61,837 14,598 27,080 (4,187) (10,846) (14,282) 74,200
Income taxes........... 23,912 5,680 10,832 (1,309) (4,340) (5,916) 28,859
---------- ---------- -------- -------- -------- -------- ----------
Income before
cumulative effect
of change in
accounting
principle.......... 37,925 8,918 16,248 (2,878) (6,506) (8,366) 45,341
Cumulative effect of
change in accounting
principle............ 175 175
---------- ---------- -------- -------- -------- -------- ----------
Net income (loss)...... $ 38,100 $ 8,918 $ 16,248 $ (2,878) $ (6,506) $ (8,366) $ 45,516
========== ========== ======== ======== ======== ======== ==========
Assets at December
31,.................. $ 926,946 $1,648,294 $602,226 $266,670 $ 7,421 $ (4,955) $3,446,602
========== ========== ======== ======== ======== ======== ==========
2000
Net interest income.... $ 18,477 $ 35,774 $ 37,192 $ 1,737 $ (597) $ (6,719) $ 85,864
Intersegment
interest............. (2,719) (295) (1,789) (54) (1) 4,858 --
Other revenue.......... 125,174 11,840 68,044 799 5,146 640 211,643
Intersegment
revenues............. -- 166 -- -- 420 (586) --
---------- ---------- -------- -------- -------- -------- ----------
Total net revenues... 140,932 47,485 103,447 2,482 4,968 (1,807) 297,507
Other expense.......... 117,188 33,359 71,479 5,024 431 10,495 237,976
Intersegment
expenses............. 2,199 2,446 1,144 21 -- (5,810) --
---------- ---------- -------- -------- -------- -------- ----------
Net income before
taxes.............. 21,545 11,680 30,824 (2,563) 4,537 (6,492) 59,531
Income taxes........... 8,539 4,590 12,330 (945) 1,814 (2,463) 23,865
---------- ---------- -------- -------- -------- -------- ----------
Net income (loss).... $ 13,006 $ 7,090 $ 18,494 $ (1,618) $ 2,723 $ (4,029) $ 35,666
========== ========== ======== ======== ======== ======== ==========
Assets at December
31,.................. $ 522,349 $1,167,559 $550,526 $159,773 $ 15,198 $ 10,285 $2,425,690
========== ========== ======== ======== ======== ======== ==========
102
NOTE 25 -- IRWIN FINANCIAL CORPORATION (PARENT ONLY) FINANCIAL INFORMATION
The condensed financial statements of the parent company as of December 31,
2002 and 2001, and for the three years ended December 31, 2002 are presented
below:
CONDENSED BALANCE SHEET
DECEMBER 31,
-------------------
2002 2001
-------- --------
(IN THOUSANDS)
ASSETS:
Cash and short-term investments........................... $ 1,747 $ 1,293
Investment in bank subsidiary............................. 452,474 361,289
Investments in non-bank subsidiaries...................... 170,588 146,336
Loans to bank subsidiaries................................ 62,740 31,000
Loans to non-bank subsidiaries............................ -- 556
Other assets.............................................. 17,905 10,240
-------- --------
$705,454 $550,714
======== ========
LIABILITIES:
Short-term borrowings..................................... $ 61,261 $ 71,123
Long-term debt............................................ 270,207 233,247
Other liabilities......................................... 13,431 14,679
-------- --------
344,899 319,049
-------- --------
SHAREHOLDERS' EQUITY:
Preferred stock........................................... -- 1,386
Common stock.............................................. 112,000 29,965
Other shareholders' equity................................ 248,555 200,314
-------- --------
360,555 231,665
-------- --------
$705,454 $550,714
======== ========
103
CONDENSED STATEMENTS OF INCOME
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------
2002 2001 2000
--------- --------- ---------
(IN THOUSANDS)
INCOME
Dividends from non-bank subsidiaries...................... $ 66,411 $ 451 $ 87,269
Dividends from bank subsidiary............................ -- 10,000 37,153
Interest income........................................... 1,876 2,221 4,949
Other..................................................... 5,928 6,555 6,635
-------- -------- --------
74,215 19,227 136,006
-------- -------- --------
EXPENSES
Interest expense.......................................... 24,127 20,069 12,643
Salaries and benefits..................................... 3,872 9,111 7,906
Other..................................................... 4,108 5,874 2,933
-------- -------- --------
32,107 35,054 23,482
-------- -------- --------
Income before income taxes and equity in undistributed
income of subsidiaries.................................... 42,108 (15,827) 112,524
Income tax benefit, less amounts charged to subsidiaries.... (11,732) (10,738) (5,966)
-------- -------- --------
53,840 (5,089) 118,490
Equity in undistributed income of subsidiaries.............. (512) 50,605 (82,824)
-------- -------- --------
Net income........................................ $ 53,328 $ 45,516 $ 35,666
======== ======== ========
104
CONDENSED STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------
2002 2001 2000
--------- --------- ---------
(IN THOUSANDS)
Net income................................................ $ 53,328 $ 45,516 $ 35,666
Adjustments to reconcile net income to cash provided by
operating activities:
Equity in undistributed income of subsidiaries.......... 512 (50,605) 82,824
Depreciation and amortization........................... 732 448 505
Increase (decrease) in taxes payable.................... 1,583 10,130 (1,102)
Increase (decrease) in interest receivable.............. 356 (360) (122)
Increase (decrease) in interest payable................. 37 (577) 986
Net change in other assets and other liabilities........ (12,124) 8,268 (8,518)
--------- --------- ---------
Net cash provided by operating activities....... 44,424 12,820 110,239
--------- --------- ---------
Lending and investing activities:
Net (increase) decrease in loans to subsidiaries........ (31,184) 46,722 7,245
Investments in subsidiaries............................. (116,133) (138,314) (172,409)
Net sales of premises and equipment..................... 187 72 314
--------- --------- ---------
Net cash used by lending and investing
activities.................................... (147,130) (91,520) (164,850)
--------- --------- ---------
Financing activities:
Net increase (decrease) in borrowings................... (9,862) 36,777 (46,398)
Proceeds from long-term debt............................ 36,960 45,000 106,701
Issuance of preferred stock............................. -- -- 1,386
Proceeds from common stock offering..................... 82,035 -- --
Purchase of treasury stock.............................. (1,176) (3,223) (3,414)
Proceeds from sale of stock for employee benefit
plans................................................ 2,702 5,834 1,866
Dividends paid.......................................... (7,469) (5,520) (5,038)
--------- --------- ---------
Net cash provided by financing activities....... 103,190 78,868 55,103
--------- --------- ---------
Net increase in cash and cash equivalents............... 484 168 492
Effect of exchange rate changes on cash................. (30) (2) (8)
Cash and cash equivalents at beginning of year.......... 1,293 1,127 643
--------- --------- ---------
Cash and cash equivalents at end of year................ $ 1,747 $ 1,293 $ 1,127
========= ========= =========
Supplemental disclosures of cash flow information:
Cash paid during the year:
Interest............................................. $ 24,091 $ 20,646 $ 11,657
========= ========= =========
Income taxes......................................... $ 48,877 $ 5,235 $ 13,769
========= ========= =========
Non cash transactions:
Conversion of preferred stock to common stock........ $ 1,386 -- --
========= ========= =========
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
105
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE CORPORATION
The information contained in our proxy statement for the 2003 Annual
Meeting of Shareholders under the caption "Election of Directors" is
incorporated herein by reference in response to this item. See also the
"Executive Officers" section in Part I, Item 1.
ITEM 11. EXECUTIVE COMPENSATION
The information contained in our proxy statement for the 2003 Annual
Meeting of Shareholders under the captions "Election of Directors -- Outside
Director Compensation," "Executive Compensation and Other Information,"
"Compensation Committee Interlocks and Insider Participation" and "Board
Compensation Committee Report on Executive Compensation" is incorporated herein
by reference in response to this item.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
EQUITY COMPENSATION PLAN INFORMATION
The following provides information about securities authorized for issuance
under our equity compensation plans as of December 31, 2002:
(A) (B) (C)
-------------------- -------------------- ------------------------------
NUMBER OF SECURITIES NUMBER OF SECURITIES REMAINING
TO BE ISSUED UPON WEIGHTED-AVERAGE AVAILABLE FOR FUTURE ISSUANCE
EXERCISE OF EXERCISE PRICE OF UNDER EQUITY COMPENSATION
OUTSTANDING OPTIONS, OUTSTANDING OPTIONS, PLANS (EXCLUDING SECURITIES
PLAN CATEGORY WARRANTS AND RIGHTS WARRANTS AND RIGHTS REFLECTED IN COLUMN (A))
------------- -------------------- -------------------- ------------------------------
Equity compensation plans approved
by security holders............. 2,083,156 $17.22 2,247,538
Equity compensation plans not
approved by security
holders(1)...................... 275,304
---------------
(1) Shares shown in column (c) for this category reflect securities available
for future issuance under the Irwin Union Bank Business Development Board
Compensation Program (see immediately below).
EQUITY COMPENSATION PLANS ADOPTED WITHOUT APPROVAL OF SECURITY HOLDERS
Irwin Union Bank Business Development Board Compensation Program. We
established this program to assist our commercial banking line of business in
developing its current and future markets. The program covers members of
business development boards of Irwin Union Bank and Trust Company and Irwin
Union Bank, F.S.B. Under the program, business development board members receive
their retainer and meeting fees in Irwin Financial Corporation common stock in
lieu of cash. Currently, business development board members receive annual
retainer fees of $1,000 per member and meeting fees of $350 per meeting
attended. Irwin Financial Corporation's board of directors approved the program
and we filed a Form S-8 with the SEC on July 19, 2000, which registered a total
of 300,000 shares for this purpose. From January 1, 1998 through June 30, 2000,
we issued 2,508 shares of our common shares under the program. We purchase the
shares on the last business day of the quarter preceding each payment date,
using the mean between the closing bid and asked prices of our common stock as
reported by the New York Stock Exchange.
The information contained in our proxy statement for the 2003 Annual
Meeting of Shareholders under the captions "Voting Securities and Principal
Holders" and "Security Ownership of Management" is incorporated herein by
reference in response to this item.
106
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information contained in our proxy statement for the 2003 Annual
Meeting of Shareholders under the caption "Interest of Management in Certain
Transactions" is incorporated herein by reference in response to this item.
ITEM 14. CONTROLS AND PROCEDURES
As of December 31, 2002, we performed an evaluation under the supervision
and with the participation of our management, including the Chief Executive
Officer and the Chief Financial Officer, of the effectiveness of the design and
operation of our disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14(c)). Based on that evaluation, our management, including the CEO
and CFO, concluded that our disclosure controls and procedures were effective as
of December 31, 2002, to ensure that material information relating to the
Corporation would be made known to them by others within the Corporation,
particularly during the period in which the Form 10-K was being prepared.
Except as described below, there were no significant changes in our
internal controls or in other factors that could significantly affect these
controls subsequent to our most recent evaluation, nor any corrective actions
required with regard to significant deficiencies or material weaknesses. In
connection with our ongoing risk assessment review, we modified our wire
transfer procedures to limit the potential for unauthorized distributions by
employees. We incurred no loss in connection with this matter.
107
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report.
1. Financial Statements
Management Report on Responsibility for Financial Reporting
Report of Independent Accountants
Irwin Financial Corporation and Subsidiaries
Consolidated Balance Sheets for the years ended 2002 and 2001
Consolidated Statements of Income for the years ended 2002, 2001 and
2000
Consolidated Statements of Changes in Shareholders' Equity for the
years ended 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the years ended 2002, 2001
and 2000
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
None
3.A. Exhibits to Form 10-K
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- ----------------------
3.1 Restated Articles of Incorporation of Irwin Financial
Corporation. (Incorporated by reference to Exhibit 3(a) to
Form 10-K Report for year ended December 31, 2000, File No.
0-06835.)
3.2 Articles of Amendment to Restated Articles of Incorporation
of Irwin Financial Corporation dated March 2, 2001.
(Incorporated by reference to Exhibit 3(b) to Form 10-K
Report for year ended December 31, 2000, File No. 0-06835.)
3.3 Code of By-laws of Irwin Financial Corporation.
(Incorporated by reference to Exhibit 3 to Form 10-Q for
period ended March 31, 2001, File No. 0-06835.)
4.1 Specimen Common Stock Certificate. (Incorporated by
reference to Exhibit 4(a) to Form 10-K report for year ended
December 31, 1994, File No. 0-06835.)
4.2 Certain instruments defining the rights of the holders of
long-term debt of Irwin Financial Corporation and certain of
its subsidiaries, none of which authorize a total amount of
indebtedness in excess of 10% of the total assets of the
Corporation and its subsidiaries on a consolidated basis,
have not been filed as Exhibits. The Corporation hereby
agrees to furnish a copy of any of these agreements to the
Commission upon request.
4.3 Rights Agreement, dated as of March 1, 2001, between Irwin
Financial Corporation and Irwin Union Bank and Trust.
(Incorporated by reference to Exhibit 4.1 to Form 8-A filed
March 2, 2001, File No. 0-06835.)
4.4 Appointment of Successor Rights Agent dated as of May 11,
2001 between Irwin Financial Corporation and National City
Bank. (Incorporated by reference to Exhibit 4.5 to Form S-8
filed on September 7, 2001, File No. 333-69156.)
10.1 *Amended 1986 Stock Option Plan. (Incorporated by reference
to Exhibit 10(b) to Form 10-K Report for year ended December
31, 1991, File No. 0-06835.)
108
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- ----------------------
10.2 *Irwin Financial Corporation 1992 Stock Option Plan.
(Incorporated by reference to Exhibit 10(h) to Form 10-K
Report for year ended December 31, 1992, File No. 0-06835.)
10.3 *Irwin Financial Corporation 1997 Stock Option Plan.
(Incorporated by reference to Exhibit 10 to Form 10-Q Report
for period ended June 30, 1994, File No. 0-06835.)
10.4 *Amendment to Irwin Financial Corporation 1997 Stock Option
Plan. (Incorporated by reference to Exhibit 10(i) to Form
10-Q Report for period ended June 30, 1997, File No.
0-06835.)
10.5 *Irwin Financial Corporation 2001 Stock Plan. (Incorporated
by reference to Exhibit 10.18 to Form S-1/A filed February
14, 2002, File No. 333-69586.)
10.6 *Amended Irwin Financial Corporation Outside Directors
Restricted Stock Compensation Plan. (Incorporated by
reference to Exhibit 10(g) to Form 10-K Report for year
ended December 31, 1991, File No. 0-06835.)
10.7 *Irwin Financial Corporation Outside Directors Restricted
Stock Compensation Plan. (Incorporated by reference to
Exhibit 10(i) to Form 10-K Report for year ended December
31, 1995, File No. 0-06835.)
10.8 *1999 Outside Director Restricted Stock Compensation Plan.
(Incorporated by reference to Exhibit 10(b) to Form 10-Q
Report for period ended June 30, 1999, File No. 0-06835.)
10.9 *Irwin Financial Corporation Employees' Stock Purchase Plan.
(Incorporated by reference to Exhibit 10(d) to Form 10-K
Report for year ended December 31, 1991, File No. 0-06835.)
10.10 *Employee Stock Purchase Plan II. (Incorporated by reference
to Exhibit 10(f) to Form 10-K Report for year ended December
31, 1994, File No. 0-06835.)
10.11 *Employee Stock Purchase Plan III. (Incorporated by
reference to Exhibit 10(a) to Form 10-Q Report for period
ended June 30, 1999, File No. 0-06835.)
10.12 *Long-Term Management Performance Plan. (Incorporated by
reference to Exhibit 10(a) to Form 10-K Report for year
ended December 31, 1986, File No. 0-06835.)
10.13 *Long-Term Incentive Plan-Summary of Terms. (Incorporated by
reference to Exhibit 10(a) to Form 10-K Report for year
ended December 31, 1986, File No. 0-06835.)
10.14 *Inland Mortgage Corporation Long-Term Incentive Plan.
(Incorporated by reference to Exhibit 10(j) to Form 10-K
Report for year ended December 31, 1995, File No. 0-06835.)
10.15 *Amended and Restated Management Bonus Plan. (Incorporated
by reference to Exhibit 10(a) to Form 10-K Report for year
ended December 31, 1986, File No. 0-06835.)
10.16 *Limited Liability Company Agreement of Irwin Ventures LLC.
(Incorporated by reference to Exhibit 10(a) to Form 10-Q/A
Report for period ended March 31, 2001, File No. 0-06835.)
10.17 *Limited Liability Company Agreement of Irwin Ventures
Co-Investment Fund LLC, effective as of April 20, 2001.
(Incorporated by reference to Exhibit 10.17 to Form S-1/A
filed February 14, 2002, File No. 333-69586.)
10.18 *Irwin Home Equity Corporation Shareholder Agreement and
Amendments. (Incorporated by reference to Exhibit 10(b) to
Form 10-Q/A Report for period ended March 31, 2001, File No.
0-06835.)
10.19 *Promissory Note dated January 30, 2002 from Elena Delgado
to Irwin Financial Corporation. (Incorporated by reference
to Exhibit 10.19 to Form S-1/A filed February 14, 2002, File
No. 333-69586.)
10.20 *Consumer Pledge Agreement dated January 30, 2002 between
Elena Delgado and Irwin Financial Corporation. (Incorporated
by reference to Exhibit 10.20 to Form S-1/A filed February
14, 2002, File No. 333-69586.)
109
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
------- ----------------------
10.21 *Irwin Financial Corporation Short Term Incentive Plan
effective January 1, 2002. (Incorporated by reference to
Exhibit 10.21 to Form 10-Q Report for period ended March 31,
2002, File No. 0-06835.)
10.22 *Irwin Union Bank Short Term Incentive Plan effective
January 1, 2002. (Incorporated by reference to Exhibit 10.22
to Form 10-Q Report for period ended March 31, 2002, File
No. 0-06835.)
10.23 *Irwin Home Equity Short Term Incentive Plan effective
January 1, 2002. (Incorporated by reference to Exhibit 10.23
to Form 10-Q Report for period ended March 31, 2002, File
No. 0-06835.)
10.24 *Irwin Mortgage Corporation Short Term Incentive Plan
effective January 1, 2002. (Incorporated by reference to
Exhibit 10.24 to Form 10-Q Report for period ended March 31,
2002, File No. 0-06835.)
10.25 *Irwin Capital Holdings Short Term Incentive Plan effective
January 1, 2002. (Incorporated by reference to Exhibit 10.25
to Form 10-Q Report for period ended March 31, 2002, File
No. 0-06835.)
10.26 *Onset Capital Corporation Employment Agreement.
(Incorporated by reference to Exhibit 10.26 to Form 10-Q
Report for period ended June 30, 2002, File No. 0-06835.)
10.27 *Irwin Financial Corporation Restated Supplemental Executive
Retirement Plan for Named Executives. (Incorporated by
reference to Exhibit 10.27 to Form 10-Q Report for period
ended June 30, 2002, File No. 0-06835.)
10.28 *Irwin Financial Corporation Supplemental Executive
Retirement Plan for Named Executives. (Incorporated by
reference to Exhibit 10.28 to Form 10-Q Report for period
ended June 30, 2002, File No. 0-06835.)
10.29 *Onset Capital Corporation Shareholders Agreement
11.1 Computation of Earnings Per Share.
12.1 Computation of Ratio of Earnings to Fixed Charges.
21.1 Subsidiaries of Irwin Financial Corporation
23.1 Consent of Independent Accountants.
99.1 Certification of the Chief Executive Officer under Section
906 of the Sarbanes -- Oxley Act of 2002
99.2 Certification of the Chief Financial Officer under Section
906 of the Sarbanes -- Oxley Act of 2002
---------------
* Indicates management contract or compensatory plan or arrangement.
B. Reports on Form 8-K during the last quarter of the period covered by
this report:
8-K October 4, 2002 Updating status of McIntosh v. Irwin Home Equity
Corporation.
8-K October 21, 2002 Attaching news release announcing third quarter earnings
conference call.
8-K October 22, 2002 Attaching news release announcing third quarter earnings.
8-K October 30, 2002 Attaching news release announcing Chairman Will Miller to
ring opening bell at NYSE on November 1, 2002.
8-K November 14, 2002 Attaching news release announcing a revision to third
quarter earnings release made with filing of 10-Q.
8-K November 17, 2003 Attaching news release announcing fourth quarter dividend.
110
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Corporation has duly caused this report to be signed
on its behalf by the Undersigned, thereunto duly authorized.
IRWIN FINANCIAL CORPORATION
Date: March 17, 2003 By: /s/ WILLIAM I. MILLER
----------------------------------------------------
William I. Miller,
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report on Form 10-K has been signed below by the following persons on behalf of
the Corporation and in the capacities on the dates indicated.
CAPACITY WITH
SIGNATURE CORPORATION DATE
--------- ------------- ----
/s/ SALLY A. DEAN Director March 17, 2003
---------------------------------------------------
Sally A. Dean
/s/ DAVID W. GOODRICH Director March 17, 2003
---------------------------------------------------
David W. Goodrich
/s/ JOHN T. HACKETT Director March 17, 2003
---------------------------------------------------
John T. Hackett
/s/ WILLIAM H. KLING Director March 17, 2003
---------------------------------------------------
William H. Kling
/s/ BRENDA J. LAUDERBACK Director March 17, 2003
---------------------------------------------------
Brenda J. Lauderback
/s/ JOHN C. MCGINTY, JR. Director March 17, 2003
---------------------------------------------------
John C. McGinty, Jr
/s/ WILLIAM I. MILLER Director, Chairman of the March 17, 2003
--------------------------------------------------- Board (Principal Executive
William I. Miller Officer)
/s/ JOHN A. NASH Director March 17, 2003
---------------------------------------------------
John A. Nash
/s/ LANCE R. ODDEN Director March 17, 2003
---------------------------------------------------
Lance R. Odden
/s/ THEODORE M. SOLSO Director March 17, 2003
---------------------------------------------------
Theodore M. Solso
/s/ GREGORY F. EHLINGER Senior Vice President March 17, 2003
--------------------------------------------------- (Principal Financial
Gregory F. Ehlinger Officer)
/s/ JODY A. LITTRELL Vice President and Controller March 17, 2003
--------------------------------------------------- (Principal Accounting
Jody A. Littrell Officer)
111
CERTIFICATIONS
I, William I. Miller, certify that:
1. I have reviewed this annual report on Form 10-K of Irwin Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operation and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
/s/ WILLIAM I. MILLER
--------------------------------------
WILLIAM I. MILLER
Chairman and Chief Executive Officer
Date: March 17, 2003
112
I, Gregory F. Ehlinger, certify that:
1. I have reviewed this annual report on Form 10-K of Irwin Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operation and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
/s/ GREGORY F. EHLINGER
--------------------------------------
GREGORY F. EHLINGER
Senior Vice President and Chief
Financial Officer
Date: March 17, 2003
113