Doral Financial was organized in 1972 under the laws of the Commonwealth of Puerto Rico.
Doral Financial’s principal executive offices are located at 1451 F.D. Roosevelt Avenue, San Juan,
Puerto Rico 00920-2717, and its telephone number is (787) 474-6700.
Doral Financial manages its business through four operating segments – mortgage banking,
banking (including thrift operations), insurance agency and institutional securities. Doral
Financial primarily conducts the following operations in these segments:
Mortgage Banking . Doral Financial originates, purchases, sells, securitizes and
services residential mortgage loans primarily in the Commonwealth of Puerto Rico. Historically,
this segment also conducted most of the Company’s risk management activities, including derivative
instruments. During 2005 and 2006, the amount of interest-only strips (“IOs”) and investment
securities held at the holding company and non-bank subsidiaries was substantially reduced.
Accordingly, risk management activities are now being principally conducted within the Company’s
banking segment.
Banking . Through Doral Bank Puerto Rico (“Doral Bank PR”), Doral Financial accepts
deposits and invests in mortgage loans, sourced primarily through the Company’s mortgage banking
operations in Puerto Rico, as well as through purchases from non-affiliates. Doral Bank PR has 44
retail bank branches throughout Puerto Rico. Doral’s banking subsidiary also provides construction
and commercial loan financing primarily secured by real estate as well as consumer loans. The
banking operation also invests in and holds a significant amount of investment securities. Doral
Financial also operates a thrift institution in the New York City metropolitan area through Doral
Bank, FSB (“Doral Bank NY”). On March 15, 2007, Doral Financial announced that it had agreed to
sell its 11 existing New York City branches to New York Commercial Bank, the commercial bank
subsidiary of New York Community Bancorp, pursuant to a definitive purchase and assumption
agreement. The transaction, which is subject to regulatory approval and other customary
conditions, is expected to be completed in the third quarter of 2007. Doral Financial will retain
Doral Bank NY’s federal thrift charter. See “Recent Significant Events — Sale of NY Branches”
below.
Insurance Agency . Doral Financial offers property, casualty, life and title insurance
as an insurance agency, primarily to its mortgage loan customers.
Institutional Securities . Doral Financial operates an institutional broker-dealer.
The operations of this broker-dealer have been greatly reduced and currently its operations are
limited to providing investment management services to a local investment company.
Mortgage banking and investing in mortgage loans have traditionally been Doral Financial’s
core business. New management, however, has made an evaluation of the Company’s business strategy
and has made the decision to transform the Company into a more traditional community banking
institution with a broader range of loan products and banking services and place less emphasis on
trading and investment activities, with the intent of reducing the volatility of Doral Financial’s
earnings and improving its interest rate risk-profit profile. See “—Business Transformation
Strategy” below for additional information as to recent changes in the Company’s business strategy.
Availability of Information on Website
Doral Financial’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current
Reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Sections
13(a) or 15(d) of the Securities
Exchange Act of 1934, as amended (the “Exchange Act”) are
available free of charge, through its website, http://www.doralfinancial.com, as soon as reasonably
practicable after such material is electronically filed with or furnished to the SEC. In addition,
Doral Financial makes available on its website under the heading “Corporate Governance” its: (i)
Code of Business Conduct and Ethics; (ii) Corporate Governance Guidelines; (iii) Information
Disclosure Policy; and (iv) the charters of the Audit, Compensation, Corporate Governance and
Nominating, and Risk Policy committees, and also intends to disclose any amendments to its Code of
Business Conduct and Ethics, or waivers of the Code of Business Conduct and Ethics on behalf of its
Chief Executive Officer, Chief Financial Officer, and Controller, on its website or upon written
request to the Secretary of the Company at 1451 F.D. Roosevelt Avenue, San Juan, Puerto Rico
00920-2717.
The public may read and copy any materials Doral Financial files with the SEC at the SEC’s
Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. In addition, the public may
obtain information on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically with the SEC,
including Doral Financial, at its website (http://www.sec.gov).
Holding Company Structure
Doral Financial is a corporation organized under the laws of the Commonwealth of Puerto Rico.
Doral Financial conducts its activities primarily through its wholly-owned subsidiaries, Doral Bank
(“Doral Bank PR”), Doral Mortgage Corporation (“Doral Mortgage”), Doral Bank, FSB (“Doral Bank
NY”), Doral Insurance Agency, Inc. (“Doral Insurance Agency”), Doral Securities, Inc. (“Doral
Securities”) and Doral Properties, Inc. (“Doral Properties”). Doral Bank PR in turn has three
wholly-owned subsidiaries: Doral Money, Inc. (“Doral Money”), which is engaged in commercial
lending in the New York City metropolitan area, Doral International, Inc., a Puerto Rico-based
international banking entity, and CB, LLC, an entity formed to dispose of a real estate project
that Doral Bank PR received in lieu of foreclosure.
Recent Significant Events
Recapitalization Process
Doral Financial will need significant outside financing during 2007, principally for the
payment of its $625 million floating rate senior notes that mature on July 20, 2007 and of amounts
required under the settlement agreement dated April 27, 2007 in respect of the consolidated
securities class action and shareholder derivative litigation brought against the Company following
the announcement of the restatement of its financial statements in 2005. The Company currently
estimates that these external funding needs for 2007 will range between
approximately $700 million and $800 million (without considering the distribution of any
proceeds from the sale of Doral Bank NY’s branches). The Company’s consolidated financial
statements included in this annual report have been prepared assuming Doral Financial will continue
as a going concern. In light of the holding company’s liquidity needs and the risks and
uncertainties surrounding its recapitalization process, the holding company’s liquidity position
raises substantial doubts about the holding company’s ability to continue operating as a going
concern without such recapitalization.
Doral Financial is in active negotiations with a private equity firm (the “lead sponsor”)
regarding a substantial investment in the Company by a new bank holding company. The new holding
company would be capitalized by a number of private equity and other sophisticated financial
investors, and their investment would take into account the various ownership restrictions imposed
by banking regulations. The lead sponsor is actively engaged in discussions with a number of
potential investors to raise the contemplated capital for the new holding company to invest in
Doral.
Based on its discussions to date, the Company believes that the proposed transaction, if
executed, would be accomplished predominantly through the issuance of new equity securities at a
discount to market price and would result in very significant dilution to the Company’s existing
shareholders. If the Company is successful in entering into the proposed transaction and it is
consummated on a timely basis, the Company believes that the proposed transaction would adequately
satisfy its capital and liquidity needs. However, the Company cannot provide assurances that it
will ultimately be able to enter into an agreement with respect to the proposed transaction.
The proposed transaction would be subject to various conditions precedent, including but not
limited to the receipt of regulatory and shareholder approvals, the receipt of sufficient equity
commitments from other investors, final district court approval of the settlement agreement in
respect of the consolidated securities class action and shareholder derivative claims brought
against the Company, the absence of certain adverse developments and other customary closing
conditions.
Although the Company would attempt to enter into an alternative transaction that would provide
it with the liquidity and capital needed to continue its business in the event that it is unable to
enter into the proposed transaction, the Company cannot provide assurance that it would succeed in
entering into such a transaction, especially in the limited time available prior to the July 20,
2007 maturity of the senior notes. The failure to refinance the senior notes and recapitalize the
holding company would have a material adverse effect on, and impair, the holding company’s
financial condition and ability to operate as going concern. See Item 1A. Risk Factors, “— Risks
Relating to the Recapitalization Process”, of this Annual Report on Form 10-K.
Sale of New York Branches
On March 15, 2007, Doral Bank NY, Doral Financial’s wholly owned New York City-based thrift
subsidiary, entered into a definitive purchase and assumption agreement with New York Commercial
Bank, the commercial bank subsidiary of New York Community Bancorp, pursuant to which New York
Commercial Bank agreed to acquire Doral Bank NY’s 11 existing branches in the New York City
metropolitan area. The sale of the New York branches will allow Doral Financial to focus its
efforts on its well-capitalized, core Puerto Rico banking operations and is expected to improve the
holding company’s liquidity. Doral Financial will retain Doral Bank NY’s federal thrift charter
and initially intends to maintain an internet-based deposit gathering operation as it evaluates
other possible strategic business opportunities on the U.S. mainland.
Pursuant to the terms of the agreement, New York Commercial Bank will assume certain of Doral
Bank NY’s assets and liabilities, including deposits of approximately $370 million. The purchase
price for the transaction will be equal to the difference between the value of the assets sold and
the value of the liabilities assumed as of the closing date, plus a deposit premium of
approximately 4% of the deposits assumed as of the closing date. The transaction is expected to
result in a pre-tax profit to Doral Bank NY of approximately $10 million. Following the
consummation of the transaction, Doral Financial intends to request the authorization of the Office
of Thrift Supervision to distribute a substantial portion of Doral Bank NY’s capital to Doral
Financial. Doral Bank NY is organized under a federal thrift charter and operates independently
of Doral Bank PR, Doral Financial’s principal banking subsidiary.
The transaction, which is subject to regulatory approval and other customary conditions, is
expected to be completed in the third quarter of 2007.
Settlement of Class Action and Shareholder Derivative Lawsuits
On
April 27, 2007, Doral Financial entered into an agreement to settle all claims in the
consolidated securities class action and shareholder derivative litigation filed against the
Company following the announcement in April 2005 of the need to restate its financial statements
for the period of 2000 to 2004. The settlement is subject to notice and approval from the U.S.
District Court for the Southern District of New York.
Under the terms of the settlement agreement and a concurrent agreement entered into
by insurers to the Company and its current and former directors and officers, the Company and
insurers will pay an aggregate of $129 million, of which insurers will pay approximately $34
million. In addition, one or more individual defendants will pay an aggregate of $1 million (in
cash or Doral Financial stock). As part of the
settlement, the Company also agreed to certain corporate governance enhancements.
The Company’s payment obligations under the settlement agreement are subject to the closing
and funding of one or more transactions through which the Company obtains outside financing during
2007 to meet its liquidity and capital needs, including the repayment of the Company’s $625 million
senior notes due on July 20, 2007, payment of the amounts due under the settlement agreement and
certain other working capital and contractual needs. Either side may terminate the settlement
agreement if the Company has not raised the necessary funding by September 30, 2007 or if the
settlement has not been fully funded within 30 days from the receipt of such funding.
As a result of this settlement agreement, Doral Financial established a litigation reserve and
recorded a charge to the Company’s full-year financial results for 2006 of $95.0 million.
The parties to the settlement agreement will seek final court approval of the settlement
before the maturity of the senior notes due July 20, 2007, but no assurance can be given that it
will receive final court approval by this date. See “Risk Factors — Risks Relating to the
Recapitalization Process” under Item 1A of this Annual Report on Form 10-K.
Business Transformation Strategy
The
Company is implementing changes to its business strategies that are aimed at transforming the
Company into a more traditional community banking institution offering a broader range of products
and services, combined with the efficiency, automation and sophistication of leading financial
institutions. Doral Financial is currently building a center of excellence based on Six Sigma
process improvement techniques, credit, customer care, production and collection fulfillment, and
information technology. The center of excellence will combine process, technology and people to
enhance returns through better efficiency and competitiveness.
The
key components of Doral Financial’s new business strategy are:
Retail Banking . The principal objective of Doral Financial’s retail banking segment
will be to become its customer’s main banking relationship. Doral Financial has already invested in
many of the systems it needs to implement this strategy. Doral Financial plans to leverage its
best-in-class service model combined with a well-executed sales process to capture new
relationships and cross-sell additional products to its existing customers. The development of new
products and services is an integral part of Doral Financial’s growth strategy.
Mortgage Business . Doral Financial intends to maintain an important position in the
retail mortgage segment with an emphasis on quality, profitability, risk management, and
compliance. The Company intends to use focused marketing initiatives, a best-in-class sales process
and innovative and competitive product offerings to regain its strength in this segment.
Commercial and S Banking . Doral Financial intends to grow its market
share in the commercial and s segments. The strategy focuses on becoming the main bank
of choice for commercial and s clients that demand competitive products delivered
through a relationship-driven model of superior
customer service. Doral Financial will develop product offerings designed to meet the needs
of commercial and s clients, including deposit, credit, and cash management needs.
Doral Financial’s ability to cross-sell these products to its retail and mortgage customers is a
key component of the strategy.
Residential Construction . Doral Financial has refocused this business with the aim of
becoming the lender of choice for established, reputable developers in the affordable and mid-range
housing sectors. Doral Financial expects that its expertise in these sectors positions it to be
the best-in-class lender in the market.
Banking Activities
Doral Financial is engaged in retail banking activities in Puerto Rico through its subsidiary,
Doral Bank PR. Doral Bank PR operates through 44 branches in Puerto Rico. Doral Bank PR offers a
variety of consumer loan products and banking services. Doral Bank PR also originates construction
loans to finance the construction of residential home developments and commercial real estate
projects, and commercial loans secured by real estate collateral. Doral Bank PR’s lending
activities have traditionally been concentrated primarily on the origination of residential
mortgage loans and are closely integrated with Doral Financial’s mortgage banking units as
described below. As of December 31, 2006, Doral Bank PR had a portfolio of mortgage loans
held-for-sale of approximately $1.1 billion, which includes mortgage loans held-for-sale by Doral
Bank PR’s wholly-owned subsidiaries, Doral Money and Doral International. As of December 31, 2006,
Doral Bank PR had loans classified as loans receivable of approximately $2.8 billion, of which
approximately $2.0 billion consisted of loans secured by residential mortgages.
Doral Bank PR’s mortgage origination activities are closely integrated with Doral Financial’s
mortgage banking business through a Master Loan Production Agreement. Under this agreement, Doral
Mortgage has agreed to assist Doral Bank PR meet its stated mortgage loan production goals by,
among other things, (i) advertising, promoting and marketing to the general public; (ii)
interviewing prospective borrowers and conducting the initial processing of loan applications,
consistent with Doral Bank PR’s underwriting guidelines; and (iii) providing personnel and
facilities with respect to the execution of loan agreements. Doral Bank PR independently
underwrites all loans closed through the Master Loan Production Agreement. In the future, Doral
Bank PR may determine to engage in direct mortgage loan originations through its branch network.
Doral Bank PR is also a party to a Master Servicing and Collection Agreement (the “Master
Servicing Agreement”) with Doral Financial, whereby Doral Financial has agreed to service all
mortgage loans originated by Doral Bank PR. Under the terms of the Master Servicing Agreement,
Doral Financial is entitled to receive a servicing fee, ranging from 25 to 44 basis points of the
outstanding principal amount of the loans being serviced. Doral Bank PR, however, retains the right
to terminate Doral Financial’s servicing rights, without cause, upon notice to Doral Financial.
Doral Financial is also engaged in the banking business in the New York City metropolitan area
through its federal savings bank subsidiary, Doral Bank NY. Doral Bank NY offers retail banking
services and products and currently operates 11 branch locations in the New York City metropolitan
area. To date, Doral Bank NY has focused its lending activities on loans secured by multi-family
apartment buildings and commercial properties located in the New York City metropolitan area, as
well as on taxi medallion loans. Doral Bank NY also purchases conforming residential loans without
the related servicing rights from financial institutions. On March 15, 2007, Doral Financial
announced that it had agreed to sell its 11 existing branches in the New York City metropolitan
area pursuant to a definitive purchase and assumption agreement. The transaction, which is subject
to regulatory approval and other customary conditions, is expected to be completed in the third
quarter of 2007. Doral Financial will retain Doral Bank NY’s federal thrift charter and initially
intends to maintain an internet-based deposit gathering operation as it evaluates other possible
strategic business opportunities on the U.S. mainland. See “Recent Significant Events — Sale of
New York Branches” above.
Doral Bank NY is a party to a Master Loan Production Agreement, and a Master Servicing and
Collection Agreement with Doral Financial’s mortgage banking units similar to those in effect for
Doral Bank PR.
In addition to originating residential mortgage loans, construction loans and commercial loans
secured by multi-family buildings, Doral Bank PR and Doral Bank NY also originate consumer loans,
unsecured commercial loans and loans secured by undeveloped real property. See Part II, Item 7.
Management’s Discussion and Analysis of
Financial Condition and Results of Operations , “— Loans Receivable,” for detailed information
regarding Doral Financial’s loans receivable portfolio.
Doral Bank PR and Doral Bank NY complement their lending activities by earning fee income,
collecting service charges for deposit accounts and other traditional banking services and, in the
case of Doral Bank PR, with income from trading activities conducted through its international
banking entity subsidiary. See “Other Investment Activities” below.
For detailed information regarding the deposit accounts of Doral Financial’s banking
subsidiaries please refer to Part II, Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations , “— Liquidity and Capital Resources” in this report.
Mortgage Banking Business
Doral Financial historically conducted its mortgage banking activities in Puerto Rico through
its four mortgage banking units – HF Mortgage Bankers, an operating division of the Company, and
three wholly owned subsidiaries, Doral Mortgage, Centro Hipotecario de Puerto Rico, Inc. (“Centro
Hipotecario”) and Sana Mortgage Corporation (“Sana Mortgage”). In the mainland United States, Doral
Financial conducts limited mortgage banking activities through its subsidiary, Doral Money, Inc.
During 2006, in order to achieve operational efficiency and strengthen its principal brand, the
Company decided to consolidate all of its mortgage origination under a single Doral Mortgage brand,
thus eliminating the mortgage banking operations of Sana Mortgage, Centro Hipotecario and HF
Mortgage Bankers. During 2006, the Company also decided to eliminate its stand-alone mortgage
banking branches and concentrate on branches co-located within Doral Bank branches, which combine
banking and mortgage banking operations.
Mortgage Loan Origination
Mortgage Loan Products. Doral Financial is an approved seller/servicer for the Federal Home
Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”), an
approved issuer for the Government National Mortgage Association (“GNMA”) and an approved servicer
under the GNMA, FNMA and FHLMC mortgage-backed securities programs. Doral Financial is also
qualified to originate mortgage loans insured by the Federal Housing Administration (“FHA”) or
guaranteed by the Veterans Administration (“VA”) or by the Rural Housing Service (“RHS”).
Doral Financial offers a variety of mortgage loan products that are designed to meet consumer
needs and competitive conditions. Doral Financial has traditionally emphasized 15- to 30-year fixed
rate first mortgage loans secured by single-family residences. Doral Financial generally classifies
mortgage loans between those that are guaranteed or insured by FHA, VA or RHS and those that are
not. The latter type of loans is referred to as conventional loans. Conventional loans that meet
the underwriting requirements for sale or exchange under standard FNMA or FHLMC programs are
referred to as conforming loans, while those that do not are referred to as non-conforming loans.
Doral Financial’s current principal mortgage loan products are summarized below:
FHA and VA Loans . These are 15- to 30-year first mortgage loans that qualify for the
insurance program of FHA or the guarantee programs of VA. As of December 31, 2006, the maximum loan
amount for a VA loan was $417,000 and for FHA loans the maximum loan amount ranged from $200,160 to
$247,000, for a one-family dwelling and, depending on the location of the mortgaged property, could
go as high as $390,000, for a four-family dwelling.
RHS Loans . These are 30-year first mortgage loans made to low-income individuals that
qualify for the guarantee program of RHS. As of December 31, 2006, the maximum loan amount for an
RHS loan was based on an income table, which is revised periodically.
Conforming Conventional Loans . These are predominantly fixed rate loans that satisfy
the underwriting criteria for standard sale or exchange programs of FNMA or FHLMC. As of December
31, 2006, the maximum loan amount for conforming conventional loans was $417,000, for a one-family
dwelling.
Non-conforming Loans . These are predominantly fixed rate conventional mortgage loans
that do not qualify for sale or exchange under the standard programs of FNMA or FHLMC. These loans
do not qualify for such programs primarily because of more flexible requirements for income
verification or credit history, or loan amounts that exceed those permitted by FNMA or FHLMC. Doral
Financial uses its own credit system to evaluate these loans and generally requires lower
loan-to-value ratios and higher borrower equity.
Second Mortgage Loans . Doral Financial has traditionally offered loans secured by
second mortgage liens on single family residences as part of its non-conforming loan products.
Other Mortgage Loans . Doral Financial’s mortgage banking units also originate
construction loans for owner occupied single-family residences and real estate development
projects, as well as land loans and loans secured by income-producing residential, multi-family and
commercial properties. However, most construction loans for real estate development projects are
originated by Doral Bank PR. See “—Banking Activities” below for more information.
For additional information on Doral Financial’s mortgage loan originations, refer to Table H —
Loan Production included in Part II, Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations , in this report.
Mortgage Origination Channels
Doral Financial’s strategy is to increase the size of its mortgage servicing portfolio
primarily by internal originations through its retail branch network. Doral Financial supplements
retail originations with wholesale originations that include purchases of loans with the related
servicing rights from third parties and referrals from mortgage brokers. Doral Financial maintains
specialized units for the origination of construction loans and loans to finance purchases of
residences in new housing developments. The principal origination channels of Doral Financial’s
mortgage banking units are summarized below.
Retail Branch Network . Doral Financial’s mortgage banking offices are co-located
within Doral Bank PR’s 44 retail bank branches throughout Puerto Rico. Customers are sought through
aggressive advertising campaigns in local newspapers, as well as television, direct mail and
telemarketing campaigns. Doral Financial emphasizes quality customer service and offers extended
operating hours to accommodate the needs of customers. Doral Financial’s mortgage banking units
also target the realtor community by emphasizing the same quality of service provided to customers.
New Housing Unit . In Puerto Rico, Doral Financial maintains a separate unit that works
closely with residential housing developers and specializes in originating mortgage loans to
finance the purchase of homes in newly developed housing projects. During the year ended December
31, 2006, Doral Financial originated approximately $417 million of mortgage loans to finance the
purchase of homes within new housing projects, compared to $563 million for the year ended December
31, 2005.
Wholesale Activities . Doral Financial purchases mortgage loans from other mortgage
bankers in Puerto Rico consisting primarily of conventional mortgage loans. For the years ended
December 31, 2006 and 2005, total loan purchases amounted to approximately $88.7 million and $483.1
million, respectively. In the past, Doral Financial has also purchased conforming mortgage loans on
a wholesale basis from U.S. mainland financial institutions without the related servicing rights.
These loans were generally securitized into FNMA or FHLMC securities and sold into the market.
During the third quarter of 2005, Doral Financial terminated its purchases of whole loans in bulk
without the associated servicing rights. Such wholesale purchases of loans from U.S. mainland
institutions amounted to $2.0 billion for 2005.
New York Multi-Family and Commercial Real Estate Lending Subsidiary . During 1998,
Doral Financial established Doral Money, Inc., a lending subsidiary in the New York City
metropolitan area that specializes in
originating mortgage loans secured by income producing multi-family residential and commercial
properties, including bridge loans and loans to finance the rehabilitation of multi-family
residential buildings. Most of these loans involve loan participations with Doral Bank NY. During
the years ended December 31, 2006 and 2005, this
subsidiary originated approximately $40 million
and $60 million, respectively, of mortgage loans, consisting principally of this type of mortgage
product.
Construction Loans . Construction loans on residential housing developments are
primarily originated by Doral Bank PR. See “Banking Activities” below.
For more information on Doral Financial’s loan origination channels, refer to Table I — Loan
Origination Sources in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition
and Results of Operations , in this report.
Loan Underwriting
Doral Financial’s underwriting standards are designed to comply with the relevant guidelines
set forth by the Department of Housing and Urban Development (“HUD”), VA, FNMA, FHLMC, federal and
Puerto Rico banking regulatory authorities, private mortgage investment conduits and private
mortgage insurers, as applicable.
In connection with the changes to Doral Financial’s business strategies, the Company’s current
management determined that Doral Financial’s underwriting procedures and controls were not
sufficiently robust or effective to enable the Company to fully benefit from the U.S. institutional
secondary market for non-conforming loans and were not consistent with the Company’s goals of
retaining a greater portion of loan production and improving the quality of its loan portfolio.
Accordingly, during 2006, Doral Financial’s current management, with the assistance of outside
experts, implemented adjustments to its underwriting processes in order to achieve uniform,
automated and rules-based underwriting standards. The implementation of these standards contributed
to a significant reduction in the Company’s loan originations during the second half of 2006. The
Company, however, believes that these changes will allow it to more efficiently underwrite assets
with better credit quality and more appropriately price its loan products in the future.
The Company’s underwriting policies focus primarily on the borrower’s ability to pay and
secondarily on collateral value. Although the maximum loan-to-value ratio on conventional
mortgages generally does not exceed 80%, the Company offers certain loan products with higher
loan-to-value ratios. The Company has not and currently does not generally originate adjustable
rate mortgages or negatively amortizing loans.
The Company understands that the bulk of its non-conforming loan originations have similar
credit characteristics to “Alt-A” loans in the U.S. mainland mortgage market and are predominantly
fixed rate. The Company uses external credit scores as a useful measure for assessing the credit
quality of a borrower. These scores are numbers supplied by credit information providers, based on
statistical models that summarize an individual’s credit record. FICO ® scores, developed
by Fair Isaac Corporation, are the most commonly used credit scores. The implementation of the
adjustments to the Company’s underwriting standards described above has resulted in loan
originations with higher FICO ® scores. Set forth below is additional information about
the FICO ® scores (as of the latest available date) of all residential loans serviced by
the Company, together with loan balances as of December 31, 2006.
(In thousands)
FICO ® scores
Residential
Servicing
Portfolio
Percentage of
Total
Portfolio
Not available
$
345,864
2.4
%
619 or below
4,038,511
27.9
%
620-659
1,829,551
12.7
%
660-719
3,760,683
26.0
%
720 and above
4,479,021
31.0
%
Total (1)
$
14,453,630
100.0
%
Weighted average FICO ® (2)
667
(1)
Excludes U.S. servicing.
(2)
Weighted average FICO ® scores do not include loans for which the FICO ®
score was not available.
Loan Servicing
When Doral Financial sells originated or purchased mortgage loans, it generally retains the
right to service such loans and to receive the associated servicing fees. Doral Financial’s
principal source of servicing rights has traditionally been its mortgage loan production. Doral
Financial also seeks to purchase servicing rights in bulk when it can identify attractive
opportunities.
Servicing rights represent a contractual right and not a beneficial ownership interest in the
underlying mortgage loans. Failure to service the loans in accordance with contract requirements
may lead to a termination of the servicing rights and the loss of future servicing fees. In
general, Doral Financial’s servicing agreements are terminable by the investors for cause.
However, certain servicing arrangements, such as those with FNMA and FHLMC, contain termination
provisions that may be triggered by changes in the servicer’s financial condition that materially
and adversely affect its ability to provide satisfactory servicing of the loans. Approximately 27%
and 18% of Doral Financial’s mortgage loan servicing portfolio on behalf of third parties as of
December 31, 2006 relates to mortgage servicing for FNMA and GNMA, respectively. As of December
31, 2006, Doral Financial serviced approximately $12.0 billion in mortgage loans on behalf of third
parties. Termination of Doral Financial’s servicing rights by either of these agencies could have
a material adverse effect on Doral Financial’s results of operations and financial condition. In
certain instances, the Company also services loans with no contractual servicing fee. The servicing
asset or liability associated with such loans is evaluated based on ancillary income, float, late
fees, prepayment penalties and costs.
Doral Financial’s mortgage loan servicing portfolio is subject to reduction by reason of
normal amortization, prepayments and foreclosure of outstanding mortgage loans. Additionally, Doral
Financial may sell mortgage loan servicing rights from time to time to other institutions if market
conditions are favorable. For additional information regarding the composition of Doral Financial’s
servicing portfolio as of each of the Company’s last three fiscal year-ends, refer to Table J —
Mortgage Loan Servicing in Part II, Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations , in this report.
The degree of risk associated with a mortgage loan servicing portfolio is largely dependent on
the extent to which the servicing portfolio is non-recourse or recourse. In non-recourse servicing,
the principal credit risk to the servicer is the cost of temporary advances of funds. In recourse
servicing, the servicer agrees to share credit risk with the owner of the mortgage loans, such as
FNMA or FHLMC, or with a private investor, insurer or guarantor. Losses on recourse servicing occur
primarily when foreclosure sale proceeds of the property underlying a defaulted mortgage loan are
less than the outstanding principal balance and accrued interest of such mortgage loan and the cost
of holding and disposing of the underlying property. In the past, Doral Financial often sold
non-conforming loans on a partial recourse basis. For additional information regarding recourse
obligations, see Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and
Results of Operations , “— Off-Balance Sheet Activities” in this report.
Sale of Loans and Securitization Activities
Residential Mortgage Loans. Doral Financial customarily sells or securitizes a portion of the
residential mortgage loans that it originates and purchases. As described below, Doral Financial
utilizes various channels to sell its mortgage products. Doral Financial issues GNMA-guaranteed
mortgage-backed securities, which involve the packaging of FHA loans, RHS loans or VA loans into
pools of $1 million or more for sale primarily to broker-dealers and other institutional investors.
During the years ended December 31, 2006 and 2005, Doral Financial issued approximately $198.1
million and $322.4 million, respectively, in GNMA-guaranteed mortgage-backed securities.
Conforming conventional loans are generally either sold directly to FNMA, FHLMC or private
investors for cash, or are grouped into pools of $1 million or more in aggregate principal balance
and exchanged for FNMA or
FHLMC-issued mortgage-backed securities, which Doral Financial sells to broker-dealers. In
connection with such exchanges, Doral Financial pays guarantee fees to FNMA and FHLMC. The issuance
of mortgage-backed securities provides Doral Financial with flexibility in selling the mortgage
loans that it originates or purchases and also
provides income by increasing the value and
marketability of such loans. For the years ended December 31, 2006 and 2005, Doral Financial
securitized approximately $53.5 million and $1.0 billion, respectively, of loans into FNMA and
FHLMC mortgage-backed securities. In addition, for the years ended December 31, 2006 and 2005,
Doral Financial sold approximately $177.1 million and $317.1 million, respectively, of loans
through the FNMA and FHLMC cash window programs.
In the past, the Company generally sold mortgage loans that did not conform to GNMA, FNMA or
FHLMC requirements (non-conforming loans) as whole loans to local financial institutions or to FNMA
or FHLMC and other financial institutions in negotiated transactions. Many of Doral Financial’s
whole loan sales to local financial institutions historically were structured similarly to
securitization transactions. When Doral Financial sold a pool of loans to an investor, it retained
the servicing rights and agreed to pay the purchaser a specified pass-through rate for the entire
pool that was below the weighted-average coupon of the underlying mortgage loans. Any amounts
received on the mortgages above the pass-through rate were retained by Doral Financial. The
pass-through rate paid to the investors was normally a variable rate generally based on a spread
over the three-month LIBOR. The present values of the future cash flows retained by Doral Financial
above any contractual servicing fees are recognized on Doral Financial’s financial statements as
IOs. Since July 2005, Doral Financial no longer structures its whole loan sales in this manner and
has been selling its non-conforming loans in the U.S. secondary market for cash without any
retained interest, other than the retained mortgage servicing rights.
Prior to the fourth quarter of 2005, Doral Financial’s non-conforming loan sales were
generally made on a limited recourse basis. Pursuant to the restructuring of several recourse
transactions consummated during 2006, the Company’s outstanding principal balance of loans sold
subject to recourse decreased by $1.2 billion, from $2.4 billion as of December 31, 2005 to $1.2
billion as of December 31, 2006. As of December 31, 2006 and 2005, Doral Financial’s maximum
contractual exposure relating to its portfolio of loans sold with recourse was approximately $956.2
million and $1.8 billion, respectively, which included recourse obligations to FNMA and FHLMC as of
such dates of approximately $863.3 million and $1.0 billion, respectively. As of December 31, 2006
and 2005, Doral Financial recognized an estimated recourse liability of $9.5 million and $17.2
million, respectively, to absorb potential losses from such recourse arrangements.
Commencing in the fourth quarter of 2005 and continuing throughout 2006, the Company has sold
non-conforming loans to major financial institutions in the U.S. mainland on a non-recourse basis,
except recourse for certain early defaults. The Company will seek to continue to diversify
secondary market outlets for its non-conforming loan products both in the U.S. mainland and Puerto
Rico. See “— Business Transformation Strategy” above for additional information regarding certain
changes to the Company’s business strategy.
In the ordinary course of business, Doral Financial makes certain representations and
warranties to purchasers and insurers of mortgage loans, and in certain circumstances, such as in
the event of early or first payment default, the Company retains credit risk exposure on those
loans. If there is a breach of a representation or warranty or if there is an early payment
default, Doral Financial may be required to repurchase the mortgage loan and bear any subsequent
loss related to the loan. Recently, certain institutions have approached the Company alleging
violations of representations and warranties relating to documentation issues (primarily loan file
deficiencies) involving mortgage loans sold to these institutions. Doral Financial is working with
these financial institutions to review the claims and correct alleged documentation deficiencies.
See Item 1A. Risk Factors , “Risks Relating to Doral Financial’s Business — Defective and
Repurchased Loans May Harm Doral Financial’s Business and Financial Condition,” and Item 7.
Management’s Discussion and Analysis and Results of Operations , “—Liquidity and Capital Resources.”
Puerto Rico Secondary Mortgage Market and Favorable Tax Treatment
In general, the Puerto Rico market for mortgage-backed securities is an extension of the U.S.
market with respect to pricing, rating of investment instruments, and other matters. However, Doral
Financial has benefited historically from certain tax incentives provided to Puerto Rico residents
to invest in FHA and VA loans and GNMA securities backed by such loans.
Under the Puerto Rico Internal Revenue Code of 1994 (the “PR Code”), the interest received on
FHA and VA loans used to finance the original purchase of newly constructed housing in Puerto Rico
and mortgage-backed
securities backed by such loans is exempt from Puerto Rico income taxes. This
favorable tax treatment allows Doral Financial to sell tax-exempt Puerto Rico GNMA mortgage-backed
securities to local investors at higher prices than those at which comparable instruments trade in
the U.S. mainland, and reduces its effective tax rate through the receipt of tax-exempt interest.
Institutional Securities Operations
Doral Financial is involved in the securities business through Doral Securities, a
broker-dealer firm registered with the SEC and a member of the National Association of Securities
Dealers, Inc. (the “NASD”). During 2002, Doral Financial sold its retail securities brokerage
business to an unaffiliated broker-dealer. As part of the Company’s expense reduction efforts,
during the fourth quarter of 2005, the Company terminated its institutional sales and investment
banking services. Doral Securities’ operations are currently limited to acting as a co-investment
manager to a local fixed-income investment company. The Company is currently considering
opportunities for this business unit within its community banking strategy.
Insurance Agency Activities
Taking advantage of the cross-marketing opportunities provided by financial modernization
legislation, during 2000, Doral Financial entered the insurance agency business in Puerto Rico.
Doral Insurance Agency currently earns commissions by acting as agent in connection with the sale
of insurance policies issued by unaffiliated insurance companies. During 2006, 2005 and 2004, Doral
Insurance Agency produced insurance fees and commissions of $8.8 million, $12.4 million and $11.9
million, respectively. Doral Insurance Agency’s activities are closely integrated with the
Company’s mortgage loan originations with most policies sold to mortgage customers. Future growth
of Doral Insurance Agency’s revenues will be tied to the Company’s level of mortgage originations,
its ability to expand the products and services it provides and its ability to cross-market its
services to Doral Financial’s existing customer base.
Other Investment Activities
As a result of Doral Financial’s mortgage securitization activities, Doral Financial
maintains a portfolio of mortgage-backed securities classified as held-for-trading. Doral
Financial also invests in securities that are classified either as available-for-sale or
held-to-maturity. In addition, Doral Financial operates an international banking entity subsidiary.
Under Puerto Rico law, Doral Financial’s international banking entity subsidiary is generally not
subject to Puerto Rico income taxation on the interest earned on the securities held by it or on
the gains from the sale of securities held by it. Doral Financial and its Puerto Rico
subsidiaries, including its international banking entity subsidiary, are considered foreign
corporations for U.S. federal income tax purposes and are generally not subject to U.S. income tax
on the interest earned on such securities.
Refer to Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and
Results of Operations , “— Investment and Trading Activities” and to Notes 6, 7, 8 and 9 to Doral
Financial’s consolidated financial statements for more detailed information on Doral Financial’s
investment activities.
Puerto Rico Income Taxes
In August 2005, the Government of Puerto Rico approved legislation that imposed a special
transitory income tax of 2.5% on certain corporations and partnerships, including Doral Financial
and its Puerto Rico subsidiaries, that increased the maximum statutory income tax rate from 39% to
41.5%. This law is effective for taxable years beginning after December 31, 2004 and ending on or
before December 31, 2006. In May 2006, the Government of Puerto Rico approved an additional 2%
transitory tax applicable only to banking institutions such as Doral Bank that increased the
maximum statutory tax rate for banks to 43.5% for taxable years commencing during 2006. For
taxable years beginning after December 31, 2006, the maximum statutory tax rate for all
corporations, including banks, will return to 39%. Under the PR Code, corporations are not
permitted to file consolidated returns with their
subsidiaries and affiliates. Doral Financial is entitled to a 100% dividend received deduction
on dividends received from Doral Bank PR, Doral Mortgage or any other Puerto Rico subsidiary
subject to tax under the PR Code.
In computing its interest expense deduction, Doral Financial’s interest deduction is reduced
in the same proportion that its average exempt obligations (including FHA and VA loans and GNMA
securities) bear to its average total assets. Therefore, to the extent that Doral Financial holds
FHA loans or VA loans and other tax exempt obligations, part of its interest expense may be
disallowed for tax purposes.
Doral Financial’s international banking entity subsidiary is generally not subject to Puerto
Rico income taxes on interest earned on, or gains realized from the sale of, non-Puerto Rico assets
including certain U.S. government and agency securities.
United States Income Taxes
Except for Doral Bank NY and Doral Money, Doral Financial and its subsidiaries are
corporations organized under the laws of Puerto Rico. Accordingly, Doral Financial and its Puerto
Rico subsidiaries are generally only required to pay U.S. federal income tax on their income, if
any, derived from the active conduct of a trade or business within the United States (excluding
Puerto Rico) or from certain investment income earned from U.S. sources. Doral Bank NY and Doral
Money are subject to both federal and state income taxes on the income derived from their
operations in the United States. Dividends paid by Doral Bank NY to Doral Financial are subject to
a 10% withholding tax. On March 15, 2007, Doral Bank NY, Doral Financial’s wholly owned New York
City-based thrift subsidiary, entered into a definitive purchase and assumption agreement with New
York Commercial Bank, the commercial bank subsidiary of New York Community Bancorp, pursuant to
which New York Commercial Bank agreed to acquire Doral Bank NY’s 11 existing branches in the New
York City metropolitan area. Doral Financial will record a deferred tax liability representing the
expected tax on the retained earnings it intends to repatriate from this subsidiary following the
closing of the sale.
Employees
As of January 31, 2007, Doral Financial employed 1,278 persons, of which 1,163 were employed
in Puerto Rico. Of these, 533 were employed in mortgage banking, with 194 involved in loan
production and sale activities and 131 involved in loan servicing activities. As of such date,
Doral Financial’s banking operations employed 622 employees. None of Doral Financial’s employees
are represented by a labor union and Doral Financial considers its employee relations to be good.
Segment Disclosure
For information regarding Doral Financial’s operating segments, please refer to Note 34 to
Doral Financial’s consolidated financial statements, “Segment Information,” and the information
provided under Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and
Results of Operation , “— Operating Segments” in this report.
Puerto Rico is the principal market for Doral Financial. Doral Financial’s Puerto Rico-based
operations accounted for 95% of Doral Financial’s consolidated assets as of December 31, 2006 and
83% of Doral Financial’s consolidated revenues for the year then ended. Approximately 91% of total
loan originations were secured by real estate properties located in Puerto Rico. The following
table sets forth the geographic composition of Doral Financial’s loan originations:
Year Ended December 31,
2006
2005
2004
Puerto Rico
93
%
95
%
97
%
United States
7
%
5
%
3
%
Market Area and Competition
Puerto Rico is Doral Financial’s primary service area. The competition in Puerto Rico for the
origination of mortgages loans is substantial. Competition comes not only from other mortgage
bankers but also from major commercial banks, including affiliates of banks headquartered in the
United States, Spain and Canada. Doral
Financial competes principally by offering loans with
competitive features, by emphasizing the quality of its service and pricing its range of products
at competitive rates.
The Commonwealth of Puerto Rico
General. The Island of Puerto Rico, located in the Caribbean, is approximately 100 miles long
and 35 miles wide, with an area of 3,423 square miles and an estimated population of 3.9 million as
of 2005. Puerto Rico is the fourth largest and most economically developed of the Caribbean
islands. Its capital, San Juan, is located approximately 1,600 miles southeast of New York City
and had an estimated population of 434,375 as of 2000.
Relationship of Puerto Rico with the United States. Puerto Rico has been under the
jurisdiction of the United States since 1898. The United States and Puerto Rico share a common
defense, market and currency. As a commonwealth of the United States, Puerto Rico exercises
virtually the same control over its internal affairs as do the fifty states. There is a federal
district court in Puerto Rico and most federal laws are applicable to Puerto Rico. The United
States postal service operates in Puerto Rico in the same manner as in the mainland United States.
The people of Puerto Rico are citizens of the United States, but do not vote in national elections,
and are represented in Congress by a Resident Commissioner who has a voice in the House of
Representatives, but only limited voting rights. Most federal taxes, except those, such as social
security taxes, which are imposed by mutual consent, are not levied in Puerto Rico. No federal
income tax is collected from Puerto Rico residents on ordinary income earned from sources within
Puerto Rico, except for certain federal employees who are subject to taxes on their salaries.
The Economy. The economy of Puerto Rico is closely linked to that of the mainland United
States, as most of the external factors that affect the Puerto Rico economy (other than the price
of oil) are determined by the policies of, and economic conditions prevailing in, the United
States. These external factors include exports, direct investment, the amount of federal transfer
payments, the level of interest rates, the rate of inflation, and tourist expenditures. During the
fiscal year ended June 30, 2005, approximately 83% of Puerto Rico’s exports went to the U.S.
mainland, which was also the source of approximately 49% of Puerto Rico’s imports. In the past,
the economy of Puerto Rico has generally followed economic trends in the overall United States
economy. However, in recent years, economic growth in Puerto Rico has lagged behind growth in the
United States.
The dominant sectors of the Puerto Rico economy in terms of production and income are
manufacturing and services. The manufacturing sector has undergone fundamental changes over the
years as a result of an increased emphasis on higher-wage, high-technology industries, such as
pharmaceuticals, biotechnology, computers, microprocessors, professional and scientific
instruments, and certain high-technology machinery and equipment. The services sector, including
finance, insurance, real estate, wholesale and retail trade, and tourism, also plays a major role
in the economy. It ranks second to manufacturing in contribution to Puerto Rico’s gross domestic
product and leads all sectors in providing employment.
Preliminary figures for fiscal year 2006 show that gross national product increased from $45.0
billion (in current dollars) for fiscal year 2002 to $56.7 billion (in current dollars) for fiscal
year 2006. Since fiscal year 1985, personal income per capita has increased consistently each
fiscal year. In fiscal year 2006, personal income per capita was $12,997. Average employment
increased from 1,152,000 for fiscal year 2002 to 1,253,000 for fiscal year 2006. Unemployment,
although at relatively low historical levels, remains above the Unites States average. The average
unemployment rate increased from 10.6% in fiscal year 2005 to 11.7% in fiscal year 2006. The
unemployment rate for the first seven months of fiscal year 2007 was 10.3%, a decrease from 11.7%
for the same period of fiscal year 2006.
Future growth of the Puerto Rico economy will depend on several factors including the
condition of the United States economy, the relative stability in the price of oil imports, the
exchange value of the United States dollar, the level of interest rates and changes to existing tax
incentive legislation. Currently, after a number of downward revisions reflecting deterioration in
several key economic indicators, the Puerto Rico Planning Board forecasts an
increase in the real gross national product of 0.6% for the fiscal year ending June 30, 2007.
Although updated forecasts for fiscal year 2007 are not available, key economic indicators show
that the economy has been contracting since April 2006 and this trend is expected to continue
through the first half of 2007. The major factors currently affecting the economy are the still
relatively high level of oil prices, the depreciation of the dollar (which affects the
value of
imports from foreign countries, which account for approximately 50% of total imports to Puerto
Rico), and the continuing economic uncertainty generated by the Commonwealth’s fiscal crisis, among
others.
Current Fiscal Situation. During 2005 and 2006, the Commonwealth of Puerto Rico considered
several alternatives for a comprehensive tax and fiscal reform. On May 25, 2006, the Governor
signed legislation providing for a fiscal reform of the Commonwealth government, including, among
other things, the reduction of government spending, the elimination or consolidation of redundant
agencies and the reduction of government payroll. On July 4, 2006, the Puerto Rico legislature
approved legislation amending the PR Code to provide, among other things, for a general sales and
use tax of 5.5%, a municipal sales and use tax of 1.5% and certain tax relief measures to be
implemented as part of the tax reform. Although the tax and fiscal reforms have been adopted, there
can be no assurance that such measures will generate the projected revenues or savings. Recently,
the Government of Puerto Rico announced a possible lack of budgetary funds to complete the fiscal
year ending June 30, 2007 of approximately $650 million. Similar conditions at the end of fiscal
year 2006 led to a two-week government shutdown. The Company cannot predict the impact that the
current fiscal situation of the Commonwealth of Puerto Rico will have on the Puerto Rico economy
and thus on Doral Financial’s results of operations.
Ratings of Commonwealth of Puerto Rico Obligations. On July 20, 2006, S&P confirmed its “BBB”
and “BBB-” rating on the Commonwealth’s general obligation debt and appropriation debt,
respectively, and removed the ratings from “CreditWatch with negative implications”, where it had
been placed on March 22, 2006, as a result of the Commonwealth’s anticipated budget deficit for
fiscal year 2006, slow progress on tax and fiscal reform and the apparent political impasse
regarding these measures. The following day, Moody’s confirmed its “Baa3” and “Ba1” rating on the
Commonwealth’s general obligation debt and appropriation debt, respectively, and removed the
ratings from “Watchlist with negative implications.” Moody’s had previously downgraded the
Commonwealth’s general obligation debt and appropriation debt and kept the rating on Watchlist for
possible further downgrade due to the Commonwealth’s strained financial condition, ongoing
political conflict and lack of agreement on measures to end the Commonwealth’s financial
deterioration. Both S&P’s and Moody’s ratings outlooks remain negative. For more information
relating to the rating downgrades please refer to www.moodys.com and www.standardandpoors.com.
REGULATION AND SUPERVISION
Mortgage Banking Business
Doral Financial’s mortgage banking business is subject to the rules and regulations of FHA,
VA, RHS, FNMA, FHLMC, HUD and GNMA with respect to the origination, processing, selling and
servicing of mortgage loans and the issuance and sale of mortgage-backed securities. Those rules
and regulations, among other things, prohibit discrimination and establish underwriting guidelines
which include provisions for inspections and appraisals, require credit reports on prospective
borrowers and fix maximum loan amounts, and with respect to VA loans, fix maximum interest rates.
Moreover, lenders such as Doral Financial are required annually to submit to FHA, VA, RHS, FNMA,
FHLMC, GNMA and HUD audited financial statements, and each regulatory entity has its own
requirements. Doral Financial’s affairs are also subject to supervision and examination by FHA, VA,
RHS, FNMA, FHLMC, GNMA and HUD at all times to ensure compliance with the applicable regulations,
policies and procedures. Mortgage origination activities are subject to, among others, the Equal
Credit Opportunity Act, Federal Truth-in-Lending Act, the Real Estate Settlement Procedures Act and
the regulations promulgated thereunder which, among other things, prohibit discrimination and
require the disclosure of certain basic information to mortgagors concerning credit terms and
settlement costs. Doral Financial is also subject to regulation by the Office of the Commissioner
of Financial Institutions of Puerto Rico (the “Office of the Commissioner”), with respect to, among
other things, licensing requirements and maximum origination fees on certain types of mortgage loan
products.
Each of Doral Financial’s mortgage banking units that operate in Puerto Rico is licensed by
the Office of the Commissioner as a mortgage banking institution. Such authorization to act as a
mortgage banking institution must be renewed as of December 1 of each year. In the past, Doral
Financial and its subsidiaries have not had any
difficulty in renewing their authorizations to act as mortgage banking institutions and
management is unaware of any existing practices, conditions or violations which would result in
Doral Financial being unable to receive such authorization in the future. Doral Financial’s
operations in the mainland United States are subject to regulation by state regulators in the
states in which it conducts business.
Section 5 of the Puerto Rico Mortgage Banking Institutions Law (the “Mortgage Banking Law”)
requires the prior approval of the Office of the Commissioner for the acquisition of control of any
mortgage banking institution licensed under the Mortgage Banking Law. For purposes of the Mortgage
Banking Law, the term “control” means the power to direct or influence decisively, directly or
indirectly, the management or policies of a mortgage banking institution. The Mortgage Banking Law
provides that a transaction that results in the holding of less than 10% of the outstanding voting
securities of a mortgage banking institution shall not be considered a change of control. Pursuant
to Section 5 of the Mortgage Banking Law, upon receipt of notice of a proposed transaction that may
result in a change of control, the Office of the Commissioner is obligated to make such inquiries
as it deems necessary to review the transaction. Under the Mortgage Banking Law, the determination
of the Office of the Commissioner whether or not to authorize a proposed change of control is final
and non-appealable.
Banking Operations
Federal Regulation
General
Doral Financial is a bank holding company subject to supervision and regulation by the Board
of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company
Act of 1956 (the “BHC Act”), as amended by the Gramm-Leach-Bliley Act of 1999 (the
“Gramm-Leach-Bliley Act”). As a bank holding company that has elected to be treated as a financial
holding company under the Gramm-Leach-Bliley Act, Doral Financial’s activities and those of its
banking and non-banking subsidiaries are limited to activities that are financial in nature. See
“—Financial Modernization Legislation” below for a description of recent legislation expanding the
powers of financial holding companies. Under the BHC Act, Doral Financial may not, directly or
indirectly, acquire the ownership or control of more than 5% of any class of voting shares of a
bank or another bank holding company, without the prior approval of the Federal Reserve.
Doral Bank PR is subject to supervision and examination by applicable federal and state
banking agencies, including the Federal Deposit Insurance Corporation (“FDIC”) and the Office of
the Commissioner. Doral Bank NY is subject to supervision and examination by the Office of Thrift
Supervision (“OTS”) and the FDIC. Doral Financial’s banking subsidiaries are subject to
requirements and restrictions under federal and state law, including requirements to maintain
reserves against deposits, restrictions on the types and amounts of loans that may be granted and
the interest that may be charged thereon, and limitations on the types of other investments that
may be made and the types of services that may be offered. Various consumer laws and regulations
also affect the operations of Doral Financial’s banking subsidiaries. In addition to the impact of
regulation, commercial and savings banks are affected significantly by the actions of the Federal
Reserve as it attempts to control the money supply and credit availability in order to influence
the economy.
On March 17, 2006, the Company and its principal Puerto Rico Banking subsidiary, Doral Bank
PR, entered into consent orders with the Federal Reserve, the FDIC and the Office of the
Commissioner. For a detailed description of how these orders and certain other regulatory
proceeding affect Doral Bank PR, please refer to Part I, Item 3. Legal Proceedings , in this report.
Doral Financial’s banking subsidiaries are subject to certain regulations promulgated by the
Federal Reserve including Regulation B (Equal Credit Opportunity Act), Regulation DD (The Truth in
Savings Act), Regulation E (Electronic Funds Transfer Act), Regulation F (Limits on Exposure to
Other Banks), Regulation Z (Truth-in-Lending Act), Regulation CC (Expedited Funds Availability
Act), Regulation X (Real Estate Settlement Procedures Act), Regulation BB (Community Reinvestment
Act) and Regulation C (Home Mortgage Disclosure Act).
Holding Company Structure
Doral Bank PR and Doral Bank NY, as well as any other insured depository institution
subsidiary organized by Doral Financial in the future, are subject to restrictions under federal
law that govern certain transactions with Doral Financial or other non-banking subsidiaries of
Doral Financial, whether in the form of loans, other extensions of credit, investments or asset
purchases and sales. Such transactions by any depository institution subsidiary with
Doral
Financial, or with any one of Doral Financial’s non-banking subsidiaries, are limited in amount to
10% of the depository institution’s capital stock and surplus and, with respect to all of its
non-banking subsidiaries, to an aggregate of 20% of the transferring institution’s capital stock
and surplus. Furthermore, such loans and extensions of credit by the depository institution
subsidiary are required to be secured in specified amounts and must be at market rates and on terms
and conditions that are consistent with safe and sound banking practices. All other transactions
between Doral Financial or any of its non-banking subsidiaries and any of the depository
institution subsidiaries, while not subject to quantitative or collateral requirements, are subject
to the requirement that they be on terms and conditions no less favorable to the banking subsidiary
than would be available to unaffiliated third parties.
Under Federal Reserve policy, a bank holding company such as Doral Financial is expected to
act as a source of financial strength to each of its subsidiary banks and to commit resources to
support each such subsidiary bank. This support may be required at times when, absent such policy,
the bank holding company might not otherwise provide such support. In addition, any capital loans
by a bank holding company to any of its subsidiary banks are subordinate in right of payment to
deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding
company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory
agency to maintain the capital of a subsidiary depository institution will be assumed by the
bankruptcy trustee and entitled to priority of payment.
As a bank holding company, Doral Financial’s right to participate in the assets of any
subsidiary upon the latter’s liquidation or reorganization will be subject to the prior claims of
the subsidiary’s creditors (including depositors in the case of depository institution
subsidiaries) except to the extent that Doral Financial may itself be a creditor with recognized
claims against the subsidiary.
Under the Federal Deposit Insurance Act (the “FDIA”), a depository institution (which term
includes both commercial banks and savings banks), the deposits of which are insured by the FDIC,
can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in
connection with (i) the default of a commonly controlled FDIC-insured depository institution; or
(ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured depository
institution “in danger of default.” “Default” is defined generally as the appointment of a
conservator or a receiver and “in danger of default” is defined generally as the existence of
certain conditions indicating that a default is likely to occur in the absence of regulatory
assistance. In some circumstances (depending upon the amount of the loss or anticipated loss
suffered by the FDIC), cross-guarantee liability may result in the ultimate failure or insolvency
of one or more insured depository institutions in a holding company structure. Any obligation or
liability owned by a subsidiary depository institution to its parent company is subordinated to the
subsidiary bank’s cross-guarantee liability with respect to commonly controlled insured depository
institutions.
Financial Modernization Legislation
Doral Financial has elected to be treated as a financial holding company as permitted by the
Gramm-Leach-Bliley Act. Under the Gramm-Leach-Bliley Act, bank holding companies, such as Doral
Financial, all of whose depository institutions are “well capitalized” and “well managed,” as
defined in the BHC Act, and which obtain satisfactory Community Reinvestment Act ratings, may elect
to be treated as financial holding companies (“FHCs”). FHCs are permitted to engage in a broader
spectrum of activities than those permitted to other bank holding companies. FHCs can engage in any
activities that are “financial” in nature, including insurance underwriting and brokerage, and
underwriting and dealing in securities without a revenue limit or other limits applicable to
foreign securities affiliates (which include Puerto Rico securities affiliates for these purposes).
On October 3, 2006, Doral Financial was notified by the Federal Reserve that it no longer
satisfies the financial holding company requirements for purposes of the Gramm-Leach-Bliley Act.
In accordance with applicable regulations, Doral Financial has
submitted a plan with the Federal Reserve on how it intends to satisfy the applicable
requirements to remain a financial holding company. See “—Banking Regulatory Matters” under Item
3. Legal Proceedings , below.
Subject to certain limitations, under new merchant banking rules, FHCs are also permitted to
make investments in companies that engage in activities that are not financial in nature without
regard to the existing 5% limit for domestic investments and 20% limit for overseas (including
Puerto Rico) investments applicable to bank holding companies that are not FHCs.
Under the Gramm-Leach-Bliley Act, if Doral Financial fails to meet the requirements for being
an FHC and is unable to correct such deficiencies within certain prescribed time periods, the
Federal Reserve could require Doral Financial to divest control of its depository institution
subsidiaries or alternatively to cease conducting activities that are not permissible for bank
holding companies that are not FHCs.
The Gramm-Leach-Bliley Act also modified other laws, including laws related to financial
privacy and community reinvestment. The new financial privacy provisions generally prohibit
financial institutions, including Doral Financial’s mortgage banking and banking subsidiaries from
disclosing non-public personal financial information to third parties unless customers have the
opportunity to “opt out” of the disclosure.
Capital Adequacy
Under the Federal Reserve’s risk-based capital guidelines for bank holding companies, the
minimum guidelines for the ratio of qualifying total capital (“Total Capital”) to risk-weighted
assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. At
least half of the Total Capital is to be comprised of common equity, retained earnings, minority
interests in unconsolidated subsidiaries, noncumulative perpetual preferred stock and a limited
amount of cumulative perpetual preferred stock, in the case of a bank holding company, less
goodwill and certain other intangible assets discussed below (“Tier 1 Capital”). The remainder may
consist of a limited amount of subordinated debt, other preferred stock, certain other instruments
and a limited amount of loan and lease loss reserves (“Tier 2 Capital”).
The Federal Reserve has adopted regulations that require most intangibles, including core
deposit intangibles, to be deducted from Tier l Capital. The regulations, however, permit the
inclusion of a limited amount of intangibles related to readily marketable mortgage servicing
rights and purchased credit card relationships and include a “grandfather” provision permitting the
continued inclusion of certain existing intangibles.
In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank
holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to total assets,
less goodwill and certain other intangible assets discussed below (the “Leverage Ratio”) of 3% for
bank holding companies that have the highest regulatory rating or have implemented the Federal
Reserve’s market risk capital measure. All other bank holding companies are required to maintain a
minimum Leverage Ratio of 4%. The guidelines also provide that banking organizations experiencing
significant internal growth or making acquisitions are expected to maintain strong capital
positions substantially above the minimum supervisory levels, without significant reliance on
intangible assets. Furthermore, the guidelines indicate that the Federal Reserve will continue to
consider a “tangible Tier 1 Leverage Ratio” and other indicators of capital strength in evaluating
proposals for expansion or new activities. The tangible Tier 1 leverage ratio is the ratio of a
banking organization’s Tier 1 Capital, less all intangibles, to average total assets, less all
intangibles.
The U.S. federal bank regulatory agencies’ risk-capital guidelines are based upon the 1988
capital accord of the Basel Committee on Banking Supervision (the “BCS”). The BCS is a committee
comprised by central bank governors and bank supervisor authorities of the Group of Ten countries
(“G10”). The BCS is in charge of developing broad policy guidelines used by each country’s
supervisor to determine its own supervisory guidelines. On June 26, 2004 (subsequently amended in
November 2005), the BSC released a proposal to replace the 1988 capital accord with a new set of
guidelines. The new Basel Accord, which is often referred to as the Basel II Accord, would, among
other things, set capital requirements for operational risk and refine the existing capital
requirements for credit risk and market risk exposures. The 1988 capital accord does not include a
separate capital requirement for operational risk, which is defined under the proposed accord as
the risk of direct or indirect loss resulting from inadequate or failed internal processes, people
and systems or from external events.
On September 30, 2005, the U.S. banking regulators delayed the United States implementation of
the Basel II Accord by one year. The current Unites States implementation timetable consists of
parallel calculations under the current regulatory capital regime (Basel I) and the Basel II
Accord, starting January 1, 2008, and an implementation transition period, starting January 1, 2009
through year-end 2011 or possibly later. The U.S. regulators have also reserved the right to change
how the Basel II Accord is applied in the United States, and retain the existing Prompt
Corrective Action and leverage capital requirements applicable to U.S. banking organizations. See, “—Basel II
Capital Standards” below.
The FDIC and the OTS have established regulatory capital requirements for state non-member
insured banks and federal savings banks, such as Doral Bank PR and Doral Bank NY, respectively,
that are substantially similar to those adopted by the Federal Reserve for bank holding companies.
Set forth below are Doral Financial’s, Doral Bank PR’s and Doral Bank NY’s capital ratios at
December 31, 2006, based on existing Federal Reserve, FDIC and OTS guidelines.
Banking Subsidiaries
Well
Capitalized
Doral Financial
Doral Bank PR
Doral Bank NY
Minimum
Total capital ratio (total capital to risk weighted assets)
13.7
%
21.1
%
16.3
%
10.0
%
Tier 1 capital ratio (Tier 1 capital to risk weighted
assets)
10.3
%
19.8
%
15.8
%
6.0
%
Leverage ratio (1)
4.5
%
6.8
%
10.3
%
5.0
%
(1)
Tier 1 capital to average assets in the case of Doral Financial and Doral Bank PR and Tier 1 Capital to adjusted total
assets in the case of Doral Bank NY.
As of December 31, 2006, Doral Bank PR and Doral Bank NY were in compliance with all the
regulatory capital requirements that were applicable to them as a state non-member bank and federal
savings bank, respectively. See Pat II, Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations , “— Regulatory Capital Ratios” for additional information
regarding Doral Financial’s regulatory capital ratios. Both of the Company’s banking subsidiaries
are “well capitalized.” However, as a result of the losses incurred during 2006, Doral Financial’s
leverage ratio fell below the minimum threshold for the holding company to classify as
well-capitalized. Under the consent order entered into with the Federal Reserve, the Company filed
a capital plan with the Federal Reserve in which it agreed to maintain a leverage ratio of at least
5.5% and 6.0% for Doral Financial and Doral Bank, respectively. As a result of the loss recorded
during 2006, Doral Financial’s leverage ratio fell below 5.5%. As required by the capital plan,
the Company is taking steps to increase its leverage ratio. The loss of “well capitalized” status
may adversely affect the holding company’s access to liquidity. See “—Recent Significant Events —
Recapitalization Process” and Item 3. Legal Proceedings , “—Banking Regulatory Matters”.
Failure to meet capital guidelines could subject a bank holding company or an insured bank to
a variety of enforcement remedies, including, with respect to an insured bank or savings bank, the
termination of deposit insurance by the FDIC, and to certain restrictions on its business. See
“FDICIA” below.
Basel II Capital Standards
Doral Financial may be required to comply with, or decide to adopt, certain new capital and
other regulatory requirements proposed by the BCS, as proposed to be implemented in the United
States. These proposed requirements, which are often referred to as the Basel II Accord, would,
among other things, modify the capital charge applicable to credit risk and incorporate a capital
charge for operational risk. The Basel II Accord also places greater reliance on market discipline
than current standards. The Basel II Accord standards will be mandatory with respect to banking
organizations with total banking assets of $250 billion or more or total on-balance-sheet foreign
exposure of $10 billion or more, and optional for other banking organizations. As a bank holding
company, the threshold for mandatory adoption is determined by reference to the consolidated
company.
Opting into the Basel II Accord standard would require Doral Financial to implement advanced
measurement techniques employing internal estimates of certain key risk drivers to derive capital
requirements. Opting into the Basel II Accord may also require meeting more onerous computational
requirements. Prior to implementation of the new capital regime, a bank holding company will be
required to demonstrate to its primary federal regulator that its measurement approaches meet
relevant supervisory standards. U.S. regulators have proposed an effective date of January 1, 2009
for Basel II, with a gradual phase-in schedule. If Doral Financial does not adopt the Basel II
Accord, voluntarily, it will remain subject to existing risk-based capital requirements, or, when
adopted, the Basel 1A standards described below.
In December 2006, the bank regulatory agencies issued a revised notice of proposed rulemaking
with respect to a new regulatory capital framework (“Basel 1A”) which will be available to banking
organizations that are not required to adopt, and have not elected to adopt, the Basel II
framework. Doral Financial may implement the Basel 1A framework once it has been finalized and an
implementation date is established, unless it has adopted the Basel II Accord. The comment period
for the Basel 1A proposed rulemaking expires on March 26, 2007, after which the bank regulatory
agencies will evaluate the proposed rule in light of the comments that are submitted. Among the
key issues under consideration in connection with Basel 1A are the use of loan-to-value ratios to
determine risk weights for most residential mortgages, an increase in the number of risk weight
categories to which credit exposures may be assigned; expansion of the use of external credit
ratings for certain externally rated exposures, expansion of the range of collateral and guarantors
that may qualify an exposure for lower risk weights, and assessment of a risk-based capital charge
to reflect the risk in securitizations with early amortization provisions.
At this time, Doral Financial cannot predict the final form the Basel 1A capital framework
will take, when it will be implemented, the effect that it might have on Doral Financial’s
financial condition or results of its operations, or how these effects might impact Doral
Financial. Doral Financial is monitoring the evolution of the Basel 1A capital framework, its
potential impact on the Company and its banking subsidiaries, and the industry at large.
FDICIA
Under the Federal Deposit Insurance Corporation Improvement Act of 1991 and the regulations
promulgated thereunder (“FDICIA”), federal banking regulators must take prompt corrective action
with respect to depository institutions that do not meet minimum capital requirements. FDICIA and
the regulations thereunder, establish five capital tiers: “well capitalized,” “adequately
capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically
undercapitalized.” A depository institution is deemed to be well capitalized if it maintains a
Leverage Ratio of at least 5%, a risk-based Tier 1 capital ratio of at least 6% and a risk-based
Total Capital ratio of at least 10%, and is not subject to any written agreement or regulatory
directive to meet a specific capital level. A depository institution is deemed to be adequately
capitalized if it is not well capitalized but maintains a Leverage Ratio of at least 4% (or at
least 3% if given the highest regulatory rating and not experiencing or anticipating significant
growth), a risk-based Tier l capital ratio of at least 4% and a risk-based Total Capital ratio of
at least 8%. A depository institution is deemed to be undercapitalized if it fails to meet the
standards for adequately capitalized institutions (unless it is deemed to be significantly or
critically undercapitalized). An institution is deemed to be significantly undercapitalized if it
has a Leverage Ratio of less than 3%, a risk-based Tier 1 capital ratio of less than 3% or a
risk-based Total Capital ratio of less than 6%. An institution is deemed to be critically
undercapitalized if it has tangible equity equal to 2% or less of total assets. A depository
institution may be deemed to be in a capitalization category that is lower than is indicated by its
actual capital position if it receives a less than satisfactory examination rating in any one of
four categories.
At December 31, 2006, Doral Financial’s banking subsidiaries were well capitalized. Doral
Financial’s, Doral Bank PR’s and Doral Bank NY’s capital categories, as determined by applying the
prompt corrective action provisions of FDICIA, may not constitute an accurate representation of the
overall financial condition or prospects of Doral Financial, Doral Bank PR or Doral Bank NY, and
should be considered in conjunction with other available information regarding the institutions’
financial condition and results of operations.
FDICIA generally prohibits a depository institution from making any capital distribution
(including payment of a dividend) or paying any management fee to its holding company if the
depository institution would thereafter be undercapitalized. Undercapitalized depository
institutions are subject to restrictions on borrowing from the Federal
Reserve System. In addition, undercapitalized depository institutions are subject to growth
limitations and are required to submit capital restoration plans. A depository institution’s
holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the
depository institution’s assets at the time it becomes undercapitalized or the amount of the
capital deficiency when the institution fails to comply with the plan. The federal banking agencies
may not accept a capital plan without determining, among other things, that the plan is based on
realistic assumptions and is likely to succeed in restoring the depository institution’s capital.
If a depository
institution fails to submit an acceptable plan, it is treated as if it were
significantly undercapitalized. Significantly undercapitalized depository institutions may be
subject to a number of requirements and restrictions, including orders to sell sufficient voting
stock to become adequately capitalized, requirements to reduce total assets and cessation of
receipt of deposits from correspondent banks. Critically undercapitalized depository institutions
are subject to appointment of a receiver or conservator.
The capital-based prompt corrective action provisions of FDICIA and their implementing
regulations apply to FDIC-insured depository institutions such as Doral Bank PR and Doral Bank NY,
but they are not directly applicable to bank holding companies, such as Doral Financial, which
control such institutions. However, federal banking agencies have indicated that, in regulating
bank holding companies, they may take appropriate action at the holding company level based on
their assessment of the effectiveness of supervisory actions imposed upon subsidiary insured
depository institutions pursuant to such provisions and regulations.
Interstate Banking Legislation
Effective June 1, 1997, the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 (the “Riegle-Neal Act”) amended the FDIA and certain other statutes to permit state and
national banks with different home states to merge across state lines, with the approval of the
appropriate federal banking agency, unless the home state of a participating bank had passed
legislation prior to May 31, 1997, expressly prohibiting interstate mergers. Under the Riegle-Neal
Act amendments, once a state or national bank has established branches in a state, that bank may
establish and acquire additional branches at any location in the state at which any bank involved
in the interstate merger transaction could have established or acquired branches under applicable
federal or state law. If a state opts out of interstate branching within the specified time period,
no bank in any other state may establish a branch in the state which has opted out, whether through
an acquisition or de novo .
For purposes of the Riegle-Neal Act amendments to the FDIA, Doral Bank PR is treated as a
state bank and is subject to the same restrictions on interstate branching as other state banks.
However, for purposes of the International Banking Act (the “IBA”), Doral Bank PR is considered to
be a foreign bank and may branch interstate by merger or de novo to the same extent as a domestic
bank in Doral Bank PR’s home state. Because Doral Bank PR does not currently operate in the
mainland United States, it has not designated a “home state” for purposes of the IBA. It is not yet
possible to determine how these statutes will be harmonized, with respect either to which federal
agency will approve interstate transactions or with respect to which “home state” determination
rules will apply.
As a federal savings bank, Doral Bank NY is subject to the branching regulations promulgated
by the OTS. Such regulations allow Doral Bank NY to branch on an interstate basis without
geographic limitations.
American Jobs Creation Act of 2004
On October 22, 2004, the President of the United States signed into law the American Jobs
Creation Act of 2004, which lowered the withholding tax rate imposed on distributions of
U.S.-sourced dividends to a corporation organized under the laws of the Commonwealth of Puerto Rico
from 30% to 10%.
Dividend Restrictions
The payment of dividends to Doral Financial by its banking subsidiaries may be affected by
regulatory requirements and policies, such as the maintenance of adequate capital. If, in the
opinion of the applicable regulatory authority, a depository institution under its jurisdiction is
engaged in, or is about to engage in, an unsafe or unsound practice (that, depending on the
financial condition of the depository institution, could include the payment of dividends), such
authority may require, after notice and hearing, that such depository institution cease and desist
from such practice. The Federal Reserve has issued a policy statement that provides that insured
banks and bank
holding companies should generally pay dividends only out of current operating earnings. In
addition, all insured depository institutions are subject to the capital-based limitations required
by FDICIA. See “—FDICIA” above for additional information.
On February 9, 2006, the OTS notified Doral Bank NY that, until further notice, it could not
pay any dividends to Doral Financial without the prior written approval of the OTS. Since its
organization in October 1999, Doral
Bank NY has never paid a dividend to Doral Financial. On March
15, 2007, Doral Financial announced that it had entered into a definitive agreement to sell Doral
Bank NY’s 11 existing branches. Following the consummation of the transaction, which is expected
to occur in the third quarter of 2007, Doral Financial intends to request the approval of the OTS
to distribute a substantial amount of Doral Bank NY’s excess capital to the holding company.
On March 17, 2006, Doral Financial and its principal Puerto Rico Banking subsidiary, Doral
Bank PR, entered into consent orders with the Federal Reserve, the FDIC and the Office of the
Commissioner. The mutually agreed upon orders prohibit Doral Bank PR from paying dividends to
Doral Financial without obtaining prior written approval from the FDIC and Federal Reserve.
Historically, Doral Financial has not depended on dividends from its banking subsidiaries to
support its operation.
See “Regulation and Supervision — Banking Operations—Puerto Rico Regulation,” below, for a
description of certain restrictions on Doral Bank PR’s ability to pay dividends under Puerto Rico
law. See “Regulation and Supervision — Banking Operations — Savings Bank Regulation,” below, for a
description of certain restrictions on Doral Bank NY’s ability to pay dividends under OTS
regulations.
FDIC Insurance Assessments
The deposits of Doral Bank PR and Doral Bank NY are subject to FDIC deposit insurance
assessments. On February 8, 2006 the President of the United States signed the Federal Deposit
Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act provides for the merger of the Bank
Insurance Fund (“BIF”) and Savings Association Insurance Fund (“SAIF”) into a single Deposit
Insurance Fund (“DIF”), an increase in the maximum amount of insurance coverage for certain
retirement accounts, and possible “inflation adjustments” in the maximum amount of coverage
available with respect to other insured accounts. In addition, it granted a one-time initial
assessment credit (of approximately $4.7 billion) to recognize institutions’ past contributions to
the fund.
Pursuant to FDICIA, the FDIC has adopted a risk-based assessment system, under which the
assessment rate for an insured depository institution varies according to the level of risk
incurred in its activities. An institution’s risk category is based partly upon whether the
institution is well capitalized, adequately capitalized or less than adequately capitalized. Each
insured depository institution is also assigned to one of the following “supervisory subgroups”:
“A,” “B” or “C.” Group “A” institutions are financially sound institutions with only a few minor
weaknesses; group “B” institutions are those that demonstrate weaknesses that, if not corrected,
could result in significant deterioration; and group “C” institutions are those for which there is
a substantial probability that the FDIC will suffer a loss in connection with the institution,
unless effective action is taken to correct the areas of weakness.
For 2006, premiums related to deposits assessed by both the BIF and the SAIF are to be
assessed at a rate of between 0 cents and 27 cents per $100.00 of deposits. In recent years, well
capitalized and well managed banks have in recent years paid no premiums for FDIC insurance. In the
future, even well capitalized and well managed banks may be required to pay premiums on deposit
insurance. It is not possible to determine when any such premiums will become assessable or the
level of such premiums.
Under the Reform Act, the FDIC made significant changes to its risk-based assessment system so
that effective January 1, 2007 the FDIC imposes insurance premiums based upon a matrix that is
designed to more closely tie what banks pay for deposit insurance to the risks they pose. The new
FDIC risk-based assessment system imposes premiums based upon factors that vary depending upon the
size of the bank. These factors are: for banks with less than $10 billion in assets — capital
level, supervisory rating, and certain financial ratios; for banks with $10 billion up to $30
billion in assets — capital level, supervisory rating, certain financial ratios and (if at least
one is available) debt issuer ratings, and additional risk information; and for banks with over $30
billion in assets — capital level, supervisory rating, debt issuer ratings (unless none are
available in which case certain financial ratios are used), and
additional risk information. The FDIC has adopted a new base schedule of rates that the FDIC
can adjust up or down, depending on the revenue needs of the DIF, and has set initial premiums for
2007 that range from 5 cents per $100 of domestic deposits for the banks in the lowest risk
category to 43 cents per $100 of domestic deposits for banks in the highest risk category. The new
assessment system is expected to result in increased annual assessments on the deposits of Doral
Financial’s banking subsidiaries of 5 to 7 basis points per $100 of deposits. Doral
Financial’s
banking subsidiaries have available an FDIC credit to offset future assessments. Significant
increases in the insurance assessments of our bank subsidiaries will increase our costs once the
credit is fully utilized.
The Deposit Insurance Funds Act of 1996 also separated the Financing Corporation assessment to
service the interest on its bond obligations from the BIF and SAIF assessments. The amount assessed
on individual institutions by the Financing Corporation is in addition to the amount, if any, paid
for deposit insurance according to the FDIC’s risk-related assessment rate schedules. The current
Financing Corporation annual assessment rate is 1.44 cents per $100 of deposits. As of December 31,
2006, Doral Bank PR and Doral Bank NY had a deposit base of approximately $4.0 billion and $357.3
million, respectively (consisting entirely of SAIF assessment deposits).
Brokered Deposits
FDIC regulations adopted under FDICIA govern the receipt of brokered deposits. Under these
regulations, a bank cannot accept, roll over or renew brokered deposits (which term is defined also
to include any deposit with an interest rate more than 75 basis points above prevailing rates)
unless (i) it is well capitalized, or (ii) it is adequately capitalized and receives a waiver from
the FDIC. A bank that is adequately capitalized may not pay an interest rate on any deposits in
excess of 75 basis points over certain prevailing market rates specified by regulation. There are
no such restrictions on a bank that is well capitalized. Doral Financial does not believe the
brokered deposits regulation has had or will have a material effect on the funding or liquidity of
its banking subsidiaries, which are currently well capitalized institutions.
As of December 31, 2006, Doral Bank PR and Doral Bank NY had a total of approximately $2.0
billion and $6.5 million, respectively, of brokered deposits, compared to approximately $1.9
billion and $17.0 million, respectively, as of December 31, 2005. Doral Bank PR and Doral Bank NY
use brokered deposits as a source of inexpensive long-term funding.
USA Patriot Act of 2001
On October 26, 2001, the President of the United States signed into law comprehensive
anti-terrorism legislation known as the USA PATRIOT Act of 2001 (the “USA Patriot Act”). Title III
of the USA Patriot Act substantially broadened the scope of U.S. anti-money laundering laws and
regulations by imposing significant new compliance and due diligence obligations, creating new
crimes and penalties and expanding the extra-territorial jurisdiction of the United States.
The U.S. Treasury Department (“Treasury”) has issued a number of regulations implementing the
USA Patriot Act that apply certain of its requirements to financial institutions, including Doral
Financial’s banking subsidiaries. The regulations impose new obligations on financial institutions
to maintain appropriate policies, procedures and controls to detect, prevent and report money
laundering and terrorist financing.
Failure of a financial institution to comply with the USA Patriot Act’s requirements could
have serious legal and reputational consequences for the institution. Doral Financial believes that
the cost of compliance with Title III of the USA Patriot Act is not likely to be material to Doral
Financial.
Puerto Rico Regulation
General
As a commercial bank organized under the laws of the Commonwealth of Puerto Rico, Doral Bank
PR is subject to supervision, examination and regulation by the Office of the Commissioner,
pursuant to the Puerto Rico Banking Act of 1933, as amended (the “Banking Law”).
Section 27 of the Banking Law requires that at least 10% of the yearly net income of Doral
Bank PR be credited annually to a reserve fund until such fund equals 100% of total paid-in capital
(preferred and common). As of December 31, 2006, Doral Bank PR’s reserve fund complied with the
legal requirement.
Section 27 of the Banking Law also provides that when a bank suffers a loss, the loss must
first be charged against retained earnings, and the balance, if any, must be charged against the
reserve fund. If the balance of the reserve fund is not sufficient to cover the loss, the
difference shall be charged against the capital account of the bank and no dividend may be declared
until the capital has been restored to its original amount and the reserve fund to 20% of the
original capital of the institution. This reserve fund is reflected in Doral Financial’s
consolidated financial statements as “Legal Surplus.”
Section 16 of the Banking Law requires every bank to maintain a reserve requirement which
shall not be less than 20% of its demand liabilities, other than government deposits (federal,
state and municipal) secured by actual collateral. The Office of the Commissioner can, by
regulation, increase the reserve requirement to 30% of demand deposits.
Section 17 of the Banking Law generally permits Doral Bank PR to make loans on an unsecured
basis to any one person, firm, partnership or corporation, up to an aggregate amount of 15% of the
paid-in capital and reserve fund of the bank and of such other components as the Office of the
Commissioner may permit from time to time. The Office of the Commissioner has permitted up to 50%
of retained earnings. As of December 31, 2006, the legal lending limit for Doral Bank PR under this
provision based solely on its paid-in capital and reserve fund was approximately $66.8 million. If
such loans are secured by collateral worth at least 25% more than the amount of the loan, the
aggregate maximum amount may reach one third of the paid-in capital of the bank, plus its reserve
fund and such other components as the Office of Commissioner may permit from time to time. As of
December 31, 2006, the lending limit for loans secured by collateral worth at least 25% more than
the amount of the loan was $111.3 million. There are no restrictions under Section 17 on the amount
of loans that are wholly secured by bonds, securities and other evidences of indebtedness of the
Government of the United States or the Commonwealth, or by current debt bonds, not in default, of
municipalities or instrumentalities of the Commonwealth.
Section 14 of the Banking Law authorizes Doral Bank PR to conduct certain financial and
related activities directly or through subsidiaries, including finance leasing of personal
property, making and servicing mortgage loans and operating a small-loan company. Doral Bank PR
currently operates three subsidiaries, Doral Money, Inc., which engages in mortgage banking
activities in the mainland United States, Doral International, Inc., which is licensed as an
international banking entity under the International Banking Center Regulatory Act of Puerto Rico,
and CB, LLC, a Puerto Rico limited liability company organized in connection with the receipt, in
lieu of foreclosure, of the real property securing an interim construction loan and the Company’s
decision to continue the development of the residential housing project on a temporary basis.
The Finance Board, which is a part of the Office of the Commissioner, but also includes as its
members the Secretary of the Treasury, the Secretary of Commerce, the Secretary of Consumer
Affairs, the President of the Planning Board, and the President of the Government Development Bank
for Puerto Rico, has the authority to regulate the maximum interest rates and finance charges that
may be charged on loans to individuals and unincorporated businesses in the Commonwealth. The
current regulations of the Finance Board provide that the applicable interest rate on loans to
individuals and unincorporated businesses is to be determined by free competition. The Finance
Board also has the authority to regulate the maximum finance charges on retail installment sales
contracts and credit cards. Currently, there is no maximum rate set for installment sales contracts
or credit cards.
On March 17, 2006, Doral Financial and its principal Puerto Rico Banking subsidiary, Doral
Bank PR, entered into consent orders with the Federal Reserve, the FDIC and the Office of the
Commissioner. The mutually agreed upon orders require Doral Financial and Doral Bank PR to conduct
reviews of their mortgage portfolios, and to submit plans regarding the maintenance of capital
adequacy and liquidity. The consent orders also prohibit Doral Financial and any of its
non-banking affiliates, directly or indirectly, from entering into, participating, or in any other
manner engaging in any covered transactions with its subsidiary banks, Doral Bank PR and Doral Bank
NY.
Savings Bank Regulation
As a federal savings bank, Doral Bank NY’s investments, borrowings, lending, issuance of
securities, establishment of branch offices and all other aspects of its operations are subject to
the jurisdiction of the OTS.
Doral Bank NY’s payment of dividends is subject to the limitations of the capital distribution
regulation promulgated by the OTS. The OTS’ regulation determines a savings bank’s ability to pay
dividends, make stock repurchases, or make other types of capital distributions, according to the
institution’s capital position. The rule establishes amounts of capital distributions that
institutions can make after providing notice to the OTS, without constituting an unsafe or unsound
practice. Institutions that do not meet their capital requirements can make distributions only with
the prior approval of the OTS.
Savings banks, such as Doral Bank NY, that meet all applicable capital requirements may make a
distribution without an application in an amount equal to the sum of (i) the current year’s net
income, and (ii) the retained net income (net income less capital distributions) from the preceding
two years; so long as the association continues to satisfy applicable capital requirements after
the distribution. If such a distribution would cause Doral Bank NY to fall below the
well-capitalized requirement, a prior 30-day notice to the OTS would be required.
OTS regulations generally permit Doral Bank NY to make total loans and extensions of credit to
one borrower up to 15% of its unimpaired capital and surplus. As of December 31, 2006, the legal
lending limit for Doral Bank NY under this regulation was approximately $9.5 million. Doral Bank
NY’s legal lending limit may be increased by an additional 10% of its unimpaired capital and
surplus if such additional extension of credit is fully secured by readily marketable collateral
having a market value as determined by reliable and continuously available price quotations. Doral
Bank NY’s expanded aggregate legal lending limit under this provision was approximately $15.7
million as of December 31, 2006.
On February 9, 2006, the OTS notified Doral Bank NY that, until further notice, it could not
pay any dividend to Doral Financial without the prior approval of the OTS. The OTS also directed
Doral Bank NY not to make any extensions of credit to Doral Financial, purchases of assets or
similar transactions, without the prior written consent of the OTS. On March 15, 2006, Doral
Financial announced that it had entered into a definitive agreement to sell Doral Bank NY’s 11
existing branches. Following the consummation of the transaction, which is expected to occur in
the third quarter of 2007, Doral Financial intends to request the approval of the OTS to distribute
a substantial amount of Doral Bank NY’s excess capital to the holding company.
Certain Regulatory Restrictions on Investments in Common Stock
Because of Doral Financial’s status as a bank holding company, owners of Doral Financial’s
common stock are subject to certain restrictions and disclosure obligations under various federal
laws, including the BHC Act. Regulations pursuant to the BHC Act generally require prior Federal
Reserve approval for an acquisition of control of an insured institution (as defined) or holding
company thereof by any person (or persons acting in concert). Control is deemed to exist if, among
other things, a person (or persons acting in concert) acquires more than 25% of any class of voting
stock of an insured institution or holding company thereof. Control is presumed to exist subject to
rebuttal, if a person (or persons acting in concert) acquires more than 10% of any class of voting
stock and either (i) the company has registered securities under Section 12 of the Exchange Act, or
(ii) no person will own, control or hold the power to vote a greater percentage of that class of
voting securities immediately after the transaction. The concept of acting in concert is very broad
and also is subject to certain rebuttable presumptions, including among others, that relatives,
business partners, management officials, affiliates and others are presumed to be acting in concert
with each other and their businesses.
Section 12 of the Banking Law requires the prior approval of the Office of the Commissioner
with respect to a transfer of voting stock of a bank that results in a change of control of the
bank. Under Section 12, a change of control is presumed to occur if a person or group of persons
acting in concert, directly or indirectly, acquires more than 5% of the outstanding voting capital
stock of the bank. The Office of the Commissioner has interpreted the restrictions of Section 12 as
applying to acquisitions of voting securities of entities controlling a bank, such as a bank
holding company. Under the Banking Law, the determination of the Office of the Commissioner whether
to approve a change of control filing is final and non-appealable.
The provisions of the Mortgage Banking Law also require regulatory approval for the
acquisition of more than 10% of Doral Financial’s outstanding voting securities. See “—Regulation
and Supervision—Mortgage Banking Business” above.
The above regulatory restrictions relating to investment in Doral Financial may have the
effect of discouraging takeover attempts against Doral Financial and may limit the ability of
persons, other than Doral Financial directors duly authorized by Doral Financial’s board of
directors, to solicit or exercise proxies, or otherwise exercise voting rights, in connection with
matters submitted to a vote of Doral Financial’s stockholders.
Broker-Dealer Operations
Doral Securities is registered as a broker-dealer with the SEC and the Office of the
Commissioner, and is also a member of the NASD. As a registered broker-dealer, it is subject to
regulation by the SEC, the NASD and the Office of the Commissioner in matters relating to the
conduct of its securities business, including record keeping and reporting requirements,
supervision and licensing of employees and obligations to customers. In particular, Doral
Securities is subject to the SEC’s net capital rules, which specify minimum net capital
requirements for registered broker-dealers and are designed to ensure that broker-dealers maintain
adequate regulatory capital in relation to their liabilities and the size of their customer
business.
Insurance Operations
Doral Insurance Agency is registered as a corporate agent and general agency with the Office
of the Commissioner of Insurance of Puerto Rico (the “Commissioner of Insurance”). Doral Insurance
Agency is subject to regulation by the Commissioner of Insurance relating to, among other things,
licensing of employees, sales practices, charging of commissions and obligations to customers.
Item 1A. Risk Factors.
Some of the factors that could cause Doral Financial’s actual results for future periods to
differ materially from those anticipated are discussed below.
Risks Relating to the Recapitalization Process
Doral Financial will need significant outside financing during 2007.
Doral Financial will need significant outside financing during 2007, principally for the
payment of its $625 million floating rate senior notes that mature on July 20, 2007 and of amounts
required under the settlement agreement dated April 27, 2007 in respect of the consolidated
securities class action and shareholder derivative litigation brought against the Company following
the announcement of the restatement of its financial statements in 2005. The Company currently
estimates that these external funding needs for 2007 will range between approximately $700 million
and $800 million (without considering the distribution of any proceeds from the sale of Doral Bank
NY’s branches).
Doral Financial is in active negotiations with a private equity firm (the “lead sponsor”)
regarding a substantial investment in the Company by a new bank holding company. The new holding
company would be capitalized by a number of private equity and other sophisticated financial
investors, and their investment would take into account the various ownership restrictions imposed
by banking regulations. The lead sponsor is actively engaged in discussions with a number of
potential investors to raise the contemplated capital for the new holding company to invest in
Doral.
Based on its discussions to date, the Company believes that the proposed transaction, if
executed, would be accomplished predominantly through the issuance of new equity securities at a
discount to market price and would result in very significant dilution to the Company’s existing
shareholders. If the Company is successful in entering into the proposed transaction and it is
consummated on a timely basis, the Company believes that the proposed transaction would adequately
satisfy its ca