First BanCorp.
Annual Report 2002

Plain-text annual report

L e a d e r s h i p Leadership is Power. Vision. And setting standards. It provides us with the opportunity to open new markets, develop new products and set the groundwork toward the future. Experience is knowledge. Skill. And Wisdom. It gives us the ability to influence, achieve our goals and face new challenges. At First BanCorp we are, and have been, a leading institution in the banking industry for over 54 years. Experience is what has taken us, and continues to guide us, to higher levels of quality, growth and value. E x p e r i e n c e p r o C n a B t s r i F 2 2 0 0 2 Table of Contents Financial Highlights Highlights of Growth Selected Financial Data Offices and Corporate Structure Business Profile President’s Letter Economy Board of Directors First BanCorp Officers Financial Review Financial Statements Stockholders’ Information 3 5 8 10 13 15 19 20 22 27 48 83 Market Price Per Common Share (end of year) Return on Assets (percentage) Diluted Earnings Per Common Share $20.13 $13.83 1.48 1.49 $15.75 $19.00 1.28 1.28 $1.32 $1.47 $1.73 $1.16 $22.60 1.23 $2.01 1998 1999 2000 2001 2002 Financial Highlights p r o C n a B t s r i F 3 2 0 0 2 In thousands (except for per share results) Operating results: Net interest income Provision for loan losses Other income Other operating expenses Income tax provision Cumulative effect of accounting change Net income Per common share: Net income - basic Net income - diluted Weighted average common shares: Basic Diluted At year end: Assets Loans Allowance for loan losses Investments Deposits Borrowings Capital 2002 2001 $ 266,850 62,302 58,492 132,756 22,327 107,956 $ 2.04 2.01 39,901 40,553 $ 9,643,852 5,637,851 111,911 3,728,669 5,482,918 3,249,355 798,424 $ 236,055 61,030 52,980 120,855 20,134 (1,015) 86,001 $ 1.74 1.73 39,851 40,144 $ 8,197,518 4,308,780 91,060 3,715,999 4,098,554 3,425,235 602,919 Return on common equity (percentage) 20.54 22.13 21.90 27.81 24.68 Net interest income (In millions) $166.2 $185.7 $190.8 $236.1 $266.9 Common stockholders’ equity (In millions) $270.4 $269.5 $204.9 $334.4 $437.9 1998 1999 2000 2001 2002 Highlights of Growth This history begins in 1991, shortly after a new Management team headed by Angel Alvarez Pérez took over the operations of the oldest Savings and Loan institution in Puerto Rico. At that time the Bank had less than $2 billion in total assets and approximately 900 employees, compared with $9.6 billion in assets and 2,000 employees today. In the 1991 Annual Report, Mr. Alvarez stated: p r o C n a B t s r i F 5 “Net income for {1991} was $10.1 million or $1.77 per share {the equivalent of $0.15 per share 2 0 0 2 today after allowing for subsequent stock splits}. This . . . is the most clear and tangible indication that First Federal {the Bank’s name at that time} is on the road to a healthy recovery.” The accompanying table shows the course of this “healthy recovery” over the following eleven years. Over that period the Corporation has reported consistent growth in assets and earnings without earnings restatements. Asset size increased more than five times from $1.9 billion to $9.6 billion. Net income grew more than ten times from $10.1 million to $108 million and earnings per common share diluted increased more than 13 times from $0.15 to $2.01. A milestone along this road came in 1994, with the conversion to a Commercial Bank charter. In that year’s Annual Report, Mr. Alvarez said: “Our previous thrift charter contained significant limitations on lending which could have sidelined management’s strategy of emphasizing growth in non-mortgage areas. With a commercial charter we are free to pursue our preferred business strategy.” During the next few years Management laid the groundwork for later growth of the consumer side of the Bank’s business. Mr. Alvarez described two important advances in the 1995 Annual Report: “In May we opened our small loan subsidiary, Money Express. Small loans are an important source of consumer credit in Puerto Rico, where many creditworthy families do not have the financial resources or the credit history required to obtain loans through regular banking channels . . .Starting in January {of 1996} we will be combining our auto leasing area with the car and truck rental operations of our existing subsidiary . . . under the name of First Leasing and Rental Corp.” p r o C n a B t s r i F 6 2 0 0 2 The accompanying table shows that FirstBank increased its branch network from 32 to 48 in the five years between 1994 and 1999. The new facilities included a modern “Superbranch” in Hato Rey with ample parking and drive through facilities. The consumer banking operations were centralized in this facility in 1996. In 1999 FirstBank acquired the Puerto Rico operations of the Royal Bank of Canada together with four Citibank branches in Puerto Rico and the U.S. Virgin Islands. Mr. Alvarez summarized the guiding philosophy of this consumer banking expansion as follows in the 1996 Annual Report: “FirstBank’s Management has long recognized the importance of new data processing technologies that are revolutionizing the Banking industry. We strongly believe that face-to-face communication is at the heart of our customer relationships. Our goal is to find the appropriate balance between these two approaches to meet the needs of our clients in a cost-effective manner. Locally based management gives FirstBank a strong competitive advantage in doing this.” Although the Bank grew rapidly, Management never lost sight of the need to maintain strict cost controls. The accompanying table shows the efficiency ratio improved dramatically from 63.69% to 40.81% over the period covered in the accompanying table. In the 1998 Annual Report Mr. Alvarez reiterated Management’s commitment to cost control as follows: “In 1998 Management began a comprehensive re-design plan to streamline all corporate operations. The Corporation named the project ‘The Next Fifty’ because Management launched it in the Corporation’s fiftieth anniversary year as a way to initiate the second fifty years of growth. Management has invested most of the savings from this project in new technology.” In the late 1990’s the Bank began moving to diversify operations and strengthen its management team as it expanded more into commercial and mortgage lending. In 1998 the Corporation converted to a bank holding company structure. In that year’s Annual Report Mr. Alvarez reported: “. . .we have enhanced our management team by bringing in senior executives with extensive experience in consumer, mortgage and commercial lending. We have also initiated active lending programs in construction lending and auto leasing, led by talented and experienced executives whom we have recently recruited. Over the next few years we expect our strengthened management team to improve efficiency and contribute new ideas that will help us to increase our market share.” The Bank also began introducing more sophisticated products to grow in a highly competitive market with increasingly sophisticated clients. Besides adding state of the art business services such as cash management accounts, the Bank also added sophisticated deposit products. In 1999 it introduced the “Bonus Account”, which rewards clients who have additional relationships with FirstBank. Deposits in this account have since grown to $173.7 million. The Bank was also expanding in other areas. In the Annual Report for 2000 Mr. Alvarez summarized recent developments as follows: “Management has been taking steps to diversify the Corporation’s revenues by moving p r o C n a B t s r i F 7 toward fee based activities in some areas. In 2000 FirstBank began offering brokerage services 2 0 0 2 in selected branches through a new alliance {with a major international brokerage firm}. . . . Early in 2000 Management entered an agreement {with another large firm} to participate in bond issues by the Government Development Bank of Puerto Rico. Finally, First BanCorp reorganized as a financial holding company in 2000, opening the way for the Corporation to enter new lines of business permitted by the Gramm Leach Bliley Act.” In 2001 First BanCorp followed up on this change by organizing an insurance subsidiary, the FirstBank Insurance Agency, which sells insurance in FirstBank branches. Also in 2001 Management embarked on a three-year project to improve service quality and efficiency in all of the Corporation’s operations. To summarize our story, the table shows the broad outlines of how our institution has transformed itself from First Federal Savings Bank, a small Savings and Loan Institution, into First BanCorp, a diversified financial services organization. This transformation has increased net income tenfold over the 1991-2002 period, and has benefited shareholders, employees and clients of the Corporation. p r o C n a B t s r i F 10 2 0 0 2 Offices PUERTO RICO 2 1 3 4 26 25 6 7 8 9 5 12 10 11 13 14 15 24 23 17 16 22 18 19 21 20 1. Aguada 2. Aguadilla 3. Isabela 4. San Sebastián 5. Arecibo 6. Manatí 7. Vega Baja 8. Dorado 9. Toa Baja 10. Bayamón 11. Guaynabo 12. San Juan 13. Carolina 14. Río Grande 15. Fajardo 16. Humacao 17. Caguas 18. Aguas Buenas 19. Cidra 20. Guayama 21.Cayey 22. Barranquitas 23. Ponce 24. Yauco 25. Cabo Rojo 26. Mayagüez 54 Branch 27 Money Express 6 First Leasing & Rental Corp. 2 Auto Loan Center 9 Mortgage Loan Center 6 1 FirstBank Insurance FirstBank Insurance V.I. 2 First Trade Inc. U.S., BRITISH VIRGIN ISLANDS & BARBADOS St Thomas Tortola St Croix St John Barbados Corporate Structure p r o C n a B t s r i F 11 2 0 0 2 Virgin Islands • Barbados & RENTAL CORPORATION p r o C n a B t s r i F 13 2 0 0 2 Business Profile First BanCorp (“the Corporation”), incorporated in Puerto Rico, is the financial holding company for FirstBank (“the Bank”), the second largest commercial bank in Puerto Rico. First BanCorp also owns an insurance subsidiary, FirstBank Insurance Agency. First BanCorp had total assets of $9.6 billion as of December 31, 2002. The Corporation operates in the Puerto Rico and Virgin Islands banking markets, offering a wide selection of financial services to a growing number of consumer and commercial customers. Commercial, consumer and mortgage loans and investment securities are the most important areas of its business. The Corporation has a $2.5 billion portfolio of commercial loans, commercial mortgages, construction loans and other related commercial products. Its commercial clients include businesses of all sizes covering a wide range of economic activities. First BanCorp has a $1.8 billion portfolio of residential mortgages. The institution also has $1.3 billion in consumer loans concentrated in auto loans and leases, personal loans and credit cards. Its $3.7 billion investment portfolio consists mostly of U.S. Treasury and agency securities and mortgage- backed securities. A strategic alliance with a major international firm allows FirstBank to offer brokerage services in its largest branches. Approximately 2,000 professionals and a sophisticated computer system support the business activities of the Corporation. First chartered in 1948, First BanCorp was the first savings bank established in Puerto Rico, under the name of “First Federal Savings and Loan Association”. It has been a stockholder owned institution since 1987. In October, 1994 it became a Puerto Rico chartered commercial bank and assumed the name of “FirstBank Puerto Rico”. Effective October 1, 1998 the Bank reorganized, making FirstBank Puerto Rico a subsidiary of the holding company First BanCorp. FirstBank, which is a well-capitalized institution under federal standards, operates 54 full- service branches including 11 offices in the U.S. and British Virgin Islands. In addition, the FirstBank Insurance Agency operates six sales offices within FirstBank branches. A subsidiary of FirstBank, Money Express, operates 27 small loan offices throughout Puerto Rico. FirstBank also operates First Leasing and Rental Corp., a subsidiary which rents and leases motor vehicles from six offices in Puerto Rico. Another FirstBank subsidiary, FirstBank Insurance Agency V.I., Inc., operates one office which sells insurance in the US Virgin Islands. Finally, FirstBank owns a trade financing subsidiary, First Trade Inc., which operates two offices: one in the U.S. Virgin Islands and one in Barbados. First BanCorp has distinguished itself by providing innovative marketing strategies and novel products to attract clients. Besides its branches and specialized lending offices, the Corporation has offered a telephone information service called “Telebanco” since 1983. This was the first telebanking service offered in Puerto Rico. First BanCorp clients have access to an extensive ATM network with access all over the world. The Corporation was also the first in Puerto Rico to open on weekends and the first to offer in-store branches to its clients. First BanCorp was also the first banking institution in Puerto Rico with a presence on the internet. The Corporation now offers a wide menu of internet banking services to its clients. First BanCorp and its subsidiaries are subject to supervision, examination and regulation by the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Commissioner of Financial Institutions of Puerto Rico. The FirstBank Insurance Agency is regulated by the Puerto Rico Insurance Commissioner. The Virgin Islands operations of FirstBank are regulated by the Virgin Islands Banking Board (for the USVI) and by the British Virgin Islands Financial Services Commission (for the BVI). First BanCorp is committed to providing the most efficient and cost effective banking services possible. Management’s goal is to make the Corporation the premier financial institution in Puerto Rico and the Virgin Islands, recognized for consistently exceeding the expectations of its clients, employees and stockholders. p r o C n a B t s r i F 14 2 0 0 2 p r o C n a B t s r i F 15 2 0 0 2 President’s Letter To our stockholders: On behalf of the Board of Directors and Officers of First BanCorp I am pleased to submit our annual report for 2002, another excellent year. In 2002 First BanCorp earned $108 million, representing $2.04 per common share (basic) or $2.01 per common share (diluted). Earnings increased 25.5% compared with 2001, when the Corporation earned $86 million, equivalent to $1.74 per common share (basic) or $1.73 per common share (diluted). Net interest income was a key factor in this outstanding performance, expanding by 13% or $30.8 million to $266.8 million during 2002. These results are outstanding when we consider the difficult economic and financial environment which prevailed last year. Growth in 2002 First BanCorp grew substantially in spite of last year’s economic slowdown, which affected Puerto Rico as well as the rest of the U.S. Assets rose 17% from $8.2 billion at year-end 2001 to $9.6 billion at the end of 2002. Net loans increased 31% to $5.5 billion, mostly due to increases of $345 million in commercial loans and $842 million in residential real estate loans. Consumer loans and finance leases grew by $142 million. Deposits increased 34% to $5.5 billion. During 2002 First BanCorp consolidated its position as the second largest commercial bank in Puerto Rico. FirstBank also expanded outside Puerto Rico. In October 2002, the Bank completed the acquisition of the operations of JP Morgan Chase Eastern Caribbean Region business in the Virgin Islands with $590 million in total assets. The purchase included several branch offices, a trade finance operation and an insurance agency. FirstBank is now one of the largest commercial banks in the U.S. and British Virgin Islands. Cassan Pancham, a seasoned executive with over 22 years of experience in Chase’s Caribbean operations, heads up these operations. Our expanded presence in the Virgin Islands will increase geographic diversification and allow us to better serve our clients in that part of the Caribbean. Key Competitive Advantages Our branch network has been one important factor in our successful growth. FirstBank has 43 branch offices in Puerto Rico, including 20 with drive up services, 16 in shopping centers and 7 in supermarkets. We are working to diversify our larger branches to give our clients superior service. A major international brokerage firm maintains offices in 13 FirstBank branches, while nine branches have specialized mortgage offices and six have offices of the FirstBank Insurance Agency. We are constantly improving the banking facilities. During 2002 we relocated the branch in Rexville Plaza, Bayamon and upgraded facilities in three other branches. Our purchase of the Chase operation in the Virgin Islands also strengthened our branch network in that region. FirstBank now has 11 branches on four islands in the U.S. and British Virgin Islands. p r o C n a B t s r i F 16 2 0 0 2 Another key to our success is careful, prudent control of costs. For several years we have been investing in state of the art technology to improve service to our clients and increase efficiency. Operating expenses rose relatively little, from $120.9 million in 2001 to $132.8 million in 2002, in spite of the expansion we experienced. During 2002 the Corporation’s efficiency ratio improved by one percent to 40.81%. The quality of our loan portfolio was another factor which contributed importantly to the Corporation’s record profits last year. Starting in 1998 we have been improving loan underwriting, introducing tighter approval procedures and improving computer systems. These efforts have brought hard-won gains in asset quality. The year 2002 provided a severe test for these enhanced processes, and they have been performing well. In spite of large increases in the loan portfolio and a deteriorating economy, charge offs did not increase. During 2002 First BanCorp’s loans net charge offs amounted to $41.5 million of loans on a net basis, compared with $46.9 million in 2001, $42.0 million in 2000, and $44.6 million in 1999. We have also increased reserves in line with the loan portfolio, which more than doubled from $2.7 billion at the end of 1999 to $5.6 billion at year-end 2002. The Bank provided $62 million for losses in 2002, $61 million in 2001, $46 million in 2000, and $48 million in 1999. This has allowed loan loss reserves to reach $111.9 million at the end of 2002 compared with $91.1 million for 2001, $76.9 million for 2000, and $71.8 million for 1999. As a result, asset quality has remained constant or improved. The reserve coverage ratio (allowance for loan losses as a percentage of non-performing loans) has remained above100% for the last five years. At the end of 2002 the ratio of non-performing loans to total loans had fallen to 1.63%, compared with 1.69% at the end of 2001, 1.94% at the end of 2000, 1.96% at the end of 1999 and 2.69% at year-end 1998. Maintaining good asset quality has been one of the most important ingredients of our success during the recent economic slowdown. Finally, we rely heavily on our employees and the quality of service they provide to our clients. We are in the middle of a three-year effort to improve service quality in all areas of our operations. Quality teams composed of bank officers and employees are evaluating, redesigning and improving procedures throughout the organization. The goal of this project is to satisfy fully the banking needs of our consumer and corporate clients. Community Service and Corporate Image First BanCorp began operations in 1948 as “First Federal Savings Bank” and for many years was the leading Savings and Loan institution on the Island. Even after converting to a commercial bank in 1994 the Bank specialized in consumer lending for many years and still maintains strong ties with the Puerto Rican community, helping a number of charitable organizations. p r o C n a B t s r i F 17 2 0 0 2 In response to the recent economic slowdown on the Island, we have been running a publicity campaign with the slogan “Puerto Rico stays ahead.” The campaign encourages Puerto Ricans to think positively and improve their quality of life. Management is also encouraging employees to get involved in community activities. In addition, FirstBank has begun providing special benefits for senior citizens, including coupons in participating businesses and discounts on some of our services. FirstBank also made a $70 million loan for the construction of a medical office building in the southern city of Ponce. This project will include 93 medical offices, a 32,472 square foot shopping area and parking space for 600 cars. Finally, we are participating in a massive urban renewal project in Santurce, where our home offices are located. Bank officials have taken a leading role in organizing this project, which involves five local banks supported by a $50 million credit line from the Puerto Rico Housing Finance Authority. Enhancing Shareholder Value The efforts of Management and employees have paid off in strong earnings growth in 2002. The Corporation experienced a return on common equity of 21.90% compared with 22.13% in the previous year. The return on assets was 1.23%, not very different from the 1.28% of 2001. Our stock price has reflected these strong results, and our shareholders experienced a return of 21.05% on their investment during 2002. Investors who held First BanCorp stock over the ten year period from year-end 1992 to year-end 2002 received a cumulative total return of 1,549%, equivalent to an annualized return of 32.33%. On September 30, 2002 the Bank also distributed a three for two stock split. The Corporation has traditionally followed a conservative dividend policy, in the belief that we can better serve our shareholders by reinvesting most of our profits in our growing business. In 2002 the dividend payout ratio was 19.58%. Officers and directors of First BanCorp own approximately eleven percent of its shares. This shows their confidence in First BanCorp’s future and their commitment to keep its fundamentals sound. As First BanCorp begins another year of growth and service to Puerto Rico and the Virgin Islands, we are confident that our Corporation is stronger and better positioned than ever. We have a truly outstanding group of employees, officers and directors. I am confident that we can meet the challenges ahead, and that we will provide better service than ever to our clients, while benefiting employees and stockholders in the years to come. Angel Alvarez-Pérez Chairman President Chief Executive Officer Economy p r o C n a B t s r i F 19 2 0 0 2 The island of Puerto Rico is a U.S. Commonwealth with a population of 3.8 million, located in the Caribbean approximately 1,600 miles southeast of New York. Puerto Rico grew moderately over most of the 1990’s, but its growth has paused recently due to the U.S. recession. Real GNP fell by 0.2% in the 2002 fiscal year according to the Puerto Rico Planning Board. Puerto Rico’s economic performance is a natural result of its increasing integration into the U.S. economy. Puerto Ricans are U.S. citizens and serve in the United States armed forces, and the Island has several large U.S. military bases. The Island uses U.S. currency and forms part of the U.S. financial system. Federal courts enforce U.S. laws here. Since Puerto Rico falls within the U.S. for purposes of customs and migration, there is full mobility of funds, people and goods between Puerto Rico and the U.S. mainland. Puerto Rico banks are subject to the same Federal laws, regulations and supervision as other financial institutions in the rest of the U.S. The Federal Deposit Insurance Corporation insures the deposits of Puerto Rico chartered commercial banks, including FirstBank, the banking subsidiary of First BanCorp. Manufacturing is the backbone of Puerto Rico’s economy, and many multinational corporations have substantial operations here. The island’s pharmaceutical industry is especially strong. In recent years, however, a reduction of tax incentives combined with intense wage competition from other areas and the U.S. recession have been reducing island manufacturing employment. Still, Puerto Rico is becoming somewhat less dependent on manufacturing than it was in the early postwar period, as its economy has been diversifying with substantial investments in tourism, retail trade, services, banking and transportation. During the recent slowdown construction, manufacturing and consumption have weakened somewhat. Tourism has been affected along with the rest of the Caribbean region, though new hotels and some economic recovery have mitigated this effect. Island economists project real GNP growth in the 1% to 2% range during fiscal 2003, which is currently in progress. Board of Directors p r o C n a B t s r i F 20 2 0 0 2 Angel Alvarez-Pérez Chairman Angel L. Umpirre, C.P.A. Annie Astor-Carbonell José Teixidor José Julián Alvarez-Bracero Juan Acosta-Reboyras Jorge L. Díaz p r o C n a B t s r i F 21 2 0 0 2 Rafael Bouet-Souffront José L. Ferrer-Canals Héctor M. Nevares First BanCorp Officers Fernando L. Batlle, Luis M. Beauchamp, Aurelio Alemán, Annie Astor-Carbonell, Angel Alvarez-Pérez p r o C n a B t s r i F 22 2 0 0 2 Randolfo Rivera, Josianne M. Rosselló, Miguel Mejías, Carmen G. Szendrey-Ramos, Cassan Pancham Aida M. García, Luis M. Cabrera, Laura Villarino, Dacio A. Pasarell p r o C n a B t s r i F 23 2 0 0 2 p r o C n a B t s r i F 24 2 0 0 2 PRESIDENT Angel Alvarez-Pérez Chief Executive Officer SENIOR EXECUTIVE VICE PRESIDENTS Annie Astor-Carbonell Chief Financial Officer Luis M. Beauchamp Wholesale Banking Executive and Chief Lending Officer EXECUTIVE VICE PRESIDENTS Aurelio Alemán Consumer Banking Executive Fernando L. Batlle Retail and Mortgage Banking Executive Dacio A. Pasarell Operations and Technology Executive Randolfo Rivera Commercial Banking Executive FIRST SENIOR VICE PRESIDENT Cassan Pancham Eastern Caribbean Region Executive SENIOR VICE PRESIDENTS José H. Aponte Commercial Mortgage Lending Miguel Babilonia Consumer Risk Management Luis M. Cabrera Treasury and Investments Salvador Calaf Government and Institutional James E. Crites Regional Credit Officer Eastern Caribbean Region Aida M. García Human Resources Michael García Consumer Collection Fernando Iglesias Special Loans Roger Lay Internal Audit Emilio Martinó Credit Risk Management Miguel Mejías Information Systems Carmen Nigaglioni Middle Market and Asset Based Financing John Ortiz Consumer Products and Credit Cards Jorge Rendón Facilities Management Haydeé Rivera Sales & Distribution Operations Julio Rivera Construction Lending Nayda Rivera General Auditor Carmen Rocafort Corporate and Structured Finance Josianne M. Rosselló Marketing and Public Relations Demetrio Santiago Auto Wholesale Héctor Santiago Auto Business and Operations Denise Segarra Branch Banking Luis Sueiro Commercial Wholesale Operations Carmen Gabriela Szendrey-Ramos General Counsel and Secretary of the Board of Directors Laura Villarino Controller VICE PRESIDENTS Alexis Aguiar Structured Finance William Alvarez Indirect Business and Merchants José Alvelo Information Systems Vivian Arteaga Commercial Department Marga Avilés Consumer Loans Operations Beverly Bachetti VIP Customer Group María Benabe Consumer Collections Ana Colón Centralized Accounting María Conor-Freeman Lending and Client Group Eastern Caribbean Region Wanda Cooper FirstLine Customer Center Lenitzia Delgado Corporate Services Deidre Elias Compliance Manager Eastern Caribbean Region Laura Escalante Compliance Officer Mayra Gascot Information Systems José Gómez Mortgage Servicing and Operations David González Corporate Business Development Nelson González Structured Finance Paul Gourieux Consumer Credit Manager Eastern Caribbean Region Rahamet Hosein Territory Manager British Virgin Islands Tessa Hugh Finance and Risk Manager Eastern Caribbean Region Carol Jackson Human Resources Manager Eastern Caribbean Region Ariane Lewis Branch Banking Manager Eastern Caribbean Region John E. Lewis System & Programming Manager Eastern Caribbean FIRST LEASING AND RENTAL CORPORATION Angel Alvarez-Pérez Chief Executive Officer Aurelio Alemán President and Chief Operating Officer Agustín Dávila General Manager FIRSTBANK INSURANCE AGENCY, INC. Angel Alvarez-Pérez Chief Executive Officer Aurelio Alemán President and Chief Operating Officer Víctor Santiago Vice President and General Manager p r o C n a B t s r i F 25 FIRSTBANK INSURANCE AGENCY V.I., INC. 2 0 0 2 Angel Alvarez-Pérez Chief Executive Officer Fernando L. Batlle President and Chief Operating Officer Walter Hauck Vice President and General Manager Cassan A. Pancham First Senior Vice President FIRST TRADE INC. Angel Alvarez-Pérez Chief Executive Officer Fernando L. Batlle President and Chief Operating Officer Pamela Clarke Manager Cassan A. Pancham First Senior Vice President Gilberto López Middle Market Marcelo López Regional Manager Sales & Distribution Juanita Marrero Mortgage Banking John McDonald Commercial Department Eastern Caribbean Region José Negrón Auto Lot Ricardo Negrón Mortgage Banking José Nevárez Information Systems Luis Orengo Commercial Wholesale Eduardo Ortiz Auto Wholesale María Cristina Oruña Customer Relationship Management & Service Quality Osvaldo Padilla Corporate Services Reynaldo Padilla Auto Finance Dionisio Ramírez Construction Lending Migdalia Rivera Middle Market Sandra Rivera Consumer Collections Belinda Rodríguez Remote Sales José L. Rodríguez Information Systems Pedro Romero Assistant Controller Elizabeth Sánchez Marine Finance Roberto Sánchez Consumer Loans Credit Risk José J. Santiago Commercial Wholesale Ramón Santiago Asset Based Unit Miguel Santin Structured Finance Carmen Torres Branch Manager Ralph Torres Regional Manager Sales & Distribution FIRST FEDERAL FINANCE CORPORATION DBA MONEY EXPRESS “LA FINANCIERA” Angel Alvarez-Pérez Chief Executive Officer Aurelio Alemán President and Chief Operating Officer Carlos Power Senior Vice President and General Manager Financial Review Financial Statements p r o C n a B t s r i F 28 2 0 0 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis relates to the accompanying consolidated financial statements of First BanCorp (the Corporation) and should be read in conjunction with the financial statements and the notes thereto. Information in the notes referred to in this discussion and analysis is hereby incorporated by reference herein. The use of terms such as “see”, “refer to”, “included in” or “explained in” shall be deemed to incorporate by reference into this discussion and analysis the information to which reference is made. Forward Looking Statements When used in this report and in other filings by First BanCorp with the Securities and Exchange Commission, in the Corporation’s press releases or other public or shareholder communication, or in oral statements made with the approval of an authorized executive officer, the words or phrases “would be”, “will be”, “will determine”, “will allow”, “intends to”, “will likely result”, “are expected to”, “will continue”, “is anticipated”, “estimated”, “project”, “believe”, or similar expressions are intended to identify “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The future results of the Corporation could be affected by subsequent events and could differ materially from those expressed in forward-looking statements. If future events and actual performance differ from the Corporation’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements. The Corporation wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities, competitive and regulatory factors and legislative changes, could affect the Corporation’s financial performance and could cause the Corporation’s actual results for future periods to differ materially from those anticipated or projected. The Corporation does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements. OVERVIEW The year 2002 was a challenging year for all business sectors. It followed a year, 2001, where the Federal Reserve Bank cut interest rates by a total of 475 basis points in an effort to stimulate the economy. The Fed monetary policy resulted in an additional cut of 50 basis points during 2002 to 1.25%, the lowest level in more than 40 years. During the economic slowdown, construction, manufacturing and consumption have weakened somewhat. First BanCorp grew substantially and improved its financial performance last year in spite of the economic slowdown. For the year 2002, First BanCorp recorded earnings of $107,956,351 or $2.04 per common share basic and $2.01 per common share diluted, compared to $86,001,444 or $1.74 per common share basic and $1.73 per common share diluted for 2001, and $67,275,609 or $1.48 per common share basic and $1.47 per common share diluted for 2000. For 2002 as compared to 2001, net income increased by $21,954,907 or $0.28 per common share diluted, and for 2001 as compared to 2000, by $18,725,835 or $0.26 per common share diluted. The increase in the Corporation’s earnings is mainly attributed to the net interest income earned on the growing portfolio of average earning assets and other income, net of increases in operating expenses. Assets rose 17% from $8.2 billion at year-end 2001 to $9.6 billion at the end of 2002. Deposits increased 34% to $5.5 billion. Net loans increased 31% to $5.5 billion, mostly due to increases of $345 million in commercial loans and $842 million in residential real estate loans. Consumer loans and finance leases grew by $142 million. In spite of increases in the loan portfolio and a deteriorating economy, charge offs have not been increasing, mainly attributed to prior years efforts that improved loan underwriting and implemented tighter approval procedures. During 2002, the Corporation restructured its portfolio of mortgage backed securities in order to shorten its duration and reduce its prepayment risk under current economic environment; this restructuring resulted in gains of approximately $40.1 million. Total gains on sales of $48.9 million were partially offset by impairment losses of $36.9 million recognized during the year. p r o C n a B t s r i F 29 2 0 0 2 Another important factor in the Corporation’s strategy is prudent control of costs. For several years the Corporation has been investing in state of the art technology to improve service to its clients and increase efficiency. Operating expenses rose relatively little, from $120.9 million in 2001 to $132.8 million in 2002. During 2002 the Corporation’s efficiency ratio improved by one percent to 40.81%. Return on average assets was 1.23% for 2002, and 1.28% for 2001 and 2000. Return on average equity was 14.90% for 2002, 16.20% for 2001 and 21.22% for 2000. Return on average common equity was 21.90% for 2002, 22.13% for 2001 and 27.81% for 2000. First BanCorp has also been expanding outside Puerto Rico. In October 2002 the Corporation completed a $590 million acquisition of the operations of JP Morgan Chase in the Virgin Islands. The expanded presence in the Virgin Islands will give the Corporation the opportunity to better serve its clients in that part of the Caribbean and provides with certain geographic diversification. CRITICAL ACCOUNTING POLICIES AND PRACTICES The accounting and reporting policies of the Corporation and its subsidiaries conform with accounting principles generally accepted in the United States of America. A summary of accounting policies and recently issued accounting pronouncements is included in Note 2 of the Corporation’s financial statements. The reported amounts are based on judgments, estimates and assumptions made by Management that affect the recorded assets and liabilities and contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates, if different assumptions or conditions prevail. Investments The Corporation classifies its investments in debt and equity securities into trading, held to maturity and available for sale securities. The available for sale securities are carried at fair value, with unrealized holding gains and losses, net of deferred tax effects, reported in other comprehensive income as a separate component of stockholders’ equity. The fair values of these securities were calculated based on quoted market prices and dealer quotes. Changes in the assumptions used in calculating the fair values, could affect the reported valuations. Evaluation for Other-than-temporary Impairments on Available for Sale and Held to Maturity Securities The Corporation evaluates its investment’s securities for impairment. An impairment charge in the Consolidated Statements of Income is recognized when the decline in the fair value of investments below their cost basis is judged to be other-than-temporary. The Corporation considers various factors in determining whether it should recognize an impairment charge, including, but no limited to the length of time and extent to which the fair value has been less than its cost basis, and the Corporation’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. For debt securities, the Corporation also considers, among other factors, the investees repayment ability on its bond obligations and its cash and capital generation’s ability. At December 31, 2002 the Corporation did not hold any investment securities with significant unrealized losses sustained for more than one year. The Corporation’s accounting policy for other-than-temporary impairments is included in Note 2 of the Corporation’s financial statements. During 2002, the Corporation experienced significant volatility in the market prices of its publicly traded equity investments and in addition two bonds in the Corporation’s portfolio were downgraded to non investment grade quality by two credit rating agencies. See Note 10 of the Corporation’s financial statements, which gives details as to impairments charges recognized during 2002. p r o C n a B t s r i F 30 2 0 0 2 Allowance for Loan Losses The Corporation maintains the allowance for loan losses at a level that Management considers adequate to absorb losses inherent in the loan portfolio. The adequacy of the allowance for loan losses is reviewed on a quarterly basis as part of the continuing evaluation of the quality of the assets. Groups of small balance, homogeneous loans are collectively evaluated for impairment. The portfolios of consumer loans, auto loans and finance leases are considered homogeneous and are evaluated collectively for impairment. In determining probable losses for each category of homogeneous pools of loans, Management uses historical information about loan losses over several periods of time that reflect varying economic conditions and adjusts such historical data based on the current conditions, considering information and trends on charge offs, non-accrual loans and delinquencies. The Corporation measures impairment individually for those commercial and real estate loans with a principal balance exceeding $1 million. An allowance is established based on the present value of expected future cash flows or the fair value of the collateral, if the loan is collateral dependent. Accordingly, the measurement of impairment for loans evaluated individually involves assumptions by Management as to the amount and timing of cash flows to be recovered and of appropriate discount rates. Where the loans are collateral dependent, Management generally obtains an independent appraisal. Those appraisals also involve estimates of future cash flows and appropriate discount rates or adjustments to comparable properties in determining fair values. The Corporation’s primary lending area is Puerto Rico. At December 31, 2002, there is no significant concentration of credit risk in any specific industry. Income Taxes The Corporation is routinely subject to examinations from governmental taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Corporation to specific transactions. Management believes that the assumptions and judgment used to record tax-related assets or liabilities have been appropriate. Should tax laws change or the tax authorities determine that Management’s assumptions were inappropriate, the result and adjustments required could have a material effect on the Corporation’s results of operation. Information regarding income taxes is included in Note 25 of the Corporation’s financial statements. Impact of Recent Accounting Pronouncements During 2002, the Financial Accounting Standards Board (FASB) issued several accounting pronouncements, namely SFAS (Statement of Financial Accounting Standard) No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of SFAS No. 13, and Technical Corrections, SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, SFAS No. 147, Acquisitions of Certain Financial Institutions, SFAS No. 148, Accounting for Stock-Based Compensation, and FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees. Management estimated that the adoption of these pronouncements did not have or will not have, as applicable depending on adoption date, a significant impact on the Corporation’s financial statements. Refer to Note 2 of the Corporation’s financial statements for a summary of the major provisions of these pronouncements. RESULTS OF OPERATIONS The Corporation’s results of operations depend primarily on its net interest income, which is the difference between the interest income earned on interest earning assets, including investment securities and loans, and the interest expense on interest bearing liabilities, including deposits and borrowings. Also, the results of operations depend on the provision for loan losses, operating expenses (such as personnel, occupancy and other costs), other income (mainly service charges and fees on loans), gains on sale of investments and income taxes. Net Interest Income Net interest income increased to $267 million for 2002 from $236 million in 2001 and $191 million in 2000. The increase in net interest income for the year 2002 is the result of volume increases of $2,052 million in the Corporation’s average loan and investment portfolios. The following table includes a detailed analysis of net interest income. Part I presents average volumes and rates on a tax equivalent basis and Part II presents the extent to which changes in interest rates and changes in volume of interest related assets and liabilities have affected the Corporation’s net interest income. For each category of earning assets and interest bearing liabilities, information is provided on changes attributable to changes in volume (changes in volume multiplied by old rates), and changes in rate (changes in rate multiplied by old volumes). Rate-volume variances (changes in rate multiplied by changes in volume) have been allocated to the changes in volume and changes in rate based upon their respective percentage of the combined totals. p r o C n a B t s r i F 31 2 0 0 2 Part I Year ended December 31, Average volume 2001 2002 2000 Interest income (1) / expense 2001 2002 (Dollars in thousands) 2002 2000 Average rate (1) 2001 2000 60,522 $ 46,517 $ 9,293 $ 999 $ 1,476 $ Earning assets: Money market instruments $ Government obligations 1,236,281 Mortgage backed securities 2,144,236 259,840 Corporate bonds 32,586 FHLB stock 3,733,465 1,048,283 Consumer loans Residential real estate loans 1,283,710 223,627 Construction loans 2,080,892 Commercial loans 136,851 Finance leases 4,773,363 Total investments Total loans (2) Total earning assets 588,932 1,711,980 247,094 21,841 2,616,364 1,036,637 869,374 219,890 1,584,910 127,872 3,838,683 528,903 1,457,044 51,508 18,008 2,064,756 1,026,044 573,866 169,257 1,210,783 103,114 3,083,064 56,130 147,779 15,493 1,635 222,036 142,612 74,411 11,726 110,315 14,659 353,723 35,955 126,098 21,230 1,289 186,048 140,050 65,496 17,323 119,867 14,661 357,397 1.65% 3.17% 5.67% 527 4.54% 6.11% 6.81% 36,043 6.89% 7.37% 6.89% 100,415 5.96% 8.59% 8.48% 4,366 5.02% 5.90% 6.94% 1,249 142,600 5.95% 7.11% 6.91% 140,635 13.60% 13.51% 13.71% 5.80% 7.53% 8.56% 5.24% 7.88% 10.78% 110,808 5.30% 7.56% 9.15% 12,499 10.71% 11.47% 12.12% 7.41% 9.31% 10.75% 6.77% 8.42% 9.21% 49,115 18,251 331,308 $8,506,828 $6,455,047 $5,147,820 $ 575,759 $543,445 $473,908 Interest bearing liabilities: Interest bearing checking accounts Savings accounts Certificate accounts Interest bearing deposits Other borrowed funds FHLB advances Total interest bearing liabilities Net interest income Interest rate spread Net interest margin $ 215,462 $ 186,111 $ 162,456 $ 436,595 2,859,181 3,481,887 2,125,022 256,354 609,324 3,622,918 4,447,704 2,868,212 339,477 433,937 2,173,244 2,769,637 1,851,524 51,053 5,146 $ 14,603 113,486 133,235 123,925 16,024 5,926 $ 5,546 12,792 134,945 153,283 116,130 3,201 12,954 141,878 160,758 106,858 12,585 2.39% 3.18% 3.41% 2.40% 2.97% 2.94% 3.13% 4.96% 6.20% 3.00% 4.62% 5.53% 4.32% 5.03% 6.27% 4.72% 4.91% 6.27% $7,655,393 $5,863,263 $4,672,214 $ 273,184 $280,201 $272,614 3.57% 4.78% 5.83% $ 302,575 $263,244 $201,294 3.20% 3.64% 3.38% 3.56% 4.08% 3.91% (1) On a tax equivalent basis. The tax equivalent yield was computed dividing the interest rate spread on exempt assets by (1- statutory tax rate of 39%) and adding to it the cost of interest bearing liabilities. When adjusted to a tax equivalent basis, yields on taxable and exempt assets are comparative. (2) Non-accruing loans are included in the average balances. p r o C n a B t s r i F 32 2 0 0 2 Part II Earning assets: Money market instruments Government obligations Mortgage backed securities Corporate bonds FHLB stock Total investments Consumer loans Residential real estate loans Construction loans Commercial loans Finance leases Total loans Total interest income Interest bearing liabilities: Deposits Other borrowed funds FHLB advances 2002 compared to 2001 Increase (decrease) Due to: Rate 2001 compared to 2000 Increase (decrease) Due to: Rate Total Volume Total Volume $ 338 34,457 30,815 928 587 67,125 1,580 27,616 245 31,903 993 62,337 129,462 $ (815) $ (14,282) (9,134) (6,665) (241) (31,137) 982 (18,701) (5,842) (41,455) (995) (66,011) (97,148) (In thousands) $ (477) 20,175 21,681 (5,737) 346 35,988 2,562 8,915 (5,597) (9,552) (2) (3,674) 32,314 $ 1,646 3,878 18,437 16,803 246 41,010 1,505 23,778 4,729 30,796 2,920 63,728 104,738 $ (697) (3,966) 7,246 61 (206) 2,438 (2,090) (7,397) (5,657) (21,737) (758) (37,639) (35,201) 949 (88) 25,683 16,864 40 43,448 (585) 16,381 (928) 9,059 2,162 26,089 69,537 7,475 (9,272) 9,384 7,587 61,950 Total interest expense Change in net interest income $ 36,762 34,742 4,002 75,506 53,956 (64,285) (17,675) (563) (82,523) (27,523) 17,067 3,439 (7,017) $ (14,625) $ 39,331 $ 36,152 15,454 11,476 63,082 41,656 (28,677) (24,726) (2,092) (55,495) $ 20,294 $ Total interest income includes tax equivalent adjustments of $36 million, $27 million and $11 million for 2002, 2001, and 2000, respectively. On a tax equivalent basis, net interest income increased to $303 million for 2002 from $263 million for 2001, and $201 million for 2000. The interest rate spread and net interest margin amounted to 3.20% and 3.56%, respectively, for 2002, as compared to 3.64% and 4.08%, respectively, for 2001 and to 3.38% and 3.91%, respectively, for 2000. 2002 compared to 2001 On a tax equivalent basis interest income increased by $32 million for 2002 as compared to 2001. On a tax equivalent basis the yield on earning assets was 6.77% for 2002 as compared to 8.42% for 2001. The increase in interest income resulted from the growth in the average volume of interest earning assets of $2,052 million in 2002, partially offset by lower yields due to lower market rates. The current economic slowdown has led the Federal Reserve Bank to cut the federal funds rate several times during the last two years to 1.25%, which has resulted in a lower average cost of fund (3.57% for the year ended 2002 versus 4.78% for the year ended 2001). On a rate/volume basis, the increase of $39 million in net interest income (on a tax equivalent basis) is the result of a positive volume variance of $54 million, net of a negative rate variance of $15 million. The negative rate variance was mainly due to the high level of variable rate assets, and the acceleration of prepayments on the Corporation’s mortgage backed securities. As shown in Part I, the Corporation continued to experience growth in its loan portfolio during 2002. Total loans average volume increased by $935 million as compared to 2001. Residential real estate loans and commercial loans, accounted for the largest growth in the portfolio, with average volumes rising $414 million and $496 million, respectively. The growth in the commercial and residential real estate portfolios resulted mainly from the Corporation’s ongoing strategy of maintaining a diversified asset base. For the loan portfolio, the growth in average volume represented an increase of $62 million in interest income due to volume. The $66 million decrease in interest income due to rate is mainly attributed to the floating rate characteristics of a portion of the Corporation’s portfolio and to the origination of new loans in a lower rate environment. At December 31, 2002, approximately 75% of the commercial, 49% of the residential mortgage and 88% of the construction portfolios have floating rates. p r o C n a B t s r i F 33 2 0 0 2 Average investment securities increased by $1,117 million. The average yield on investment securities was 5.95% in 2002 and 7.11% in 2001, on a tax equivalent basis. The portfolio of investment securities contributed $67 million on the interest income increase due to volume partially offset by a decrease of $31 million in interest income due to rate. The yield on government obligations had a negative variance of 157 basis points declining from 6.11% in 2001 to 4.54% in 2002. The yield on mortgage backed securities also had a negative variance as it decreased 48 basis points from 7.37% in 2001 to 6.89% in 2002. Interest expense decreased by $7 million for 2002 as compared to 2001. This was the result of the decrease in the average rates of interest bearing liabilities which generated a positive rate variance of $83 million, that was partially offset by increases in the average volume of liabilities to support the Corporation’s growth. 2001 compared to 2000 On a tax equivalent basis interest income increased by $70 million for 2001 as compared to 2000. On a tax equivalent basis the yield on earning assets was 8.42% for 2001 as compared to 9.21% for 2000. The increase in interest income results from the growth in the average volume of interest earning assets of $1,307 million in 2001, partially offset by a lower yield due to lower market rates. On a rate/volume basis, the increase of $62 million in net interest income (on a tax equivalent basis) is the result of a positive volume variance of $42 million, plus a positive rate variance of $20 million. During the year 2001, the Federal Reserve Bank cut short term rates by a total of 475 basis points to 1.75%. Long term rates fell by less than 50 basis points, increasing the spread between short and long yields and increasing the Corporation’s interest rate spread and net interest margin. For the loan portfolio, the growth in 2001 of $374 million in the average volume of commercial loans (including commercial real estate loans) represented an increase of $31 million in interest income due to volume, and a decrease of $22 million in interest income due to rate. The average portfolio of construction loans increased by $51 million for 2001, representing a positive volume variance of $5 million and a negative rate variance of $6 million. Management has been pursuing a consistent strategy of shifting the lending portfolio towards commercial lending without sacrificing the consumer area. The average portfolio of residential mortgage loans increased by $296 million for 2001, representing a positive volume variance of $24 million and a negative rate variance of $7 million. The average finance lease portfolio (mostly composed of consumer loans) increased by $25 million in 2001, representing a positive volume variance of $3 million. The increase of $11 million in the average volume of consumer loans in 2001, represented a positive variance in interest income due to volume of $2 million and a negative rate variance of $2 million. For the investment portfolio, the average volume of mortgage backed securities increased by $255 million in 2001. The tax equivalent yield on mortgage backed securities was 7.37% in 2001 and 6.89% in 2000. The portfolio of mortgage backed securities contributed $18 million in interest income due to volume and $7 million in interest income due to rate. The average volume of corporate bonds increased by $196 million for 2001 as compared to 2000, causing an increase in interest income of $17 million totally due to volume. Interest expense increased by $8 million for 2001 as compared to 2000. This was the result of the increase in the average volume of interest bearing liabilities of $1,191 million for 2001 as compared to 2000 which generated a negative volume variance of $63 million, partially offset by the decrease in the cost of interest bearing liabilities due to lower market rates, causing a positive rate variance of $55 million. The cost of interest bearing liabilities decreased from 5.83% for 2000 to 4.78% for 2001. Provision for Loan Losses During 2002, the Corporation provided $62 million for loan losses, as compared to $61 million in 2001 and $46 million in 2000. Charge offs were stable despite weakened economic conditions. Net charge offs for 2002 amounted to $41.5 million, as compared to net charge offs for 2001 of $46.9 million, and of $42.0 million for 2000. Net charge offs to average loans outstanding has improved to 0.87% as compared to 1.22% and 1.36% for 2001 and 2000, respectively. p r o C n a B t s r i F 34 2 0 0 2 The allowance activity for 2002, and previous four years was as follows: Year ended December 31, 2002 2001 2000 (Dollars in thousands) 1999 1998 Allowance for loan losses, beginning of year Provision for loan losses Loans charged off: Residential real state Commercial Finance leases Consumer Recoveries Net charge offs Other adjustments (1) Allowance for loan losses, end of year Allowance for loan losses to year end total loans and loans held for sale Net charge offs to average loans outstanding during the period $ 91,060 62,302 $ 76,919 $ 61,030 71,784 $ 45,719 67,854 47,960 $ 57,712 76,000 (555) (4,643) (2,532) (41,261) 7,540 (41,451) $ 111,911 $ (192) (9,523) (2,316) (42,349) 7,391 (46,989) 100 91,060 $ (3,463) (2,145) (46,223) 9,807 (42,024) 1,440 76,919 $ (825) (793) (52,047) 9,048 (44,617) 587 71,784 $ (880) (3,438) (67,906) 6,034 (66,190) 332 67,854 1.99% 2.11% 2.20% 2.61% 3.20% 0.87% 1.22% 1.36% 1.90% 3.31% (1) Other adjustments mainly consist of the carrying allowance of the loan portfolios acquired each year. The Corporation maintains the allowance for loan losses at a level that Management considers adequate to absorb losses inherent in the loan portfolio. The adequacy of the allowance for loan losses is reviewed on a quarterly basis as part of the continuing evaluation of the quality of the assets. This evaluation is based upon a number of factors, including the following: historical loan loss experience, projected loan losses, loan portfolio composition, current economic conditions, fair value of the underlying collateral, financial condition of the borrowers, and, as such, includes amounts based on judgments and estimates made by Management. The allowance for loan losses on commercial and real estate loans over $1 million is determined based on the present value of expected future cash flows or the fair value of the collateral, if the loan is collateral dependent. Other Income The following table presents the composition of other income: Year ended December 31, Other fees on loans Service charges on deposit accounts Mortgage banking activities Rental income Other commissions Insurance income Dividend on equity securities Other operating income Other income before net gain on sale of investments, derivatives loss and trading income Net gain on sale of investments Impairment on investments Net gain on sale of investments, and impairment Derivatives loss Trading income Total 2002 $ 21,441 9,200 3,540 2,285 1,081 2,269 705 10,032 50,553 48,873 (36,872) 12,001 (4,062) 2001 (In thousands) $ 19,632 9,213 1,562 2,293 1,511 700 669 7,794 43,374 9,606 9,606 $ 58,492 $ 52,980 2000 $ 19,913 8,898 409 2,434 1,340 698 8,071 41,763 7,850 7,850 419 $ 50,032 p r o C n a B t s r i F 35 2 0 0 2 Other income primarily consists of fees on loans, service charges on deposit accounts, commissions derived from various banking activities, securities and insurance activities, and the net gain of investments, net of derivatives losses. Other fees on loans consist mainly of credit card fees and late charges collected on loans. Service charges on deposit accounts represent an important and stable source of other income for the Corporation. Mortgage banking activities income includes gain on sale of loans and the servicing fees on residential mortgage loans originated by the Corporation and subsequently securitized or sold. Gains on sale of loans amounted to approximately $3.4 million in 2002 (2001-$1.2 million). No sales were made in 2000. The Corporation’s subsidiary, First Leasing and Rental Corporation, generates income on the rental of various types of motor vehicles. This source of income has averaged approximately $2 million in the past three years. Insurance income consists of commissions earned by the new subsidiary FirstBank Insurance Agency, Inc., which started operations in May 2001. Other commissions income is the result of an agreement with Goldman, Sachs & Co. to participate in bond issues by the Government Development Bank of Puerto Rico, and an agreement with a national brokerage house in Puerto Rico to offer brokerage services in selected branches. The other operating income category is composed of miscellaneous fees such as check fees and rental of safe deposit boxes. Other operating income also includes earned discounts on tax credits purchased and utilized against income tax payments, and other fees generated on the portfolio of commercial loans. The gain on sale of investment securities reflects gains that resulted from sales that are in consonance to the Corporation’s investment policies. A substantial portion earned in 2002 represents gains of $40.1 million on the sale of mortgage backed securities, realized as part of the restructuring of the investment portfolio, as explained in the Corporation’s financial statements, see Note 10. In addition, during the year ended on December 31, 2002 losses of $37 million on other-than-temporary impairment of certain securities were recognized, as explained in the Corporation’s financial statements, refer to Notes 2 and 10. As explained in Note 29 of the Corporation’s financial statements, the derivatives loss consists mainly of an unrealized loss of $4.5 million due to the valuation to fair value of a portfolio of swaps that does not qualify for hedge accounting. Other Operating Expense Other operating expenses amounted to $133 million for 2002 as compared to $121 million for 2001 and $113 million for 2000. The following table presents the components of other operating expenses: Year ended December 31, Salaries and benefits Occupancy and equipment Deposit insurance premium Other taxes and insurance Professional and service fees Business promotion Communications Expense of rental equipment Other Total 2002 $ 59,432 29,015 746 8,915 7,685 9,304 5,865 1,588 10,206 $ 132,756 2001 (In thousands) $ 54,703 24,992 645 7,804 7,931 7,506 5,395 1,578 10,300 $ 120,854 2000 $ 50,014 22,792 547 6,355 8,740 8,468 5,573 1,525 9,036 $ 113,050 p r o C n a B t s r i F 36 2 0 0 2 Management’s goal is to limit expenditures to those that directly contribute to increase the efficiency, service quality and profitability of the Corporation. This control over other operating expenses has been an important factor contributing to the increase in earnings in recent years. The Corporation’s efficiency ratio, which is the ratio of other operating expenses to the sum of net interest income and other income, improved to 40.81% for 2002 as compared to 41.81% and 46.95% for 2001 and 2000, respectively. The Corporation has maintained a better than average efficiency ratio, while it has provided the latest in delivery channels for its commercial and consumer financial products and services. The increase in operating expenses for 2002 is mainly the result of the Corporation’s continuous investment in technology to provide the latest in delivery channels to its commercial and consumer lending business and to the general growth in the subsidiary Bank’s operations. Operating expenses have also increased due to higher expenditures on advertising campaigns, which support the Corporation’s growth and image. The salary and benefits category was affected by annual increases in salary and fringe benefits and an increase in the number of employees to support the Corporation’s growth. Income Tax Expense The provision for income tax amounted to $22 million (or 17% of pre-tax earnings) for 2002 as compared to $20 million (or 19% of pre-tax earnings) in 2001, and $15 million (or 18% of pre-tax earnings) in 2000. The Corporation has maintained an effective tax rate lower than the statutory rate of 39% mainly by investing in government obligations and mortgage backed securities exempt from U.S. and Puerto Rico income tax combined with gains on sale of investments held by the international banking division of the Corporation and the Bank. These divisions were created under the International Banking Entity Act of P. R., which provides for total P. R. tax exemption on its interest income, other income and gain on sale of investments. The decrease in the effective tax rate is mainly due to an increase in the portfolio of exempt investments and investments held in the Corporation’s international banking divisions. For additional information relating to income taxes, see Note 25 of the Corporation’s financial statements. p r o C n a B t s r i F 37 2 0 0 2 FINANCIAL CONDITION The following table presents an average balance sheet for the following years: Interest earning assets: Money market instruments Government obligations Mortgage backed securities Corporate bonds FHLB stock Total investments Commercial loans Consumer loans Residential real estate loans Construction loans Finance leases Total loans Total interest earning assets Equity securities Total non-earning assets (1) Total assets Liabilities and stockholders’ equity Interest bearing liabilities: Interest bearing checking accounts Savings accounts Certificate accounts Interest bearing deposits Other borrowed funds FHLB advances Total interest bearing liabilities Total non-interest bearing liabilities Total liabilities Stockholders’ equity Total liabilities and stockholders’ equity 2002 $ 60,522 1,236,281 2,144,236 259,840 32,586 3,733,465 2,080,892 1,048,283 1,283,710 223,627 136,851 4,773,363 8,506,828 52,703 188,691 $8,748,222 $ 215,462 609,324 3,622,918 4,447,704 2,868,212 339,477 7,655,393 368,315 8,023,708 724,514 $ 8,748,222 December 31, 2001 (In thousands) $ 46,517 588,932 1,711,980 247,094 21,841 2,616,364 1,584,910 1,036,637 869,374 219,890 127,872 3,838,683 6,455,047 48,122 198,233 $ 6,701,402 $ 186,111 436,595 2,859,181 3,481,887 2,125,022 256,354 5,863,263 307,237 6,170,500 530,902 $ 6,701,402 2000 $ 9,293 528,903 1,457,044 51,508 18,008 2,064,756 1,210,783 1,026,044 573,866 169,257 103,114 3,083,064 5,147,820 29,254 62,302 $ 5,239,376 $ 162,456 433,937 2,173,244 2,769,637 1,851,524 51,053 4,672,214 250,135 4,922,349 317,027 $ 5,239,376 (1) Net of the allowance for loan losses and the valuation on investments securities available for sale. p r o C n a B t s r i F 38 2 0 0 2 Assets The Corporation’s total assets at December 31, 2002 amounted to $9,644 million, $1,446 million over the $8,198 million at December 31, 2001, mainly due to the growth in the loan portfolio. The following table presents the composition of the loan portfolio at year-end for each of the last five years: December 31, 2002 % of Total 2001 % of Total % of Total (Dollars in thousands) 2000 1999 % of Total 1998 % of Total Residential real estate loans Commercial real estate loans Construction loans Commercial loans Total commercial Finance leases Consumer loans Total $ 1,854,068 33 $ 1,011,908 23 $ 746,792 21 $ 473,563 17 $ 303,011 14 813,513 259,053 1,418,792 2,491,358 143,412 1,149,012 14 5 25 44 3 20 $ 5,637,850 100 688,922 219,396 1,238,173 2,146,491 127,935 1,022,445 $ 4,308,779 16 5 29 50 3 24 100 438,321 203,955 947,709 1,589,985 122,883 1,038,538 $ 3,498,198 13 6 27 46 3 30 100 371,643 132,068 655,417 1,159,128 85,692 1,026,985 $ 2,745,368 14 5 24 43 3 37 100 332,219 62,963 368,549 763,731 52,214 1,001,098 $ 2,120,054 16 3 17 36 3 47 100 Total loans receivable increased by $1,329 million in 2002 when compared with 2001. During 2002 the Corporation continued its strategy of diversifying its loan portfolio composition through the origination and purchase of commercial loans and residential real estate loans, while maintaining its investment in consumer loans. In addition, the Corporation acquired a banking operation in the U.S. and British Virgin Islands with $291 million in residential real estate loans, $40 million in commercial loans and $105 million in consumer loans. This acquisition provides the Corporation with a geographic diversification. The Corporation’s strategy and the acquisition resulted in a significant increase of $345 million in the commercial loan portfolio and of $842 million in residential real estate loans. Finance leases, which are mostly composed of loans to individuals to finance the acquisition of an auto, increased by $15 million, and consumer loans increased by $127 million in 2002. The Corporation’s investment portfolio at December 31, 2002 amounted to $3,729 million, an increase of $13 million when compared with the investment portfolio of $3,716 million at December 31, 2001. Mortgage backed securities represent a substantial balance of the Corporation’s portfolio. These securities are subject to prepayment risk. As described in Note 10 of the Corporation’s financial statements, during 2002, the Corporation restructured its portfolio to shorten maturities and reduce the existing prepayment risk under current interest rate scenario. Government obligations included approximately $644 million and $1.3 million in zero coupon bonds and government agency securities, respectively, that are callable. At December 31, 2002 money market instruments included approximately $237 million of FHLB discount notes maturing in less than ninety days, which collateralized repurchase agreements. Management of the Corporation will determine during 2003 how prepayments on the mortgage backed securities and repayments on the callable securities will be reinvested, considering, among other factors, the interest rate outlook. The composition and estimated tax equivalent weighted average interest and dividend yields of the Corporation’s earning assets at December 31, 2002 were as follows: Money market instruments Government obligations Mortgage backed securities FHLB stock Corporate bonds Equity securities Total investments Consumer loans Residential real estate loans Construction loans Commercial and commercial real estate loans Finance leases Total loans (1) Total earning assets (1) Excludes the reserve for loan losses. Non-performing Assets Amount (In thousands) $ 273,660 666,946 2,512,606 35,629 198,174 41,654 3,728,669 1,149,012 1,854,068 259,053 2,232,305 143,412 5,637,850 9,366,519 $ p r o C n a B t s r i F 39 2 0 0 2 Tax Equivalent Weighted Average Rate 1.66% 10.84% 6.26% 5.58% 6.93% 1.72% 6.72% 13.13% 5.43% 5.13% 5.03% 10.14% 6.95% 6.86% Total non-performing assets are the sum of non-accruing loans and investments, other real estate owned and other repossessed properties. Non-accruing loans and investments are loans and investments as to which interest is no longer being recognized. When loans and investments fall into non-accruing status, all previously accrued and uncollected interest is charged against interest income. At December 31, 2002, total non-performing assets amounted to $105 million (1.09% of total assets) as compared to $79 million (0.96% of total assets) at December 31, 2001 and $74 million (1.25% of total assets) at December 31, 2000. Approximately $9.1 million of the increase in non-performing assets when compared to the amount at December 31, 2001 is attributed to a construction loan fully secured with finished homes, where the Corporation stopped accruing interest due to a slow down in the selling process of the homes. More than half of the project houses have been either sold or optioned and are in the process of closing. The remaining increase in non performing assets is attributed to a corporate bond of approximately $3.8 million, which was reclassified to non-accruing status during 2002, to non-performing assets acquired in the Virgin Islands and to the general growth in the Corporation’s commercial loan portfolio. The Corporation’s allowance for loan losses to non-performing loans was 121.95% at December 31, 2002 as compared to 124.74% and 113.59% at December 31, 2001 and 2000, respectively. The following table presents non-performing assets at the dates indicated: p r o C n a B t s r i F 40 2 0 0 2 Non-accruing loans: Residential real estate Commercial and commercial real estate Finance leases Consumer Other real estate owned Other repossessed property Investment securities Total non-performing assets Past due loans Non-performing assets to total assets Non-performing loans to total loans Allowance for loan losses Allowance to total non-performing loans Non-accruing Loans 2001 December 31, 2000 (Dollars in thousands) 1999 1998 18,540 $ 29,378 2,469 22,611 72,998 1,456 4,596 15,977 $ 31,913 2,032 17,794 67,716 2,981 3,374 8,633 $ 17,975 2,482 24,726 53,816 517 3,112 9,151 19,355 1,716 26,736 56,958 3,642 2,277 2002 $ 23,018 $ 47,705 2,049 18,993 91,765 2,938 6,222 3,750 $ 104,675 $ $ 24,435 $ 1.09% 1.63% $ 111,911 $ 62,877 15,110 1.57% 2.69% 67,854 121.95% 124.74% 113.59% 133.39% 119.13% 74,071 $ 16,358 $ 1.25% 1.94% 76,919 $ 57,445 $ 13,781 $ 1.22% 1.96% 71,784 $ 79,050 $ 27,497 $ 0.96% 1.69% 91,060 $ Residential Real Estate Loans - The Corporation classifies all real estate loans delinquent 90 days or more in non-accruing status. Even though these loans are in non-accruing status, Management considers, based on the value of the underlying collateral, the loan to value ratios and historical experience, that no material losses will be incurred in this portfolio. Non-accruing real estate loans amounted to $23 million (1.24% of total residential real estate loans) at December 31, 2002, as compared to $19 million (1.83% of total residential real estate loans) and $16 million (2.14% of total residential real estate loans) at December 31, 2001 and 2000, respectively. The increase as compared to 2001 is mainly attributed to non performing loans of approximately $4 million acquired in the Virgin Islands. Commercial Loans - The Corporation places commercial loans (including commercial real estate and construction loans) 90 days delinquent as to principal and interest in non-accruing status. The risk exposure of this portfolio is diversified. Non-accruing commercial loans amounted to $48 million (1.91% of total commercial loans) at December 31, 2002 as compared to $29 million (1.37% of total commercial loans) and $32 million (2.01% of total commercial loans) at December 31, 2001 and 2000, respectively. At December 31, 2002 there were five non-accruing commercial loans of over $1 million, for a total of $17.7 million including the afore mentioned non-accruing construction loan of $9.1 million. Finance Leases – Finance leases are classified as non-accruing when they are delinquent 90 days or more. Non-accruing finance leases amounted to approximately $2 million at December 31, 2002, 2001 and 2000, representing 1.43%, 1.93% and 1.65%, respectively, of total finance leases. Consumer Loans - Consumer loans are classified as non-accruing when they are delinquent 90 days in auto, boat and home equity reserve loans, 120 days in personal loans (including small loans) and 180 days in credit cards and personal lines of credit. Non-accruing consumer loans amounted to $19 million (1.65% of the total consumer loan portfolio) at December 31, 2002, $23 million (or 2.21% of the total consumer loan portfolio) at December 31, 2001 and $18 million (or 1.71% of the total consumer loan portfolio) at December 31, 2000. p r o C n a B t s r i F 41 2 0 0 2 Other Real Estate Owned Other real estate owned acquired in settlement of loans is carried at the lower of cost (carrying value of the loan) or fair value less estimated cost to sell the real estate at the date of acquisition. Other Repossessed Property The other repossessed property category includes repossessed boats and autos acquired in settlement of loans. Repossessed boats are recorded at the lower of cost or estimated fair value. Repossessed autos are recorded at the principal balance of the loans less an estimated loss on the disposition. Investment securities This category presents the carrying amount of $3.8 million of the Corporation’s investment in WorldCom Corporation bonds, which was reclassified to non-accruing status during the year, as more fully explained in Note 10 of the Corporation’s financial statements. Management’s impairment analysis on the investment in WorldCom Corporation bonds concluded that an other-than-temporary impairment of approximately $11.7 million had occurred. As aforementioned, the remaining $3.8 million were reclassified to non-accruing status. Past Due Loans Past due loans are accruing commercial and consumer loans, which are contractually delinquent 90 days or more. Past due commercial loans are current as to interest but delinquent in the payment of principal. Past due consumer loans include personal lines of credit and credit card loans delinquent 90 days up to 179 days and personal loans (including small loans) delinquent 90 days up to 119 days. Sources of Funds The Corporation’s principal funding sources are branch-based deposits, retail brokered deposits, institutional deposit, federal funds purchased, securities sold under agreements to repurchase, and FHLB advances. Deposits Total deposits amounted to $5,483 million at December 31, 2002, as compared to $4,099 million and $3,346 million at December 31, 2001 and 2000, respectively. The following table presents the composition of total deposits: Savings accounts Interest bearing checking accounts Certificates of deposit Interest bearing deposits Non-interest bearing deposits Total Weighted average rate during the period on interest bearing deposits Interest bearing deposits: Average balance outstanding Non-interest bearing deposits: Average balance outstanding 2002 921,103 230,743 3,883,996 5,035,842 447,076 5,482,918 3.00% December 31, 2001 (Dollars in thousands) $ $ 469,452 205,760 3,183,491 3,858,703 239,851 4,098,554 4.62% 2000 $ $ 430,298 170,631 2,512,891 3,113,820 232,164 3,345,984 5.53% 4,447,704 $ 3,481,887 $ 2,769,637 $ $ $ $ 257,454 $ 233,254 $ 213,728 Total deposits are composed of branch-based deposits, brokered deposits and to a lesser extent of institutional deposits. Institutional deposits include certificates issued to agencies of the Government of Puerto Rico and to Governments in the Virgin Islands. p r o C n a B t s r i F 42 2 0 0 2 Total deposits increased by approximately $1,384 million at December 31, 2002 when compared to December 31, 2001. This fluctuation was mainly due to: (1) an increase in branch-based deposits of $813 mil- lion and to (2) an increase of $456 million in brokered certificates of deposit. The increase in branch-based deposits reflects the acquisition of approximately $557 million in deposits in the Virgin Islands. Retail brokered certificates of deposits, which are certificates sold through brokers, represent a large portion of the Corporation’s deposits. The total U.S. market for this source of funding approximates $280,000 million. At December 31, 2002, approximately 73% of retail brokered certificates of deposit held by the Corporation are callable, but only at Corporation’s option. At December 31, 2002, the average life of callable and fixed term brokered certificates approximated 12 years and 2.54 years, respectively. As more fully explained in Note 29 to the Corporation’s financial statements, the Corporation enters into interest rate swap agreements where it agrees to pay variable-rates of interest as a hedge against changes in the fair value of fixed-rate brokered certificates of deposit. The effect of this agreements is that interest expense of retail brokered certificates of deposits is generally variable interest rate. The interest rate swap agreements are not callable. Borrowings At December 31, 2002 total borrowings amounted to $3,249 million as compared to $3,425 million and $2,069 million at December 31, 2001 and 2000, respectively. 2002 December 31, 2001 (Dollars in thousands) 2000 Federal funds purchased and securities sold under agreements to repurchase $ Advances from FHLB Subordinated notes Notes payable Total 2,793,540 373,000 82,815 $ 2,997,174 343,700 84,362 $ 3,249,355 $ 3,425,236 $ $ 1,856,436 67,000 90,548 55,500 2,069,484 Weighted average rate during the period 4.36% 5.02% 6.27% The Corporation uses federal funds purchased, repurchase agreements, advances from FHLB and notes payable as additional funding sources. The borrowings of the Corporation consist primarily of federal funds purchased and securities sold under agreements to repurchase (repurchase agreements) which at December 31, 2002 amounted to $2,794 million or 86% of total borrowings. Repurchase agreements had a total weighted average cost of 3.82% during the year ended December 31, 2002. For more information on borrowings please refer to Notes 18 through 21 of the Corporation’s financial statements. The composition and estimated weighted average interest rates of interest bearing liabilities at December 31, 2001, were as follows: Interest bearing deposits Borrowed funds Amount (In thousands) $ 5,035,842 3,249,355 $ 8,285,197 Weighted Average Rate 2.58% 3.98% 3.13% p r o C n a B t s r i F 43 2 0 0 2 Contractual Obligations and Commitments The following table presents a detail of the maturities of contractual debt obligations, operational leases and commitments to extend credit: Payments Due/Commitments Expiration by Period (In thousands) Total Less than 1 year 1-3 years 4-5 years After 5 years Contractual Obligations: Federal funds purchased and securities sold under agreements to repurchase Advances from FHLB Subordinated Notes Total Contractual Cash Obligations $ 3,249,355 $ Other Commitments: $ 2,793,540 $ 373,000 82,815 Lines of Credit Standby Letters of Credit Other Commercial Commitments Operating Leases Total Commercial Commitments $ 322,351 $ 30,313 729,369 22,897 718,580 $ 50,000 768,580 $ 156,500 $ 50,000 82,815 289,315 $ 100,000 $ 1,818,460 273,000 100,000 $ 2,091,460 322,351 30,313 729,369 4,894 $ $ 1,104,930 $ 1,086,927 $ 6,905 $ 6,905 $ 3,765 $ 3,765 $ 7,333 7,333 The Corporation has obligations and commitments to make future payments under contracts, such as debt and lease agreements, and under other commitments to extend credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since certain commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. In the case of credit cards and personal lines of credit, the Corporation can at any time and without cause, cancel the unused credit facility. Capital During 2002, the Corporation increased its total capital from $603 million at December 31, 2001 to $798 million at December 31, 2002. Total capital increased by $195 million mainly due to earnings of $108 million, the issuance of 3,680,000 shares of preferred stock with a net proceed of $89 million, the issuance of 96,750 (as adjusted for 2002 stock split) shares of common stock through the exercise of stock options with proceeds of $1.3 million, a positive fluctuation in the valuation of securities available for sale, net of a negative valuation of fair value hedges of $40 million, and cash dividends of $42 million. The Corporation’s objective is to maintain a solid capital position above the “well capitalized” classification under the federal banking regulations. The Corporation continues to exceed the well capitalized guidelines. To be in a “well capitalized” position, an institution should have: (i) a leverage ratio of 5% or greater; (ii) a total risk based capital ratio of 10% or greater; and (iii) a Tier 1 risk-based capital ratio of 6% or greater. At December 31, 2002 the Corporation had a leverage ratio of 7.35%; a total risk based capital ratio of 13.75%; and a Tier 1 risk-based capital ratio of 11.90%. Dividends In 2002, 2001 and 2000 the Corporation declared four quarterly cash dividends of $0.10, $0.09 and $0.07 per common share, respectively, for an annual dividend of $0.40, $0.35 and $0.29, respectively. Total cash dividends paid on common shares amounted to $16 million for 2002 (or a 19.58% dividend payout ratio), $14 million for 2001 (or a 19.91% dividend payout ratio) and $12 million for 2000 (or a 19.72% dividend payout ratio). Dividends declared on preferred stock amounted to $26 million in 2002, $17 million in 2001, and $7 million in 2000. Increase in dividends on preferred stocks resulted from the issuance of preferred stock of $92 million in 2002, $103.5 million in 2001 and $75 million in 2000. p r o C n a B t s r i F 44 2 0 0 2 Quantitative and Qualitative Disclosures about Market Risk First BanCorp manages its asset/liability position in order to limit the effects of changes in interest rates on net interest income, subject to other goals of Management and within guidelines set forth by the Board of Directors. The day-to-day management of interest rate risk, as well as liquidity management and other related matters, is assigned to the Asset Liability Management and Investment Committee of FirstBank (ALCO). The ALCO is composed of the following officers: President and CEO, the Senior Executive Vice President and Chief Financial Officer, the Executive Vice President for Retail and Mortgage Banking, the Senior Vice President of Treasury and Investments and the Economist. The ALCO meets on a weekly basis. The Economist also acts as secretary, keeping minutes of all meetings. An Investment Committee for First BanCorp also monitors the investment portfolio of the Holding Company, including a stock portfolio which amounted to $42 million at December 31, 2002. This Committee meets weekly and has the same membership as the ALCO Committee described previously. Committee meetings focus on, among other things, current and expected conditions in world financial markets, competition and prevailing rates in the local deposit market, reviews of liquidity, unrealized gains and losses in securities, recent or proposed changes to the investment portfolio, alternative funding sources and their costs, hedging and the possible purchase of derivatives such as swaps and caps, and any tax or regulatory issues which may be pertinent to these areas. The ALCO approves funding decisions in light of the Corporation’s overall growth strategies and objectives. On a quarterly basis the ALCO performs a comprehensive asset/liability review, examining the measures of interest rate risk described below together with other matters such as liquidity and capital. The Corporation uses simulations to measure the effects of changing interest rates on net interest income. These measures are carried out over a one year time horizon, assuming gradual upward and downward interest rate movements of 200 basis points. Simulations are carried out in two ways: (1) using a balance sheet which is assumed to be at the same levels existing on the simulation date, and (2) using a balance sheet which has growth patterns and strategies similar to those which have occurred in the recent past. These simulations assume gradual upward or downward movements of interest rates over the year of projection, with the change totaling 200 basis points at the end of the twelve month period. The balance sheet is divided into groups of similar assets and liabilities in order to simplify the process of carrying out these projections. As interest rates rise or fall, these simulations incorporate expected future lending rates, current and expected future funding sources and cost, the possible exercise of options, changes in prepayment rates, and other factors which may be important in determining the future growth of net interest income. All computations are done on a tax equivalent basis, including the effects of the changing cost of funds on the tax-exempt spreads of certain investments. The projections are carried out for First BanCorp on a fully consolidated basis. These simulations are highly complex, and they use many simplifying assumptions that are intended to reflect the general behavior of the Corporation over the period in question, but there can be no assurance that actual events will parallel these assumptions in all cases. For this reason, the results of these simulations are only approximations of the true sensitivity of net interest income to changes in market interest rates. Assuming a no growth balance sheet as of December 31, 2002, tax equivalent net interest income projected for 2003, would rise by $27.8 million (8.23%) under a rising rate scenario and would decrease by $1.5 million (0.5%) under falling rates. The same simulations were also carried out assuming that the Corporation would grow. As of December 31, 2002 the growing balance sheet simulations indicate that tax equivalent net interest income projected for 2003, would rise by $27.0 million (7.70%) under a rising rate scenario and would decrease by $0.8 million (0.2%) with falling rates. p r o C n a B t s r i F 45 2 0 0 2 The simulation for the year 2002 assuming a no growth balance sheet as of December 31, 2001, concluded that under a rising rate scenario net interest income would have declined by $6.2 million (1.7%) and that under a falling rate scenario would have increased by $1.9 million (0.5%). The same simulations were also carried assuming that Corporation was going to grow. As of December 31, 2001, the growing balance sheet simulation indicated that the tax equivalent net interest income for 2002 would have fallen by $8.8 million (2.4%) under a rising interest rate scenario and increased by $3.8 million (1.0%) with falling rates. The Corporation compared 2002 projections with actual results. In the growth scenario, which is more realistic, the Bank projected taxable equivalent net interest income of $369.7 million under flat rates and $373.5 million under falling rates for 2002. In reality, taxable equivalent net interest income was $302.6 million. The most important reason for this difference was that FirstBank restructured its investment portfolio to reduce the Bank’s exposure to rising rates. Some corporate bonds were sold and most 30 year MBS were replaced with 15 year securities at lower tax equivalent spreads. While these changes were going on, the Bank also had substantial investments in discount notes for short periods of time. These changes all led to smaller spreads than anticipated in the initial projection. Partially offsetting the effect of smaller spreads was a more rapid growth of the balance sheet. The consolidated balance sheet actually reached $9.64 billion at the end of 2002, compared with a projected figure of $8.68 billion in the baseline scenario. Part of this growth was due to the unanticipated purchase of a $590 million banking operation in the Virgin Islands, which closed in October, 2002. Substantial unanticipated growth also occurred in average commercial loans, which reached $2.30 billion by the end of 2002, compared with a projected figure of $2.00 billion in the baseline scenario. Liquidity Liquidity refers to the level of cash and eligible investments to meet loan and investment commitments, potential deposit outflows and debt repayments. The Asset Liability Management and Investment Committee, using measures of liquidity developed by Management, reviews the Corporation’s liquidity position on a weekly basis. The principal sources of short-term funds are loan repayments, deposits, securities sold under agreements to repurchase, and lines of credit with the FHLB and other financial institutions. The Investment Committee reviews credit availability on a regular basis. In the past, the Corporation has securitized and sold auto and mortgage loans as supplementary sources of funding. Commercial paper had also provided additional funding. The Corporation has obtained long-term funding through the issuance of notes and long-term institutional certificates of deposit. The Corporation’s principal uses of funds are the origination of loans and the repayment of maturing deposit accounts and borrowings. A large portion of the Corporation’s funding represent retail brokered certificates of deposit. In the event that the Corporation falls under the ratios of a well-capitalized institution, it faces the risk of not being able to replace this source of funding. It is Management’s believe that this possibility is remote. In addition, the average life of the retail brokered certificates of deposit was 9.54 years at December 31, 2002. Approximately 73% of these certificates are callable, but only at the Corporation’s option. The Corporation’s liquidity plan contemplates alternative sources of funding that could provide significant amounts of funding at reasonable cost. The alternative sources of funding include, among others, FHLB advances, lines of credits from other banks, sale of commercial loans participations, securitization of auto loans and commercial paper. Impact of Inflation and Changing Prices The financial statements and related data presented herein have been prepared in conformity with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. p r o C n a B t s r i F 46 2 0 0 2 Unlike most industrial companies, substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a greater impact on a financial institution’s performance than the effects of general levels of inflation. Interest rate movements are not necessarily correlated with changes in the prices of goods and services. Concentration Risk The Corporation conducts its operations in a geographically concentrated area, as its main market is Puerto Rico. However, the Corporation continues diversifying its geographical risk as evidenced by recent acquisitions in the Virgin Islands. Puerto Rico’s economy is generally similar to U.S. economy and its economic performance is a natural result of its increasing integration into the U.S. economy. At December 31, 2002, there is no significant concentration of credit risk in any specific industry. Selected Quarterly Financial Data Financial data showing results of the 2002 and 2001 quarters is presented below. In the opinion of Management, all adjustments necessary for a fair presentation have been included: March 31 June 30 Sept. 30 Dec. 31 2002 (In thousands, except for per share results) $ $ $ Interest income Net interest income Provision for loan losses Net income Earnings per common share-basic Earnings per common share-diluted Interest income Net interest income Provision for loan losses Net income Earnings per common share-basic Earnings per common share-diluted $ $ $ $ $ $ 136,716 69,271 19,801 25,650 0.49 0.49 128,750 52,474 15,000 18,786 0.39 0.39 March 31 June 30 Sept. 30 Dec. 31 2001 (In thousands, except for per share results) $ $ $ 136,348 68,523 14,501 26,979 0.51 0.50 126,178 58,101 17,800 20,172 0.43 0.43 $ $ $ $ 129,606 60,338 14,000 27,357 0.52 0.51 127,527 61,989 12,790 23,019 0.45 0.45 $ $ $ $ 137,364 68,717 14,001 27,971 0.53 0.52 133,801 63,491 15,440 24,024 0.47 0.47 $ $ $ $ Market Prices and Stock Data The Corporation’s common stock is traded in the New York Stock Exchange (NYSE) under the symbol FBP. On December 31, 2002, there were 640 holders of record of the Corporation’s common stock. The following table sets forth the high and low prices of the Corporation’s common stock for the periods indicated as reported by the NYSE. Quarter ended High Low Last 2002: December September June March 2001: December September June March 2000: December September June March $ $ $ 26.38 27.61 25.13 19.80 20.00 20.00 17.99 17.42 16.46 16.33 12.50 14.00 $ $ $ 22.08 22.82 19.13 18.43 17.07 16.00 15.32 13.00 13.67 12.00 11.13 10.83 $ 22.60 25.41 25.13 19.27 $ 19.00 17.24 17.99 17.27 $ 15.75 16.29 12.37 11.75 p r o C n a B t s r i F 47 2 0 0 2 Report of Independent Accountants 49 To the Board of Directors and Stockholders of First BanCorp. In our opinion, the accompanying consolidated statements of financial condition and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows present fairly, in all material respects, the financial position of First BanCorp. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Notes 2, 9 and 29 to the accompanying consolidated financial statements, in 2001 the Company adopted the Statement of Financial Accounting Standards No. 133, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” as amended, which effect was accounted for as a cumulative effect of a change in accounting principle. March 7, 2003 CERTIFIED PUBLIC ACCOUNTANTS (OF PUERTO RICO) License No. 216 Expires Dec. 1, 2004 Stamp 1838396 of the P.R. Society of Certified Public Accountants has been affixed to the file copy of this report p r o C n a B t s r i F 50 2 0 0 2 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION Assets Cash and due from banks Money market instruments Investment securities available for sale, at market: Securities pledged that can be repledged Other investment securities Total investment securities available for sale Investment securities held to maturity, at cost: Securities pledged that can be repledged Other investment securities Total investment securities held to maturity Federal Home Loan Bank (FHLB) stock Loans, net of allowance for loan losses of $111,911,470 (2001 - $91,060,307) Loans held for sale, at lower of cost or market Total loans Other real estate owned Premises and equipment, net Accrued interest receivable Due from customers on acceptances Other assets Total assets Liabilities and Stockholders’ Equity Liabilities: Non-interest bearing deposits Interest bearing deposits Federal funds purchased and securities sold under agreements to repurchase Advances from FHLB Bank acceptances outstanding Accounts payable and other liabilities Subordinated notes Stockholders’ equity: Preferred stock, authorized 50,000,000 shares; issued and outstanding 14,420,000 shares at $25 liquidation value per share (2001 - 10,740,000) Common stock, $1 par value, authorized 250,000,000 shares; issued 44,875,435 shares, including 14,958,383 shares issued on September 30, 2002 from a stock split (2001-29,852,552) Less: Treasury stock, including 1,640,300 shares issued on September 30, 2002 from a stock split (at par value) Common stock outstanding Additional paid-in capital Capital reserve Legal surplus Retained earnings Accumulated other comprehensive income (loss), net of tax of $11,127,054 (2001-$2,097,785) December 31, 2002 2001 $ 108,305,943 273,659,553 $ 59,898,550 34,564,568 2,379,786,252 336,987,292 2,716,773,544 541,047,654 161,558,730 702,606,384 35,629,500 5,515,185,610 10,753,585 5,525,939,195 2,938,249 87,595,569 39,282,010 304,346 150,818,003 $ 9,643,852,296 2,988,828,088 385,419,989 3,374,248,077 171,152,930 113,142,662 284,295,592 22,890,600 4,213,089,836 4,629,562 4,217,719,398 1,455,577 76,155,620 37,630,883 262,153 88,396,770 $ 8,197,517,788 $ 447,076,347 5,035,841,381 $ 239,850,816 3,858,703,322 2,793,539,832 373,000,000 304,346 112,851,285 8,762,613,191 82,815,105 2,997,173,944 343,700,000 262,153 70,547,126 7,510,237,361 84,361,525 360,500,000 268,500,000 44,875,435 (4,920,900) 39,954,535 70,000,000 149,345,178 145,243,124 33,381,163 798,424,000 29,852,552 (3,280,600) 26,571,952 14,214,877 60,000,000 136,792,514 103,132,913 (6,293,354) 602,918,902 Contingencies and commitments Total liabilities and stockholders’ equity $ 9,643,852,296 $ 8,197,517,788 The accompanying notes are an integral part of these statements. p r o C n a B t s r i F 51 2 0 0 2 CONSOLIDATED STATEMENTS OF INCOME Interest income: Loans Investment securities Short-term investments Dividends on FHLB stock Total interest income Year ended December 31, 2002 2001 2000 $ 351,838,718 185,561,056 998,710 1,634,899 540,033,383 $ 353,777,585 159,713,664 1,475,521 1,289,125 516,255,895 $ 329,007,974 132,603,596 527,155 1,248,755 463,387,480 Interest expense: Deposits Short-term borrowings Notes payable Advances from FHLB Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Other income: Other fees on loans Service charges on deposit accounts Mortgage banking activities Trading income Gain on sale of investments, net Rental income Derivatives loss, net Other operating income Total other income Other operating expenses: Employees’ compensation and benefits Occupancy and equipment Business promotion Other taxes Insurance Other Total other operating expenses Income before income tax provision and cumulative effect of accounting change Income tax provision Income before cumulative effect of accounting change Cumulative effect of accounting change, net of tax Net income Net income available to common stockholders Net income per common share basic: Income before cumulative effect of accounting change Cumulative effect of accounting change Earnings per common share basic Net income per common share diluted: Income before cumulative effect of accounting change Cumulative effect of accounting change Earnings per common share diluted Dividends declared per common share 133,234,567 117,127,270 6,797,889 16,023,967 273,183,693 266,849,690 160,758,451 97,952,979 8,904,611 12,585,108 280,201,149 236,054,746 153,283,358 105,326,693 10,803,634 3,200,940 272,614,625 190,772,855 62,301,996 61,030,000 45,718,500 204,547,694 175,024,746 145,054,355 21,440,852 9,200,327 3,540,034 12,000,487 2,285,021 (4,061,988) 14,087,218 58,491,951 59,432,111 29,015,200 9,304,277 6,857,010 2,803,905 25,343,669 132,756,172 19,631,741 9,213,436 1,562,158 9,606,314 2,292,541 10,673,633 52,979,823 54,702,977 24,991,540 7,506,040 5,973,897 2,475,411 25,204,513 120,854,378 19,913,340 8,898,170 409,011 419,367 7,850,472 2,433,664 10,108,036 50,032,060 50,014,110 22,791,863 8,468,916 5,054,748 1,846,984 24,872,883 113,049,504 130,283,473 22,327,122 107,150,191 20,133,858 82,036,911 14,761,302 107,956,351 87,016,333 67,275,609 $ $ 107,956,351 81,550,077 $ $ $ $ $ $ $ 2.04 2.04 2.01 2.01 0.40 (1,014,889) 86,001,444 69,493,246 $ $ $ $ $ 1.77 (0.03) 1.74 1.76 (0.03) 1.73 0.35 $ $ 67,275,609 59,868,067 $ $ $ $ $ 1.48 1.48 1.47 1.47 0.29 The accompanying notes are an integral part of these statements. p r o C n a B t s r i F 52 2 0 0 2 CONSOLIDATED STATEMENTS OF CASH FLOWS Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Core deposit intangible amortization Provision for loan losses Deferred income tax benefit Gain on sale of investments, net Derivative loss Net gain on sale of loans Increase (decrease) in accrued income tax payable Increase in accrued interest receivable (Decrease) increase in accrued interest payable Amortization of deferred loan (fees) costs Net origination of loans held for sale Decrease in other assets Increase (decrease) in other liabilities Total adjustments Net cash provided by operating activities Cash flows for investing activities: Principal collected on loans Loans originated Purchase of loans Proceeds from sales of loans Proceeds from sales of investment securities Purchase of securities held to maturity Purchase of securities available for sale Principal repayments and maturities of securities held to maturity Principal repayments of securities available for sale Additions to premises and equipment Net liabilities assumed on acquisition of business Purchase of FHLB stock Net cash used in investing activities Cash flows from financing activities: Net increase in deposits Net (decrease) increase in federal funds purchased Year ended December 31, 2002 2001 2000 $ 107,956,351 $ 86,001,444 $ 67,275,609 11,710,016 1,165,488 62,301,996 (8,610,812) (12,000,487) 4,522,925 (3,416,222) 3,434,149 (141,451) (1,364,672) (1,544,375) (40,264,215) 39,671,318 27,974,273 83,437,931 191,394,282 9,844,282 919,261 61,030,000 (5,402,000) (9,606,314) (1,282,845) 11,306,695 (9,661,332) 4,841,187 522,685 (4,629,562) 22,893,906 (9,395,151) 71,380,812 157,382,256 9,014,068 866,330 45,718,500 (4,356,000) (7,850,472) (19,474,679) (10,052,025) 11,677,924 (144,768) 4,657,136 20,740,407 50,796,421 118,072,030 635,765,469 (903,166,444) (734,531,121) 83,862,533 2,242,654,071 (17,031,372,741) (10,336,516,102) 16,613,061,948 8,816,493,581 (14,412,317) 73,357,625 (12,738,900) (567,542,398) 897,831,839 (1,334,581,873) (481,200,701) 42,343,060 847,716,293 (254,818,754) (12,462,323,482) 74,529,997 10,377,705,993 (13,912,556) 646,581,300 (1,222,590,263) (238,055,000) 58,452,236 (6,949,462) (5,125,184,351) 4,692,427,578 (19,153,597) (4,354,100) (2,311,064,284) (710,000) (1,215,181,559) 790,122,398 764,012,251 780,840,486 and securities sold under agreements to repurchase (202,096,134) 1,134,888,478 Decrease in other short-term borrowings FHLB advances taken Payments of notes payable Dividends Issuance of preferred stock Treasury stock acquired Exercise of stock options Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Cash and cash equivalents include: Cash and due from banks Money market instruments 29,300,000 (1,550,000) (42,372,613) 88,906,000 1,340,843 663,650,494 287,502,378 94,463,118 381,965,496 108,305,943 273,659,553 381,965,496 276,700,000 (62,000,000) (30,343,298) 100,069,250 (1,929,685) 1,355,211 2,182,752,207 29,070,179 65,392,939 94,463,118 59,898,550 34,564,568 94,463,118 $ $ $ $ $ $ 403,553,556 (152,484,084) 17,000,000 (3,125,000) (19,212,141) 72,437,500 (30,086,592) 93,750 1,069,017,475 (28,092,054) 93,484,993 65,392,939 63,372,591 2,020,348 65,392,939 $ $ $ The accompanying notes are integral part of these statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY p r o C n a B t s r i F 53 2 0 0 2 Preferred stock Common stock Additional paid-in capital Capital reserve Legal surplus Retained earnings Accumulated other comprehensive income (loss) December 31, 1999 $ 90,000,000 $ 28,060,552 $ 19,863,466 $ 40,000,000 $ 126,792,514 $ 58,834,676 $ (68,648,959) Net income Other comprehensive income Issuance of preferred stock Addition to capital reserve Treasury stock acquired Stock options exercised Cash dividends: Common stock Preferred stock December 31, 2000 Net income Other comprehensive income Issuance of preferred stock Addition to legal surplus Addition to capital reserve Treasury stock acquired Stock options exercised Cash dividends: Common stock Preferred stock December 31, 2001 Net income Other comprehensive income Issuance of preferred stock Addition to legal surplus Addition to capital reserve Stock options exercised Common stock split on September 30, 2002 Cash dividends: Common stock Preferred stock December 31, 2002 75,000,000 (2,562,500) (1,642,400) 6,000 (821,200) 87,750 10,000,000 165,000,000 26,424,152 16,567,516 50,000,000 126,792,514 103,500,000 (3,430,750) 10,000,000 10,000,000 (86,200) 234,000 (43,100) 1,121,211 268,500,000 26,571,952 14,214,877 60,000,000 136,792,514 67,275,609 (10,000,000) (27,622,992) (11,804,599) (7,407,542) 69,275,152 86,001,444 (10,000,000) (10,000,000) (1,800,385) (13,835,100) (16,508,198) 103,132,913 107,956,351 49,050,174 (19,598,785) 13,305,431 (6,293,354) 39,674,517 92,000,000 (3,094,000) 10,000,000 12,552,664 (12,552,664) (10,000,000) 64,500 1,276,343 13,318,083 (12,397,220) (920,863) (15,966,339) (26,406,274) $360,500,000 $ 39,954,535 $ – $ 70,000,000 $ 149,345,178 $145,243,124 $ 33,381,163 The accompanying notes are an integral part of these statements. p r o C n a B t s r i F 54 2 0 0 2 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Net income $107,956,351 $86,001,444 $67,275,609 Year ended December 31, 2002 2001 2000 Other comprehensive income, net of tax: Unrealized gains on securities: Unrealized holding gains arising during the period, net of tax of $16,289,254 (2001-$6,820,246; 2000-$18,312,676) Less: Reclassification adjustment for gains included in net income, net of tax of $3,000,122 (2001-$2,401,578; 2000-$1,962,618) Cumulative effect of accounting change, net of tax benefit of $331,500 Unrealized gains on securities Unrealized loss on fair value hedge attributable to credit risk, net of tax of $64,294 (2001-$315,024) Total other comprehensive income 48,867,763 20,460,738 54,938,028 (9,000,365) (7,204,736) (5,887,854) 39,867,398 994,500 14,250,502 49,050,174 (192,881) 39,674,517 (945,071) 13,305,431 49,050,174 Comprehensive income $147,630,868 $99,306,875 $116,325,783 The accompanying notes are an integral part of these statements. p r o C n a B t s r i F 55 2 0 0 2 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Nature of Business First BanCorp (the Corporation) is a financial holding company offering a full range of financial services. First BanCorp also offers insurance services through its wholly-owned insurance subsidiary, the FirstBank Insurance Agency. First BanCorp is subject to the Federal Bank Holding Company Act and its insurance subsidiary is subject to the supervision, examination and regulation of the Commissioner of Insurance of Puerto Rico. FirstBank Puerto Rico (FirstBank or the Bank), the Corporation’s wholly-owned bank subsidiary, is a commercial bank chartered under the laws of the Commonwealth of Puerto Rico. Its main office is located in San Juan, Puerto Rico, and it has 43 full-service banking branches in Puerto Rico and 11 in the U.S. and British Virgin Islands. It has 11 loan origination offices in Puerto Rico focusing on consumer loans and residential mortgage loans. The Bank, through wholly-owned subsidiaries, operates 33 offices in Puerto Rico specializing in small personal loans, finance leases, and vehicle rental. The Bank offers brokerage services in selected branches through an alliance with a national brokerage house in Puerto Rico. The Bank is subject to the supervision, examination and regulation of the Office of the Commissioner of Financial Institutions of Puerto Rico and the Federal Deposit Insurance Corporation (FDIC), which insures its deposits through the Savings Association Insurance Fund (SAIF). In October 2002, the Corporation acquired JPMorgan Chase’s Eastern Caribbean Region business in the U.S. Virgin Islands, British Virgin Islands and Barbados. In addition to branches acquired, this transaction included the acquisition of the assets of the former Chase Trade, Inc., now First Trade, Inc., and of all outstanding shares of the former Chase Agency Services, Inc., now FirstBank Insurance Agency V.I., Inc. Total assets acquired in this transaction amounted to aproximately $590 million, including aproximately $435 million in loans receivable, and total deposits amounted to aproximately $557 million. Note 2 - Summary of Significant Accounting Policies The accounting and reporting policies of the Corporation and its subsidiaries conform with accounting principles generally accepted in the United States of America, and, as such, include amounts based on judgments, estimates and assumptions made by Management that affect the reported amounts of assets and liabilities and contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Following is a description of the more significant accounting policies followed by the Corporation: Principles of consolidation The consolidated financial statements include the accounts of the Corporation and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Statements of cash flows For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and short-term money market instruments with original maturities of 90 days or less. Investment securities The Corporation classifies its investments in debt and equity securities into one of three categories: Held to maturity - Securities which the entity has the positive intent and ability to hold to maturity. These securities are carried at amortized cost. Trading - Securities that are bought and held principally for the purpose of selling them in the near term. These securities are carried at fair value, with unrealized gains and losses reported in earnings. Available for sale - Securities not classified as trading or as held to maturity. These securities are carried at fair value, with unrealized holding gains and losses, net of deferred tax effects, reported in other comprehensive income as a separate component of stockholders’ equity. Premiums and discounts are amortized as an adjustment to interest income over the life of the related securities using a method that approximates the interest method. Realized gains or losses on securities are reported in earnings. When computing realized gains or losses, the cost of securities is determined on the specific identification method. p r o C n a B t s r i F 56 2 0 0 2 Other-than-temporary impairments The Corporation evaluates for impairment its debt and equity securities when their market value has remained below cost for six months or more or earlier if other factors indicative of potential impairment exist. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. The Corporation employs a systematic methodology that considers available evidence in evaluating potential impairment of its investments. The impairment analysis on the fixed income investments is done placing special emphasis on the analysis of the cash position of the company, its cash and capital generation capacity, which could increase or diminish the company’s ability to repay its bond obligations. The Corporation also considers its intent and ability to hold the fixed income securities. If Management believes, based on the analysis, that the company will not be able to service its debt and pay its obligations on a timely manner, the security is written down to Management’s estimate of net realizable value. The equity securities impairment analyses are performed and reviewed quarterly based on the latest financial information and any supporting research report made by a major brokerage house. These analyses are very subjective and based, among other things, on relevant financial data such as capitalization, cash flow, liquidity, systematic risk, and debt outstanding. Management also considers the industry trends, the historical performance of the stock, as well as the Corporation’s intent to hold the security for an extended period. If Management believes there is a low probability of achieving book value in a reasonable time frame, then an impairment will be recorded by writing the security down to market value. Loans held for sale Loans held for sale are stated at the lower of cost or market. The amount by which cost exceeds market value in the aggregate portfolio of loans held for sale, if any, is accounted for as a valuation allowance with changes included in the determination of net income. Loans and allowance for loan losses Loans are stated at their outstanding balance less unearned interest and net deferred loan origination fees and costs. Unearned interest on installment loans (i.e., personal and auto) is recognized as income under a method, which approximates the interest method. Loans on which the recognition of interest income has been discontinued are designated as non-accruing. When loans are placed on non-accruing status, any accrued but uncollected interest income is reversed and charged against interest income. Consumer loans are classified as non-accruing when they are delinquent: 90 days or more for auto, boat and home equity reserve loans; 120 days or more for personal loans; and 180 days or more for credit cards and personal lines of credit. Commercial and mortgage loans are classified as non-accruing when they are delinquent 90 days or more. This policy is also applied to all impaired loans based upon an evaluation of the risk characteristics of said loans, loss experience, economic conditions and other pertinent factors. Loan losses are charged and recoveries are credited to the allowance for loan losses. The Corporation has defined impaired loans as loans with interest and/or principal past due 90 days or more and other specific loans for which, based on current information and events, it is probable that the debtor will be unable to pay all amounts due according to the contractual terms of the loan agreement. The Corporation measures impairment individually for those commercial and real estate loans with a principal balance exceeding $1 million. Groups of small balance, homogeneous loans are collectively evaluated for impairment. The portfolios of residential mortgage loans, consumer loans, auto loans and finance leases are considered homogeneous and are evaluated collectively for impairment. An allowance is established based on the present value of expected future cash flows or the fair value of the collateral, if the loan is collateral dependent. p r o C n a B t s r i F 57 2 0 0 2 Loan fees and costs Loan fees and costs incurred in the origination of loans are deferred and amortized using the interest method or under a method that approximates the interest method over the life of the loans as an adjustment to interest income. When a loan is paid off or sold, any unamortized net deferred fee (cost) is credited (charged) to income. Servicing assets The Corporation recognizes as separate assets the rights to service loans for others, whether those servicing assets are originated or purchased. The total cost of the loans to be sold with servicing assets retained is allocated to the servicing assets and the loans (without the servicing asset), based on their relative fair values. Servicing assets are amortized in proportion to and over the period of estimated net servicing income. Loan servicing fees, which are based on a percentage of the principal balances of the loans serviced, are credited to income as loan payments are collected. To estimate the fair value of servicing assets the Corporation considers the present value of expected future cash flows associated with the servicing assets. For purposes of measuring impairment of servicing assets, the Corporation stratifies such assets based on predominant risk characteristics of underlying loans. The amount of impairment recognized, if any, is the amount by which the servicing asset exceeds its estimated fair value. Impairment, if any, is charged against servicing income. Other real estate owned Other real estate owned, acquired in settlement of loans, is recorded at the lower of cost (carrying value of the loan) or fair value minus estimated cost to sell the real estate. Gains or losses resulting from the sale of these properties and losses recognized on the periodic reevaluations of these properties are credited or charged to net cost (gain) of operations and disposition of other real estate owned. The cost of maintaining and operating these properties is expensed as incurred. Premises and equipment Premises and equipment are carried at cost less accumulated depreciation. Depreciation is provided on the straight-line method over the estimated useful lives of the individual assets. Depreciation of leasehold improvements is computed on the straight-line method over the terms of the leases or estimated useful lives of the improvements, whichever is shorter. Costs of maintenance and repairs, which do not improve or extend the life of the respective assets are expensed as incurred. Costs of renewals and betterments are capitalized. When assets are sold or disposed of, their cost and related accumulated depreciation are removed from the accounts and any gain or loss is reflected in earnings. Securities sold under agreements to repurchase The Corporation sells securities under agreements to repurchase the same or similar securities. Generally, similar securities are securities from the same issuer, with identical form and type, similar maturity, identical contractual interest rates, similar assets as collateral and the same aggregate unpaid principal amount. The Corporation retains control over the securities sold under these agreements, accordingly, these agreements are considered financing transactions and the securities underlying the agreements remain in the asset accounts. The counter party to certain agreements may have the right to repledge the collateral by contract or custom. Such assets are presented separately in the statements of financial condition as securities pledged to creditors that can be repledged. Accounting for income taxes Deferred taxes arise because certain transactions affect the determination of income for financial reporting purposes in periods different from the period in which the transactions affect taxable income. Deferred taxes have been recorded based upon the Puerto Rico enacted tax rates. Current tax expense has been provided based upon the estimated tax liability incurred for tax return purposes. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. p r o C n a B t s r i F 58 2 0 0 2 Treasury stock The Corporation accounts for treasury stock at par value. Under this method, the treasury stock account is increased by the par value of each share of common stock reacquired. Any excess paid per share over the par value is debited to additional paid-in capital for the amount per share that it was originally credited. Any remaining excess is charged to retained earnings. Stock option plan The Corporation has a stock-based employee compensation plan, which is described more fully in Note 5. The Corporation accounts for the plan under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. The table below illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock Based Compensation, to stock-based employee compensation granted in year 2002 and 2000 (no options were granted during 2001). Pro forma information Year ended December 31, 2002 2000 (In thousands, except per share data) Employees’ compensation and benefits Net income-available to common stockholders Earnings per common share-basic Earnings per common share-diluted $ $ $ $ 61,647 79,335 1.99 1.96 $ $ $ $ 51,763 58,119 1.44 1.43 Earnings per common share Earnings per share-basic is calculated by dividing income available to common stockholders by the weighted average number of outstanding common shares. The computation of earnings per share-diluted is similar to the computation of earnings per share-basic except that the weighted average common shares are increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. Stock options outstanding under the Corporation’s stock option plan are considered in the earnings per share-diluted by application of the treasury stock method, which assumes that proceeds for the exercise of options are used to repurchase common stock in the open market. Any stock splits or stock dividends are retroactively recognized in all periods presented in financial statements. Comprehensive income Comprehensive income includes net income and several other items that current accounting standards require to be recognized outside of net income, primarily the unrealized gain (loss) on securities available for sale and the change in fair value attributable to credit risk on securities hedged with interest rate swaps, net of estimated tax effect. Derivative instruments On January 1, 2001, the Corporation adopted the Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. All derivatives are recognized in the statement of financial position at fair value. Changes in the fair value of derivative instruments are accounted for as current income or other comprehensive income, depending on their intended use and designation. For transactions that qualify for hedge accounting, SFAS No. 133 provides for a matching of the timing of gain or loss recognition on the hedging instrument with the recognition in earnings of (a) the changes in the fair value of the hedged asset or liability, that are attributable to the hedged risk (fair value hedges) or (b) the effect of the exposure to the variability of cash flows from the hedged asset or liability (cash flows hedges). Note 29 describes in more detail the hedging transactions entered into by the Corporation. p r o C n a B t s r i F 59 2 0 0 2 Acquisition of business Business combinations are accounted using the purchase method of accounting, as required by SFAS No. 141, Business Combinations. Assets acquired and liabilities assumed are recorded at estimated fair values at the date of acquisition. After initial recognition, any resulting intangible assets are accounted under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. Recently issued accounting pronouncements SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of SFAS No. 13, and Technical Corrections - In April 2002, the FASB issued SFAS No. 145, which rescinds SFAS No. 4 and amends SFAS No. 13. This amendment became effective for transactions occurring after May 15, 2002. The adoption of this statement did not have a significant impact on the Corporation’s financial statements. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities - In June 2002, the FASB issued SFAS No. 146, which requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002. Management expects that the adoption of this statement will not have a significant impact on the Corporation’s financial statements. SFAS No. 147, Acquisitions of Certain Financial Institutions - In October 2002, effective immediately, the FASB issued SFAS No. 147, which requires financial acquisitions of financial institutions to be accounted for in accordance with FASB Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. In addition, SFAS No. 147 amends FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor and borrower relationship intangible assets and credit cardholder intangible assets. The adoption of SFAS No. 147 did not have an impact on the Corporation’s financial statements. SFAS No. 148, Accounting for Stock-Based Compensation- Transition and Disclosure an amendment of FASB Statement No. 123- In December 2002, the FASB issued SFAS No. 148, which provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. All required disclosures under SFAS No. 123, as amended by SFAS No. 148, are included in these financial statements. The Corporation has not adopted the fair value method for recognition of stock based compensation. FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees - In November 2002, the FASB issued this interpretation, which requires a guarantor of certain types of guarantees to recognize, at the inception of guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. These provisions for initial recognition are effective for guarantees that are issued or modified after December 31, 2002. In the case of the Corporation, these provisions apply for the standby letters of credit. See Note 29 for details of the letters of credit outstanding as of December 31, 2002. The adoption of this interpretation will not have a significant effect in the Corporation’s financial statements. Note 3 - Stockholders’ Equity Common stock On August 27, 2002, the Corporation declared a three for two (or 50%) stock split on its 26,636,452 outstanding shares of common stock at September 13, 2002. As a result, a total of 14,958,383 additional shares of common stock were issued on September 30, 2002, of which 1,640,300 shares were recorded as treasury stock. All per share amounts have been adjusted for the effect of the stock split in the third quarter of 2002. Stock repurchase plan and treasury stock The Corporation has a stock repurchase program under which from time to time it repurchases shares of common stock in the open market and hold them as treasury stock. Under this program, the Corporation repurchased a total of 86,200 shares of common stock at a cost of $1,929,685 during 2001, and 1,642,400 shares of common stock at a cost of $30,086,592 during 2000. No shares of common stock were repurchased during 2002. From the total amount of common stock repurchased, 4,920,900 shares, as adjusted for September 30, 2002 stock split, were held as treasury stock at December 31, 2002 (2001 - 3,280,600 shares) and were available for general corporate purposes. Preferred stock p r o C n a B t s r i F 60 The Corporation has 50,000,000 shares of authorized non-cumulative and non-convertible preferred stock with a par value of $1, redeemable at the Corporation’s option subject to certain terms. This stock may be issued in series and the shares of each series shall have such rights and preferences as shall be fixed by the Board of Directors when authorizing the issuance of that particular series. During 2002, the Corporation issued 3,680,000 shares of preferred stock (2001-4,140,000 shares; 2000-3,000,000 shares; 1999-3,600,000 shares). The liquidation value per share is $25. Annual dividends of $1.8125 per share (issuance of 2002), $1.85 per share (issuance of 2001), $2.0875 per share (issuance of 2000) and of $1.78125 per share (issuance of 1999), are payable monthly, if declared by the Board of Directors. During the year, dividends declared on preferred stock amounted to $26,406,274 (2001 - $16,508,198; 2000 - $7,407,542). 2 0 0 2 Capital reserve The capital reserve account was established to comply with certain regulatory requirements of the Office of the Commissioner of Financial Institutions of Puerto Rico related to the issuance of subordinated notes by FirstBank in 1995. An amount equal to 10% of the principal of the notes is set aside each year from retained earnings until the reserve equals the total principal amount. At the notes repayment date the balance in capital reserve is to be transferred to the legal surplus account or retained earnings after the approval of the Commissioner of Financial Institutions of Puerto Rico. Legal surplus The Banking Act of the Commonwealth of Puerto Rico requires that a minimum of 10% of FirstBank’s net income for the year be transferred to legal surplus, until such surplus equals the total of paid in capital on common and preferred stock. Amounts transferred to the legal surplus account from the retained earnings account are not available for distribution to the stockholders. Note 4 - Regulatory Capital Requirements The Corporation is subject to various regulatory capital requirements imposed by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation’s capital amounts and classification are also subject to qualitative judgment by the regulators about components, risk weightings and other factors. Capital standards established by regulations require the Corporation to maintain minimum amounts and ratios of Tier 1 capital to total average assets (leverage ratio) and ratios of Tier 1 and total capital to risk-weighted assets, as defined in the regulations. The total amount of risk-weighted assets is computed by applying risk-weighting factors to the Corporation’s assets and certain off-balance sheet items, which vary from 0% to 100% depending on the nature of the asset. At December 31, 2002 and 2001, the most recent notification from FDIC, categorized the Corporation as a well-capitalized institution under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Corporation must maintain minimum total risk based, Tier 1 risk based and Tier 1 leverage ratios as set forth in the following table. Management believes that there are no conditions or events since that date that have changed that classification. p r o C n a B t s r i F 61 2 0 0 2 The Corporation’s and its banking subsidiary’s regulatory capital positions were as follows: Actual Amount Ratio Regulatory Requirements For capital adequacy purposes Amount Ratio (Dollars in thousands) To be well capitalized Ratio Amount $816,946 739,996 13.75% 12.50% $475,155 473,617 $707,083 632,487 11.90% 10.68% $237,578 236,809 $707,083 632,487 7.35% 6.62% $288,628 286,801 $678,679 590,652 14.50% 12.75% $374,498 370,472 $569,255 481,850 12.16% 10.41% $187,249 185,236 $569,255 481,850 7.49% 6.40% $228,074 225,738 8% 8% 4% 4% 3% 3% 8% 8% 4% 4% 3% 3% $593,944 592,022 10% 10% $356,366 355,213 $481,046 478,002 6% 6% 5% 5% $468,123 463,090 10% 10% $280,874 277,854 6% 6% $380,124 376,231 5% 5% At December 31, 2002 Total Capital (to Risk-Weighted Assets): First BanCorp FirstBank Tier I Capital (to Risk-Weighted Assets): First BanCorp FirstBank Tier I Capital (to Average Assets): First BanCorp FirstBank At December 31, 2001 Total Capital (to Risk-Weighted Assets): First BanCorp FirstBank Tier I Capital (to Risk-Weighted Assets): First BanCorp FirstBank Tier I Capital (to Average Assets): First BanCorp FirstBank Note 5 - Stock Option Plan The Corporation has a stock option plan covering certain employees. The options granted under the plan cannot exceed 20% of the number of common shares outstanding. Each option provides for the purchase of one share of common stock at a price not less than the fair market value of the stock on the date the option is granted. Stock options are fully vested upon issuance. The maximum term to exercise the options is ten years. The stock option plan provides for a proportionate adjustment in the exercise price and the number of shares that can be purchased in the event of a stock dividend, stock split, reclassification of stock, merger or reorganization and certain other issuance and distributions. Management uses the Black-Scholes option pricing model for the computation of the estimated fair value of each option granted to buy shares of the Corporation’s common stock (refer to Note 2 for accounting policy). The fair value of each option granted during 2002 and 2000 (no options were granted during 2001) was estimated using the following assumptions: weighted dividend growth of 20% (2002) and 0% (2000); expected life of 3.29 years (2002) and 3.11 years (2000); weighted expected volatility of 31.76% (2002) and 31.74% (2000); and weighted risk-free interest rate of 3.66% (2002) and 5.36% (2000). The weighted estimated fair value of the options granted was $4.08 (2002) and $3.67 (2000) per option, as adjusted for the September 2002 stock split. Following is a summary of the activity related to stock options, adjusted to reflect the stock split of September 30, 2002: p r o C n a B t s r i F 62 2 0 0 2 At December 31, 1999 Granted Exercised Canceled At December 31, 2000 Exercised Canceled At December 31, 2001 Granted Exercised At December 31, 2002 Number of Options 1,449,750 477,000 (9,000) (10,500) 1,907,250 (351,000) (3,000) 1,553,250 542,750 (96,750) 1,999,250 Weighted Average Exercise Price per Option $ 11.38 $ 14.87 $ 10.42 $ 17.33 $ 12.24 $ 3.86 $ 18.92 $ 14.12 $ 18.96 $ 13.86 $ 15.44 The exercise price of the options outstanding at December 31, 2002, as adjusted for September 2002 stock split, ranges from $10.42 to $25.99 and the weighted average remaining contractual life is approximately seven years. Following is additional information concerning the stock options outstanding at December 31, 2002. Number of Options Exercise Price per Option 300,000 75,000 60,000 18,000 261,000 3,000 5,250 270,750 465,000 521,250 20,000 1,999,250 $ 10.42 $ 12.79 $ 18.06 $ 17.71 $ 17.33 $ 17.29 $ 17.63 $ 13.08 $ 14.88 $ 18.69 $ 25.99 Contractual Maturity November 2007 2008 February May 2008 2008 June November 2008 2009 February April 2009 November 2009 December 2010 2012 February 2012 October p r o C n a B t s r i F 63 2 0 0 2 Note 6 - Earnings Per Common Share The calculations of earnings per common share for the years ended December 31, 2002, 2001 and 2000 follow: Year ended December 31, 2002 2001 (In thousands, except per share data) 2000 Net income Less: Preferred stock dividend Net income-attributable to common stockholders $ 107,956 (26,406) $ 81,550 Earnings per common share-basic: Net income - available to common stockholders Weighted average common shares outstanding Earnings per common share-basic $ 81,550 39,901 2.04 $ $ $ $ $ 86,001 (16,508) 69,493 $ 67,276 (7,408) $ 59,868 69,493 39,851 1.74 $ 59,868 40,415 1.48 $ Earnings per common share-diluted: Net income - available to common stockholders Weighted average common shares and share equivalents: Average common shares outstanding Common stock equivalents - Options Total Earnings per common share-diluted: $ 81,550 $ 69,493 $ 59,868 39,901 652 40,553 2.01 $ 39,851 293 40,144 1.73 $ 40,415 303 40,718 1.47 $ The earnings per share for prior years have been restated to reflect the effect of the stock split in the third quarter of 2002. The 2001 earnings per common share basic and diluted are net of cumulative effect of change in accounting principle. Stock options outstanding, under the Corporation’s stock option plan for officers, are common stock equivalents and, therefore, considered in the computation of earnings per common share diluted. Common stock equivalents were computed using the treasury stock method. In 2002, 20,000 stock options (2001-10,500, 2000-858,750) were not included in the computation of outstanding shares because they were antidilutive. These amounts have been adjusted for 2002 stock split. Note 7 - Cash and Due from Banks The Corporation is required by law to maintain minimum average reserve balances. The amount of those average reserve balances was approximately $93,263,632 at December 31, 2002 (2001 - $46,078,200). Note 8 - Investment Securities Held For Trading At December 31, 2002 and 2001, there were no securities held for trading purposes or options on such securities. All trading instruments are subject to market risk, the risk that future changes in market conditions, such as fluctuations in market prices or interest rates, may make an instrument less valuable or more onerous. The instruments are accounted for at market value, and their changes are reported directly in earnings. The Corporation may write options on trading securities as part of its trading activities. Also the Corporation may enter in transactions of securities sold not yet purchased for trading purposes. These transactions are carried at market value. Net gains and losses resulting from these transactions are recorded in the trading income or loss account. The net gain from the sale of trading securities amounted to $419,367 for the year ended December 31, 2000, and was included in earnings as trading income. No trading activities were recorded during 2002 and 2001. p r o C n a B t s r i F 64 2 0 0 2 Note 9 - Investment Securities Held To Maturity The amortized cost, gross unrealized gains and losses, approximate market value, weighted average yield and final maturities of investment securities held to maturity at December 31, 2002 and 2001 were as follows: December 31, 2002 December 31, 2001 Amortized cost Gross Unrealized gains losses Market value Weighted average Amortized yield% cost Gross Unrealized losses gains Weighted Market average yield% value (Dollars in thousands) Obligations of other U.S. Government Agencies: After 10 years Puerto Rico Government Obligations: After 1 to 5 years After 10 years United States and Puerto Rico Government obligations Corporate bonds: Due within 1 year After 1 to 5 years Corporate bonds Total Investment Securities Held to Maturity $ 628,820 $3,307 $59 $632,068 7.85 $ 211,194 $3 $ 6,466 $204,731 7.39 5,000 4,354 113 586 5,113 4,940 5.00 6.50 5,000 4,084 228 5,000 4,312 5.00 6.50 $ 638,174 $4,006 $59 $642,121 7.82 $ 220,278 $231 $ 6,466 $214,043 7.32 $ 25,000 39,432 $ 64,432 $ 25,000 38,823 $ 63,823 $609 $609 3.05 2.95 2.98 $ 64,018 $ 64,018 63,741 $ 277 $ 277 $ 63,741 3.49 3.49 $ 702,606 $4,006 $668 $705,944 7.38 $ 284,296 $231 $ 6,743 $277,784 6.46 Expected maturities of investments might differ from contractual maturities because they may be subject to prepayments and / or call options. At January 1, 2001, in connection with the adoption of SFAS No. 133, the Corporation transferred a portfolio of $207 million of GNMA certificates held to maturity into the available for sale category. The unrealized gain of $994,500, net of taxes, was reflected in other comprehensive income as a cumulative effect of the change in accounting principle. Note 10 - Investment Securities Available For Sale The amortized cost, gross unrealized gains and losses, approximate market value, weighted average yield and final maturities of investment securities available for sale at December 31, 2002 and 2001 were as follows: December 31, 2002 Gross Unrealized gains losses Amortized cost Market value Weighted average Amortized yield% cost (Dollars in thousands) December 31, 2001 Gross Unrealized gains losses Market value Weighted average yield% $ 7,726 $ 30 $ 7,756 3.18 $ 500 $ 750 15,568 4,999 5,679 3 17 480 375 401 407,324 $ 32 407,292 1.72 $ 503 767 16,048 3.87 5.60 7.69 500 87,519 5,374 6,080 6.27 6.30 4,458 5,932 1 469 128 151 1,805 501 86,183 5.59 7.55 4,586 6,083 6.19 6.34 $ 27,496 $ 1,276 $ 28,772 7.02 $ 513,459 $ 779 $ 1,837 $ 512,401 2.83 U.S. Treasury Securities: Within 1 year Obligations of other U.S. Government Agencies: Within 1 year After 1 to 5 years After 5 to 10 years After 10 years Puerto Rico Government Obligations: After 5 to 10 years After 10 years United States and Puerto Rico Government Obligations p r o C n a B t s r i F 65 2 0 0 2 Mortgage Backed Securities: FHLMC certificates: Within 1 year After 1 to 5 years After 5 to 10 years After 10 years $ 1,458 $ 8,211 6,347 16,016 GNMA certificates: After 5 to 10 years After 10 years 3,608 524,278 527,886 82 613 358 1,053 170 9,439 9,609 53 39,523 39,576 $ 1,540 8,824 6,705 17,069 3,778 533,717 537,495 29 5 817 1,955,983 1,956,834 6.47 7.42 6.86 7.11 6.41 5.11 5.12 6.33 7.68 7.66 4.93 4.93 $ 8 112 $ 13,211 8,030 21,361 4 576 172 $ 752 $ 6 6 116 8 5.85 7.63 7.29 6.95 7.16 13,787 8,196 22,107 4,605 2,515,953 2,520,558 101 12,672 12,773 6,539 6,539 4,706 2,522,086 2,526,792 158 124 7,095 7,377 4 5 408 417 162 129 7,503 7,794 6.39 6.52 6.52 6.92 7.32 7.96 7.93 29 5 764 1,916,460 1,917,258 1,175 32 1,207 7.23 1,958 38 1,996 8.70 $ 2,462,335 $ 50,270 $2,512,605 4.99 $ 2,551,254 $13,980 $6,545 $ 2,558,689 6.53 $ $ $ 979 $ 36 $ 85,711 57,276 1,244 $ 10,865 1,084 445 1,015 76,090 56,637 7.87 $ 6.16 6.94 143,966 $ 1,725 $ 11,949 $ 133,742 6.48 $ 19,246 $ 410 $ 19,656 118,919 114,855 18,531 1,770 $ 2,899 1,906 117,790 113,026 18,859 271,551 $ 2,585 $ 4,805 $ 269,331 77 328 7.70 6.68 7.34 7.35 7.08 36,951 $ 10,006 $ 5,302 $ 41,655 1.72 $ 45,115 $ 4,901 $16,189 $ 33,827 1.43 $ 2,670,748 $ 63,277 $ 17,251 $2,716,774 5.04 $ 3,381,379 $22,245 $29,376 $ 3,374,248 5.95 FNMA certificates: Within 1 year After 1 to 5 years After 5 to 10 years After 10 years Mortgage pass through certificates: After 10 years Mortgage Backed Securities Corporate Bonds: Within 1 year After 1 to 5 years After 5 to 10 years After 10 years Corporate bonds Equity securities (without contractual maturity) Total Investments Securities Available for Sale p r o C n a B t s r i F 66 2 0 0 2 Maturities for mortgage backed securities are based upon contractual terms assuming no repayments. The weighted average yield on investment securities held for sale is based on amortized cost; therefore, it does not give effect to changes in fair value. During 2002, the Corporation’s bank subsidiary restructured its portfolio of mortgage backed securities available for sale in order to shorten its duration and reduce its prepayment risk. As a result, in late June and early July of 2002, approximately $1 billion of 30-year mortgage backed securities were sold. The sales derived a gain of $14 million. The securities sold were substantially substituted with $900 million of 15-year mortgage backed securities, which have a lower average life and yield, and which value is less sensitive to increases in interest rates. In addition, in September and October, the Corporation sold its 7% GNMA portfolio of approximately $964 million to substitute with lower coupons. The sales derived a gain of $26.1 million. These securities were substituted in November with $1 billion FNMA’s 15 years. It is the Corporation’s policy to invest in corporate bonds, which at the time of the purchase, are of an investment grade quality. The total carrying amount of the corporate bonds portfolio is $198 million, or approximately 5% of total investments of the Corporation as of December 31, 2002. In 2002, two of the bonds in FirstBank’s portfolio were downgraded, to non-investment grade quality by two credit rating agencies. These were, WorldCom Corporation, $15.5 million outstanding at the time of the downgrade and Nortel Networks Corporation, $23.5 million outstanding at the time of the downgrade. Management’s impairment analysis on these securities concluded that an other-than-temporary impairment of approximately $11.7 million had occurred in the case of the WorldCom Corporation bonds. The estimated impairment amount of this security was recognized as a loss in the statement of income. In addition, Management reclassified to non-accruing status the remaining carrying amount of $3.8 million. Management’s impairment analysis concluded that no other-than-temporary impairment existed on Nortel’s bonds. The unrealized loss of the Nortel’s bonds at December 31, 2002 approximated $8.5 million. At December 31, 2002, the Corporation’s equity securities portfolio carrying amount is $41.7 million, and its adjusted cost is $37 million. The Corporation’s current policy guidelines limit investments in equity securities to $60 million, which is 1.6% of the Corporation’s total investments as of December 31, 2002. The Corporation invests in equity securities that have long-term appreciation prospects. During the year ended on December 31, 2002, the Corporation recognized a loss of $25.2 million for other-than-temporary impairment on equity securities. At December 31, 2002, these securities have not been sold. Management determined that except for the impairments on the bonds and stocks mentioned above, there are no other-than-temporary impairments on the rest of the bonds and equity securities portfolio. Management will continue its ongoing monitoring of the Corporation’s investment on individual corporate bonds and equity securities to identify any other-than-temporary impairment. At December 31, 2002, the net unrealized gain of $34,519,114 (2001 - net unrealized loss of $5,348,283) on securities available for sale, net of the deferred income tax of $11,506,371 (2001 - $1,782,761), was reported as part of accumulated other comprehensive income. For 2002, the change in the net unrealized holding gain on the available for sale securities amounted to $53,156,531 (2001 - a gain of $19,000,669) before deferred income taxes. For 2002, proceeds from the sale of securities amounted to $2,243 million (2001 - $847.7 million, 2000 - $58.5 million) resulting in gross realized gains of $49.7 million (2001 - $13.6 million, 2000 -$7.9 million), and gross realized losses on sale of investments and impairments of $37.7 million (2001 - $4 million). No losses were realized during 2000. Note 11 - Federal Home Loan Bank (FHLB) Stock At December 31, 2002 and 2001, there were investments in FHLB stock with book value of $35,629,500 and $22,890,600 respectively. The estimated market value of such investments is its redemption value. Note 12 - Interest and Dividend on Investments A detail of interest and dividend income on investments follows: Mortgage Backed Securities: Taxable Exempt Other Investment Securities: Taxable Exempt Note 13 - Loans Receivable The following is a detail of the loan portfolio: Residential real estate loans: Secured by first mortgages: Conventional Insured by government agencies: Federal Housing Administration and Veterans Administration Puerto Rico Housing Bank and Finance Agency Secured by second mortgages Deferred net loan fees Residential real estate loans Commercial loans: Construction loans Commercial loans Commercial mortgage Commercial loans Finance leases Consumer and other loans: Personal Personal lines of credit Auto Boat Credit card Home equity reserve loans Unearned interest Consumer and other loans Loans receivable Allowance for loan losses Loans receivable, net Loans held for sale Total loans 2002 Year ended December 31, 2001 (In thousands) 2000 $ 3,765 117,338 $ 121,103 $ 3,079 64,013 $ 67,092 $ 2,666 106,571 $ 109,237 $ $ 2,639 50,602 53,241 $ 3,325 91,416 $ 94,741 $ 1,577 38,060 $ 39,637 p r o C n a B t s r i F 67 2 0 0 2 2002 December 31, 2001 (In thousands) $1,778,046 $955,573 41,805 19,060 7,650 1,846,561 (3,247) 1,843,314 259,053 1,418,792 813,513 2,491,358 143,412 413,931 10,401 565,478 53,017 164,172 4,566 (62,553) 1,149,012 5,627,096 (111,911) 5,515,185 10,754 $5,525,939 25,211 23,513 8,088 1,012,385 (5,107) 1,007,278 219,396 1,238,173 688,922 2,146,491 127,935 362,490 11,216 502,902 39,570 176,226 1,851 (71,810) 1,022,445 4,304,149 (91,060) 4,213,089 4,630 $4,217,719 The Corporation’s primary lending area is Puerto Rico. At December 31, 2002 and 2001 there is no significant concentration of credit risk in any specific industry on the loan portfolio. At December 31, 2002, loans in which the accrual of interest income had been discontinued amounted to $91,765,000 (2001 - $72,998,000; 2000 - $67,716,000). If these loans had been accruing interest, the additional interest income realized would have been approximately $5,833,000 (2001 - $5,735,000; 2000 - $5,937,000). There are no material commitments to lend additional funds to borrowers whose loans were in non-accruing status at these dates. At December 31, 2002 mortgage loans held for sale amounted to $10.8 million (2001-$4.6 million). p r o C n a B t s r i F 68 2 0 0 2 At December 31, 2002, the Corporation was servicing residential mortgage loans owned by others aggregating approximately $196,748,000 (2001 - $160,583,000; 2000 - $144,805,000). Various loans secured by first mortgages were assigned as collateral for term notes, certificates of deposit, advances from the Federal Home Loan Bank, and unused lines of credit. The mortgage loans pledged as collateral amounted to $778,829,294 and $195,267,091 at December 31, 2002 and 2001, respectively. Note 14 - Allowance for Loan Losses The changes in the allowance for loan losses were as follows: Balance at beginning of period Provision charged to income Losses charged against the allowance Recoveries credited to the allowance Other adjustments Balance at end of period Year ended December 31, 2002 $ 91,060 62,302 (48,991) 7,540 $ 111,911 2001 (In thousands) $ 76,919 61,030 (54,380) 7,391 100 $ 91,060 2000 $ 71,784 45,719 (51,831) 9,807 1,440 $ 76,919 At December 31, 2002, $27 million ($10.7 million at December 31, 2001) in commercial and real estate loans over $1,000,000 were considered impaired with an allowance of $5.9 million ($3.7 million at December 31, 2001), which was established based on the fair value of the collateral. For 2001, $2 million of the allowance on impaired loans was established based on the fair value of the collateral and $1.7 million was established based on the present value of expected future cash flows. The average recorded investment in impaired loans amounted to $18.9 million for 2002 (2001 - $11.9 million). Interest income in the amount of approximately $803,000 was recognized on impaired loans in 2002 (2001 -$377,000; 2000 - $227,000). Note 15 - Related Party Transactions The Corporation granted loans to its directors, executive officers and to certain related individuals or entities in the ordinary course of business. The movement and balance of these loans were as follows: Balance at December 31, 2000 New loans Payments Balance at December 31, 2001 New loans Payments Balance at December 31, 2002 Amount (In thousands) $ 20,174 14,659 (170) $ 34,663 48,784 (1,943) $ 81,504 Note 16 - Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation as follows: Land Buildings and improvements Leasehold improvements Furniture and equipment Accumulated depreciation Projects in progress Total premises and equipment, net Note 17 - Intangible Assets Useful life in years 10-40 1-15 3-10 December 31, 2002 (In thousands) $ $ 8,203 41,918 20,436 94,675 165,232 (87,083) 78,149 9,447 87,596 December 31, 2001 $ 7,357 39,809 14,753 62,466 124,385 (55,001) 69,384 6,772 $ 76,156 p r o C n a B t s r i F 69 2 0 0 2 At December 31, 2002, the Corporation has a core deposit intangible with a carrying amount of $20,807,539 (2001-$7,199,439) included in the Other Assets category. Increase in this category represents the recognition of an intangible asset as part of the acquisition of the JP Morgan Chase’s Eastern Caribbean Region business. The straight-line amortization expense for the year ended December 31, 2002 amounted to approximately $1,165,000. The estimated aggregate amortization expense for each of the five succeeding fiscal years will be approximately $2,400,000. Management has reviewed the core deposits intangible assets concluding that no impairment is necessary and that the useful life of ten years used to amortize them is the best estimate of the economic benefit period. Note 18 - Deposits and Related Interest Deposits and related interest consist of the following: December 31, December 31, 2002 2001 (In thousands) Type of account and interest rate: Savings accounts - 1.25% to 2.25% (2001 - 2.25% to 3.50%) Interest bearing checking accounts - 1.15%to 2.00% (2001 - 2.25% to 3.05%) Non-interest bearing checking accounts Certificate accounts - 1.00% to 7.50% (2001 - 2.00% to 7.50%) $ 921,103 230,743 447,076 3,883,996 $ 5,482,918 $ 469,452 205,760 239,851 3,183,491 $ 4,098,554 The weighted average interest rate on total deposits at December 31, 2002 and 2001 was 2.58% and 3.82%, respectively. At December 31, 2002, the aggregate amount of overdraft in demand deposits that were reclassified as loans amounted to $7,281,895 (2001 - $7,807,724). The following table presents a summary of certificates of deposits with remaining term of more than one year at December 31, 2002: Over one year to two years Over two years to three years Over three years to four years Over four years to five years Over five years Total Total (In thousands) $ 258,698 162,066 341,276 199,752 1,814,983 $ 2,776,775 At December 31, 2002 certificates of deposit (CD’s) in denominations of $100,000 or higher amounted to $3,379,748,775 (2001 - $2,669,536,603) including brokered certificates of deposit of $2,645,909,222 (2001 - $2,189,687,222) at a weighted average rate of 2.64%, after hedging (2001 - 4.0%). See Note 29 for a description of the program used to hedge the fair value of the brokered certificates of deposit. At December 31, 2002, deposit accounts issued to government agencies with a carrying value of $220,869,357 (2001 - $63,639,152) were collateralized by securities with a carrying value of $259,433,606 (2001 - $75,126,925) and estimated market value of $263,467,485 (2001 - $71,979,923), by specific mortgage loans with a carrying value of $2,416,677 (2001 - $2,895,723) and estimated market value of $3,010,938 (2001 - $3,370,043) and by municipal obligations with a carrying value and estimated market value of $27,810,000. A table showing interest expense on deposits follows: p r o C n a B t s r i F 70 2 0 0 2 Savings Interest bearing checking accounts Certificates of deposit Total Year ended December 31, 2002 $ 15,096 4,763 113,376 $ 133,235 2001 (In thousands) $ 12,954 5,296 142,508 $ 160,758 2000 $ 12,792 5,546 134,945 $ 153,283 Note 19 - Federal Funds Purchased and Securities Sold Under Agreements to Repurchase Federal funds purchased and securities sold under agreements to repurchase (repurchase agreements) consist of the following: Federal funds purchased, interest rate 1.80% Repurchase agreements, interest ranging from 1% to 5.37% (2001 - 1.25% to 6.09%) Accrued interest payable Total 2002 December 31, 2001 (In thousands) $ 2,784,078 9,462 $ 2,793,540 $ 10,000 2,976,174 11,000 $ 2,997,174 The weighted average interest rates of federal funds purchased and repurchase agreements at December 31, 2002 and 2001 was 3.82% and 4.05%, respectively. Federal funds purchased and repurchase agreements mature as follows: One to thirty days Over thirty to ninety days Over ninety days to one year Over one year Total December 31, 2002 2001 (In thousands) $ 708,924 194 2,074,960 $ 2,784,078 $ $ 723,010 14,062 274,142 1,974,960 2,986,174 The following securities were sold under agreements to repurchase: Underlying securities U.S. Treasury Securities and obligations of other U.S. Government Agencies P.R. Government Securities Mortgage backed securities Corporate bonds Total December 31, 2002 Amortized cost of underlying securities Balance of borrowing Approximate market value of underlying securities Weighted average interest rate (In thousands) $ 718,886 290 2,248,037 130,525 $ 3,097,738 $ 646,095 260 2,020,414 117,309 $ 2,784,078 $ 721,216 324 2,293,031 130,523 $ 3,145,094 5.70% 6.48% 5.67% 5.20% p r o C n a B t s r i F 71 2 0 0 2 Accrued interest receivable $ 12,257 Underlying securities U.S. Treasury Securities and obligations of other U.S. Government Agencies Mortgage backed securities Corporate bonds Total Amortized cost of underlying securities December 31, 2001 Balance of borrowing Approximate market value of underlying securities Weighted average interest rate (In thousands) $ 506,685 2,441,777 262,648 $ 3,211,110 $ 392,081 2,380,851 203,242 $ 2,976,174 $ 515,447 2,389,645 260,542 $ 3,165,634 3.80% 6.70% 7.17% Accrued interest receivable $ 15,715 The maximum aggregate balance outstanding at any month-end during 2002 was $3,342,284,753 (2001 - $2,986,174,065). The average balance during 2002 was approximately $2,784,701,323 (2001 - $1,997,705,000). At December 31, 2002 and 2001, the securities underlying such agreements were delivered to, and are being held by the dealers with which the repurchase agreements were transacted, except for transactions where the Corporation has agreed to repurchase similar but not identical securities. Note 20 - Advances From The Federal Home Loan Bank (FHLB) Following is a detail of the advances from the FHLB: Maturity January 2, 2002 January 13, 2003 August 16, 2005 October 9, 2008 October 16, 2008 February 28, 2011 March 21, 2011 Interest rate December 31, 2002 (In thousands) 1.85% 1.44% 6.30% 5.10% 5.09% 4.50% 4.42% $ 50,000 50,000 14,000 15,000 79,000 165,000 $ 373,000 2001 $ 20,700 50,000 14,000 15,000 79,000 165,000 $ 343,700 p r o C n a B t s r i F 72 2 0 0 2 Advances are received from the FHLB under an Advances, Collateral Pledge and Security Agreement (the Collateral Agreement). Under the Collateral Agreement, the Corporation is required to maintain a minimum amount of qualifying mortgage collateral with a market value at least 110% of the outstanding advances. At December 31, 2002, specific mortgage loans with an estimated value of $553,144,554 (2001 - $197,506,039), as computed by Federal Home Loan Bank for collateral purposes, were pledged to the FHLB as part of the Collateral Agreement. The carrying value of such loans at December 31, 2002 amounted to $776,412,617 (2001 - $192,371,368). In addition, securities with an approximated market value of $26,587,830 (2001 - $145,140,574) and a carrying value of $29,149,623 (2001 - $158,117,351) were pledged to the FHLB. Note 21 - Subordinated Notes On December 20, 1995, the Corporation issued 7.63% subordinated capital notes in the amount of $100,000,000 maturing in 2005. The notes were issued at a discount. At December 31, 2002 the outstanding balance net of the unamortized discount and notes repurchased was $82,815,105 (2001 - $84,361,525). Interest on the notes is payable semiannually and at maturity. The notes represent unsecured obligations of the Corporation ranking subordinate in right of payment to all existing and future senior debt including the claims of depositors and other general creditors. The notes may not be redeemed prior to their maturity. At December 31, 2002, the Corporation has transferred to capital reserves from the retained earnings account $70,000,000 as a result of the requirement explained in Note 3 - “Stockholders’ Equity.” Note 22 - Unused Lines Of Credit The Corporation maintains unsecured standby lines of credit with other banks. At December 31, 2002 and 2001, the Corporation’s total unused lines of credit with these banks amounted to approximately $180,000,000. At December 31, 2002, the Corporation has an available line of credit with the FHLB guaranteed with excess collateral, in the amount of $206,732,384. Note 23 - Employees’ Benefit Plan FirstBank provides contributory retirement plans pursuant to Section 1165(e) of the Puerto Rico Internal Revenue Code for Puerto Rico employees and Section 401(K) of the U.S. Internal Revenue Code for U.S.V.I. employees. All employees are eligible to participate in the Plan after one year of service. Under the provisions of the Plan, the Bank contributes a quarter of the first 4% of each participant’s compensation. Participants are permitted to contribute up to 10% of their annual compensation, limited to $8,000 per year ($11,000 for U.S.V.I. employees). Additional contributions to the Plan are voluntarily made by the Bank as determined by its Board of Directors. The Bank made a total contribution of $861,478, $845,227 and $699,060 during 2002, 2001 and 2000 respectively, to the Plan. Note 24 - Other Expenses A detail of other expenses follows: Professional and service fees Communications Revenue earning equipment Supplies and printing Other Total 2002 $ 7,685 5,865 1,588 1,963 8,243 $ 25,344 Year ended December 31, 2001 (In thousands) $ 7,461 5,395 1,578 1,282 9,489 $ 25,205 2000 $ 8,406 5,573 1,525 1,214 8,155 $ 24,873 p r o C n a B t s r i F 73 2 0 0 2 Note 25 - Income Taxes The Corporation is subject to Puerto Rico income tax on its income from all sources. For United States income tax purposes, the Corporation is treated as a foreign corporation. Accordingly, it is generally subject to United States income tax only on its income from sources within the United States or income effectively connected with the conduct of a trade or business within the United States. Any United States income tax paid by the Corporation is creditable, within certain conditions and limitations, as a foreign tax credit against its Puerto Rico tax liability. The provision for income taxes was as follows: Current Deferred Total 2002 $ 30,938 (8,611) $ 22,327 Year ended December 31, 2001 (In thousands) $ 25,536 (5,402) $ 20,134 2000 $ 19,117 (4,356) $ 14,761 Income tax expense applicable to income before provision for income tax differs from the amount computed by applying the Puerto Rico statutory rate of 39% as follows: 2002 % of pre-tax Amount Income Year ended December 31, 2001 % of pre-tax Amount (Dollars in thousands) Income 2000 % of pre-tax Amount Income $ $ 50,811 (31,819) 3,335 22,327 39 (24) 2 17 $ $ 41,789 (24,442) 2,787 20,134 39 (23) 3 19 $ $ 31,994 (12,707) (4,526) 14,761 39 (15) (6) 18 Computed income tax at statutory rate Benefit of net exempt income Other-net Total income tax provision The components of the deferred tax asset and liability were as follows: December 31, 2002 2001 (In thousands) Deferred tax asset: Allowance for loan losses Unrealized loss on available for sale securities Unrealized loss on fair value hedges attributable to credit risk Other Deferred tax asset Deferred tax liability: Unrealized gain on available for sale securities Other Deferred tax liability $ 43,645 379 6,584 $ 50,608 $(11,506) (98) $(11,604) $ 34,732 1,783 315 7,110 $ 43,940 $ $ (322) (322) No valuation allowance was considered necessary for the deferred tax asset. The tax effect of the unrealized holding gain or loss for securities available for sale was computed based on a 25% capital gain tax rate, and is included in accumulated other comprehensive income as a part of stockholders’ equity. p r o C n a B t s r i F 74 2 0 0 2 The Puerto Rico Treasury Department is conducting an investigation of the Bank’s income tax returns for the years 1995, 1997, 1998 and 1999. Management has prepared these tax returns in accordance with the Puerto Rico Internal Revenue Code and its regulations. Therefore, Management believes that a deficiency, if any, resulting from this investigation, will not have a material effect on the Corporation’s financial statements. Note 26 - Commitments At December 31, 2002 certain premises are leased with terms expiring through the year 2022. The Corporation has the option to renew or extend certain leases from two to ten years beyond the original term. Some of these leases require the payment of insurance, increases in property taxes and other incidental costs. At December 31, 2002, the obligation under various leases follows: Year Amount (In thousands) 2003 2004 2005 2006 2007 2008 and later years Total $ 4,894 4,079 2,826 2,039 1,726 7,333 $ 22,897 Rental expense included in occupancy and equipment expense was $4,509,798 in 2002 (2001 - $4,240,437; 2000 - $4,042,069). Note 27 - Fair Value of Financial Instruments The information about the estimated fair values of financial instruments as required by accounting principles generally accepted in the United States of America, is presented hereunder. The disclosure requirements exclude certain financial instruments and all non - financial instruments. Accordingly, the aggregate fair value amounts presented do not represent Management’s estimate of the underlying value of the Corporation. A summary table of estimated fair values and carrying values of financial instruments at December 31, 2002 and 2001 follows: December 31, 2002 2001 Estimated fair value Carrying value Estimated fair value Carrying value (In thousands) $ 381,965 3,422,718 35,630 $ 381,965 3,419,380 35,630 $ 94,463 3,652,031 22,891 $ 94,463 3,658,544 22,891 5,527,122 27,022 5,525,939 27,022 4,226,033 4,217,719 5,499,998 5,482,918 4,121,145 4,098,554 2,966,580 399,941 89,084 9,739 2,793,540 373,000 82,815 9,739 3,005,466 348,733 83,729 15,053 2,997,174 343,700 84,362 15,053 Assets: Cash and due from banks and money market instruments Investment securities FHLB stock Loans receivable, including loans held for sale - net Interest rate swaps Liabilities: Deposits Federal funds, securities sold under agreements to repurchase Advances from FHLB Subordinated notes Interest rate swaps The estimated fair values are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in the underlying assumptions used in calculating the fair values could significantly affect the results. In addition, the fair value estimates are based on outstanding balances without attempting to estimate the value of anticipated future business. Therefore, the estimated fair values may materially differ from the values that could actually be realized on a sale. The estimated fair values were calculated using certain facts and assumptions, which vary depending on the specific financial instrument, as follows: Cash and due from banks and money market instruments The carrying amounts of cash and due from banks and money market instruments are reasonable estimates of their fair values. p r o C n a B t s r i F 75 2 0 0 2 Investment securities The fair values of investment securities are the market values based on quoted market prices and dealer quotes. FHLB stock Investments in FHLB stock are valued at their redemption values. Loans receivable, including loans held for sale - net The fair value of all loans was estimated by the discounted present values of loans with similar financial characteristics. Loans were classified by type such as commercial, residential mortgage, credit card and automobile. These asset categories were further segmented into fixed and adjustable rate categories and by accruing and non-accruing groups. Performing floating rate loans were valued at book if they reprice at least once every three months, as were performing credit lines. The fair value of fixed rate performing loans was calculated by discounting expected cash flows through the estimated maturity date. Recent prepayment experience was assumed to continue for mortgage loans, auto loans and personal loans. Other loans assumed little or no prepayment. Prepayment estimates were based on the Corporation’s historical data for similar loans. Discount rates were based on the Treasury Yield Curve at the date of the analysis, with an adjustment, which reflects the risk and other costs inherent in the loan category. Non-accruing loans covered by a specific loan loss allowance were viewed as immediate losses and were valued at zero. Other non-accruing loans were arbitrarily assumed to be repaid after one year. Presumably this would occur either because loan is repaid, collateral has been sold to satisfy the loan or because general reserves are applied to it. The principal of non-accruing loans not covered by specific reserves was discounted for one year at the going rate for similar new loans. Deposits The estimated fair values of demand deposits and savings accounts, which are the deposits with no defined maturities, equal the amount payable on demand at the reporting date. For deposits with stated maturities, but that reprice at least quarterly, the fair values are also estimated to be the amount payable at the reporting date. The fair values of fixed rate deposits with stated maturities, are based on the present value of the future cash flows expected to be paid on deposits. The cash flows are based on contractual maturities; no early repayments are assumed. Discount rates are based on the LIBOR yield curve. The estimated fair values of total deposits exclude the fair value of core deposits intangible, which represent the value of the customer relationship measured by the values of demand deposits and savings deposits that bear a low or zero rate of interest and do not fluctuate in response to changes in interest rates. Substantially all swaps currently held by the Corporation form part of structured broker CD’s. In these instruments a fixed rate CD is matched with a swap of the same rate and maturity, thereby converting the fixed rate broker CD to a floating rate instrument which reprices quarterly based on a fixed differential to three month LIBOR. The swaps are recorded at fair value with a corresponding adjustment to CD’s, therefore, for purposes of fair value analysis, these structured broker CD’s are valued at book. Federal funds and securities sold under agreements to repurchase Federal funds purchased and some repurchase agreements reprice at least quarterly, and their outstanding balances are estimated to be their fair values. Where longer commitments are involved, fair values are estimated in the same way as fixed term deposits. Advances from FHLB and subordinated notes The fair value of advances from FHLB with fixed maturities was determined using discounted cash flow analysis over the full term of the borrowings. The cash flows assumed no early repayment of the borrowings. Discount rates were based on the LIBOR yield curve. The fair value of subordinated notes was based on indications of market prices. p r o C n a B t s r i F 76 2 0 0 2 Interest rate swaps The fair values of the interest rate swaps were provided by the counter party. Note 28 - Supplemental Cash Flow Information Supplemental cash flow information follows: Cash paid for: Interest Income tax Non-cash investing and financing activities: Additions to other real estate owned Year ended December 31, 2002 $274,548 15,799 2001 (In thousands) $275,360 12,535 2000 $260,937 30,477 3,338 1,797 3,121 Note 29 - Financial Instruments With Off-Balance Sheet Risk, Commitments to Extend Credit and Standby Letters of Credit The following table presents a detail of commitments to extend credit and standby letters of credit: Financial instruments whose contract amounts represent credit risk: Commitments to extend credit: To originate loans Unused credit card lines Unused personal lines of credit Commercial lines of credit Commercial letters of credit Standby letters of credit December 31, 2002 2001 (In thousands) $208,925 307,492 14,859 439,996 80,448 30,313 $194,363 291,120 13,480 222,821 19,067 24,172 The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument on commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. Management uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally expire within one year. Since certain commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. In the case of credit cards and personal lines of credit, the Corporation can at any time and without cause, cancel the unused credit facility. The amount of collateral, obtained if deemed necessary by the Corporation upon extension of credit, is based on Management’s credit evaluation of the borrower. Rates charged on the loans that are finally disbursed is the rate being offered at the time the loans are closed, therefore, no fee is charged on these commitments. The fee is the amount which is used as the estimate of the fair value of commitments. In general, commercial and standby letters of credit are issued to facilitate foreign and domestic trade transactions. Normally, commercial and standby letters of credit are short-term commitments used to finance commercial contracts for the shipment of goods. The collateral for these letters of credit include cash or available commercial lines of credit. The fair value of commercial and standby letters of credit is based on the fees currently charged for such agreements, which at December 31, 2002 is not significant. Interest rate risk management The operations of the Corporation are subject to interest rate fluctuations to the extent that interest-earning assets and interest-bearing liabilities mature or reprice at different times or in different amounts. As part of the interest rate risk management, the Corporation has entered into a series of interest rate swap agreements. Under the interest rate swaps, the Corporation agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts calculated by reference to an agreed notional principal amount. Net interest settlements on interest rate swaps are recorded as an adjustment to interest expense on deposit accounts or interest income on investment accounts. The following table indicates the types of swaps used: p r o C n a B t s r i F 77 2 0 0 2 Pay-fixed and receive-variable swaps: Balance at December 31, 2000 New Contracts Balance at December 31, 2001 New contracts Balance at December 31, 2002 Receive-fixed and pay variable swaps: Balance at December 31, 2000 Expired contracts New contracts Balance at December 31, 2001 Expired contracts New contracts Balance at December 31, 2002 Notional amount (In thousands) $ $ 58,165 58,165 20,000 78,165 $ 1,151,000 (1,116,000) 1,460,000 $ 1,495,000 (1,193,681) 1,656,590 $ 1,957,909 Interest rate swap agreements under which the Corporation agrees to pay variable-rates of interest are considered to be a hedge against changes in the fair value of the Corporation fixed-rate brokered certificates of deposit. The interest rate swap agreements are reflected at fair value in the Corporation’s consolidated statement of financial condition and the related portion of fixed-rate debt being hedged is reflected at an amount equal to the sum of its carrying value plus an adjustment representing the change in fair value of the debt obligations attributable to the interest rate risk being hedged. The hedge relationship is estimated to be 100 percent effective; therefore, there is no impact on the statement of income nor on comprehensive income, because the gain or loss on the swap agreements will completely offset the loss or gain on the certificates of deposit. The Corporation, in order to achieve 100% effectiveness, incorporates in the hedge of fixed-rate brokered CD’s the right to lower the notional amount for a stated period of time, in the case of cancellations prior to maturity. The net effect of this accounting is that the interest expense on the hedged certificates of deposit generally reflects variable interest rates. Interest rate swap agreements under which the Corporation agrees to pay fixed-rates of interest are considered to be a hedge against changes in the fair value attributable to market interest rates of fixed rate available for sale corporate bonds. Accordingly, the interest rate swap agreements and the securities being hedged are reflected at p r o C n a B t s r i F 78 2 0 0 2 fair value in the Corporation’s consolidated statement of financial condition. The adjustment of the hedged item’s carrying amount attributable to the hedged risk is recorded in earnings in order to offset the gain or loss on the hedging instrument. The change in the fair value of the security attributable to credit risk is recorded in other comprehensive income. The hedge relationship is estimated to be 100 percent effective; therefore, there is no impact on the statement of income, because the gain or loss on the interest rate swap reflects the full amount of the gain or loss on the hedged item attributable to the hedged risk. The net effect of this accounting is that the interest of the fixed-rate securities being hedged generally reflects variable interest rates. During the year ended on December 31, 2002, the Corporation sold certain corporate bonds to which interest rate swap agreements with an aggregate notional principal balance of $53.2 million were attributable. Therefore, these swaps no longer qualify for hedge accounting, and an unrealized loss of $4.5 million was recorded to reflect changes in the fair value of these derivatives as part of derivative loss in the Other Income section of the statement of income. Interest rate swaps with an aggregate notional principal balance of $25 million had an unrealized loss of $1,517,268 (2001 - $1,260,094 unrealized loss), attributable to credit risk, which was recorded in accumulated comprehensive income net of income tax. Pay-fixed swaps at December 31, 2002 had a fixed weighted average rate payment of 6.53% (2001 - 7.14%) and a floating weighted average rate receiving of 3.53% (2001 - 4.20%). Receive-fixed swaps at December 31, 2002, have a floating weighted average rate payment of 1.58% (2001 - 2.16%) and a fixed weighted average rate receiving of 5.60% (2001 - 6.32%). Floating rates on pay fixed swaps range from 175 to 240 basis points over LIBOR and from minus 25 basis points to 7 over LIBOR rate on receive fixed swaps. For swap transactions, the amounts potentially subject to credit loss are the net streams of payments under the agreements and not the notional principal amounts used to express the volume of the swaps. At December 31, 2002, the Corporation had total net receivable of $12,147,354 (2001 - $12,755,949) related to the swap transactions. The Corporation controls the credit risk of its interest rate swap agreements through approvals, limits, and monitoring procedures. The Corporation does not anticipate non-performance by the counter parties. The Corporation has a policy of diversifying swap counter parties to reduce the risk that any counter party will fail. As part of the swap transactions, the Corporation is required to pledge collateral in the form of deposits in banks or securities. The book value and aggregate market value of securities pledged as collateral for interest rate swaps at December 31, 2002 was approximately $42.1 million and $42.9 million, respectively (2001 - $48.1 million and $47.9 million, respectively). The final maturity of the swaps at December 31, 2002 ranged from one month through nineteen years (2001 - from one year through twenty years). Interest rate swaps with an aggregate notional principal balance of $2,036,074,000 had a gross unrealized gain of approximately $27,021,907 and gross unrealized loss of $9,738,638 at December 31, 2002, which are included in the Other Assets category and Other Liabilities category, respectively. Interest rate protection agreements (Caps) From time to time the Corporation also uses interest rate protection agreements (Caps) to limit its exposure to rising interest rates on its deposits. Under these agreements, the Corporation pays an up front premium or fee for the right to receive cash flow payments in excess of the predetermined cap rate; thus, effectively capping its interest rate cost for the duration of the agreement. There were no caps agreements outstanding at December 31, 2002 On January 1, 2001 a loss of approximately $1.3 million was recognized in the statement of income as a cumulative effect of the adoption of SFAS No. 133, as a result of unamortized premium paid for caps of $1.5 million less an estimated fair market value of $200,000. Prior to the implementation of SFAS No. 133, the premium was amortized as an adjustment to interest expense on borrowings. Note 30 - Segment Information The Corporation has three reportable segments: Retail business, Treasury and Investments, and Commercial Corporate business. Management determined the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Corporation’s organizational chart, nature of the products, distribution channels and the economic characteristics of the products were also considered in the determination of the reportable segments. The Retail business segment is composed of the Corporation’s branches and loan centers together with the retail products of deposits and consumer loans. Consumer loans include loans such as personal, residential real estate, auto, credit card and small loans. Finance leases are also included in Retail business. The Commercial Corporate segment is composed of commercial loans including commercial real estate and construction loans. The Treasury and Investment segment is responsible for the Corporation investment portfolio and treasury functions. The Other Income segment is mainly composed of insurance and other commission’s income. The accounting policies of the segments are the same as those described in Note 2 - “Summary of Significant Accounting Policies.” The Corporation evaluates the performance of the segments based on net interest income after the estimated pro- vision for loan losses, other income and direct operating expenses. The segments are also evaluated based on the average volume of its earning assets less the allowance for loan losses. The only intersegment transaction is the net transfer of funds by the Treasury and Investment segment and other segments. The Treasury and Investment segment sells funds to the Retail and Commercial Corporate segments to finance their lending activities and purchases funds gathered by those segments. The interest rates charged or credited by Investment and Treasury is based on market rates. The following table presents information about the reportable segments: p r o C n a B t s r i F 79 2 0 0 2 For the year ended December 31, 2002: Interest income Net (charge) credit for transfer of funds Interest expense Net interest income Provision for loan losses Other income Direct Operating Expenses Segment income Average earning assets For the year ended December 31, 2001: Interest income Net (charge) credit for transfer of funds Interest expense Net interest income Provision for loan losses Other income Direct Operating Expenses Segment income Average earning assets For the year ended December 31, 2000: Interest income Net (charge) credit for transfer of funds Interest expense Net interest income Provision for loan losses Other income Direct Operating Expenses Segment income Average earning assets Retail Treasury and Investments Commercial Corporate (In thousands) Other Total $ 230,141 $ 188,194 $ 121,698 $ 540,033 (46,552) (58,835) 124,754 (43,090) 39,352 (74,357) 46,659 $2,410,548 97,360 (214,349) 71,205 8,643 (2,227) 77,621 $3,746,245 (50,808) 70,890 (19,212) 5,080 (6,439) 50,319 $2,258,025 (273,184) 266,850 (62,302) 58,492 (83,721) 179,319 $ 8,414,818 $5,417 (697) 4,720 $ 217,021 $ 162,478 $ 136,757 $ 516,256 (21,043) (71,410) 124,568 (44,541) 35,384 (69,198) 46,213 $1,970,768 102,123 (208,791) 55,810 10,211 (1,844) 64,177 $2,627,205 (81,081) 55,676 (16,489) 4,440 (5,664) 37,963 $1,781,314 (280,201) 236,055 (61,030) 52,980 (77,069) 150,936 $6,379,287 $2,945 (362) 2,583 $ 222,950 $ 134,328 $ 106,110 $ 463,388 (12,582) (74,093) 136,275 (28,084) 34,556 (69,369) 73,378 $1,893,699 85,013 (198,522) 20,819 8,968 (1,922) 27,865 $1,985,580 (72,431) 33,679 (17,635) 4,221 (5,010) 15,255 $1,110,608 (272,615) 190,773 (45,719) 50,032 (76,619) 118,467 $4,989,887 $2,287 (318) 1,969 p r o C n a B t s r i F 80 2 0 0 2 The following table presents a reconciliation of the reportable segment financial information to the consolidated totals: Year ended December 31, Net income: Total income for segments Other operating expenses Income taxes Income before cumulative effect of accounting change Cumulative effect of accounting change Total consolidated net income Average assets: Total average earning assets for segments Average assets not assigned to segments 2002 $ 179,319 (49,036) (22,327) 107,956 $ 107,956 2001 (In thousands) $ $ 150,936 (43,786) (20,134) 87,016 (1,015) 86,001 2000 $ 118,467 (36,430) (14,761) 67,276 $ 67,276 $ 8,414,818 333,404 $ 6,379,287 322,115 $ 4,989,887 249,489 Total consolidated average assets $ 8,748,222 $ 6,701,402 $ 5,239,376 Note 31 - Litigation The Corporation is a defendant in a number of legal proceedings arising in the normal course of business. Management believes, based on the opinion of legal counsel, that the final disposition of these matters will not have a material adverse effect on the Corporation’s financial position or results of operations. Note 32 - First BanCorp (Holding Company Only) Financial Information The following condensed financial information presents the financial position of the Holding Company only at December 31, 2002 and 2001, and the results of its operations and its cash flows for the years ended on December 31, 2002, 2001 and 2000. Statements of Financial Condition Assets: Cash and due from banks Money market instruments Investment securities available for sale, at market value: United States Government obligations Other investments Total investment securities available for sale Investment securities held to maturity, at cost: United States Government obligations Total investment securities held to maturity Loans receivable Investment in FirstBank Puerto Rico, at equity Investment in FirstBank Insurance Agency, at equity Other assets Total assets Liabilities and Stockholders’ Equity: Accounts payable and other liabilities Stockholders’ equity Contingencies and commitments Total liabilities and stockholders’ equity December 31, 2002 December 31, 2001 (In thousands) $ 26,276 300 42,674 42,674 5,700 5,700 6,000 718,480 1,445 726 $ 801,601 $ 3,177 798,424 $ 801,601 $ 17,422 300 24,802 35,507 60,309 5,682 515,623 371 3,383 $ 603,090 $ 171 602,919 $ 603,090 Statements of Income Year ended December 31, Income: Interest income on investment securities Interest income on other investments Interest income on loans Dividend from FirstBank Other income Expenses: Interest expense Other operating expenses Gain (loss) on sale of investments, net Income before income taxes and equity in undistributed earnings of subsidiaries Income taxes Equity in undistributed earnings of subsidiaries Net income Other comprehensive income, net of tax Comprehensive income 2002 $ 351 248 5,269 28,000 705 34,573 2 709 711 (22,321) 11,541 2,250 98,665 107,956 39,675 $ 147,631 2001 (In thousands) $ 658 250 306 24,000 668 25,882 559 559 1,093 26,416 170 59,755 86,001 13,306 $ 99,307 2000 $ 776 289 24,000 1,117 26,182 25 487 512 7,134 32,804 209 34,681 67,276 49,050 $ 116,326 The principal source of income for the Holding Company consists of the earnings of FirstBank. p r o C n a B t s r i F 81 2 0 0 2 p r o C n a B t s r i F 82 2 0 0 2 Statement of Cash Flows Cash flows from operating activities: Year ended December 31, 2002 2001 (In thousands) 2000 Net income $ 107,956 $ 86,001 $ 67,276 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiaries Net loss (gain) on sale of investments securities Net (increase) decrease in other assets Net increase (decrease) in other liabilities Total adjustments Net cash provided by operating activities Cash flows from investing activities: Capital contribution to subsidiaries Loans originated Purchases of securities available for sale Sales and maturity of securities held to maturity and available for sale Other investing activities Net cash used in investing activities Cash flows from financing activities: Net decrease in other borrowings Proceeds from issuance on preferred stock Exercise of stock options Cash dividends paid Treasury stock acquired Net cash provided by financing activities Net increase in cash Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year Cash and cash equivalents include: Cash and due from banks Money market instruments (98,662) 22,321 (175) 2,069 (74,447) 33,509 (88,000) (88,000) (1,235,145) 1,240,079 98,537 (72,529) 88,906 1,341 (42,373) 47,874 8,854 17,722 26,576 26,276 300 26,576 $ $ $ (59,755) (1,093) (75) (186) (61,109) 24,892 (80,305) (5,682) (24,203) 10,227 6,316 (93,647) 100,069 1,355 (30,343) (1,930) 69,151 396 17,326 17,722 17,422 300 17,722 $ $ $ (34,681) (7,134) 120 (527) (42,222) 25,054 (40,000) (50,119) 44,807 278 (45,034) (865) 72,438 94 (19,212) (30,087) 22,368 2,388 14,938 17,326 17,026 300 17,326 $ $ $ Stockholders’ information INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS PricewaterhouseCoopers LLP p r o C n ANNUAL MEETING:The annual meeting of stockholders will be held on April 29, 2003, at 2:00 p.m., at the main a B office of the Corporation located at 1519 Ponce de León Avenue, Santurce, Puerto Rico. Telephone (787) 729-8200 Internet http://www.firstbankpr.com ADDITIONAL INFORMATION AND FORM 10-K: Additional financial information about First BanCorp may be requested to Mrs. Laura Villarino, Senior Vice President and Controller, PO Box 9146, Santurce, Puerto Rico 00908. First BanCorp’s filings with the Securities and Exchange Commission (SEC) may be accessed in the web site maintained by the SEC at http://www.sec.gov and at our web site http://firstbankpr.com, First BanCorp section, Company Filings link. 83 t s r i F 2 0 0 2 TRANSFER AGENT AND REGISTRAR: The Bank of New York 1-800-524-4458 ADDRESS SHAREHOLDER INQUIRIES TO: Shareholder Relations Department PO Box 11258 Church Street Station New York, NY 10286 E-MAIL ADDRESS: shareowner-svcs@bankofny.com THE BANK OF NEW YORK’S STOCK TRANSFER WEB SITE: http://www.stockbny.com SEND CERTIFICATES FOR TRANSFER AND ADDRESS CHANGES TO: Receive and Deliver Department PO Box 11002 Church Street Station New York, NY 10286 

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