Annual Report (Form 10-K), fiscal year 1994

ITEM 1. BUSINESS
GENERAL
B.F. Saul Real Estate Investment Trust (the "Trust") operates as an unincorporated common law trust governed by Maryland law. The Trust began its operations in 1964 as an unincorporated business trust organized under a Declaration of Trust governed by District of Columbia law. The Trust terminated its status as a qualified real estate investment trust for federal income tax purposes in 1978 and is now taxable as a corporation.
The principal business activity of the Trust and its real estate subsidiaries is the ownership and development of income- producing properties. The Trust owns 80% of the outstanding common stock of Chevy Chase Bank, F.S.B., formerly Chevy Chase Savings Bank, F.S.B. ("Chevy Chase" or the "Bank"), whose assets accounted for approximately 93% of the Trust's consolidated assets at September 30, 1994. The Trust is a thrift holding company by virtue of its ownership of a majority interest in Chevy Chase. See "Real Estate - Holding Company Regulation."
The Trust recorded net income of $23.1 million in the fiscal year ended September 30, 1994, compared to net income of $4.5 million in the fiscal year ended September 30, 1993 and net income of $5.9 million in the fiscal year ended September 30, 1992.
The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The Term "Trust" used in the text and the financial statements included herein refers to the combined entity, which includes B.F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust" refers to B.F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase's subsidiaries. The operations conducted by the Real Estate Trust are designated as "Real Estate," while the business conducted by Chevy Chase and its subsidiaries is identified by the term "Banking."
The principal offices of the Trust are located at 8401 Connecticut Avenue, Chevy Chase, Maryland 20815, and the Trust's telephone number is (301) 986-6000.
REAL ESTATE. The Real Estate Trust's long-term objectives are to increase cash flow from operations and to maximize capital appreciation of its real estate. The properties owned by the Real Estate Trust are located predominantly in the Mid Atlantic and Southeastern regions of the United States and consist principally of office and industrial projects, hotels and undeveloped land parcels.
BANKING. Chevy Chase is a federally chartered and federally insured stock savings bank which at September 30, 1994 was
conducting business from 81 full-service offices and 383 automated teller machines ("ATMs") in Maryland, Virginia and the District of Columbia. The Bank, which is headquartered in Montgomery County, Maryland, a suburban community of Washington, D.C., also maintains 17 loan production offices in Maryland, Virginia and the District of Columbia, 16 of which are operated by a wholly-owned mortgage banking subsidiary. At September 30, 1994, the Bank had total assets of $4.7 billion and total deposits of $4.0 billion. Based on total consolidated assets at September 30, 1994, Chevy Chase is the largest savings institution operating primarily in the Washington, D.C. metropolitan area and is also the largest savings institution headquartered in Maryland.
Chevy Chase is principally engaged in the business of attracting deposits from the public and using such deposits, together with borrowings and other funds, to make loans secured by real estate, primarily residential mortgage loans, and credit card and other types of consumer loans. As a complement to its basic deposit and lending activities, the Bank provides a number of related financial services to its customers, including securities brokerage and insurance products offered through its subsidiaries.
Chevy Chase recorded operating income of $53.2 million for the year ended September 30, 1994, compared to operating income of $63.8 million for the year ended September 30, 1993. The Bank was in compliance with all of its regulatory capital requirements at September 30, 1994. The Bank's tangible, core (or leverage) and risk-based regulatory capital ratios at September 30, 1994 were 4.96%, 5.34% and 12.19%, respectively, compared to the requirements under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 of 1.5%, 3.0% and 8.0%, respectively. At September 30, 1994, the Bank's leverage, tier 1 risk-based and total risk-based regulatory capital ratios of 5.34%, 6.95% and 12.19%, respectively, were sufficient for the Bank to meet the standards of 5.0%, 6.0% and 10.0%, respectively, for classification of the Bank as "well capitalized" under the "prompt corrective action" regulations of the Office of Thrift Supervision ("OTS"). In November 1994, the OTS revised its existing policy and announced that, beginning as early as December 1994, savings associations may exclude net unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital for purposes of computing regulatory capital ratios. If this revised policy had been in effect on September 30, 1994, the Bank's tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios would have increased to 5.27%, 5.64%, 7.35% and 12.66%,
respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Capital."
Chevy Chase is subject to comprehensive regulation, examination and supervision by the OTS and by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank's deposit accounts are fully insured up to $100,000 per insured depositor by the Savings Association Insurance Fund (the "SAIF"), which is administered by the FDIC.
REAL ESTATE
REAL ESTATE INVESTMENTS
The following tables set forth, at and for the periods indicated, certain information regarding the properties in the Real Estate Trust's investment portfolio at September 30, 1994.
OFFICE AND INDUSTRIAL
HOTELS
OTHER REAL ESTATE INVESTMENTS
The investment portfolio consists principally of seasoned operating properties. The Real Estate Trust expects to hold its properties as long-term investments and has no maximum period for retention of any investment. It may acquire additional income- producing properties, expand and improve its properties, or sell such properties, as and when circumstances warrant.
INVESTMENT IN SAUL HOLDINGS LIMITED PARTNERSHIP
On August 26, 1993 the Real Estate Trust consummated a series of transactions (together with related transactions, the "Formation Transactions") in which it transferred its 22 shopping center properties and one of its office properties (the "Transferred Properties"), together with the debt associated with such properties, to a newly organized limited partnership, Saul Holdings Limited Partnership ("Saul Holdings Partnership"), and one of two newly organized subsidiary limited partnerships of Saul Holdings Partnership (the "Subsidiary Partnerships" and, collectively with Saul Holdings Partnership, the "Partnerships"). In exchange for the Transferred Properties, the Real Estate Trust received a 21.5% limited partnership interest (and 3,495,713 partnership units corresponding thereto) in Saul Holdings Partnership, which it holds directly and through two wholly owned subsidiaries. Saul Centers, Inc. ("Saul Centers"), a newly organized, publicly held real estate investment trust, received a 73.0% general partnership interest in Saul Holdings Partnership in exchange for the contribution of approximately $220.7 million to Saul Holdings Partnership. Entities under common control with the Trust (the "Trust Affiliates") received limited partnership interests collectively representing a 5.5% partnership interest in Saul Holdings Partnership in exchange for the transfer of property management functions (the "Management Functions") and certain other properties to the Partnerships. In addition, the Trust Affiliates received certain cash distributions from Saul Holdings Partnership and purchased 4.0% of the common stock of Saul Centers in a private offering consummated concurrently with the initial public offering of such common stock. B. Francis Saul II, the Chairman of the Board of Trustees and Chief Executive Officer of the Trust, serves as Chairman of the Board of Directors and Chief Executive Officer of Saul Centers.
The Real Estate Trust and the Trust Affiliates own rights (the "Rights") enabling them to convert their limited partnership interests in Saul Holdings Partnership into shares of Saul Centers common stock on the basis of one share of Saul Centers common stock for each partnership unit at the end of a 36-month period commencing after the initial public offering, provided that they do not own Rights to the extent that they collectively would be treated as owning, directly or indirectly, more than 24.9% of the value of the outstanding equity securities of Saul Centers. The shares of Saul Centers common stock are listed on
the New York Stock Exchange (trading symbol "BFS").
In July 1994, Saul Centers established Saul QRS, Inc. and SC Finance Corporation, as wholly owned subsidiaries of Saul Centers. Saul QRS, Inc. was established to succeed to the interest of Saul Centers as the sole general partner of one of the Subsidiary Partnerships, Saul Subsidiary I Limited Partnership, and SC Finance Corporation was established for the purpose of issuing $128 million of collateralized floating rate mortgage notes (the "Mortgage Notes"). In connection with these transactions, Saul Holdings Partnership transferred ten shopping centers previously owned by it to Saul Subsidiary I Limited Partnership as an additional capital contribution and the second Subsidiary Partnership, Saul Subsidiary II Limited Partnership, transferred one shopping center previously owned by it to Saul Subsidiary I Limited Partnership as an initial capital contribution in return for a limited partnership interest in Saul Subsidiary I Limited Partnership. As a consequence of these transfers, Saul Subsidiary I Limited Partnership currently owns a total of 17 shopping centers (the "Mortgaged Properties"). The Mortgaged Properties, which continue to be managed by Saul Holdings Partnership and Saul Subsidiary II Partnership, secure the mortgage purchased with the proceeds of issuance of the Mortgage Notes.
At September 30, 1994, Saul Holdings Partnership owned, directly or indirectly through the Subsidiary Partnerships, 29 community and neighborhood shopping centers (including the 22 shopping centers transferred by the Real Estate Trust) located in seven states and the District of Columbia, one office property and one office/retail property located in the District of Columbia and one research park located in a Maryland suburb of Washington, D.C. (the "Portfolio Properties").
SAUL CENTERS. Saul Centers has made an election to be treated as a real estate investment trust ("REIT") for federal income tax purposes under Sections 856 through 860 of the Internal Revenue Code commencing with the year ended December 31, 1993. Under the Internal Revenue Code, REITs are subject to numerous organizational and operational requirements. If Saul Centers continues to qualify, it generally will not be subject to federal income tax, provided it makes certain distributions to its stockholders and meets certain organizational and other requirements. Saul Centers has announced that it intends to make regular quarterly dividend distributions to its stockholders.
MANAGEMENT OF THE PROPERTIES. The Partnerships manage the Portfolio Properties and any subsequently acquired properties through the Management Functions, which include personnel and such functions as property management, leasing, design, renovation, development and accounting. The Management Functions provide the Partnerships with a fully integrated property
management capability through approximately 150 professionals and staff personnel and with an extensive and mature network of relationships with tenants and potential tenants as well as with members of the brokerage and property owners' communities.
Saul Centers shares with the Real Estate Trust and the Trust Affiliates certain ancillary functions at cost, such as computer and payroll services, benefits administration and in-house legal services, and shares insurance expense on a pro rata basis. The Real Estate Trust and the Trust Affiliates sublease office space to Saul Centers at their cost. The terms of all sharing arrangements, including payments related thereto, are reviewed periodically by the independent directors of Saul Centers, who constitute five of the nine members of the Board of Directors.
EXCLUSIVITY AGREEMENT AND RIGHT OF FIRST REFUSAL. The Real Estate Trust has entered into an Exclusivity Agreement (the "Exclusivity Agreement") with, and has granted a right of first refusal (the "Right of First Refusal") to, Saul Centers and the Partnerships (collectively, the "Company"). The purpose of these agreements is to minimize potential conflicts of interest between the Real Estate Trust and the Company. The Exclusivity Agreement and Right of First Refusal generally require the Real Estate Trust to conduct its shopping center business exclusively through the Company and to grant the Company a right of first refusal to purchase commercial properties and development sites that become available to the Real Estate Trust in the District of Columbia or adjacent suburban Maryland. Subject to the Exclusivity Agreement and Right of First Refusal, the Real Estate Trust has the right to continue to develop, acquire, own and manage commercial properties and own land suitable for development as, among other things, shopping centers and other commercial properties.
ALLOCATIONS AND DISTRIBUTIONS OF SAUL HOLDINGS PARTNERSHIP. The net income or net loss of Saul Holdings Partnership for tax purposes generally will be allocated to Saul Centers and the limited partners in accordance with their percentage interests, subject to compliance with the applicable provisions of the Internal Revenue Code and the regulations promulgated thereunder. Net cash flow after reserves of Saul Holdings Partnership and after reimbursement of specified expenses will be distributed quarterly to the partners in proportion to their respective partnership interests.
REIMBURSEMENT AGREEMENT. Pursuant to a reimbursement agreement, as amended, among the partners of the Partnerships, the Real Estate Trust and those of its subsidiaries that are partners in the Partnerships have agreed to reimburse Saul Centers and the other partners in the event the Partnerships fail to make payments with respect to certain portions of the Partnerships' debt obligations and Saul Centers or any such other partners personally make payments with respect to such debt
obligations. At September 30, 1994, the maximum potential obligations of the Real Estate Trust and its subsidiaries under this agreement totaled $116.1 million. See Note 1 to the Consolidated Financial Statements in this report. The Real Estate Trust believes that the Partnerships will be able to make all payments due with respect to their debt obligations.
POTENTIAL CONFLICTS OF INTEREST. The fair market value of each of the properties contributed to the Partnerships by the Real Estate Trust and its subsidiaries at the date of the Formation Transactions (the "FMV" of each such property) exceeded the tax basis of such property (with respect to each property, such excess is referred to as the "FMV-Tax Difference"). In the event Saul Centers or Saul QRS, Inc., acting as general partner of a Partnership, causes such Partnership to dispose of, or there is an involuntary disposition of, one or more of such properties, a disproportionately large share of the total gain for federal income tax purposes would be allocated to the Real Estate Trust or its subsidiaries as a result of the property disposition. In general, if the gain recognized by the Partnership on such a property disposition is less than or equal to the FMV-Tax Difference for such property (as previously reduced by the amounts of special tax allocations of depreciation deductions to the partners), all such gain will be allocated to the Real Estate Trust or its subsidiaries. To the extent the gain recognized by the Partnership on the property disposition exceeds the FMV-Tax Difference (as adjusted), such excess generally will be allocated among all partners in Saul Holdings based on their relative percentage interests. In general, the amount of federal income tax liability in respect of gain allocated to the Real Estate Trust or its subsidiaries in the event of such a property disposition is likely to exceed, perhaps substantially, the amount of cash, if any, distributable to the Real Estate Trust or its subsidiaries as a result of the property disposition. In addition, future reductions in the level of the Partnerships' debt, any release of the guarantees of such debt by the Real Estate Trust or its subsidiaries (described above under "Reimbursement Agreement") or any refinancings in which the Real Estate Trust or its subsidiaries do not assume a comparable obligation to that contained in the Reimbursement Agreement could cause the Real Estate Trust or its subsidiaries to have taxable constructive distributions without the receipt of any corresponding amounts of cash. See Note 2 to the Consolidated Financial Statements in this report.
REGISTRATION RIGHTS. Saul Centers has granted the Real Estate Trust and the Trust Affiliates certain "demand" and "piggyback" registration rights (collectively, the "Registration Rights") with respect to the shares of Saul Centers common stock acquired in connection with the Formation Transactions or as a consequence of exercise of the Rights (the "Registration Shares"). Subject to certain limitations, the Registration
Rights grant the holders of Registration Shares the opportunity to register all or any portion of their respective Registration Shares once in each calendar year and to have such Shares registered incidentally to any registration, by Saul Centers, of shares of common stock or other securities substantially similar to common stock. Except with respect to the Registration Rights incident to a pledge of Registration Shares or Saul Holdings Partnership interests, the demand Registration Rights may be exercised only after the transfer restrictions imposed in connection with the Saul Centers initial public offering have lapsed and prior to such time, if any, as the holder is permitted to sell the Registration Shares pursuant to Rule 144(k) under the Securities Act of 1933. Saul Centers will bear expenses incident to its registration obligations upon exercise of the Registration Rights, except that it will not bear any underwriting discounts or commissions, Securities and Exchange Commission or state Blue Sky registration fees, or transfer taxes relating to registration of Registration Shares.
COMPETITION
As an owner of, or investor in, commercial real estate properties, the Real Estate Trust is subject to competition from a variety of other owners of similar properties in connection with their sale, lease or other disposition and use. Management believes that success in such competition is dependent upon the geographic location of the property, the performance of property managers, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors with respect to commercial and industrial properties are the ease of access to the property, the adequacy of related facilities such as parking, and the ability to provide rent concessions and additional tenant improvements without increasing rent. Management believes that general economic circumstances and trends and new properties in the vicinity of each of the Real Estate Trust's properties also will be competitive factors.
ENVIRONMENTAL MATTERS
The Real Estate Trust's properties are subject to various laws and regulations relating to environmental and pollution controls. Although the effect upon the Real Estate Trust of the application of such laws and regulations cannot be predicted with certainty, management believes that their application either prospectively or retrospectively will not have a material adverse effect on the Real Estate Trust's property operations. As a matter of policy, the Real Estate Trust requires an environmental study to be performed with respect to a property that may be subject to possible environmental hazards prior to its acquisition to ascertain that there are no material environmental hazards associated with such property.
RELATIONSHIPS WITH B. F. SAUL COMPANY
The Real Estate Trust has significant relationships with B. F. Saul Company (the "Saul Company") and two of the Saul Company's wholly owned subsidiaries, B. F. Saul Advisory Company (the "Advisor") and Franklin Property Company ("Franklin"). The Saul Company, founded in 1892, specializes in real estate investment, financing and management services, including acquisitions, management and leasing and insurance. B. Francis Saul II, Chairman of the Board of Trustees and Chief Executive Officer of the Trust, is Chairman and President of the Saul Company.
The Advisor acts as the Real Estate Trust's investment advisor and carries on the day-to-day general management, financial, accounting, legal and administrative affairs of the Real Estate Trust. Franklin acts as leasing and management agent for most of the income-producing properties owned by the Real Estate Trust, and plans and oversees the development of new properties and the expansion and renovation of existing properties.
The Trustees, including the two independent Trustees, review the fees and compensation arrangements between the Real Estate Trust and the Saul Company and its related entities and affiliates and believe that such fees and compensation arrangements are as favorable to the Real Estate Trust as would be obtainable from unaffiliated sources. See "Certain Relationships and Related Transactions."
HOLDING COMPANY REGULATION
The Trust and the Saul Company, by virtue of their direct and indirect control of the Bank (see "Security Ownership of Certain Beneficial Owners and Management"), are "savings and loan holding companies" subject to comprehensive regulation, examination and supervision by the OTS. The Bank is prohibited from making or guaranteeing loans or advances to or for the benefit of the Trust, the Saul Company or other affiliates engaged in activities beyond those permissible for bank holding companies and from investing in the securities of the Trust, the Saul Company or other affiliates. Further, transactions between Chevy Chase and the Trust or the Saul Company must be on terms substantially the same, or at least as favorable to Chevy Chase, as those that would be available to non- affiliates. See "Certain Relationships and Related Transactions."
The Trust and the Saul Company must obtain the prior approval of the OTS before acquiring any federally insured savings institution or any savings and loan holding company by merger, consolidation or purchase of assets. As unitary savings and loan holding companies, the Trust and the Saul Company are
virtually unrestricted in the types of business activities in which they may engage, provided the Bank continues to meet the qualified thrift lender test. See "Banking - Regulation - Qualified Thrift Lender ("QTL") Test." If the Trust and the Saul Company were to acquire one or more federally insured institutions and operate them as separate subsidiaries rather than merging them into Chevy Chase, the Trust and the Saul Company would become "multiple" savings and loan holding companies. As multiple savings and loan holding companies, the Trust and the Saul Company would be subject to limitations on the types of business activities in which they would be permitted to engage, unless the additional thrifts were troubled institutions acquired pursuant to certain emergency acquisition provisions and all subsidiary thrifts met the QTL test. The Trust and the Saul Company may acquire and operate additional savings institution subsidiaries outside of Maryland and Virginia only if the laws of the target institution's state specifically permit such acquisitions or if the acquisitions are made pursuant to emergency acquisition provisions.
The Trust and the Saul Company entered into an agreement with OTS's predecessor, the Federal Savings and Loan Insurance Corporation, to maintain Chevy Chase's regulatory capital at the required levels and, if necessary, to infuse additional capital to enable Chevy Chase to meet those requirements. Since the execution of that agreement, the OTS has changed its policy and now accepts more limited agreements from those acquiring thrift institutions. In addition, the regulatory capital requirements applicable to Chevy Chase have changed significantly as a result of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"). The OTS has stated that capital maintenance agreements entered into prior to such modification of OTS policy and the enactment of FIRREA were not affected by such changes. The Trust and the Saul Company have not sought to modify the existing agreement.
Following the Bank's failure to meet its risk-based capital requirement in June 1991, the OTS advised the Trust that, based on the Trust's liquidity position, the OTS did not plan to enforce the Trust's obligations at that time. Subsequently, at September 30, 1992, the Bank returned to capital compliance. However, to the extent the Bank is unable to meet its regulatory capital requirements in the future, the OTS could seek to enforce the Trust's obligations under the agreement. The Bank's business plan does not contemplate any future capital contributions from the Trust.
If the Bank were to become undercapitalized under the prompt corrective action regulations (See "Banking - Regulation - Prompt Corrective Action"), it would be required to file a capital restoration plan with the OTS setting forth, among other things, the steps the Bank would take to become adequately capitalized.
The OTS could not accept the plan unless the Trust and the Saul Company guaranteed in writing the Bank's compliance with that plan. The aggregate liability of the Trust and the Saul Company under such a commitment would be limited to the lesser of (i) an amount equal to 5.0% of the Bank's total assets at the time the Bank became undercapitalized and (ii) the amount necessary to bring the Bank into compliance with all applicable capital standards as of the time the Bank fails to comply with its capital plan. If the holding companies refused to provide the guarantee, the Bank would be subject to the more restrictive supervisory actions applicable to significantly undercapitalized institutions.
FEDERAL TAXATION
The Trust terminated its status as a real estate investment trust for federal income tax purposes in 1978 and is now taxable as a corporation. The Trust's real estate operations have generated sizeable depreciation, interest and other deductions in excess of its total income, and as a result the Trust has had substantial net operating loss carryovers for federal income tax purposes ("NOLs"). The Trust and its subsidiaries join in the filing of a consolidated federal income tax return using the accrual method of accounting on the basis of a fiscal year ending September 30.
Since June 28, 1990, the Bank and its subsidiaries have joined in the consolidated federal income tax returns filed by the Trust on a fiscal year basis. Prior to June 28, 1990, the Bank and its subsidiaries filed a consolidated federal income tax return on an accrual method, calendar-year basis.
Savings institutions such as the Bank generally are taxed in the same manner as other corporations. There are, however, several special rules that apply principally to savings institutions (and, in some cases, other financial institutions). Certain significant aspects of the federal income taxation of the Bank are discussed below.
The Internal Revenue Service ("IRS") has completed audits of the federal income tax returns of the Bank for the taxable years ended December 31, 1988, December 31, 1989 and June 27, 1990.
BAD DEBT RESERVE. Savings institutions that satisfy certain requirements are permitted to establish reserves for bad debts and to deduct each year reasonable additions to those reserves in lieu of taking a deduction for bad debts actually sustained during the taxable year. To qualify for this treatment, at least 60% of a savings institution's assets must be "qualifying assets," which include cash, certain U.S. Government and state government securities, obligations of certain deposit insurance corporations, loans secured by interests in residential real
property and loans made for the improvement of residential real property.
A qualifying thrift generally may compute the amount of the addition to a reserve for losses on qualifying real property loans under the more favorable of the "experience method," which is based on the institution's actual loan loss experience over a prescribed period, or the "percentage of taxable income method," which is based on a fixed percentage (i.e., 8%) of the institution's taxable income.
The Bank has calculated the bad debt deduction for tax purposes under the experience method since calendar year 1988. If the Bank were not treated as a qualifying institution for any taxable year, it would be required to recapture its bad debt reserve (for 1994, approximately $78.0 million) into taxable income. In addition, the Bank would be allowed to deduct only those bad debts that actually were sustained during the taxable year. If the Bank were no longer permitted to use the reserve method, the change would not have a significant adverse effect on the Bank's reported earnings under generally accepted accounting principles.
CONSOLIDATED TAX RETURNS; TAX SHARING PAYMENTS. On June 28, 1990, the Trust increased its ownership of the common stock of Chevy Chase from 60% to 80%. As a result of the Trust's 80% ownership of the common stock of the Bank, for federal income tax purposes Chevy Chase became a member of the Trust's affiliated group filing consolidated federal income tax returns for taxable years beginning on and after June 28, 1990. In recent years, the operations of the Trust have generated significant net operating losses. The Trust's NOLs as of its taxable year beginning October 1, 1994 are approximately $39.9 million. It is anticipated that, because Chevy Chase's operations will be included in the Trust's consolidated returns for the foreseeable future, these NOLs, and any other operating losses generated by the Trust or its other subsidiaries, will be available to reduce the federal income taxes that otherwise would be payable by Chevy Chase (and the other members of the Trust's affiliated group that have taxable income). Under the terms of a tax sharing agreement dated June 28, 1990 (the "Tax Sharing Agreement"), Chevy Chase is obligated to make payments to the Trust based on its taxable income, as explained more fully below. However, under the written agreement between Chevy Chase and the OTS (see "Banking - Regulation - Regulatory Capital"), Chevy Chase has agreed not to make tax sharing payments without the prior approval of the OTS.
The Tax Sharing Agreement generally provides that each member of the Trust's affiliated group is required to pay the Trust an amount equal to 100% of the tax liability that the member would have been required to pay to the IRS if the member had filed on a separate return basis. These amounts generally
must be paid even if the affiliated group has no tax liability or the group's tax liability is less than the sum of such amounts. Under the Tax Sharing Agreement, the Trust, in turn, is obligated to pay to the applicable tax authorities the overall tax liability, if any, of the group. In addition, to the extent the net operating losses or tax credits of a particular member reduce the overall tax liability of the group, the Trust is required to reimburse such member on a dollar-for-dollar basis from the amounts paid to the Trust by the other members of the group, thereby compensating the member for the group's use of its net operating losses or tax credits.
The Bank made a tax sharing payment of $20.6 million in fiscal 1990, tax sharing payments totaling $29.6 million in fiscal 1991 and a tax sharing payment of $5.0 million in fiscal 1993. OTS approval of the $5.0 million payment made in fiscal 1993 was conditioned on a pledge by or on behalf of the Trust of certain Trust assets to secure certain of its obligations under the Tax Sharing Agreement. Following execution of such a pledge, the OTS approved, and the Bank made, tax sharing payments of $9.6 million to the Trust in fiscal 1994. It is expected that the Bank will have taxable income over the next several years and that the Trust's NOLs and any additional operating losses will be utilized to reduce the overall tax liability of the group which would otherwise arise from such taxable income of the Bank (or from the taxable income of other members of the Trust's affiliated group). At September 30, 1994, the amount of tax sharing payments due to the Trust, but then unpaid, was $12.0 million. Subsequent to such date, the Bank made a tax sharing payment of $5.0 million to the Trust.
In general, if the Bank has net operating losses or unused tax credits in any taxable year, under the Tax Sharing Agreement the Trust is obligated to reimburse the Bank in an amount generally equal to (i) the tax benefit to the group of using such tax losses or unused tax credits in the group's consolidated federal income tax return for such year, plus (ii) to the extent such losses or credits are not used by the group in such year, the amount of the tax refunds which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group (but not in excess of the net amount paid by the Bank to the Trust pursuant to the Tax Sharing Agreement). There is no assurance that the Trust would be able to fulfill this obligation. If the Trust did not make the reimbursement, the OTS could attempt to characterize such nonpayment as an unsecured extension of credit by the Bank to the Trust which, as described above under "Holding Company Regulation," is prohibited under current law. The Tax Sharing Agreement itself does not provide for any remedies upon a breach by any party of its obligations under the Agreement. As noted above, at September 30, 1994 $12.0 million of tax sharing payments were due to the Trust (of which $5 million was
subsequently paid). Any reimbursement obligation of the Trust should be available to be offset against any obligation of the Bank to the Trust under the Tax Sharing Agreement that is unpaid at the time the reimbursement obligation arises.
STATE TAXATION
Maryland law does not allow the filing of consolidated income tax returns, and thus the Trust, the Bank and the subsidiaries of the Trust and the Bank subject to Maryland tax are required to file separately in Maryland. The Trust, the Bank and their respective subsidiaries are also subject to income taxes in other states.
BANKING REGULATION
Chevy Chase's operations have been significantly affected in recent years by substantial changes in applicable banking laws and regulations. The most significant changes resulted from the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") and the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA").
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the Federal Home Loan Bank ("FHLB") of Atlanta. The 12 FHLBs are administered by the Federal Housing Finance Board, an independent agency within the executive branch of the federal government. The FHLBs serve as a central credit facility for member savings institutions. Their primary credit mission is to enhance the availability of residential mortgages. From time to time, the Bank obtains advances from the FHLB. At September 30, 1994, the Bank had outstanding a $100.0 million advance from the FHLB of Atlanta. See Note 22 to the Consolidated Financial Statements in this report and "Deposits and Other Sources of Funds - Borrowings."
As a member of the FHLB of Atlanta, the Bank is required to acquire and hold shares of capital stock in that bank in an amount equal to the greater of: (i) 1.0% of mortgage-related assets (i.e., home mortgage loans, home-purchase contracts and similar obligations); (ii) 0.3% of total assets; (iii) $500; or (iv) 5.0% of outstanding advances. Pursuant to this requirement, the Bank had an investment of $31.9 million in FHLB stock at September 30, 1994. The Bank earned dividends of $1.8 million during each of the years ended September 30, 1994 and 1993, at weighted average annual rates of 5.65% and 5.63%, respectively, during such years.
LIQUIDITY REQUIREMENTS. The Bank is required to maintain a daily average balance of liquid assets (including cash, federal funds, certain time deposits, certain bankers' acceptances,
certain corporate debt securities and commercial paper, securities of certain mutual funds and specified U.S. Government, state government and federal agency obligations) equal to a specified percentage of its average daily balance of deposits (based upon the preceding month's average balances), plus borrowings (or portions thereof) payable in one year or less. This liquidity requirement is currently 5.0%. Federal regulations also require that each institution maintain an average daily balance of short-term liquid assets equal to at least 1.0% of its average daily balance of deposits, plus borrowings payable in one year or less. If an institution's liquid assets or short-term liquid assets at any time do not at least equal (on an average daily basis for the month) the amount required by the OTS, the institution could be subject to various monetary penalties imposed by the OTS. At September 30, 1994, the Bank was in compliance with both requirements, with a liquid assets ratio of 18.6% and a short-term liquid assets ratio of 5.1%.
DEPOSIT INSURANCE PREMIUMS. Under FDIC insurance regulations, the Bank is required to pay premiums to SAIF for insurance of its accounts. The FDIC has adopted a risk-based premium system, which took effect October 1, 1993, pursuant to which an institution pays premiums for deposit insurance ranging from 0.23% to 0.31% based on supervisory evaluations and on the institution's capital category under the OTS's prompt corrective action regulations. See "Prompt Corrective Action."
Although the FDIC insures commercial banks as well as thrifts, the insurance reserve funds for commercial banks and thrifts have been segregated into the Bank Insurance Fund ("BIF") and the SAIF, respectively. The FDIC is required to increase the reserves of both the BIF and the SAIF to 1.25% of insured deposits over a reasonable period of time and thereafter to maintain such reserves at not less than that level. According to forecasts by the FDIC and others, the BIF reserve is expected to reach 1.25% of insured deposits as early as mid-1995, at which point the insurance premium that commercial banks are required to pay could be reduced substantially. On the other hand, the SAIF, of which Chevy Chase is a member, is not expected to achieve the required 1.25% level until at least 2002 without Congressional action to provide additional funding or merge the BIF and SAIF. The potential resulting disparity in insurance premiums for commercial banks and thrifts could lead to a competitive disadvantage for the thrift industry in the pricing of loans and deposits and the incurrence of operating costs.
SAIF insurance may be terminated by the FDIC, after notice and a 30-day corrective period, upon a finding by the FDIC that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition
imposed by the FDIC. The 30-day period may be eliminated by the FDIC with the approval of the OTS.
REGULATORY CAPITAL. Under OTS regulations implementing the capital requirements imposed by FIRREA, savings institutions, such as the Bank, are subject to a minimum tangible capital requirement, a minimum core (or leverage) capital requirement, and a minimum total risk-based capital requirement. Each of these requirements generally must be no less stringent than the capital standards for national banks. At September 30, 1994, the Bank's tangible, core and total risk-based regulatory capital ratios were 4.96%, 5.34% and 12.19%, respectively, compared to the minimum requirements under FIRREA of 1.50%, 3.00% and 8.00%, respectively, in effect at that date. If the OTS policy to exclude net unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital had been in effect on September 30, 1994, the Bank's tangible, core and total risk-based regulatory capital ratios would have increased to 5.27%, 5.64% and 12.66%, respectively.
Under the minimum leverage ratio under FIRREA, Chevy Chase must maintain a ratio of "core capital" to tangible assets of not less than 3.0%. However, under the OTS "prompt corrective action" regulations, an institution that is not in the highest supervisory category must maintain a minimum leverage ratio of 4.0% to be considered an "adequately capitalized" institution. See "Prompt Corrective Action." "Core capital" generally includes common shareholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, less certain intangible assets, except that purchased mortgage servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs") may be included up to an aggregate amount of 50% of core capital. PCCRs are also subject to a sublimit of 25% of core capital. For these purposes, PMSRs and PCCRs are valued at the lesser of 90% of fair market value or 100% of the current unamortized book value. At September 30, 1994, the Bank had qualifying PMSRs of $13.2 million, which constituted 5.4% of core capital at that date, and had no PCCRs. Prior to March 4, 1994, PCCRs were not includable in core capital and PMSRs were includable, subject to a limit of 50% of core capital, at the lowest of 90% of fair market value, 90% of original cost or 100% of the current amortized book value.
The amount of qualifying supervisory goodwill that may be included in core capital was limited to 0.75% from January 1, 1993 through December 31, 1993, and is limited to 0.375% beginning January 1, 1994 and will be reduced to 0% beginning January 1, 1995. Phase-outs from capital also apply for investments in, and loans to, subsidiaries engaged in activities not permissible for national banks, for equity investments that are not permissible for national banks and for the portion of land loans and non-residential construction loans in excess of an
80% loan-to-value ratio.
The tangible capital requirement adopted by the OTS requires a savings institution to maintain "tangible capital" in an amount not less than 1.5% of tangible assets, which is the minimum limit permitted by FIRREA. "Tangible capital" is defined as core capital less any intangible assets (including supervisory goodwill), plus qualifying PMSRs valued at the amount includable in core capital.
The risk-based capital requirements issued by the OTS provide that the capital ratio applicable to an asset is adjusted to reflect the degree of credit risk associated with that asset and that the asset base for computing a savings institution's capital requirement includes off-balance-sheet assets. Capital must be maintained against the full amount of assets sold with recourse despite the fact that the assets are treated as having been sold under GAAP. However, the amount of capital required need not exceed the amount of recourse retained.
There are currently four categories of risk-weightings: 0% for cash and similar assets, 20% for qualifying mortgage-backed securities, 50% for qualifying residential permanent real estate loans and 100% for other loans, including credit card loans, commercial real estate loans and loans more than 90 days past due and for real estate acquired in settlement of loans. Savings institutions generally are required to maintain risk-based capital equal to 8.0% of risk-weighted assets, with at least half of that amount in the form of core capital.
A savings institution's supplementary capital may be used to satisfy the risk-based capital requirement only to the extent of the institution's core capital. Supplementary capital includes cumulative perpetual preferred stock, qualifying non-perpetual preferred stock, qualifying subordinated debt, nonwithdrawable accounts and pledged deposits, and general loan and lease loss reserves (up to a maximum of 1.25% of risk-weighted assets). At September 30, 1994, the Bank had $43.0 million in general reserves on loans and leases, all of which was includable as supplementary capital.
Subordinated debt may be included in supplementary capital with OTS approval subject to a phase-out based on its term to maturity. The phase-out established for such maturing capital instruments by the OTS permits an institution to include such instruments in supplementary capital under one of two phase-out options: (i) at the beginning of each of the last five years prior to the maturity date of the instrument, the institution may reduce the amount eligible to be included by 20% of the original amount or (ii) the institution may include only the aggregate amount of maturing capital instruments that mature in any one year during the seven years immediately prior to an instrument's
maturity that does not exceed 20% of the institution's capital. Once an institution selects either the first or second option, it must continue to select the same option for all subsequent issuances of maturing capital instruments as long as there is any outstanding balance of such instruments for which an option has been selected. The Bank has a $10.0 million capital note outstanding which is treated in accordance with the rules in effect at November 7, 1989, the date of issuance of the new regulation. At September 30, 1994, the Bank had $160.0 million in maturing capital instruments, of which $152.9 million was includable as supplementary capital. See "Deposits and Other Sources of Funds - Borrowings."
FDICIA required OTS and the other regulators to revise their risk-based capital standards to take into account interest-rate risk, concentration of credit risk and the risks of non-traditional activities. The OTS amended its risk-based capital rules effective January 1, 1994 to incorporate interest-rate risk measures to complement measures which already have been established for credit risk. An institution that would experience a change in "portfolio equity" in an amount in excess of 2.0% of the institution's assets as a result of a 200 basis point increase or decrease in the general level of interest rates is required to maintain additional amounts of risk-based capital based on the lowest interest rate exposure at the end of the three previous quarters. At September 30, 1994, the Bank was not required to maintain additional amounts of risk-based capital under the interest rate risk component of the capital regulations.
Effective January 17, 1995, the OTS will take into account concentration of credit risk and risks arising from non-traditional activities, as well as a thrift's ability to manage these risks, in evaluating whether the thrift should be subject to an individual minimum capital requirement. Based upon its review of the regulation, management does not believe that this change will cause the OTS to increase the Bank's minimum capital requirements.
OTS regulations contain special rules affecting savings institutions with certain kinds of subsidiaries. For purposes of determining compliance with each of the capital standards, a savings institution's investments in, and extensions of credit to, subsidiaries engaged in activities not permissible for a national bank ("non-includable subsidiaries") are, with certain exceptions, deducted from the savings institution's capital. At September 30, 1994, investments in non-includable subsidiaries are subject to a 40% phase-out from all three FIRREA capital requirements. This phase-out will increase to 60% on July 1, 1995 and 100% on July 1, 1996 in accordance with a delayed phase-in period approved by the OTS pursuant to legislation enacted in October 1992.
All or a portion of the assets of each of a savings institution's subsidiaries are generally consolidated with the assets of the savings institution for regulatory capital purposes unless all of the savings institution's investments in, and extensions of credit to, such subsidiary are deducted from capital. Chevy Chase's real estate development subsidiaries are its only subsidiaries engaged in activities not permissible for a national bank. At September 30, 1994, the Bank's investments in, and extensions of credit to, its non-includable subsidiaries totaled approximately $27.2 million, which was $44.3 million less than the level of such investments in, and extensions of credit to, its non-includable subsidiaries as of the regulatory "grandfather" date of April 12, 1989. Of the $27.2 million, $10.0 million constituted a deduction from tangible capital. Chevy Chase currently intends to continue to operate its non-includable subsidiaries, but to reduce gradually its aggregate investments in, and extensions of credit to, such subsidiaries.
OTS capital regulations also require the deduction from total capital of all equity investments that are not permissible for national banks and the portion of land loans and non-residential construction loans in excess of an 80% loan-to-value ratio. The deduction from total capital increased from 60% to 100% effective July 1, 1994. The Bank's only equity investments at September 30, 1994 are certain properties classified as real estate held for sale which the Bank has agreed to treat as equity investments for regulatory capital purposes. At September 30, 1994, the book value of these properties after subsequent valuation allowances amounted to $38.6 million, of which $34.0 million was required to be deducted from total capital. The Bank had no land loans or non-residential construction loans with loan-to-value ratios greater than 80% at September 30, 1994.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for real estate acquired in settlement of loans ("REO" or "real estate held for sale") to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital at the then-current phase-in percentage. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank would be required to deduct the then-current book value of such REO property from risk-based capital.
The Bank is actively managing its levels of investments in, and loans to, non-includable subsidiaries and equity investments to minimize the impact of the deductions from capital for these
investments as the deductions continue to increase. The Bank's ability to implement successfully these and other strategies for maintaining capital compliance is dependent on a number of factors, including, for example, general economic conditions and the continued recovery of local real estate markets. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Capital - Capital Maintenance Strategies."
In October 1993, the Bank and the OTS amended a written agreement dated September 30, 1991 that imposed certain restrictions on the Bank. As amended, the agreement continues to address transactions with affiliates, reduction of real estate acquired in settlement of loans, and asset quality. Specifically, the Bank has agreed that it will not, without receiving the prior approval of the OTS, (i) increase its investment in certain of its planned unit developments ("Communities"), including the four Communities which are under active development, beyond specified levels, (ii) make any additional tax sharing payments to B. F. Saul Real Estate Investment Trust (the "Trust"), which owns 80% of the Bank's common stock, or (iii) engage in any other transaction with the Trust. In addition, the Bank must (i) provide the OTS with 15 days notice prior to selling any asset with a value over $20 million, (ii) make every effort to reduce its exposure in certain of its Communities, including the four active Communities, (iii) notify the OTS 15 days prior to rejecting any purchase offers for the Communities and (iv) sell any single-family permanent loans for purchases of homes in the Communities if the terms of those loans are more favorable to the borrowers than terms prevailing in the general market. The amended agreement also requires the Bank to submit various periodic reports to the OTS. A material violation of the agreement could subject the Bank to additional regulatory sanctions. Management believes the Bank is in material compliance with the agreement.
The OTS has the authority to require an institution to maintain capital at levels above the minimum levels generally required, but has not indicated any intention to exercise its authority to do so with respect to the Bank.
PROMPT CORRECTIVE ACTION. Pursuant to FDICIA, the OTS and the other federal agencies regulating financial institutions have adopted regulations which apply to every FDIC-insured commercial bank and thrift institution a system of mandatory and discretionary supervisory actions which generally become more severe as the capital levels of an individual institution decline. The regulations establish five capital categories to which institutions are assigned for purposes of determining their treatment under these prompt corrective action provisions. An institution is categorized as "well capitalized" under the regulations if (i) it has a leverage ratio of at least 5.0%, a
tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%, and (ii) is not subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level. An institution is considered "adequately capitalized" if such capital ratios are at least 4.0% (3.0% if rated in the highest supervisory category), 4.0% and 8.0%, respectively. An institution with a leverage ratio below 4.0% (3.0% if rated in the highest supervisory category), a tier 1 risk-based capital ratio below 4.0% or a total risk-based capital ratio below 8.0% is considered "undercapitalized" and an institution with ratios under 3.0%, 3.0% or 6.0%, respectively, is considered "significantly undercapitalized." Finally, an institution is considered "critically undercapitalized," and subject to provisions mandating appointment of a conservator or receiver, if its ratio of "tangible equity" (generally defined by the OTS as core capital plus cumulative perpetual preferred stock) to total assets is 2.0% or less. An institution's classification category could be downgraded if, after notice and an opportunity for a hearing, the OTS determined that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity.
At September 30, 1994, based on the Bank's understanding of regulations in effect on that date, the Bank's leverage, tier 1 risk-based and total risk-based regulatory capital ratios were 5.34%, 6.95% and 12.19%, respectively, which exceeded the corresponding ratios of 5.0%, 6.0% and 10.0% established under the prompt corrective action regulations for "well capitalized" institutions, and the Bank was not subject to any applicable written agreement, order or directive to maintain a specific capital level. On a fully phased-in basis, at September 30, 1994, the Bank would exceed the capital standards established for "adequately capitalized" institutions. If the OTS policy to exclude unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital had been in effect on September 30, 1994, the Bank's leverage, tier 1 risk-based and total risk-based capital ratios would have been 5.64%, 7.35% and 12.66%, respectively.
GROWTH RESTRICTIONS. Primarily because of its level of non-performing assets, the Bank remains subject to restrictions on asset growth. Under the applicable OTS requirements, the Bank may not increase its total assets during any calendar quarter in excess of an amount equal to net interest credited on deposit liabilities during the quarter without prior written approval from OTS. The OTS notified the Bank on September 10, 1993 that it would waive this restriction for the period from July 1, 1993 through June 30, 1994 to allow for an increase in total assets of up to $500 million, subject to the conditions, among others, that the Bank's regulatory capital ratios increase with asset growth
and that the Bank maintain sufficient capital to meet the "well capitalized" ratios under the OTS's prompt corrective action regulations. In addition, on September 27, 1994, the OTS notified the Bank that it would not object to an increase in the Bank's total assets of approximately $75 million for the quarter ended September 30, 1994.
QUALIFIED THRIFT LENDER ("QTL") TEST. Insured savings institutions like the Bank must meet a QTL test to avoid imposition of certain restrictions. The QTL test requires thrifts to maintain a "thrift investment percentage" equal to a minimum of 65%. The numerator of such percentage is the thrift's "qualified thrift investments" and the denominator is the thrift's "portfolio assets." "Portfolio assets" is defined as total assets minus (i) the thrift's premises and equipment used to conduct its business, (ii) liquid assets, as defined, and (iii) intangible assets, including goodwill and purchased residential mortgage loan servicing rights. The QTL test must be met on a monthly average basis in nine out of every 12 months.
At September 30, 1994, the Bank had 78.2% of its portfolio assets invested in qualified thrift investments. Additionally, the Bank met the QTL test in each of the previous 12 months.
At least 55% of a thrift's "qualified thrift investments" must consist of residential housing loans (including home equity loans and manufactured housing loans), mortgage-backed securities and FHLB and Federal National Mortgage Association stock. Portions of other assets are also includable, provided that the total of these assets does not exceed 20% of portfolio assets. Assets in this category include 50% of residential housing loans originated and sold within 90 days, investments in real estate-oriented service corporations, 200% of mortgage loans for residences, churches, schools, nursing homes and small businesses in areas with unmet credit needs (low or moderate income areas where credit demand exceeds supply) and loans for personal, family household or educational purposes (which may not exceed 10% of portfolio assets). Intangible assets, including goodwill, are specifically excluded from qualified thrift investments.
An institution that fails to meet the QTL test is subject to significant penalties. Immediately after an institution ceases to be a QTL, it (i) may not make any new investment or engage directly or indirectly in any other new activity unless the investment or activity would be permissible for a national bank, (ii) may not establish any new branch office at any location at which a national bank could not establish a branch office, (iii) may not obtain new advances from the applicable FHLB and (iv) may not pay dividends beyond the amounts permissible if it were a national bank. One year following an institution's failure to meet the test, the institution's holding company parent must register and be subject to supervision as a bank holding company.
Three years after failure to remain a QTL, an institution may not retain any investments or engage in any activities that would be impermissible for a national bank, and must repay any outstanding FHLB advances as promptly as possible consistent with the safe and sound operation of the institution.
Because Chevy Chase is engaged in activities that are not currently permissible for national banks (i.e., its investments in subsidiaries that engage in real estate development activities), failure to satisfy the QTL test would require a significant change in Chevy Chase's current activities and would require a divestiture of any prohibited assets held at such time. Depending on the level of such activities at the time, compliance with these restrictions could have a significant adverse effect on the Bank. In addition, because the Trust is engaged in real estate ownership and development, which are activities that are currently prohibited for bank holding companies, failure by Chevy Chase to remain a QTL, in the absence of a significant restructuring of the Trust's operations, would, in effect, require the Trust to reduce its ownership of Chevy Chase to a level at which it no longer would be deemed to control the Bank.
The Bank has received permission from the OTS to include a specified percentage of the Bank's credit card portfolio as "housing-related" qualified thrift investments if the Bank otherwise would not meet the 65% requirement. The specified percentage is based on a statistical methodology approved by the OTS which must be updated annually. The only time the Bank has needed to include housing-relating credit card balances to meet the QTL test was in the quarter ended March 31, 1989.
The Bank has taken, and will continue to take, steps to meet the QTL test by structuring its balance sheet to include the required percentage of qualified thrift investments. The Bank's credit card loan securitization and sales activity to date has been undertaken, in part, to meet these objectives.
DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS. Under OTS regulations, the ability of thrift institutions such as the Bank to make "capital distributions" (defined to include payment of dividends, stock repurchases, cash-out mergers and other distributions charged against the capital accounts of an institution) varies depending primarily on the institution's regulatory capital level. The regulations do not apply to interest or principal payments on debt, including interest or principal payments on the Bank's outstanding subordinated debentures.
Institutions are divided into three tiers for purposes of these regulations. Tier 1 institutions are those in compliance with their "fully phased-in" capital requirements and which have not been notified by the OTS that they are "in need of more than normal supervision." Tier 1 institutions may make capital
distributions without regulatory approval in amounts up to the greater of (i) 100% of net income for the calendar year to date, plus up to one-half of the institution's surplus capital (i.e., the excess of capital over the fully phased-in requirement) at the beginning of the calendar year in which the distribution is made or (ii) 75% of net income for the most recent four quarters.
Tier 2 institutions are those in compliance with their current, but not their fully phased-in, capital requirements. Tier 2 institutions may make distributions without regulatory approval of up to 75% of their net income for the most recent four quarters. Tier 1 and Tier 2 institutions that make capital distributions under the foregoing rules must continue to meet the applicable capital requirements on a pro forma basis after giving effect to such distributions. Tier 1 and Tier 2 institutions may seek OTS approval to pay dividends beyond these amounts.
Tier 3 institutions have capital levels below their current required minimum levels and may not make any capital distributions without the prior written approval of the OTS.
The OTS retains general discretion to prohibit any otherwise permitted capital distributions on general safety and soundness grounds and must be given 30 days advance notice of all capital distributions. The OTS has approved the payment of dividends on the Bank's outstanding 13% Noncumulative Perpetual Preferred Stock, Series A (the "Preferred Stock"), provided that (i) immediately after giving effect to the dividend payment, the Bank's core and risk-based regulatory capital ratios would not be less than 4.0% and 8.0%, respectively; (ii) dividends are earned and payable in accordance with the OTS capital distribution regulation; and (iii) the Bank continues to make progress in the disposition and reduction of its non-performing loans and real estate owned.
At September 30, 1994, the Bank had sufficient levels of capital to be a Tier 1 institution. However, the OTS retains discretion under its capital distribution regulation to treat an institution that is in need of more than normal supervision (after written notice) as a Tier 2 or Tier 3 institution. In December 1994, the OTS proposed to amend its capital distribution regulation to simplify it and to conform it to the system of "prompt corrective action" established by FDICIA. The proposal would replace the current "tiered" approach with one that, in accordance with the OTS's "prompt corrective action" rule, would allow associations to make only those capital distributions that would not cause capital to drop below the level required to remain adequately capitalized. Those associations that are held by a savings and loan holding company, such as the Bank, or that receive a composite supervisory rating lower than "2" would continue to be required to notify the OTS prior to making any capital distributions. Those associations that are
undercapitalized or that would be undercapitalized following a capital distribution, or that are not undercapitalized but are in "troubled condition," could make a capital distribution only upon application to and approval by the OTS. The proposal would delete the current numerical restrictions on the amount of permissible capital distributions.
In May 1988, in connection with the merger of a Virginia thrift into the Bank, the Saul Company and the Trust entered into a capital maintenance agreement in which they agreed not to cause the Bank without prior written approval of its federal regulator to pay "dividends" in any fiscal year in excess of 50% of the Bank's net income for that fiscal year, provided that any dividends permitted under such limitation could be deferred and paid in a subsequent year. However, under the OTS capital distribution rule, with the OTS's written approval, the Bank could substitute the requirements of the proposed rule for any more stringent requirements imposed on it by a previous written agreement.
The Bank also is subject to other limitations on its ability to pay dividends. The indenture pursuant to which $150 million principal amount of the Bank's 9 1/4% Subordinated Debentures due 2005 was issued in 1993 (the "Indenture") provides that the Bank may not pay dividends on its capital stock unless, after giving effect to the dividend, no event of a continuing default shall have occurred and the Bank is in compliance with its regulatory capital requirements. In addition, the amount of the proposed dividend may not exceed the sum of (i) $15 million, (ii) 662/3% of the Bank's consolidated net income (as defined) accrued on a cumulative basis commencing on October 1, 1993 and (iii) the aggregate net cash proceeds received by the Bank after October 1, 1993 from the sale of qualified capital stock or certain debt securities, minus the aggregate amount of any restricted payments made by the Bank. Notwithstanding these restrictions on dividends, provided no event of default has occurred or is continuing under the Indenture, the Indenture does not restrict the payment of dividends on the Preferred Stock or any payment-in-kind preferred stock issued in lieu of cash dividends on the Preferred Stock or the redemption of any such payment-in-kind preferred stock.
The payment of any dividends on the Bank's common stock and Preferred Stock will be determined by the Board of Directors based on the Bank's liquidity, asset quality profile, capital adequacy and recent earnings history, as well as economic conditions and other factors deemed relevant by the Board of Directors, including applicable government regulations and policies. See "Deposits and Other Sources of Funds - Borrowings."
LENDING LIMITS. Since FIRREA, thrift institutions have been subject to the same loans-to-one-borrower limits that apply to national banks. With certain exceptions, the limits prohibit an institution from lending to one borrower (including certain related entities of the borrower) in an amount in excess of 15% of the institution's unimpaired capital and unimpaired surplus, plus an additional 10% for loans fully secured by readily marketable collateral. The Bank's loans-to-one-borrower limit was approximately $73.9 million at September 30, 1994, and no group relationships exceeded this limit at that date.
SAFETY AND SOUNDNESS STANDARDS. FDICIA, as amended in September 1994, requires the federal financial institution regulators to devise standards to evaluate the operations of depository institutions, as well as standards relating to asset quality, earnings and compensation. The operational standards must cover internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and employee compensation. The agencies have discretion to impose the standards through either regulations or guidelines. Any institution that fails to meet a standard that is imposed through regulation must submit a plan for corrective action within 30 days. If a savings association fails to submit or implement an acceptable plan, the OTS must order it to correct the deficiency, and may restrict its rate of asset growth, prohibit asset growth entirely, require the institution to increase its ratio of tangible equity to assets, restrict the interest rate paid on deposits to the prevailing rates of interest on deposits of comparable amounts and maturities, or require the institution to take any other action the OTS determines will better carry out the purpose of prompt corrective action. Imposition of these sanctions is within the discretion of the OTS in most cases, but is mandatory if the savings institution commenced operations or experienced a change in control during the 24 months preceding the institution's failure to meet these standards, or underwent extraordinary growth during the preceding 18 months.
In November 1993, the OTS and the other federal bank regulators published a joint notice of proposed rulemaking that solicited comment on proposed standards in these areas. Based on its review of the proposed regulation, management does not believe that these new requirements, if adopted substantially in the form proposed, would have a material adverse effect on the Bank's operations.
DISPOSITION OF ADC INVESTMENTS. Acquisition, development and construction ("ADC") loans classified as investments in real estate for accounting purposes are considered as ownership interests in real estate and, therefore, are not authorized investments for the Bank to hold directly. The OTS has directed
the Bank to refrain from entering into additional transactions of this nature in the future and to seek opportunities to remove existing ADC transactions that constitute real estate investments from its books as quickly as possible without material loss. At September 30, 1994, the Bank had only one ADC loan, with a book value of $8.9 million, before valuation allowances of $2.0 million, classified as an investment in real estate.
REGULATORY ASSESSMENTS. Pursuant to authority under FIRREA, the OTS has adopted the following fees to fund its operations: (i) asset-based assessments for all savings institutions, (ii) examination fees for certain affiliates of savings associations, (iii) application fees, (iv) securities filing fees and (v) publication fees. Of these fees, the asset-based assessments are the most significant. Such assessments, which are paid semi-annually every January 31 and July 31, incorporate a "general assessment" which varies depending on the asset size of the institution and an additional "premium assessment" for certain institutions requiring increased supervision. The Bank has been subject to this 50% "premium assessment" since October 1, 1991. As a result, the semi-annual assessment for the six-month period ending December 31, 1994 was $525,268, comprising a general assessment of $350,179 and a premium assessment of $175,089.
OTHER REGULATIONS AND LEGISLATION. As a thrift institution, Chevy Chase continues to be subject to a requirement that it obtain prior approval of the OTS before merging with another institution or before increasing its insured accounts through merger, consolidation, purchase of assets or assumption of liabilities. Also, as a SAIF-insured institution, the Bank is subject to limitations on its ability to buy or sell deposits from or to, or to combine with, a BIF-insured institution. Despite these restrictions, SAIF-insured thrifts may be acquired by banks or by bank holding companies under certain circumstances.
FIRREA substantially strengthened the enforcement powers of the federal agencies regulating financial institutions and increased the maximum penalties for violation of laws and regulations to as much as $1 million per day.
FDICIA imposes numerous oversight requirements on financial institutions. Among other things, FDICIA requires the Bank's management to submit an annual report on the condition of the Bank to the FDIC and the OTS.
Federally chartered thrifts like Chevy Chase generally are permitted to establish new branches anywhere in the United States, provided that they (i) meet their regulatory capital requirement; (ii) either have a satisfactory record under the OTS's regulations implementing the Community Reinvestment Act
("CRA") or have committed to improve their investment-related practices and performance to the satisfaction of the OTS; (iii) meet the domestic building and loan test of section 7701(a)(19) of the Internal Revenue Code or the asset composition test of subparagraph (C) of that section; and (iv) meet the domestic building and loan test or the asset composition test with respect to each state outside of its home state where the association has established branches.
Under legislation adopted in 1993, amounts realized by the FDIC from the liquidation or other resolution of any insured depository institution must be distributed to pay claims (other than secured claims to the extent of any such security) in the following order of priority: (i) administrative expenses of the receiver, (ii) any deposit liability of the institution, (iii) any other general or senior liability of the institution (which is not an obligation described in clause (iv) or (v)), (iv) any obligation subordinated to depositors or general creditors (which is not an obligation described in clause (v)) and (v) any obligation to stockholders arising as a result of their status as stockholders.
FEDERAL RESERVE SYSTEM. The Federal Reserve Board ("FRB") requires depository institutions, including federal savings banks, to maintain reserves against their transaction accounts and certain non-personal deposit accounts. Because reserves generally must be maintained in cash or non-interest-bearing accounts, the effect of the reserve requirement is to decrease the Bank's earning asset base. FRB regulations generally require that reserves be maintained against net transaction accounts. Prior to December 20, 1994, the first $4.0 million of a depository institution's transaction accounts were subject to a 0% reserve requirement. The next $47.9 million in net transaction accounts were subject to a 3.0% reserve requirement and any net transaction accounts over $51.9 million were subject to a 10.0% reserve requirement. Effective December 20, 1994, the FRB increased the amount of transaction accounts subject to a 0% reserve requirement from $4.0 million to $4.2 million and increased the "low reserve tranche" from $47.9 million to $49.8 million. The Bank met its reserve requirements for each period during the year ended September 30, 1994. The balances maintained to meet the reserve requirements imposed by the FRB also may be used to satisfy liquidity requirements which are imposed by the OTS.
Savings institutions may borrow from the FRB "discount window," although FRB regulations require these institutions to exhaust all reasonable alternate sources of funds, including FHLB sources, before borrowing from the FRB. FDICIA imposes additional limitations on the ability of the FRB to lend to
undercapitalized institutions through the discount window.
COMMUNITY REINVESTMENT ACT. Under the Community Reinvestment Act and the OTS's implementing regulations, a savings association has a continuing and affirmative obligation to help meet the credit needs of its local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. In connection with its examination of a savings association, the OTS is required to assess the institution's record in satisfying the intent of the CRA. In addition, the OTS is required to take into account the institution's record of meeting the credit needs of its community in determining whether to grant approval for certain types of applications.
The Bank is committed to fulfilling its CRA obligation by providing access to a full range of credit-related products and services to all segments of its community. However, in September 1994, the OTS issued a final CRA evaluation which criticized several aspects of the Bank's CRA performance and changed the Bank's rating from "satisfactory" to "needs to improve." The OTS evaluation, which was based on an examination dated May 17, 1993, focused largely on the Bank's lending performance during 1991 and 1992. Management believes that the OTS evaluation failed to give sufficient weight to the Bank's subsequent lending performance under CRA after it emerged from the effects of the recession in those years. See "Single-Family Residential Real Estate Lending."
In September 1994, the federal bank regulatory agencies issued for public comment proposed revisions to the CRA regulations that are designed to focus the CRA examination process on an institution's actual performance in meeting the credit needs of low- and moderate-income neighborhoods rather than on its CRA compliance procedures. Specifically, an institution would be evaluated on the basis of its lending and investment in, and provision of services, to low- and moderate-income areas. Institutions like the Bank, with more than $250 million in assets, would be required to report additional data concerning consumer and small business loans. If these revised regulations are adopted as proposed, they would be effective as of July 1, 1996.
OTHER ASPECTS OF FEDERAL LAW. The Bank is also subject to federal statutory provisions covering other items, including security procedures, currency transactions reporting, insider and affiliated party transactions, management interlocks, truth-in-lending, electronic funds transfers, funds availability and equal credit opportunity.
RECENT ACCOUNTING PRONOUNCEMENTS. Statement of Financial Accounting Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments" ("SFAS 119"), was issued in October 1994. SFAS 119 requires companies to disclose the amount, nature and terms of derivative financial instruments. Because SFAS 119 addresses only disclosure-related issues, its adoption will not have an impact on the financial condition or results of operations of the Bank. Adoption of SFAS 119 is required for fiscal years ending after December 15, 1994. The Bank will be required to adopt SFAS 119 by September 30, 1995.
MARKET AREA
The Bank's principal deposit and lending markets are located in the Washington, D.C. metropolitan area. Service industries and federal, state and local governments employ a significant portion of the Washington, D.C. area labor force, while a substantial number of the nation's 500 largest corporations have some presence in the area. The Washington, D.C. area's seasonally unadjusted unemployment rate is generally below the national rate and was 3.9% in September 1994, compared to the national rate of 5.6%.
Chevy Chase historically has relied on retail deposits originated in its branch network as its primary funding source. See "Deposits and Other Sources of Funds." Chevy Chase's principal market for deposits consists of Montgomery and Prince George's Counties in Maryland and, to a lesser extent, Fairfax County in Virginia. Approximately 25.3% of the Bank's deposits at September 30, 1994 were obtained from depositors residing outside of Maryland, primarily in Northern Virginia. Chevy Chase had the largest market share of deposits in Montgomery County at June 30, 1994, according to published industry statistics. The per capita income of each of Montgomery and Fairfax Counties ranks among the highest of counties and equivalent jurisdictions nationally. These two counties are also the Washington, D.C. area's largest suburban employment centers, with a substantial portion of their labor force consisting of federal, state and local government employees. Private employment is concentrated in services and retail trade centers. Unemployment in both Montgomery and Fairfax Counties in September 1994 (3.1%) was below the national rate (5.6%) and state rates (5.2% for Maryland and 4.9% for Virginia) for the same month.
The Bank historically has concentrated its lending activities in the Washington, D.C. metropolitan area. See "Lending Activities."
INVESTMENT AND OTHER SECURITIES
The Bank is required by OTS regulations to maintain a specific minimum amount of liquid assets and short-term liquid assets invested in certain qualifying types of investments. See "Regulation - Liquidity Requirements." To meet these requirements, the Bank maintains a portfolio of cash, federal funds and mortgage-backed securities with final maturities of five years or less. The balance of investments in excess of regulatory requirements reflects management's objective of maintaining liquidity at a level sufficient to assure adequate funds to meet expected and unexpected balance sheet fluctuations.
Investment and mortgage-backed securities available-for-sale are reported at fair value, with unrealized gains and losses reported as a net amount in a separate component of stockholders' equity, net of the related income tax effect.
The OTS has adopted guidelines governing investment securities held by SAIF-insured institutions. The guidelines require that investments in securities be accounted for in accordance with GAAP, summarize the applicable accounting principles and provide guidance regarding the application of GAAP in determining whether securities are properly classified as held-to-maturity, available-for-sale or trading.
LENDING ACTIVITIES
LOAN PORTFOLIO COMPOSITION. At September 30, 1994, the Bank's loan portfolio totaled $2.5 billion, which represented 53.7% of its total assets. (All references in this report to the Bank's loan portfolio refer to loans, whether they are held for sale and/or securitization or for investment, and exclude mortgage-backed securities.) Loans collateralized by single-family residences constituted 55.2% of the loan portfolio at that date.
The following table sets forth information concerning the Bank's loan portfolio (net of unfunded commitments) for the periods indicated.
Loan Portfolio (Dollars in thousands)
The Bank will continue to adjust the composition of its loan portfolio in response to a variety of factors, including regulatory requirements and asset and liability management objectives. See "Regulation - Regulatory Capital" and "- Qualified Thrift Lender ("QTL") Test" and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - - Banking - Asset and Liability Management."
CONTRACTUAL PRINCIPAL REPAYMENTS OF LOANS. The following table shows the scheduled contractual principal repayments of the Bank's loans at September 30, 1994. The entire balance of loans held for sale and/or securitization is shown in the year ending September 30, 1995, because such loans are expected to be sold in less than one year.
Contractual Principal Repayments (In thousands)
Actual payments may not reflect scheduled contractual principal repayments due to the effect of loan refinancings, prepayments and enforcement of due-on-sale clauses, which give the Bank the right to declare a "conventional loan" -- one that is neither insured by the Federal Housing Administration ("FHA") nor partially guaranteed by the Veterans' Administration ("VA") -- immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. Although the Bank's single-family residential loans historically have had stated maturities of generally 30 years, such loans normally have remained outstanding for substantially shorter periods because of these factors. At September 30, 1994, principal repayments of $265.4 million are contractually due to the Bank within the next year. Of the $265.4 million, $77.6 million is contractually due on fixed-rate loans and $186.8 million is contractually due on adjustable-rate loans.
ORIGINATION, PURCHASE AND SALE OF REAL ESTATE LOANS. The following table shows changes in the composition of the Bank's real estate loan portfolio and the net change in mortgage-backed securities.
Origination, Purchase and Sale of Real Estate Loans (In thousands)
As a federally chartered savings institution, the Bank has general authority to make loans secured by real estate located throughout the United States. Approximately 95.0% of the Bank's real estate loans at September 30, 1994 by principal balance were secured by properties located in Maryland, Virginia or the District of Columbia.
The Bank originates VA, FHA and a wide variety of conventional residential mortgage loans through its wholly-owned mortgage banking subsidiary, B. F. Saul Mortgage Company, or directly through Chevy Chase Mortgage, a division of the Bank. Commercial, real estate construction and ground and home equity credit line loans are originated directly by the Bank.
The Bank maintains a wholesale network of correspondents, including loan brokers and financial institutions, in order to supplement its direct origination of single-family adjustable-rate residential mortgage loans in the Washington, D.C. metropolitan area. The Bank determines the specific loan products and rates under which the correspondents originate the loans, and subjects the loans to the Bank's underwriting criteria and review. During the year ended September 30, 1994, approximately $256.6 million of loans settled under the correspondent program.
Loan sales provide the Bank with liquidity and additional funds for lending, enabling the Bank to increase the volume of loans originated and thereby increase loan interest and fee income, and in recent periods have produced additional non-interest income in the form of gains on sales of loans. In fiscal 1994, sales of mortgage loans originated or purchased for sale by the Bank totaled $851.6 million. The marketability of loans, loan participations and mortgage-backed securities depends on purchasers' investment limitations, general market and competitive conditions, mortgage loan demand and other factors. The Bank originates fixed-rate, single-family, long-term loans on terms which conform to Federal Home Loan Mortgage Corporation ("FHLMC") and Federal National Mortgage Association ("FNMA") guidelines in order to ensure the saleability of the loan in the public secondary mortgage market. In order to manage its interest-rate exposure, the Bank hedges its fixed-rate mortgage loan pipeline by entering into whole loan and mortgage-backed security forward sale commitments. Sales of residential mortgage loans are generally made without recourse to the Bank. At September 30, 1994, the Bank had $33.6 million of single-family residential loans held for sale to investors.
When the Bank sells a whole loan or loan participation and retains servicing, or purchases mortgage servicing rights from third parties, it continues to collect and remit loan payments, inspect the properties, make certain insurance and tax payments on behalf of borrowers and otherwise service the loans. The
normal servicing fee, generally ranging from 0.25% to 0.50% of the outstanding loan principal amount per annum, is recognized as income over the life of the loans. The Bank also typically derives income from temporary investment for its own account of loan collections pending remittance to the participation or whole loan purchaser. At September 30, 1994, the Bank was servicing residential permanent loans totaling $1.5 billion for other investors.
SALES OF MORTGAGE-BACKED SECURITIES. A significant portion of the Bank's sales of mortgage-backed securities involve sales pursuant to the Bank's normal mortgage banking operations. Generally, the Bank's policy is to sell its fixed-rate mortgage production which, in the case of most conforming fixed-rate loans, is accomplished by first pooling such loans into mortgage-backed securities. The mortgage-backed securities sold as part of the Bank's mortgage banking operations are generally issued in the same month as the sale of such securities. The securities are formed from conforming fixed-rate loans originated for sale or from fixed-rate loans resulting from the borrower's election to convert from a variable-rate loan to a fixed-rate loan. In accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," mortgage-backed securities held for sale in conjunction with mortgage banking activities are classified as trading securities. As a result, the Consolidated Statements of Cash Flows in this report reflect significant proceeds from the sales of securities, even though there are no balances of trading securities at September 30, 1994. Fixed-rate loans are designated as held for sale in the Consolidated Balance Sheets in this report.
SINGLE-FAMILY RESIDENTIAL REAL ESTATE LENDING. The Bank originates a variety of loans secured by single-family residential structures. At September 30, 1994, $1.4 billion (or 55.2%) of the Bank's loan portfolio consisted of loans secured by first or second mortgages on such properties, including $22.9 million of FHA-insured or VA-guaranteed loans.
Chevy Chase currently offers fixed-rate loans with maturities of 15 to 30 years and adjustable-rate residential mortgage loans ("ARMs"), principally with maturities of 30 years. At September 30, 1994, 44.4% of the Bank's loans consisted of ARMs scheduled to have interest rate adjustments within one to five years. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Asset and Liability Management." Interest rates on the majority of the Bank's ARMs are adjusted based on changes in yields on U.S. Treasury securities of varying maturities. The interest rate adjustment provisions of the Bank's ARMs contain limitations on the frequency and maximum amount of interest rate adjustments, although such limitations
are not required by law. These limitations are determined by a variety of factors, including mortgage loan competition in the Bank's markets. The ARMs currently offered by the Bank are generally subject to a limitation on the annual increase in the interest rate of 2.0% and a limitation on the increase in the interest rate over the term of the loan ranging from 6.0% to 9.0%.
The Bank has established a number of programs to meet the credit needs of the various communities which it serves. During fiscal 1994, the Bank announced a five-year commitment of $1.0 billion to meet the credit needs of low- and moderate-income borrowers. In March 1993, the Bank established the Chevy Chase Community Development Loan Fund, which provided $25.0 million of mortgage financing at below-market rates to low- and moderate-income families in the Washington, D.C. metropolitan area. In August 1994, the Bank established the Community Development Loan Fund Program II to provide an additional $140.0 million of mortgage financing at below-market rates to low- and moderate-income families in certain areas of Washington, D.C. and Prince George's County, Maryland. During fiscal 1994, the Bank dedicated $53.0 million to support the District of Columbia's Home Purchase Assistance Program, which furnishes assistance to low- and moderate-income first-time home buyers. The Bank's settlement agreement with the Department of Justice requires the Bank, among other things, to provide $7.0 million over a five-year period in subsidies for below-market mortgage loans to residents of designated census tracts in Washington, D.C. and Prince George's County, Maryland. See "Legal Proceedings."
The Bank's home equity credit line loan provides revolving credit secured principally by a second mortgage on the borrower's home. Home equity credit line loans bear interest at a variable rate that adjusts quarterly based on changes in the applicable interest rate index and generally are subject to a maximum annual interest rate of between 18.0% and 24.0%. Except for any amortization of principal that may occur as a result of monthly payments, there are no required payments of principal until maturity. In order to promote its home equity credit line loan program, the Bank currently offers prospective borrowers a below-market interest rate for an introductory period and settlement without closing costs.
Securitizations of home equity credit line receivables have been an integral element of the Bank's strategies to enhance liquidity and to maintain compliance with regulatory capital requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking." The Bank transferred $181.9 million, $340.4 million and $253.6 million of home equity credit line receivables in fiscal 1994, fiscal 1993 and fiscal 1992, respectively, to trusts for securitization and sale to investors.
Gains of $9.5 million, $16.8 million and $15.1 million were recognized by the Bank as a result of these transactions. The Bank continues to service the underlying accounts.
COMMERCIAL REAL ESTATE AND CONSTRUCTION LENDING. Aggregate balances of residential construction, commercial construction, ground and commercial and multifamily loans decreased 12.9% in fiscal 1994 to $136.6 million at September 30, 1994 from $156.7 million at September 30, 1993. In its past five fiscal years, the Bank has de-emphasized permanent commercial real estate loans, land acquisition and land development loans, and loans for construction of commercial income-producing properties. This type of lending generally is considered to involve a higher level of risk than single-family mortgages or other consumer lending due to the concentration of principal in a limited number of loans and borrowers. However, in fiscal 1993 and fiscal 1994, the Bank provided financing generally at market rates, to certain purchasers of its commercial REO. Additionally, the Bank continues to finance the construction of residential real estate, principally single-family detached homes and townhouses, but generally only when a home is under contract for sale by the builder to a consumer.
CREDIT CARD LENDING. Since June 1985, Chevy Chase has been providing retail credit through its credit card program, which offers VISA-R- and MasterCard-R- credit cards and the related Gold Cards. Chevy Chase issues the credit cards and receives interest income on credit extended, a fee based on a percentage of credit sales paid by merchants accepting card purchases, and an annual membership fee for use of the cards. Chevy Chase's credit card loan portfolio accounted for 25.5% of Chevy Chase's total loans at September 30, 1994. According to statistics published in SHESHUNOFF S&L QUARTERLY, Chevy Chase is the third largest issuer of credit cards among thrift institutions, based on total credit card loans outstanding at June 30, 1994. At September 30, 1994, credit card loans outstanding totaled $650.2 million and managed credit card receivables, including receivables owned by the Bank and receivables securitized, sold and serviced by the Bank, totaled $2.6 billion.
The Bank has emphasized credit card lending in recent years because the shorter term and normally higher interest rates on such loans help it maintain a profitable spread between its average loan yield and its cost of funds. In addition, credit card accounts typically may be sold at a premium over their receivables balances, thus further enhancing their potential value to the Bank. Chevy Chase also believes its credit card program contributes to market share growth in its local markets by attracting new depositors, promoting a high degree of customer loyalty and providing opportunities to cross-market other products of the Bank. For this reason, the Bank has not sold any credit card accounts maintained by cardholders having addresses
in Maryland, Virginia or the District of Columbia, the Bank's primary market area.
The Bank historically has obtained new credit card accounts through various methods, including direct-mail. In November 1990, the Bank ceased active national solicitation of new credit card accounts due in part to the significant initial cost of acquiring accounts and the Bank's desire to enhance its capital position. In fiscal 1993, as a result of the improvement in the Bank's financial condition, the Bank reinstated the active national solicitation of new credit card accounts in markets which the Bank considers to have favorable demographic characteristics.
Chevy Chase's internal data processing systems are capable of handling a broad range of credit card program operations, including processing of credit applications and collection functions. Certain data processing and administrative functions associated with the servicing of the credit card accounts are performed on behalf of the Bank by First Data Resources Incorporated from its facilities in Omaha, Nebraska.
Changes in credit card use and payment patterns by cardholders, including increased defaults, may result from a variety of social, legal and economic factors. Chevy Chase currently offers introductory periodic interest rates for varying initial periods which, at the conclusion of such periods, revert to the Bank's regular variable interest rate. If account holders choose to utilize competing sources of credit, the rate at which new receivables are generated may be reduced and certain purchase and payment patterns with respect to the receivables may be affected. Economic factors affecting credit card use include the rate of inflation and relative interest rates offered for various types of loans. Adverse changes in economic conditions could have a direct impact on the timing and amount of payments by borrowers. During times of economic recession, default rates on credit card loans generally may be expected to exceed default rates on residential mortgage loans. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - - Asset Quality - Delinquent Loans" and " - Reserves for Losses."
Certain issuers of credit cards have adjusted their pricing to provide for the different credit risks among customers based upon card usage, repayment habits and other criteria. The Bank has implemented such risk-based pricing by increasing the interest rates charged to high-risk customers and by continuing to allow premium-credit customers a more favorable rate. The Bank currently offers premium-credit customers the option to convert to a variable-rate product which currently provides the cardholder with a lower interest rate than the Bank's fixed-rate product. Periodically, the Bank offers promotional discounts to certain customers to encourage increased usage of the Bank's credit cards.
Securitizations of credit card receivables and sales of credit card relationships have been integral elements of the Bank's strategies to enhance liquidity, to further asset and liability management objectives and to maintain compliance with regulatory capital and "qualified thrift lender" requirements. In fiscal 1994, 1992, 1991 and 1990, the Bank sold approximately 400,000 credit card relationships at a premium over their receivables balances of $96.5 million, $14.9 million, $273.4 million and $646.0 million, respectively. No such sales occurred during fiscal 1993. The Bank transferred $1.4 billion, $350.0 million, $280.0 million and $450.0 million of credit card receivables in fiscal 1994, fiscal 1993, fiscal 1992 and fiscal 1990, respectively, to trusts for securitization and sale to investors. No gain or loss was recognized by the Bank as a result of these transactions; however, the Bank continues to service the underlying accounts, and excess servicing fees are recognized over the related lives of the transactions. These excess servicing fees represent the contractual interest and fees paid by the cardholders less certificate interest paid to the certificateholders and administrative fees paid to providers of services to the trusts.
Chevy Chase plans to securitize an additional $850 million of credit card receivables during the first and second quarters of fiscal 1995. Certain of these receivables at September 30, 1994 were classified as loans held for securitization and sale in the Consolidated Balance Sheets in this report.
Credit card loans are not subject to those provisions of federal laws and regulations that limit to 35% of an institution's total assets the amount of consumer loans that a federally chartered savings institution may make.
CONSUMER AND OTHER LENDING. Chevy Chase currently offers a variety of consumer loans other than credit card loans, including automobile loans, overdraft lines of credit and unsecured loans for traditional consumer purchases and needs. The largest area of growth has been in automobile loans, which increased $182.6 million during fiscal 1994 due to the Bank's expansion of its automobile lending program. The Bank's portfolio of automobile loans and other consumer loans totaled $289.3 million and $66.9 million, respectively, at September 30, 1994. Automobile loans and other consumer loans (other than credit card loans) accounted for 14.0% of total loans at that date.
Federal laws and regulations permit a federally chartered savings institution to make secured and unsecured consumer loans up to 35% of the institution's total assets. In addition, a federally chartered savings institution has lending authority above the 35% limit for certain consumer loans which include, in addition to credit card loans, home improvement, secured deposit account and educational loans.
REAL ESTATE LOAN UNDERWRITING. In the loan approval process, Chevy Chase assesses both the borrower's ability to repay the loan and, in appropriate cases, the adequacy of the proposed security. Credit approval is vested with the Board of Directors and delegated to the Executive Loan Committee and certain senior officers in accordance with the credit authorizations approved by the Board of Directors. All construction and commercial real estate loans are reviewed and approved by the Executive Loan Committee. Any significant loan not conforming to the Bank's approved policies must be approved by the Executive Loan Committee or the Chief Executive Officer. All loans of $15 million or more are presented to the Board of Directors for final approval.
The approval process for all types of real estate loans includes on-site appraisals of the properties securing such loans and a review of the applicant's financial statements and credit, payment and banking history, financial
statements of any guarantors, and tax returns of guarantors of construction and commercial real estate loans.
In an effort to minimize the increased risk of loss associated with construction and development loans, Chevy Chase considers the reputation of the borrower and the contractor, reviews pre-construction sale and leasing information, and requires an independent inspecting engineer or architect to review the progress of multifamily and commercial real estate projects. In addition, the Bank generally requires personal guarantees of developers for all development loans and, if a general contractor is used by the developer, may require the posting of a performance bond.
The Bank generally lends up to 95% of the appraised value of single-family residential dwellings to be owner-occupied. The Bank also lends up to 85% of the appraised value of the completed project to finance the construction of such dwellings, and, on a case-by-case basis, the Bank occasionally may lend up to 90% of such appraised value when such financing is limited to pre-sold units. The loan-to-value ratio generally applied by the Bank to commercial real estate loans and multifamily residential loans has been 80% of the appraised value of the completed project. Currently, the Bank generally does not originate a second mortgage loan (excluding home equity credit line loans) if the aggregate loan-to-value ratio of the second loan and the related first mortgage loan exceeds 80% of the appraised value of the property. In February 1994, the Bank increased the maximum loan-to-value ratio for home equity credit line loans to 90% from 80% provided that private mortgage insurance is obtained for the amount over 80% of the value of the underlying property. Loan-to-value ratios are determined at the time a loan is originated. Consequently, subsequent declines in the value of the loans' collateral could expose the Bank to losses.
Pursuant to FDICIA, OTS regulations require institutions to adopt internal real estate lending policies, including loan-to-value limitations conforming to specific guidelines established by the OTS. The Bank's current lending policies conform to these new regulations.
On all loans secured by real estate (other than certain home equity credit line loans), Chevy Chase requires title insurance policies protecting the priority of the Bank's liens. The Bank requires fire and casualty insurance for permanent loans (including home equity credit line loans) and fire, casualty and builders' risk insurance for construction loans. The borrower selects the insurance carrier, subject to Chevy Chase's approval. Generally, for
any residential loan (including home equity credit line loans) in an amount exceeding 80% of the appraised value of the security property, Chevy Chase currently requires mortgage insurance from an independent mortgage insurance company. The majority of the Bank's mortgage insurance is placed with four carriers.
Substantially all fixed-rate mortgage loans originated by the Bank contain a "due on sale" clause providing that the Bank may declare a loan immediately due and payable in the event, among other things, that the borrower sells the property securing the loan without the consent of the Bank. The Bank's ARMs generally are assumable.
CREDIT CARD LOAN UNDERWRITING. Beginning with the resumption of active solicitation of new accounts in fiscal 1993, the Bank generates new accounts through various methods, including direct-mail. The Bank identifies potential cardholders for preapproved solicitations by supplying a list of credit criteria to a credit bureau, which generates a list of individuals who meet such criteria. When the Bank receives an acceptance certificate from an individual that received a preapproved solicitation, the Bank obtains a credit report on such individual issued by an independent credit reporting agency, and the credit limit and terms of the account are subject to certain post-screening underwriting reviews performed by the Bank.
The Bank's underwriting approach to account approval supplements a computerized credit scoring system with an individual evaluation of each completed application for creditworthiness. In the underwriting process, the Bank considers the prospective cardholder's income, credit history, outstanding debt as a percentage of gross income and other factors intended to provide a general indication of the applicant's willingness and ability to repay his obligations. The Bank also reviews a credit report on each applicant issued by an independent credit reporting agency and, for certain applicants, independently verifies employment, income or other information contained in the credit application.
If an application is approved, the Bank establishes an initial credit limit on the cardholder's account based on the limit requested in the credit application and the Bank's evaluation of the cardholder's creditworthiness. This credit limit is adjusted from time to time based on the Bank's continuing evaluation of the cardholder's repayment ability as evidenced by the cardholder's payment history and other factors. The Bank also may increase the credit limit at the cardholder's request after completion of an
evaluation comparable to that performed during the initial underwriting.
Management reviews credit losses on a monthly basis and adjusts the Bank's underwriting standards as appropriate.
LOAN SERVICING. In addition to interest earned on loans, the Bank receives income through servicing of loans and fees in connection with loan origination, loan modification, late payments, changes of property ownership and miscellaneous services related to its loans. Loan servicing income, principally servicing income earned on the Bank's securitized credit card, home equity credit line and other consumer receivables portfolios, has been a source of substantial earnings for the Bank in recent periods. Income from these activities varies with the volume and type of loans originated and sold.
The following table sets forth certain information relating to the Bank's servicing income as of or for the years indicated.
The Bank earns fees in connection with the servicing of home equity credit line loans, credit card loans, automobile loans and single-family residential mortgage loans. The Bank's level of servicing fee income increases or decreases
with increases or decreases in securitized balances of these loan types. The substantial increase in loan servicing fee income in fiscal 1994 from the level achieved in fiscal 1993 was principally attributable to an increase in securitized credit card receivables outstanding and decreased charge-offs, which combined to increase the amount of servicing income earned on credit card securitizations. The Bank's level of servicing fee income declines upon repayment of assets previously securitized and sold and repayment of mortgage loans serviced for others. As the Bank securitizes and sells assets, purchases mortgage servicing rights, or sells mortgage loans and retains the servicing rights on those loans, the level of servicing fee income increases. During fiscal 1994, the Bank securitized and sold $1.4 billion of credit card receivables and $181.9 million of home equity credit line receivables. In fiscal 1994, the Bank also sold the rights to service mortgage loans with an aggregate principal balance of $383.9 million, which were originated by the Bank in connection with its mortgage banking activities.
The Bank's investment in loan servicing rights (including purchased mortgage servicing rights and excess loan servicing assets), and the amortization of such rights, are evaluated quarterly based on the discounted value of estimated future net cash flows to be generated by the underlying loans. Changes in the discounted value are recorded as amortization expense (in the case of purchased mortgage servicing rights) or as a reduction of fee income (in the case of excess loan servicing assets) in the period in which the change occurs. Several estimates are used when determining the discounted value, the most significant of which is the estimated rate of repayment of the underlying loans.
The Bank's current origination fees on its single-family mortgage loans generally range from 1.0% to 3.0% of the principal amount of the loan. Its current origination fees on construction and multifamily residential and commercial real estate loans generally range from 0.5% to 2.0% of the principal amount of the loan.
Loan origination and commitment fees, and the related costs associated with making the loans, are deferred in accordance with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." For fully amortizing loans originated for the Bank's portfolio, the net deferred fees are accredit to interest income over the estimated life of the loans using the level-yield method. Fees deferred on revolving credit lines or loans which have no scheduled amortization
originated for the Bank's portfolio are accredit to income over the estimated lives of the underlying loans using the straight-line method, which is not materially different from the level-yield method.
Fees deferred on loans originated and held for sale are not accredit to income but instead are used in determining the gain or loss on the sale of the loans.
DELINQUENCIES, FORECLOSURES AND RESERVES FOR LOSSES
DELINQUENCIES AND FORECLOSURES. When a borrower fails to make a required payment on a mortgage loan, the loan is considered delinquent and, after expiration of the applicable cure period, the borrower is charged a late fee. The Bank follows practices customary in the banking industry in attempting to cure delinquencies and in pursuing remedies upon default. Generally, if the borrower does not cure the delinquency within 90 days, the Bank initiates foreclosure action. If the loan is not reinstated, paid in full or refinanced, the security property is sold. In some instances, the Bank may be the purchaser. Thereafter, such acquired property is listed in the Bank's account for real estate acquired in settlement of loans until the property is sold. Deficiency judgments generally may be enforced against borrowers in Maryland, Virginia and the District of Columbia, but may not be available or may be subject to limitations in other jurisdictions in which loans are originated by the Bank.
The total outstanding balance of a credit card loan (the largest category of the Bank's consumer loans) is considered contractually delinquent if the minimum payment indicated on the cardholder's statement is not received by the due date indicated on such statement. Efforts to collect contractually delinquent credit card receivables currently are made by the Bank's service center personnel or the Bank's designees. Collection activities include statement messages, formal collection letters and telephone calls. The Bank may, at its option, enter into arrangements with cardholders to extend or otherwise change payment schedules. Delinquency levels are monitored by collection managers, and information is reported regularly to senior management. Accounts are charged off when they become 180 days contractually delinquent, although the Bank continues to attempt to collect balances due and, in some cases, may refer the accounts to outside collection agencies.
See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Asset Quality - Delinquent Loans" for a discussion of the Bank's delinquent loan portfolio at September 30,
1994.
RESERVES FOR LOSSES. It is the Bank's policy to maintain adequate reserves for estimated losses on loans and real estate. Generally, the reserves are based on, among other things, historical loan loss experience, evaluation of economic conditions in general and in various sectors of the Bank's customer base, and periodic reviews of loan portfolio quality by Bank personnel. Reserves for losses on loans and real estate are based on current events or facts that may ultimately lead to future losses. The Bank's actual losses may vary from management's current estimates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Asset Quality - Reserves for Losses."
The Bank's specific methods for establishing the appropriate levels of reserves vary depending upon the assets involved. The Bank's reserve for credit card loans is based on a number of factors, including historical charge-off and repayment experience and the age of the portfolio. The Bank has developed a static pool model to extrapolate its reserve needs based on an analysis of the characteristics of the portfolio and trends at any particular time. In this regard, the Bank considers historical charge-off information relative to origination date, borrower profiles, age of accounts, delinquencies, bankruptcies and other factors. Although industry standards are considered, they are given comparatively less weight due to management's belief that comparisons among different institutions' portfolios are potentially misleading because of significant differences in underwriting standards, curing and re-aging procedures and charge-off policies. Chevy Chase's policy is to charge off credit card receivables when they become 180 days contractually delinquent. The Bank's actual charge-off experience for credit card loans may vary from the levels forecasted by the Bank's static pool model because credit card loans typically are more sensitive to general economic conditions than certain other types of loans. For example, an unforeseen decline in economic activity may result in increased bankruptcy losses which the model is unable to forecast. Nevertheless, because the Bank's model employs a rolling 12-month base, such unforeseen losses are incorporated into the model as they occur and reserves are adjusted accordingly. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Banking - Asset Quality - Reserves for Losses."
The Bank's methods for determining the reserve for loans secured by real estate vary depending on whether the loans are secured by residential homes or by other real
estate. For residential mortgage loans, management computes the reserve by stratifying residential permanent loans on a state by state and ownership (i.e., investor or homeowner) basis. After the residential permanent portfolio has been stratified by state, historical loss ratios (as adjusted for predictable or quantifiable trends, if known) for the specific states are applied to delinquent loans. The sum of these calculations is the component assigned to residential permanent loans. In the Bank's experience, this approach has resulted in timely recognition of necessary reserves, which has been generally supported by the Bank's favorable results on the ultimate disposition of the underlying collateral.
The Bank assesses the adequacy of its general reserves for non-residential (i.e., other than single-family residential) mortgage loans, REO and real estate held for investment based primarily on an ongoing evaluation of individual assets. This evaluation takes into consideration a variety of factors, including cash flow analyses, independent appraisals, market studies, economic trends and management's knowledge of the market and experience with particular borrowers. The Bank obtains current appraisals when properties are classified as REO. The Bank periodically reviews appraisals and orders new appraisals as appropriate based on a number of factors, including the date of the previous appraisal, changes in market conditions and regulatory requirements.
The Bank regularly reviews its overall loan portfolio consisting of performing non-classified assets and, based on such review, establishes additional reserves for losses.
In addition to the general reserves described above, valuation allowances are provided for individual loans where the ultimate collection is considered questionable by management after reviewing the current status of loans which are contractually past due and considering the net realizable value of the collateral or guarantees, if applicable.
REO is carried at the lower of cost or fair value. To date, sales of REO, non-residential mortgage loans and loans classified as investments in real estate have resulted in no material additional aggregate loss to the Bank above the amounts already reserved. However, these results do not necessarily assure that the Bank will not suffer losses in the future beyond its level of reserves.
The Bank's individualized asset review takes place within its Loan Review Group and the Asset Classification Committee (the "Committee"). The Loan Review Group
accumulates and analyzes data relating to assets of $1.0 million or more and makes appropriate recommendations regarding asset classifications to the Committee. The Committee meets on a regular basis to discuss classifications of such assets and to review the reserves for losses. The Committee generally reviews the status of various projects, including, for example, data on recent lot sales for residential development projects and leasing activity on commercial projects. Actual progress is compared to projections made when the related loan was underwritten. Local economic conditions and known trends are also reviewed. The Committee also considers steps being taken by borrowers to address problems, and reviews financial information relating to borrowers and guarantors as well as reports by loan officers who are responsible for continually evaluating the projects. The actions of the Committee are reported to the Board of Directors.
In December 1993, the Federal Financial Institution Examination Council, which is composed of the OTS and the other federal banking agencies, issued new guidelines regarding the appropriate levels of general reserves that should be maintained by insured institutions. Although the Bank believes that its levels of general reserves at September 30, 1994 comply with the guidelines, there can be no assurances that the OTS will not seek to require the Bank to increase its levels of general reserves.
The Bank's assets are subject to review and classification by the OTS and the FDIC upon examination. Based on such examinations, the Bank could be required to establish additional reserves or incur additional charge-offs.
DEPOSITS AND OTHER SOURCES OF FUNDS
GENERAL. Deposits are the primary source of the Bank's funds for use in lending and for other general business purposes. In addition to deposits, Chevy Chase receives funds from loan repayments and loan sales. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are influenced by general interest rates and money-market conditions. Borrowings may be used to compensate for reductions in normal sources of funds, such as deposit inflows at less than projected levels or deposit outflows, or to support the Bank's operating or investing activities.
DEPOSITS. Chevy Chase currently offers a variety of deposit accounts with a range of interest rates and maturities designed to attract both long-term and short-term deposits. Deposit programs include Super Statement Savings,
Super NOW, Insured Money Fund, Checking, Simple Statement Savings, Young Savers, Certificate, and special programs for Individual Retirement and Keogh self-employed retirement accounts. All jumbo certificates of deposit are sold directly by the Bank to depositors, either through its branches or through its money desk operation.
Chevy Chase attracts deposits through its branch network and advertisements, and offers depositors access to their accounts through 383 ATMs, including 121 ATMs located in Safeway Inc. stores and 45 ATMs located in Superfresh Food Markets. The Bank also has the right to install ATMs in Safeway stores in the greater Washington, D.C./Baltimore/Richmond area which do not currently have ATM service. The acquisition of these ATMs and installation rights significantly expands both the number of ATMs and the number of locations in the Bank's ATM network and enhances the Bank's position as a leading provider of convenient ATM service in its primary market area. The Bank is a member of the regional "MOST"-R- ATM network which offers over 5,900 locations in the middle-Atlantic region. The Bank is also a member of the "PLUS"-R- ATM network, which offers over 190,000 locations worldwide.
The Bank obtains deposits primarily from customers residing in Montgomery and Prince George's Counties in Maryland and Northern Virginia. Approximately 25.3% of the Bank's deposits at September 30, 1994 were obtained from depositors residing outside of Maryland, with approximately 11.3% of the Bank's deposits being obtained from depositors residing in Northern Virginia.
The following table shows the amounts of Chevy Chase's deposits by type of account at the dates indicated.
Deposit Analysis (Dollars in thousands)
The range of deposit account products offered by the Bank through its extensive branch and ATM network allows the Bank to be competitive in obtaining funds from its local retail deposit market. At the same time, however, as customers have become increasingly responsive to changes in interest rates, the Bank has experienced some fluctuations in deposit flows. Chevy Chase's ability to attract and maintain deposits and its cost of funds will continue to be significantly affected by market conditions and its pricing strategy. The Bank does not solicit brokered deposits.
The following table sets forth Chevy Chase's deposit flows during the periods indicated.
Deposit growth may be moderated by the Bank from time to time either to take advantage of lower cost funding alternatives or in response to more modest expectations for loan and other asset growth.
The following table sets forth, by weighted average interest rates, the types and amounts of deposits as of September 30, 1994 which will mature during the fiscal years indicated.
Weighted Average Interest Rates of Deposits As of September 30, 1994 (Dollars in Thousands)
The following table summarizes maturities of certificate accounts in amounts of $100,000 or greater as of September 30, 1994.
The following table represents the amounts of deposits by various interest rate categories as of September 30, 1994 maturing during the fiscal years indicated.
Maturities of Deposits by Interest Rates As of September 30, 1994 (In thousands)
BORROWINGS. The FHLB system functions as a central reserve bank providing credit for member institutions. As a member of the FHLB of Atlanta, Chevy Chase is required to own capital stock in the FHLB of Atlanta and is authorized to apply for advances on the security of such stock and certain of its mortgages and other assets (principally securities which are obligations of, or guaranteed by, the United States or its agencies), provided certain standards related to creditworthiness have been met.
Under the credit policies of the FHLB of Atlanta, requests for advances with an original term to maturity of five years or less may be approved for any sound business purpose in which a borrower is authorized to engage. Requests for longer-term advances may be approved only for the purpose of enabling the borrower to provide funds for residential housing finance. Such borrowings may be obtained pursuant to several different credit programs, each of which has its own rate and range of maturities. Advances from the FHLB of Atlanta must be secured by certain types of collateral with a value, as determined by the FHLB of Atlanta, at least equal to 100% of the borrower's outstanding advances. The Bank had a $100.0 million FHLB advance outstanding at September 30, 1994, which accrued interest at an annual rate of 4.77%.
From time to time, the Bank enters into repurchase agreements, which are treated as financings. The Bank sells securities (usually U.S. Government or mortgage-backed securities) to a dealer and agrees to buy back the same securities at a specified time (generally within seven to 90 days). The Bank pays a stated interest rate for the use of the funds for the specified time period to the dealer. The obligation to repurchase the securities sold is reflected as a liability and the securities underlying the agreements are included in assets in the Consolidated Statements of Financial Condition in this report. These arrangements are, in effect, borrowings by the Bank secured by the securities sold. There were no repurchase agreements outstanding at September 30, 1994.
The following table sets forth a summary of the repurchase agreements of the Bank as of the dates and for the years indicated.
On November 23, 1993, the Bank sold $150 million principal amount of its 9-1/4% Subordinated Debentures due 2005 (the "Debentures"). Interest on the Debentures is payable semiannually on December 1 and June 1 of each year. The OTS has approved the inclusion of the principal amount of the Debentures in the Bank's supplementary capital for regulatory capital purposes. On or after December 1, 1998, the Debentures will be redeemable, in whole or in part, at any time at the option of the Bank. Under the OTS capital regulations, redemption of the Debentures prior to their stated maturity would be subject to prior approval of the OTS unless the Debentures are redeemed with the proceeds of, or replaced by, a like amount of "a similar or higher quality" capital instrument.
In December 1986, the Bank issued an unsecured ten-year subordinated capital note in the original principal amount of $10.0 million to BACOB Bank, s.c., a foreign private savings bank. Unless the note is earlier redeemed, the note principal is payable in one payment on December 31, 1996. Interest is payable in arrears on May 15 and November 15 of each year at a variable rate of 3% over the six-month London Interbank Offered Rate ("LIBOR"). The note may be redeemed at the Bank's option, at par, without premium or penalty, together with accrued interest.
SUBSIDIARIES
OTS regulations generally permit the Bank to make investments in service corporation subsidiaries in an amount not to exceed 3.0% of the Bank's assets, provided that any investment in excess of 2.0% of assets serves primarily
community, inner city or community development purposes. Such regulations also permit the Bank to make "conforming loans" to such subsidiaries and joint ventures in an amount not to exceed 50% of the Bank's regulatory capital. At September 30, 1994, 2.0% and 3.0% of the Bank's assets was equal to $93.3 million and $139.9 million, respectively, and the Bank had $55.8 million invested in its service corporation subsidiaries, $36.0 million of which was in the form of conforming loans. FIRREA generally requires the Bank to provide 30 days advance notice to the OTS and to the FDIC before establishing a new subsidiary or conducting a new activity in an existing subsidiary. With prior written approval from the OTS, the Bank may also establish operating subsidiaries to engage in any activities in which the Bank may engage directly.
Chevy Chase engages in significant activities through B. F. Saul Mortgage Company. See "Lending Activities." The Bank engages in other activities through its subsidiaries, including those described below.
REAL ESTATE DEVELOPMENT ACTIVITIES. Manor Investment Company ("Manor") continues to engage in certain real estate development activities as the result of activities commenced prior to the enactment of FIRREA. As a result of the stringent capital requirements that FIRREA applies to investments in subsidiaries, such as Manor, that engage in activities impermissible for national banks, Manor has not entered, and does not intend to enter, into any new real estate development arrangements.
SECURITIES BROKERAGE SERVICES. Chevy Chase Securities, Inc., a licensed broker-dealer, is in the business of selling securities on a retail basis to the general public, including customers and depositors of the Bank.
INSURANCE SERVICES. Chevy Chase Insurance Agency, Inc. is a licensed insurance broker offering a variety of "personal line" insurance programs in the property and casualty field (primarily homeowner and automobile insurance) and in the life insurance field (primarily mortgage and credit card life and disability programs).
SPECIAL PURPOSE SUBSIDIARIES. At September 30, 1994, Chevy Chase owned 25 active subsidiaries that were formed for the sole purpose of acquiring title to various real estate projects pursuant to foreclosure or deed-in-lieu of foreclosure. The Bank's investment in the active subsidiaries was $292.1 million at September 30, 1994. The Bank's investments in these subsidiaries are not subject to the 3.0% service corporation investment limit discussed above. See "Regulation - Regulatory Capital."
OPERATING SUBSIDIARY. CCB Holding Corporation is a Delaware corporation created by the Bank as an operating subsidiary in September 1994 in connection with its asset securitization activities. The subsidiary owns a seller certificate issued by a credit card trust formed by the Bank and certain other related assets.
EMPLOYEES
The Bank and its subsidiaries had 2,407 full-time and 686 part-time employees at September 30, 1994. The Bank provides its employees with a comprehensive range of employee benefit programs, including group health benefits, life insurance, disability insurance, paid sick leave and an employee loan program. The Bank offers home mortgage and credit card loans to employees at prevailing market rates, but waives up to one point of any loan origination fees on home mortgage loans and the annual fee on credit card loans, and provides a yearly rebate equal to 0.5% of the outstanding loan balance of home mortgage loans at calendar year-end. The Bank also offers employees a one percent discount on the interest rate on overdraft lines of credit. See "Executive Compensation and Other Information" for a discussion of certain compensation programs available to the Bank's executive officers. None of the Bank's employees is represented by a collective bargaining agent. The Bank believes that its employee relations are good.
COMPETITION
Chevy Chase encounters strong competition both in attracting deposits and making real estate and other loans in its markets. The Bank's most direct competition for deposits has come from other thrift institutions, commercial banks and credit unions, as well as from money market funds and corporate and government securities. In addition to offering competitive interest rates, Chevy Chase offers a variety of services, convenient ATM locations and convenient office locations and hours to attract deposits. Competition for real estate and other loans comes principally from other thrifts, banks, mortgage banking companies, insurance companies and other institutional lenders. Chevy Chase competes for loans through interest rates, loan fees and the variety and quality of services provided to borrowers and brokers.
The Bank's major competition historically has come from local depository institutions, but deregulation of the financial services industry and changing market demands in recent years have eroded distinctions between providers of financial services. In addition, both depository and non-depository institutions have greater nationwide access
to attractive markets, such as the Washington, D.C. area, than they have had in past years. Chevy Chase now competes with regional financial institutions and national providers of investment alternatives, as well as with a number of large money center and regional banks that have acquired subsidiary institutions in the area.
The Bank estimates that it competes principally with approximately 12 depository institutions in its deposit-taking activities, with approximately ten institutions in the origination of single-family residential mortgage loans (other than home equity credit line loans) and with approximately ten depository institutions in the origination of home equity credit line loans. At June 30, 1994, according to published industry statistics, Chevy Chase had the largest market share (approximately 19.3%) of deposits in Montgomery County, Maryland, and Chevy Chase ranked third in market share of deposits in Prince George's County, Maryland. Based on publicly available information, Chevy Chase estimates that, in the Washington, D.C. metropolitan area, it maintains a significant market share of single-family residential mortgage loans and the leading market share of home equity credit line loans.
The credit card industry is highly competitive and characterized by increasing use of advertising, target marketing, pricing competition in interest rates and annual membership fees, and other features (such as buyer protection plans), as both established and new credit card issuers seek to expand or to enter the market. Management anticipates that competitive pressures will continue to require adjustments, from time to time, to the pricing of the Bank's credit card products.
Interstate banking laws enacted by Congress and various states have intensified the competition faced by the Bank in attracting deposits and making loans. A number of large out-of-state financial institutions have established or acquired banking operations in Maryland, Virginia and the District of Columbia pursuant to these provisions.
ITEM 2.



ITEM 2. PROPERTIES
REAL ESTATE
A list of the investment properties of the Real Estate Trust is set forth under "Business - Real Estate - Real Estate Investments."
At September 30, 1994, the Trust conducted its business from its executive offices at 8401 Connecticut Avenue, Chevy Chase, Maryland. The Trust sells its unsecured notes due one
year to ten years from date of issue from a sales office located at 7200 Wisconsin Avenue, Suite 903, Bethesda, Maryland. The Saul Company leases both office facilities on behalf of the Trust.
BANKING
At September 30, 1994, the Bank conducted its business from its executive offices at 8401 Connecticut Avenue, Chevy Chase, Maryland; its operations centers at 6200 Chevy Chase Drive, Laurel, Maryland, 7215 Corporate Court, Frederick, Maryland, 5300 Spectrum Drive, Frederick Maryland and 5310 Spectrum Drive, Frederick Maryland; its office facilities at 7700 Old Georgetown Road, Bethesda, Maryland; and 81 full-service offices located in Maryland, Virginia and the District of Columbia. On that date, the Bank owned the building and land for 13 of its branch offices and leased its remaining 68 branch offices. Chevy Chase leases the office facilities at 8401 Connecticut Avenue, 6200 Chevy Chase Drive and 7215 Corporate Court and the land at 7700 Old Georgetown Road. Chevy Chase owns the building at 7700 Old Georgetown Road. In addition, the Bank leases office space in which its subsidiaries are housed. The office facility leases have various terms expiring from 1995 to 2019 and the ground leases have terms expiring from 2029 to 2080. See Note 17 to the Consolidated Financial Statements in this report for lease expense and commitments.
At November 30, 1994, the Bank had received OTS approval to open three additional branches. The branches, one each in Maryland, Virginia and the District of Columbia, are scheduled to open during fiscal 1995.
At September 30, 1994, the net book value of the Bank's office facilities (including leasehold improvements) was $92.7 million. See Note 16 to the Consolidated Financial Statements in this report.
The Bank currently plans to build a facility in Frederick, Maryland to consolidate the Bank's employees and operations in that area. At September 30, 1994, the Bank had invested $2.5 million in the land and $1.4 million for capital expenditures relating to this facility.
In fiscal 1991, the Bank purchased an historic office building and the underlying land in downtown Washington, D.C. with plans to establish a deposit branch office and a trust office in the building. Although the Bank terminated its trust business in fiscal 1991, it still plans to establish a branch in the building.
The Bank owns additional assets, including furniture
and data processing equipment. At September 30, 1994, these other assets had a net book value of $51.7 million. The Bank also has operating leases, primarily for certain automobiles and data processing equipment and software. The leases for automobiles are generally for periods of less than four years; the leases for the data processing equipment and software have month-to-month or year-to-year terms.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Trust is involved in certain litigation, including litigation arising out of the collection of loans, the enforcement or defense of the priority of its security interests, and the continued development and marketing of certain of its real estate properties. In the opinion of management, litigation which is currently pending will not have a material adverse impact on the financial condition or future operations of the Trust.
On August 22, 1994, Chevy Chase and its subsidiary, B. F. Saul Mortgage Company (together, the "Companies"), entered into a settlement agreement with the United States Department of Justice (the "Department") arising out of the Department's allegations that the Companies had violated the Federal Fair Housing and Equal Credit Opportunity Acts by failing to market their products sufficiently to residents of majority African-American neighborhoods in the Washington, D.C. metropolitan area.
The Companies adamantly denied the allegations. However, to avoid costs of protracted litigation and to enable management to refocus its attention on the normal business of banking, the Companies agreed to a settlement which commits them to continue the types of lending practices, branching strategies and promotional programs that are designed to increase the level of banking services available to traditionally underserved areas of the Washington, D.C. metropolitan area. Specifically, the Companies have agreed to invest $11.0 million in the African-American community of the Washington, D.C. metropolitan area over a five-year period. This commitment obligates the Companies to (i) provide $7.0 million over the five-year period in subsidies for below-market mortgage loans to residents of designated majority African-American neighborhoods in Washington, D.C. and Prince George's County, Maryland; (ii) open two additional mortgage offices in majority African-American neighborhoods in the metropolitan Washington, D.C. area; and (iii) open one new deposit branch in the Anacostia area of Washington, D.C. The Companies also have agreed over the same five-year
period, among other things, to continue efforts to increase their advertising and promotional efforts targeted to residents of African-American neighborhoods, to continue efforts to recruit African-Americans for loan production positions, and to continue various employee training programs. The Companies view these efforts as continuations of their existing programs.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 1994.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There currently is no established public trading market for the Trust's Common Shares of Beneficial Interest (the "Common Shares"). At December 1, 1994, there were nine corporate or individual holders of Common Shares. All of the holders of Common Shares at such date were affiliated with the Trust. See "Security Ownership of Certain Beneficial Owners and Management."
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Trust herein have been derived from the Consolidated Financial Statements of the Trust. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements included elsewhere in this report.
SELECTED FINANCIAL DATA
Continued on following page.
SELECTED FINANCIAL DATA (Continued)
The following table sets forth certain additional financial data with respect to the Bank.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The term "Trust" used in the text and the financial statements included herein refers to the combined entity, which includes B.F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase and Chevy Chase's subsidiaries. "Real Estate Trust" refers to B.F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase's subsidiaries. The operations conducted by the Real Estate Trust are designated as "Real Estate," while the business conducted by Chevy Chase and its subsidiaries is identified by the term "Banking."
The financial data on Banking reflect certain purchase accounting adjustments made by the Trust in connection with its acquisition of the Bank and therefore differ in certain respects from the comparable financial data set forth in the unconsolidated financial statements of the Bank.
FINANCIAL CONDITION
REAL ESTATE
The Real Estate Trust's investment portfolio at September 30, 1994 consisted primarily of office and industrial projects, hotels and land parcels. See "Business - Real Estate - Real Estate Investments." In August 1993, the Real Estate Trust transferred its 22 shopping center properties and one of its office properties, together with the debt associated with such properties, to Saul Holdings Partnership and a subsidiary limited partnership of Saul Holding Partnership in exchange for securities representing a 21.5% limited partnership interest in Saul Holdings Partnership. See "Business - Real Estate - Investment in Saul Holdings Limited Partnership."
Office space in the Real Estate Trust's office property portfolio was 93% leased at September 30,1994, compared to a lease rate of 77% at September 30, 1993. At September 30, 1994, the Real Estate Trust's office property portfolio had a total gross leaseable area of approximately 1.36 million square feet. Of the gross leaseable area at September 30, 1994, 521,000 square feet (38%) and 205,000 square feet (15%) is subject to leases whose terms expire in fiscal 1995 and fiscal 1996, respectively. Due to a decline in market lease rates for office space over the past several years, the terms of certain of the new leases may be less favorable to the Real Estate Trust than the terms of the expiring leases. Based on discussions with current and prospective
tenants of space for which leases are scheduled to expire in fiscal 1995, management currently expects that substantially all such space will be leased at rates that are at least as high as the rates of the expiring leases.
For the fiscal year ended September 30, 1994, the nine hotel properties then owned by the Real Estate Trust achieved a 62% occupancy rate, compared to an occupancy rate of 63% in fiscal 1993. Two of the hotels experienced increases in occupancy rates during fiscal 1994, six hotels registered lower occupancy rates and the ninth hotel maintained the same occupancy rate. Average room rates increased by $2.63 to $57.57 in fiscal 1994 from $54.94 in fiscal 1993.
BANKING
GENERAL. The Bank recorded operating income of $53.2 million in fiscal 1994, compared to operating income of $63.8 million in fiscal 1993. The decline in income for fiscal 1994 was primarily attributable to increased operating expenses, a decrease in net interest income, a decrease in credit card fees and a decrease in gain on sale of investment securities. The decrease in income was offset in part by a decrease in the provision for loan losses and an increase in other (non-interest) income resulting primarily from an increase in loan and deposit servicing fees and improved results on real estate held for investment or sale.
On November 23, 1993, the Bank received net proceeds of $143.6 million from the sale of $150.0 million principal amount of its 9 1/4% Subordinated Debentures due 2005. On December 23, 1993 and December 24, 1993, the Bank applied $134.2 million of such net proceeds to redeem its outstanding 13 1/2% Subordinated Capital Debentures due July 15, 2002 and 15% Subordinated Capital Debentures due November 15, 2003. The Bank incurred an extraordinary loss of $6.3 million, after related income taxes, in connection with such redemption. The OTS has approved the inclusion of the principal amount of the Debentures in the Bank's supplementary capital for regulatory capital purposes.
At September 30, 1994, the Bank remained in compliance with all of its regulatory capital requirements under FIRREA. The Bank's tangible, core and risk-based regulatory capital ratios were 4.96%, 5.34% and 12.19%, respectively, compared to the FIRREA requirements of 1.5%, 3.0% and 8.0%,
respectively. Additionally, at September 30, 1994, the Bank's leverage, tier 1 risk-based and total risk-based capital ratios of 5.34%, 6.95% and 12.19%, respectively, exceeded the corresponding ratios of 5.0%, 6.0% and 10.0% for "well-capitalized" institutions established under the prompt corrective action regulations of the OTS. On the basis of its balance sheet at September 30, 1994, the Bank met the FIRREA-mandated fully phased-in capital requirements and, on a fully phased-in basis, met the capital standards established for "adequately-capitalized" institutions under the prompt corrective action regulations. See "Capital."
During fiscal 1994, the Bank adopted four new Statements of Financial Accounting Standards: Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"), Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") and Statement of Financial Accounting Standards No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures, an amendment of FASB Statement No. 114 ("SFAS 118").
SFAS 109 changes the manner in which companies record deferred tax liabilities or assets and requires ongoing adjustments for enacted changes in tax rates and regulations. The cumulative effect of this change in accounting principle resulted in a $5.1 million increase in the Bank's net income and net deferred tax asset.
Effective October 1, 1993, the Bank adopted, on a prospective basis, SFAS 114 and SFAS 118. SFAS 114 and SFAS 118 require that impaired loans be measured based on the present value of expected future cash flows, discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price, or the fair value of the collateral, if the loan is collateral-dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. In addition, SFAS 114 requires impaired loans for which foreclosure is probable to be accounted for as loans instead of REO. No additional reserves were required by adoption of this pronouncement. Impaired loans that are also nonperforming are included in nonperforming assets. See "Summary of Significant Accounting Policies" in the Notes to the Consolidated Financial Statements in this report.
SFAS 115 requires companies to classify certain equity
securities and all debt securities into one of three categories on the date of acquisition and the date of all subsequent financial statements. Under SFAS 115, securities are categorized as either "held-to-maturity," "available-for-sale" or "trading." In implementing SFAS 115, the Bank determined that its entire investment security portfolio and its entire mortgage-backed security portfolio be classified as available-for-sale at October 1, 1993. The Bank implemented SFAS 115 effective October 1, 1993 and recorded $16.3 million of net unrealized holding gains, net of related income taxes, as a separate component of stockholders' equity as of that date. As a result of an increase in market interest rates, at September 30, 1994, net unrealized holding losses of $14.1 million are reported as a separate component of stockholders' equity. The net unrealized holding gain (loss) on the Bank's available-for-sale portfolio will fluctuate based on market interest rates and the composition of the Bank's investment security and mortgage-backed security portfolios and, at September 30, 1994, was fully deductable from tier 1 capital for regulatory capital purposes pursuant to interim guidance issued by the OTS in August 1993. In November 1994, the OTS revised its existing policy and announced that, beginning as early as December 1994, savings associations may exclude net unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital for purposes of computing regulatory capital ratios. If this revised policy had been in effect on September 30, 1994, the Bank's tangible, core and total risk-based regulatory capital ratios would have increased to 5.27%, 5.64% and 12.66%, respectively.
The Bank's assets are subject to review and classification by the OTS upon examination. The OTS concluded its annual examination of the Bank in September 1994.
ASSET QUALITY. The improvement in the Bank's asset quality during recent periods continued in fiscal 1994. The Bank will continue its efforts to resolve problem real estate assets and enhance risk management efforts.
NON-PERFORMING ASSETS. The following table sets forth information concerning the Bank's non-performing assets at the dates indicated. The figures shown are after charge-offs and, in the case of real estate acquired in settlement of loans, all valuation allowances.
Non-Performing Assets (Dollars in thousands)
Non-Performing Assets (Continued) (Dollars in thousands)
Non-performing assets include non-accrual loans (loans contractually past due 90 days or more or with respect to which other factors indicate that full payment of principal and interest is unlikely), non-accrual real estate held for investment ("non-accrual REI"), and real estate acquired in settlement of loans, either through foreclosure or deed-in-lieu of foreclosure, or pursuant to in-substance foreclosure (prior to the adoption of SFAS 114 in fiscal 1994).
Non-performing assets totaled $311.9 million, after valuation allowances on REO of $109.1 million, at September 30, 1994, compared to $372.0 million, after valuation allowances on REO of $101.5 million, at September 30, 1993. In addition to the valuation allowances on REO, the Bank maintained $4.0 million and $4.5 million of valuation allowances on its non-accrual loans and non- accrual real estate held for investment at September 30, 1994 and September 30, 1993, respectively. The decrease in non-performing assets was attributable to declines in non-accrual loans and REO of $4.9 million and $55.2 million, respectively, during the year ended September 30, 1994.
The Bank's non-performing real estate assets, which include non-accrual real estate loans, non-accrual REI and REO, totaled $295.2 million at September 30, 1994 or 94.6% of total non-performing assets at that date. As shown in the following table, the Bank's non-performing real estate assets, after valuation allowances on such assets, have declined from their peak of $567.6 million in February 1992 to $292.8 million at September 30, 1994, reflecting both additional write-downs on non-performing assets during that period and, in more recent periods, asset sales.
Decline in Non-Performing Real Estate Assets
A larger portion of the affected properties financed by the Bank involves residential rather than commercial properties. At September 30, 1994, $257.6 million or 87.3% of the Bank's total non-performing real estate assets related to residential real estate properties, including the Bank's five planned unit developments (the "Communities"). In general, the residential real estate market was less significantly affected by the downturn in the early 1990s than the commercial real estate market. The Bank has disposed of the majority of its commercial REO and is seeking to effect the orderly disposition of the remainder of its REO. See "REO" and "Disposition of REO."
NON-ACCRUAL LOANS. The Bank's non-accrual loans totaled $25.0 million at September 30, 1994, a decrease of $5.0 million from $30.0 million at September 30, 1993. At September 30, 1994, non-accrual loans consisted primarily of $8.3 million of non-accrual real estate loans and $16.2 million of non-accrual credit card loans. Non-accrual loans decreased primarily because of net principal repayments and reductions of non-accrual credit card loans of $4.3 million.
The reduction in non-accrual credit card loans reflects improved economic conditions.
At September 30, 1994, the Bank had $16.2 million of credit card loans which were classified for regulatory purposes as substandard and disclosed as non-performing assets because they were 90 days or more past due. At that date, the Bank also had $10.7 million of credit card loans classified for regulatory purposes as substandard which were not disclosed as either non-performing assets (i.e., credit card loans which are 90 days or more past due) or potential problem assets. The amount classified as substandard but not disclosed as non-performing assets ($10.7 million) primarily related to accounts for which the customers have agreed to modified payment terms, but which were 60-89 days past due. Of the $10.7 million, $4.3 million was current, $0.2 million was 30- 59 days past due and $6.2 million was 60-89 days past due at September 30, 1994. All delinquent amounts are included in the table of delinquent loans. See "Delinquent Loans."
NON-ACCRUAL REI. At September 30, 1994 and September 30, 1993, a participating loan to a developer with a balance of $8.9 million, before valuation allowances of $2.0 million, was non-performing.
REO. In the past, the Bank was an active lender on residential real estate development projects and, to a lesser extent, commercial buildings and land. The majority of the amount of loans originated were made to developers for the acquisition and development of residential planned unit developments. The majority of the loans contained provisions that entitled the Bank to a portion of the profits generated by the underlying properties. Beginning in mid-1990 and extending through 1992, as a result of the slowdown in the Washington, D.C. area economy, the Bank took active control, either through foreclosure or deed-in-lieu of foreclosure, of most of the properties securing these loans. The Bank decided that completing the infrastructure of the properties, implementing an aggressive marketing program, and then selling building lots to home builders represented the most effective method of recovering the Bank's investment in these properties.
At September 30, 1994, the Bank's REO totaled $277.9 million, after valuation allowances on such assets of $109.1 million. The principal component of REO consists of the Communities, which had an aggregate book value of $211.4 million at that date. Four of the Communities are under active development.
During the year ended September 30, 1994, REO decreased
$55.2 million. This decrease was primarily attributable to sales in the Communities and other smaller residential properties and the sale of six properties with an aggregate book value of $12.9 million after valuation allowances. See "Disposition of REO."
The Bank capitalizes costs relating to development and improvement of REO. Interest costs are capitalized on real estate properties under development. See "Disposition of REO." The Bank capitalized interest in the amount of $4.4 million in the year ended September 30, 1994, of which $4.3 million related to the Bank's four active Communities.
DISPOSITION OF REO. During the year ended September 30, 1994, the Bank received proceeds of approximately $112.2 million upon the disposition of REO consisting of two office buildings ($5.3 million), 1,094 residential lots or units in the Communities and other smaller residential properties ($88.0 million), approximately 21 acres of land in three of the Communities ($8.2 million), one industrial building ($5.7 million) and various single-family residential properties ($5.0 million).
The Bank's objective with respect to its REO is to sell such properties as expeditiously as possible and in an orderly manner which will best preserve the value of the Bank's assets. The Bank's ability to achieve this objective will depend on a number of factors, some of which are beyond its control, such as the general economic conditions in the Washington, D.C. metropolitan area. In addition, under its written agreement with OTS, the Bank is required to make every effort to reduce its exposure in certain of its real estate development properties, including the four active Communities. In accordance with this requirement, management of the Bank is pursuing several strategies. First, the Bank has focused its efforts on marketing building lots directly to homebuilders. The Bank is proceeding with lot development to meet the requirements of existing and new contracts with builders. Second, the Bank continues to seek and negotiate with potential purchasers of retail and commercial ground in the Communities. Third, the Bank continues to seek potential investors concerning the possibility of larger scale or bulk purchases of ground at the Communities.
The following table sets forth information about the Bank's REO at September 30, 1994.
At September 30, 1994, the Bank had executed contracts to sell seven of these properties at their aggregate book value of $17.2 million at that date.
The four active Communities consist primarily of 12,936 residential lots or units and 196.6 acres of land designated for retail use. At September 30, 1994, 9,125 residential units (70.5%) had been sold to builders, consisting of 6,872 units (53.1%) which had been settled and 2,253 units (17.4%) which were under contract and pending settlement. At the same date, approximately 106.8 acres (54.3%) of retail land had been sold to developers, including 20.5 acres which were under contract and pending settlement. In addition, at September 30, 1994, the Bank was engaged in discussions with potential purchasers regarding the sale of additional residential units and retail land.
The rate of home sales in the Bank's four active Communities during fiscal 1994 (1,370) declined slightly from the rate in fiscal 1993 (1,522). The decline resulted primarily from lower demand due to increased interest rates for mortgage loans.
The Bank will continue to make financing available to homebuilders and home purchasers in an attempt to facilitate sales of lots in the four Communities under active
development. The following table presents, at the periods indicated, the outstanding balances of loans provided by the Bank (subsequent to its acquisition of title to the properties) to facilitate sales of lots in such Communities.
The Bank anticipates that it will provide construction financing for approximately 20% of the remaining unsold lot inventory in the Communities. The Bank also expects that it will provide permanent financing for approximately 25% of the homes to be sold in the Communities. The Bank's policy is to sell all such single-family permanent loans for which the date of initial application is subsequent to September 30, 1991. Through September 30, 1994, the Bank had originated $170.6 million and sold $166.2 million of such loans. At September 30, 1994, the remaining $4.4 million of such loans are classified as held for sale and generally are expected to be sold in the first quarter of fiscal 1995. The total pre-tax cost to the Bank of granting more favorable terms to the borrowers was approximately $2.6 million, or 1.5% of the $170.6 million principal amount of the loans made. The estimated cost is generally recognized by the Bank as a cost of sale at the time that the Bank sells building lots to developers.
In furtherance of its objective of facilitating sales, the Bank has continued to develop some of the Communities. The following table presents net funds provided by development at the four active Communities for the years indicated.
The Bank currently anticipates that sales proceeds will continue to exceed development costs in future periods. In the event development costs exceed sales proceeds in future periods, the Bank believes that adequate funds will be available from its primary liquidity sources to fund such costs. See "Liquidity."
In addition to the four active Communities, REO includes a fifth Community, consisting of approximately 2,900 acres in Loudoun County, Virginia, which is in the pre-development stage. At September 30, 1994, this property had a book value of $30.8 million, after valuation allowances.
Under its written agreement with the OTS, the Bank may not increase its investments in certain of its large REO properties beyond levels existing at September 30, 1991 without OTS approval. The OTS has not objected to the implementation of the Bank's budgets for additional investments in these properties through September 30, 1994.
The Bank will continue to monitor closely its major non-performing and potential problem assets in light of current and anticipated market conditions. The Bank's asset workout group focuses its efforts in resolving these problem assets as expeditiously as possible. Bank does not anticipate any significant increases in non-performing and potential problem assets.
POTENTIAL PROBLEM ASSETS. Although not considered non-performing assets, primarily because the loans are not 90 or more days past due and the borrowers have not abandoned control of the properties, potential problem assets are experiencing problems sufficient to cause management to have serious doubts as to the ability of the borrowers to comply with present repayment terms. The majority of the Bank's potential problem assets involve
borrowers or properties experiencing cash flow problems due primarily to the downturn in recent years of the real estate markets in which the properties are located.
At September 30, 1994, potential problem assets totaled $34.1 million before valuation allowances of $11.2 million, as compared to $73.6 million, before valuation allowances of $15.4 million at September 30, 1993. The $39.5 million decrease in potential problem assets is primarily attributable to $25.1 million of loans incurred by borrowers whose financial condition is such that management no longer has serious doubts as to such borrowers' ability to comply with present repayment terms. The repayment of two commercial permanent loans with an aggregate principal balance of $5.2 million, the repayment of one commercial construction loan with a principal balance of $1.2 million and other net pay-downs of $8.0 million also contributed to the decrease in potential problem assets.
DELINQUENT LOANS. At September 30, 1994, delinquent loans totaled $31.8 million (or 1.2% of gross loans) compared to $49.1 million (or 2.0% of gross loans) at September 30, 1993. The following table sets forth information regarding the Bank's delinquent loans at September 30, 1994.
Mortgage loans classified as delinquent 30-89 days consists entirely of single-family permanent residential mortgage loans and home equity credit line loans. Total delinquent mortgage loans decreased to $4.3 million at September 30, 1994 from $8.9 million at September 30, 1993. The $4.6 million decrease was primarily attributable to the return to current status of loans previously delinquent 30-59 days as a result of the improvement in general economic conditions.
Non-mortgage loans (principally credit card loans) delinquent 30-89 days decreased to $27.5 million at September 30, 1994 from $40.2 million at September 30, 1993, primarily as a result of an improvement in general economic conditions. Non-mortgage loans delinquent 30-89 days as a percentage of total non-mortgage loans outstanding decreased to 2.7% at September 30, 1994 from 4.5% at September 30, 1993.
TROUBLED DEBT RESTRUCTURINGS. A troubled debt restructuring occurs when the Bank agrees to modify significant terms of a loan in favor of the borrower when the borrower is experiencing financial difficulties. The following table sets forth loans accounted for as troubled debt restructurings, before deduction of valuation allowances, at the dates indicated.
At September 30, 1994, loans accounted for as troubled debt restructurings included two commercial permanent loans with principal balances totaling $13.2 million and two residential ground loans with principal balances totaling $15.9 million. The decrease in loans accounted for as troubled debt restructurings from September 30, 1993 resulted from the repayment of one commercial permanent loan with a principal balance of $4.0 million, the repayment of one residential ground loan with a principal balance of $2.5 million, the repayment of one residential construction loan with a principal balance of $0.5 million and other net pay-downs of $0.6 million. At September 30, 1994, the Bank had commitments to lend $2.5 million of additional funds on loans that have been restructured.
REAL ESTATE HELD FOR INVESTMENT. At September 30, 1994, real estate held for investment consisted of seven properties with an aggregate book value of $52.7 million, net of accumulated depreciation of $13.6 million and valuation allowances of $9.9 million. This category includes one office building (which was approximately 82% leased at such date) and two apartment buildings (which were fully leased at such date and are financed with bonds issued through a local housing finance agency). These properties are owned and operated by subsidiaries of the Bank. Also included is a loan to a developer with a book value of $8.9 million at September 30, 1994, before valuation allowances
of $2.0 million, which has a profit participation feature. The loan, which is secured by commercial land, is included in non-performing assets. The Bank has discussions from time to time with potential investors concerning the possible sale of certain of its real estate.
RESERVES FOR LOSSES. The following tables show loss experience by asset type and the components of the reserve for losses on loans and the reserve for losses on real estate held for investment or sale. These tables reflect charge-offs taken against assets during the years indicated and may include charge-offs taken against assets which the Bank disposed of during such years.
Analysis of Reserve Balances on and Charge-offs of Loans (Dollars in thousands)
Components of Reserve for Losses on Loans by Type (Dollars in thousands)
Analysis of Reserve Balances on and Charge-offs of Real Estate Held for Investment or Sale (In thousands)
Components of Reserve for Losses on Real Estate Held for Investment or Sale (In thousands)
The Bank maintains reserves for estimated losses on loans and real estate. See "Business - Banking - Delinquencies, Foreclosures and Reserves for Losses - Reserves for Losses." The Bank's total reserves for losses on loans and real estate held for investment or sale decreased by $10.5 million from the level at September 30, 1993 to $169.2 million at September 30, 1994. The $10.5 million decrease was primarily attributable to decreased reserves on credit card loans resulting partially from the securitization and sale of $1.4 billion of such loans and the sale of credit card relationships with related receivable balances of $96.5 million during fiscal 1994, and a decline in the ratio of credit card charge-offs to outstanding credit card loans. Reserves for losses on real estate loans also decreased, primarily because of the adoption of SOP 92-3 during fiscal 1993. The decreased reserves on credit card and real estate loans were partially offset by increased reserves on real estate held for sale. The $7.6 million increase in reserves on real estate held for sale was primarily attributable to an increase of $13.2 million in the reserves on two of the five Communities based upon updated internal analyses and computations of the fair value of these assets. During the year ended September 30, 1994, the Bank recorded net charge-offs of $11.0 million on loans secured by real estate and real estate held for investment or sale and provided an additional $12.4 million in valuation allowances on these assets.
The following table shows reserves for losses on performing and non-performing assets at the dates indicated.
Reserves for losses on loans secured by real estate and real estate held for investment or sale totaled $133.1 million at September 30, 1994, which constituted 32.9% of total non-performing real estate assets. This amount represented a $1.5 million increase over the September 30, 1993 level of $131.6 million, or 29.1% of total non-performing real estate assets at that date.
When real estate collateral securing an extension of credit is initially recorded as REO, it is written down to fair value on the basis of an appraisal. Such initial write-downs represent management's best estimate of exposure to the Bank at the time that the collateral becomes REO and in effect substitutes for reserves that would otherwise be recorded if the collateral had not become REO. As circumstances change, it may be necessary to provide additional reserves based on new information. Depending on the nature of the information, these new reserves may be valuation allowances, which reflect additional impairment with respect to a specific asset, or may be unallocated reserves, which provide protection against changes in management's perception of overall economic factors. Reserves for losses on real estate held for sale at September 30, 1994 are in addition to approximately $63.3 million of cumulative charge-offs previously taken against assets remaining in the Bank's portfolio at September 30, 1994.
The Bank from time to time obtains updated appraisals on its real estate acquired in settlement of loans. As a result of such updated appraisals, the Bank could be required to increase its reserves.
Net charge-offs of credit card loans for the year ended September 30, 1994 were $46.2 million, compared to $64.8 million for the year ended September 30, 1993. The decrease in net charge-offs resulted primarily from a decline in payment defaults. The allowance at any balance sheet date relates only to receivable balances that exist as of that date. Because of the nature of a revolving credit card account, the cardholder may enter into transactions (such as retail purchases and cash advances) subsequent to a balance sheet date which increase the outstanding balance of the account. Accordingly, charge-offs in any fiscal period relate both to balances that existed at the beginning of the period and to balances created during the period, and may therefore exceed the levels of reserves established at the beginning of the fiscal period.
The reserve for losses on credit card loans decreased to $34.5 million at September 30, 1994 from $46.9 million at September 30, 1993. This decrease was attributable in part
to a lower reserve ratio resulting from a decline in the ratio of credit card charge-offs to outstanding credit card loans. In addition, the securitization and sale of $1.4 billion of credit card receivables and the sale of credit card relationships with related receivable balances of $96.5 million in fiscal 1994 reduced the amount of credit card loans against which the Bank maintains the reserve. The ratios of the reserve for such losses to non-performing credit card loans and to outstanding credit card loans decreased to 212.8% and 5.3%, respectively, at September 30, 1994 from 228.1% and 6.2%, respectively, at September 30, 1993.
The reserve for losses on consumer and other loans increased to $1.6 million at September 30, 1994 from $1.2 million at September 30, 1993, primarily because of an increase in automobile loan reserves. The ratios of the reserves for losses on consumer and other loans to non-performing consumer and other loans and to outstanding consumer and other loans decreased to 319.3% and 0.4%, respectively, at September 30, 1994 from 376.1% and 0.8%, respectively, at September 30, 1993.
ASSET AND LIABILITY MANAGEMENT. A key element of banking is the monitoring and management of liquidity risk and interest-rate risk. The process of planning and controlling asset and liability mixes, volumes and maturities to stabilize the net interest spread is referred to as asset and liability management. The objective of asset and liability management is to maximize the net interest yield within the constraints imposed by prudent lending and investing practices, liquidity needs and capital planning.
The Bank is pursuing an asset-liability management strategy to control its risk from changes in market interest rates principally by originating interest-sensitive loans for its portfolio. In furtherance of this strategy, the Bank emphasizes the origination and retention of adjustable-rate residential permanent loans, adjustable-rate home equity credit line loans and adjustable-rate credit card loans, which generally have shorter terms and higher yields than those of mortgage loans. At September 30, 1994, adjustable-rate loans accounted for 78.8% of total loans. ARMs and home equity credit line loans with rates adjustable in one year or less accounted for 12.2% of total loans, and credit card loans accounted for 25.5% of total loans at September 30, 1994.
In recent periods, the Bank's policy has generally been to sell all of its long-term fixed-rate mortgage production, thereby reducing its exposure to market interest rate fluctuations typically associated with long-term fixed-rate lending. The Bank retains in its portfolio the majority of its adjustable-rate mortgage production.
A traditional measure of interest-rate risk within the banking industry is the interest sensitivity "gap," which is the sum of all interest-earning assets minus all interest-bearing liabilities subject to repricing within the same period. A negative gap like that shown below for the Bank implies that, if market interest rates rise, the Bank's average cost of funds will increase more rapidly than the concurrent increase in the average yield on interest-earning assets. In a period of rising market interest rates, the differential effect on the average yield on interest-earning assets and the average cost of interest-bearing liabilities will decrease the Bank's net interest spread and thereby adversely affect the Bank's operating results. Conversely, in a period of declining interest rates, a negative gap may result in an increase in the Bank's net interest spread. This analysis assumes a parallel shift in interest rates for instruments of different maturities and does not reflect the possibility that retail deposit pricing changes may lag those of wholesale market funds which, in a period of rising
interest rates, might serve to mitigate the decline in net interest spread.
The Bank views control over interest rate sensitivity as a key element in its financial planning process and monitors its interest rate sensitivity through its forecasting system. The Bank manages its interest rate exposure and will narrow or widen its gap, depending on its perception of interest rate movements and the composition of its balance sheet. For the reasons discussed above, the Bank might take action to narrow its gap if it believes that market interest rates will experience a significant prolonged increase, and might widen its gap if it believes that market interest rates will decline or remain relatively stable. A number of asset and liability management strategies are available to the Bank in structuring its balance sheet. These include selling or retaining certain portions of the Bank's current residential mortgage loan production; altering the Bank's pricing on certain deposit products to emphasize or de-emphasize particular maturity categories; altering the type and maturity of securities acquired for the Bank's available-for-sale portfolio when replacing securities following normal portfolio maturation and turnover; lengthening or shortening the maturity or repricing terms for any current period asset securitizations; and altering the maturity or interest rate reset profile of borrowed funds, if any, including funds borrowed from the FHLB of Atlanta.
The following table presents the interest rate sensitivity of the Bank's interest-earning assets and interest-bearing liabilities at September 30, 1994, which reflects management's estimate of mortgage loan prepayments and amortization and provisions for adjustable interest rates. Adjustable and floating rate loans are included in the period in which their interest rates are next scheduled to adjust, and the prepayment rates assumed in each period for the Bank's loans are those rates published most recently by the FHLB of Atlanta. Statement savings and passbook accounts with balances under $20,000 are classified based upon management's assumed attrition rate of 17.5%, and those with balances of $20,000 or more, as well as all NOW accounts, are assumed to be subject to repricing within six months or less.
Interest Rate Sensitivity Table (Gap) (Dollars in thousands)
The one-year gap, as a percentage of total assets, was a negative 27.1% at September 30, 1994, compared to a negative 26.3% at September 30, 1993. As noted above, the Bank's negative one-year gap might adversely affect the Bank's net interest spread and earnings if interest rates rise and the Bank is unable to take steps to reduce its gap.
In addition to gap measurements, the Bank measures and manages interest-rate risk with the extensive use of computer simulation. This simulation includes calculations of Market Value of Portfolio Equity and Net Interest Margin as promulgated by the OTS's Thrift Bulletin 13.
At September 30, 1994, the Bank was not required to maintain additional amounts of risk-based capital under the interest-rate risk component of the OTS capital regulations. See "Business - Banking - Regulation - Regulatory Capital."
INFLATION. The impact of inflation on the Bank is different from the impact on an industrial company, because substantially all of the assets and liabilities of the Bank are monetary in nature. The most direct impact of an extended period of inflation would be to increase interest rates, and to place upward pressure on the operating expenses of the Bank. However, the actual effect of inflation on the net interest income of the Bank would depend on the extent to which the Bank was able to maintain a spread between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, which would depend to a significant extent on its asset-liability sensitivity. The effect of inflation on the Bank's results of operations for the past three fiscal years has been minimal.
DEFERRED TAX ASSET. At September 30, 1994, the Bank recorded a net deferred tax asset of $38.4 million, which generally represents the cumulative excess of the Bank's actual income tax liability over its income tax expense for financial reporting purposes. This net deferred tax asset is reported on the Bank's financial statements in accordance with SFAS 109.
TAX SHARING PAYMENTS. During fiscal 1994, after receiving OTS approval, the Bank made $9.6 million of tax sharing payments to the Real Estate Trust. The Bank made an additional tax sharing payment of $5.0 million subsequent to September 30, 1994. See "Business - Real Estate - Federal Taxation - Consolidated Tax Returns; Tax Sharing Payments."
LIQUIDITY AND CAPITAL RESOURCES
REAL ESTATE
GENERAL. The Real Estate Trust's primary cash requirements fall into four categories: operating expenses (exclusive of interest on outstanding debt), capital improvements, interest on outstanding debt and repayment of outstanding debt.
Historically, the Real Estate Trust's total cash requirements have exceeded the cash generated by its operations. This condition is currently the case and is expected to continue to be so for the foreseeable future. The Real Estate Trust's internal sources of funds, primarily cash flow generated by its income- producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding unsecured notes ("Unsecured Notes") sold to the public, the payment of interest on its Senior Secured Notes and the payment of capital improvement costs. In the past, the Real Estate Trust had funded such shortfalls through a combination of external funding sources, primarily new financings (including the sale of Unsecured Notes), refinancings of maturing mortgage debt, asset sales and tax sharing payments from the Bank. See the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements in this report.
The Real Estate Trust's liquidity position was constrained during most of the last three fiscal years, primarily because of the persistence of recessionary conditions in the Real Estate Trust's major real estate markets. Those conditions have significantly affected the availability of long-term fixed-rate mortgage financing on satisfactory terms.
The Real Estate Trust's current program of public Unsecured Note sales was initiated in the 1970's as a vehicle for supplementing other external funding sources. In fiscal 1994, the Real Estate Trust sold $15.7 million of Unsecured Notes. The table under "Recent Liquidity Trends" below provides information at September 30, 1994 with respect to the maturities of Unsecured Notes outstanding at such date.
As the owner, directly and through two wholly-owned subsidiaries, of a 21.5% limited partnership interest in Saul Holdings Partnership, the Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale or refinancing of the properties of Saul Holdings Partnership. The partnership
agreement of Saul Holdings Partnership provides for quarterly cash distributions to the partners out of net cash flow. See "Business - Real Estate - Investment in Saul Holdings Limited Partnership." In fiscal 1994, the Real Estate Trust received total cash distributions of $4.6 million from Saul Holdings Partnership.
RECENT LIQUIDITY TRENDS. The Real Estate Trust's liquidity position was positively affected by the sale on March 30, 1994 of $175.0 million aggregate principal amount of 11- 5/8% Senior Secured Notes due 2002 (the "Senior Secured Notes"). After paying offering expenses of $8.9 million, third-party mortgage indebtedness of $74.1 million, and affiliate indebtedness of $8.9 million, the Real Estate Trust retained $83.1 million of the net proceeds of the offering for application to general corporate purposes. Approximately $25.8 million was deposited with the Trustee for the Senior Secured Notes to satisfy an initial collateral requirement with respect to such securities. This collateral requirement, which will remain in effect as long as any Senior Secured Notes are outstanding, will be recalculated each calendar quarter based on the estimated amount of one year's interest payments on then- outstanding Senior Secured Notes and Unsecured Notes. Concurrently with the application of the net proceeds of the offering to repay third-party mortgage indebtedness, the terms of certain of the mortgage loans repaid in part were modified to waive deferred interest, reduce interest rates and extend maturities. After the application of such net proceeds and the modification of such loans, the final maturity of loans with total balances of $111.1 million was 12 years and the final maturity of a loan with a balance of $15.1 million was 15 years.
During the third and fourth quarters of fiscal 1994, the Trust purchased 573,900 shares of common stock of Saul Centers (representing 4.8% of such company's outstanding common stock) for approximately $10.3 million. These shares have been deposited with the Trustee for the Senior Secured Notes to satisfy in part the collateral requirements for those securities, thereby permitting release to the Trust of a portion of the cash on deposit with the Trustee.
The Senior Secured Notes are secured, general obligations of the Trust ranking pari passu with all other unsubordinated obligations of the Trust, including the Unsecured Notes. The Senior Secured Notes are secured by a first- priority perfected security interest in 80% of the issued and outstanding common stock of the Bank, which 80% is owned by the Trust, and in the collateral referred to above, which at September 30, 1994 consisted of cash and cash equivalents of $21.2 million in addition to the Saul
Centers common stock. The Indenture pursuant to which the Senior Secured Notes were issued contains covenants that, among other things, restrict the ability of the Trust and/or its subsidiaries (excluding, in most cases, the Bank and the Bank's subsidiaries) to incur additional indebtedness, make investments, sell assets or pay dividends and make other distributions to holders of the Trust's capital stock.
The maturity schedule for the Real Estate Trust's outstanding mortgage and other debt at September 30, 1994 is set forth in the following table:
Of the $185.7 million of mortgage debt outstanding at September 30, 1994, $132.1 million was nonrecourse to the Real Estate Trust.
The Real Estate Trust believes that capital improvement costs in the next several fiscal years will be in the range of $2 to $4 million per year.
The Real Estate Trust had negative cash flow from operating activities of $10.9 million, $3.1 million, $0.9 million and $16.4 million in fiscal 1994, 1993, 1992 and 1991, respectively, before tax sharing payments from the Bank of $9.6 million in fiscal 1994, $5.0 million in fiscal 1993 and $29.6 million in fiscal 1991. The Real Estate Trust's ability to meet its liquidity needs, including debt service payments, will depend in significant part on its receipt of dividends from the Bank and tax sharing payments from the Bank pursuant to the tax sharing agreement among the Trust, the Bank and their subsidiaries. The availability and amount of tax sharing payments and dividends in future periods is dependent upon, among other things, the Bank's operating performance and income, regulatory restrictions on such payments and (in the case of tax sharing payments) the continued consolidation of the Bank and the Bank's subsidiaries with the Trust for federal income tax purposes.
The Real Estate Trust believes that the improved financial condition and operating results of the Bank in recent periods should enhance the prospects of the Real Estate Trust to receive
tax sharing payments and dividends from the Bank. As of September 30, 1994, $12.0 million in tax sharing payments were due to the Real Estate Trust, of which $5.0 million was paid in October 1994 with the approval of the OTS. The Real Estate Trust to date has not received any cash dividends from the Bank. In October 1993, the Bank's written agreement with the OTS was amended to eliminate the requirement that the Bank obtain the written approval of the OTS prior to declaring or paying dividends on its common stock. OTS regulations tie the Bank's ability to pay dividends to specific levels of regulatory capital and earnings. See "Business - Banking - Regulation - Dividends and Other Capital Distributions."
If the Real Estate Trust does not receive tax sharing payments or dividends from the Bank in fiscal 1995, management estimates that the Real Estate Trust will have adequate liquidity from other sources, including unencumbered cash balances, debt service escrow balances related to the Senior Secured Notes, and proceeds from the sale of Unsecured Notes, sufficient to fund its debt service and other cash needs for fiscal 1995.
BANKING
LIQUIDITY. The standard measure of liquidity in the savings industry is the ratio of cash and short-term U.S. Government and other specified securities to net withdrawable accounts and borrowings payable in one year or less.
The OTS has established a minimum liquidity requirement, which may vary from time to time depending upon economic conditions and deposit flows. The required liquidity level is currently 5.0%. The Bank's average monthly liquidity ratio for the month ended September 30, 1994 was 18.6%, compared to 24.3% for the month ended September 30, 1993. Additionally, the Bank met the liquidity level requirements for each month of fiscal 1994. The decline in the Bank's liquidity ratio was primarily attributable to scheduled and unscheduled principal paydowns on unpledged securities, which reduced the level of qualifying collateral.
The Bank's primary sources of funds historically have consisted of (i) principal and interest payments on loans and mortgage-backed securities, (ii) savings deposits, (iii) sales of loans, mortgage-backed securities and investment securities and (iv) borrowed funds (including funds borrowed from the FHLB of Atlanta). The Bank's holdings of readily marketable securities constitute another important source of liquidity. At September 30, 1994, the Bank's portfolio included mortgage loans, U.S. Government securities and mortgage-backed securities with outstanding principal balances of $908.2 million, $4.4 million and $1.0 billion, respectively. The estimated borrowing capacity of available mortgage loans, U.S. Government securities and
mortgage-backed securities that could be pledged to the FHLB of Atlanta and various security dealers totaled $1.4 billion at September 30, 1994, after market-value and other adjustments.
In recent periods, the proceeds from sales of credit card relationships and other assets and securitization and sale of credit card, home equity credit line and automobile loan receivables have been significant sources of liquidity for the Bank. The Bank securitized and sold $1.4 billion of credit card receivables and sold credit card relationships with related receivable balances of $96.5 million during fiscal 1994. In addition, during fiscal 1994, the Bank securitized and sold $181.9 million of home equity credit line receivables. As part of its operating strategy, the Bank will continue to explore opportunities to sell assets and to securitize and sell credit card and home equity credit line receivables to meet liquidity and other balance sheet objectives.
The ability of the Bank to securitize and sell assets in the future will depend on a number of factors, including conditions in the market for asset-backed securities and competitive pressures in the credit card industry. The Bank does not currently anticipate relying upon securitizations of receivables other than credit card and home equity credit line receivables. The Bank's currently projected levels of securitization of credit card and home equity credit line receivables reflect in part a reduction in the pool of receivables eligible for such securitizations. The reduction in the amount of eligible receivables has resulted from prior securitization and sales activities. Management believes that to support future securitization activity, a sufficient pool of eligible receivables will be provided by the existing portfolio of receivables, the amortization of existing credit card trusts, increased usage of existing accounts and originations of new accounts.
The Bank uses its liquidity primarily to meet its commitments to fund maturing savings certificates and deposit withdrawals, fund existing and continuing loan commitments, repay borrowings and meet operating expenses. For the year ended September 30, 1994, the Bank used the cash provided by operating, investing and financing activities primarily to meet its commitments to fund maturing savings certificates and deposit withdrawals of $12.2 billion, repay borrowings of $3.1 billion, fund existing and continuing loan commitments (including real estate held for investment or sale) of $2.9 billion, purchase investments and loans of $547.9 million and meet operating expenses, before depreciation and amortization, of $215.4 million. These commitments were funded primarily through proceeds from customer deposits and sales of certificates of deposit of $12.3 billion, proceeds from borrowings of $2.7 billion, proceeds from sales of loans, securities and real estate
of $2.4 billion, and principal and interest collected on investments, loans, mortgage-backed securities and trading securities of $1.1 billion.
The Bank is obligated under various recourse provisions related to the securitization and sale of credit card, home equity credit line and automobile loan receivables. See Note 28 to the Consolidated Financial Statements in this report. Of the $2.4 billion of outstanding trust certificate balances at September 30, 1994, the primary recourse to the Bank was approximately $65.9 million.
The Bank also is obligated under various recourse provisions related to the swap of single-family residential loans for participation certificates and mortgage-backed securities issued to the Bank by FHLMC and FNMA. At September 30, 1994, recourse to the Bank under these arrangements was approximately $5.9 million. See Note 28 to the Consolidated Financial Statements in this report.
The Bank's commitments at September 30, 1994 are set forth in the following table:
Based on historical experience, the Bank expects to
fund substantially less than the total amount of its outstanding credit card and home equity credit line commitments, which together accounted for 96.4% of commitments at September 30, 1994.
At September 30, 1994, repayments of borrowed money scheduled to occur during the next 12 months were $2.5 million. Certificates of deposit maturing during the next 12 months amounted to $482.3 million, of which a substantial portion is expected to remain with the Bank.
There were no material commitments for capital expenditures at September 30, 1994.
The Bank's liquidity requirements in years subsequent to fiscal 1994 will continue to be affected both by the asset size of the Bank, the growth of which will be constrained by capital and other regulatory requirements, and the composition of the asset portfolio. Management believes that the Bank's primary sources of funds, described above, will be sufficient to meet the Bank's foreseeable long-term liquidity needs. The mix of funding sources utilized from time to time will be determined by a number of factors, including capital planning objectives, lending and investment strategies and market conditions.
CAPITAL. At September 30, 1994, the Bank was in compliance with all of its regulatory capital requirements under FIRREA, and its capital ratios exceeded the ratios established for "well-capitalized" institutions under OTS prompt corrective action regulations. On the basis of its September 30, 1994 balance sheet, the Bank also would meet the fully phased-in capital requirements under FIRREA that will apply as certain deductions from capital are phased in and, after giving effect to those deductions, would meet the capital standards for "adequately-capitalized" institutions under the prompt corrective action regulations.
The following table shows the Bank's regulatory capital levels at September 30, 1994 in relation to the regulatory requirement in effect at that date. The information below is based upon the Bank's understanding of the regulations and interpretations currently in effect and may be subject to change.
Regulatory Capital (Dollars in thousands)
The Bank's stockholders' equity, and therefore its regulatory capital, was adversely affected in fiscal 1994 by a decrease of $30.4 million, after related income taxes, in the market value of the Bank's securities classified as available-for-sale. As market interest rates fluctuate, the market value of the Bank's available-for-sale portfolio, and therefore its stockholders' equity, also will fluctuate. As a result of the OTS's recent reversal of its policy, however, such fluctuations no longer will affect the Bank's levels of regulatory capital. See "Business - Banking - Regulation - Regulatory Capital."
In November 1994, the OTS announced its policy to exclude net unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital for purposes of computing regulatory capital ratios. Savings associations are required to adopt the revised policy by June 1995, but may elect to adopt the revised policy beginning in December 1994. This new policy replaces the interim OTS policy issued in August 1993, pursuant to which net unrealized holding gains (losses) were fully includable in tier 1 capital for regulatory capital purposes. If this policy had been in effect on September 30, 1994, the Bank's tangible, core and total risk-based regulatory capital ratios would have increased to 5.27%, 5.64% and 12.66%, respectively.
REGULATORY ACTION AND REQUIREMENTS. The Bank is subject to an amended written agreement with the OTS, dated October 1993, which imposes certain restrictions on the Bank's operations and requires certain affirmative actions by the Bank. Primarily because of its level of non-performing assets, the Bank is also subject to restrictions on asset growth. Under the applicable OTS requirements, the Bank may not increase its total assets during any calendar quarter in excess of an amount equal to net interest credited on deposit liabilities during such quarter without prior written approval from the OTS. In September 1993, the Bank received OTS approval, subject to certain conditions, to increase incrementally its total assets during the period from July 1, 1993 through June 30, 1994 by an amount up to $500 million. In addition, on September 27, 1994, the OTS notified the Bank that it would not object to an increase in the Bank's total assets of approximately $75.0 million for the quarter ended September 30, 1994.
The Bank is subject to a requirement to obtain OTS approval for changes in directors and senior executive officers and the imposition of higher FDIC insurance premiums. In January 1994, the OTS approved the appointment of three additional directors to the Bank's Board of
Directors.
CAPITAL MAINTENANCE STRATEGIES. The regulatory capital requirements applicable to the Bank will continue to increase over time as a result of the gradual phase-out of various assets from regulatory capital. On the basis of its balance sheet at September 30, 1994, the Bank met the FIRREA-mandated fully phased-in capital requirements with tangible, core (or leverage), and total risk-based capital ratios of 4.65%, 4.65% and 11.26%, respectively, which exceeded the FIRREA requirements of 1.5%, 3.0% and 8.0%, respectively. At September 30, 1994, the Bank had $27.2 million, after subsequent valuation allowances, of extensions of credit to, and investment in, subsidiaries engaged in activities impermissible for national banks ("non-includable subsidiaries") which were subject at September 30, 1994 to a 40% phase-out from all three FIRREA capital requirements. This phase-out will increase to 60% on July 1, 1995 and 100% on July 1, 1996, in accordance with a delayed phase-in period approved by the OTS pursuant to legislation enacted in October 1992. At September 30, 1994, the Bank also had two equity investments with an aggregate balance, after subsequent valuation allowances, of $38.6 million which were subject to a 100% phase-out from total capital for risk-based capital purposes, effective July 1, 1994. Pursuant to OTS guidelines, $5.5 million of general reserves maintained against the Bank's non-includable subsidiaries and equity investments is available as a "credit" against the deduction from capital otherwise required for such investments.
The Bank will continue to attempt to reduce the level of its investments in non-includable subsidiaries and its level of equity investments. The level of the Bank's investments in non-includable subsidiaries is a key factor in the capital calculation because, under the fully phased-in capital requirements, those investments represent dollar-for-dollar reductions in core capital, which in turn limit the amount of supplementary capital which may be included for risk-based capital purposes. The Bank does not anticipate entering into any new transactions that would result in an increase in its investments in non-includable subsidiaries, and is attempting to reduce the existing level of those investments over the next several years.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or
otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from risk-based capital. Although there can be no assurances in this regard, management believes it will be able to receive the necessary extensions. The following table sets forth the Bank's REO at September 30, 1994, after valuation allowances of $109.1 million, by the fiscal year in which the property was acquired through foreclosure.
At September 30, 1994, the Bank had $48.3 million in supervisory goodwill, of which $17.3 million was includable in core capital pursuant to statutory provisions limiting the includable amount of supervisory goodwill to an amount not to exceed 0.375% of tangible assets beginning January 1, 1994 and 0% beginning January 1, 1995.
The Bank's ability to maintain capital compliance will be subject to general economic conditions, particularly in the Bank's local markets. Adverse general economic conditions or a renewed downturn in local real estate markets could require further additions to the Bank's reserves for losses and further charge-offs. Any such developments would adversely affect the Bank's earnings and thus its ability to maintain capital compliance.
PROMPT CORRECTIVE ACTION. Under the OTS prompt corrective action regulations, an institution is categorized as "well capitalized" if it has a leverage (or core capital) ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0%, a total risk-based capital ratio of at least 10.0% and is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level. At September 30, 1994, the Bank's leverage, tier 1 risk-based
and total risk-based capital ratios were 5.34%, 6.95% and 12.19%, respectively, which exceeded the ratios established for "well-capitalized" institutions, and the Bank was not subject to any applicable written agreement, order or directive to meet and maintain a specific capital level. The OTS has the discretion to reclassify an institution from one category to the next lower category, for example from "well capitalized" to "adequately capitalized," if, after notice and an opportunity for a hearing, the OTS determines that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity. The Bank's levels of nonperforming assets may result in reductions in capital to the extent losses are recognized as a result of deteriorating collateral value or economic conditions. Further, under the OTS's regulatory capital requirements, the Bank is required to phase out from regulatory capital supervisory goodwill and certain investments in subsidiaries and equity investments. There can be no assurance that the Bank will be able to maintain levels of capital sufficient to continue to meet the standards for classification as "well capitalized." On a fully phased-in basis at September 30, 1994, the Bank's regulatory capital ratios would meet the ratios established for "adequately capitalized" institutions.
RESULTS OF OPERATIONS
The Real Estate Trust's ability to generate revenues from property ownership and development is significantly influenced by a number of factors, including national and local economic conditions, the level of mortgage interest rates, governmental actions (such as changes in real estate tax rates) and the type, location, size and stage of development of the Trust's properties. Most of the operating expenses and virtually all of the debt service payments associated with income-producing properties are not decreased by reductions in occupancy or rental income. Therefore, the ability of the Trust to produce net income in any year from its income-producing properties is highly dependent on the Real Estate Trust's ability to maintain or increase the properties' levels of rental income and hotel sales revenues. The relative illiquidity of real estate investments tends to limit the ability of the Real Estate Trust to vary its portfolio promptly in response to changes in economic, demographic, social, financial and investment conditions.
The Bank's operating results historically have depended primarily on its "net interest spread," which is the difference between the rates of interest earned on its loans and securities investments and the rates of interest paid on
its deposits and borrowings. In the last three fiscal years, non-interest income from securitizations of credit card and home equity credit line receivables and gains on sales of credit card accounts (or "relationships"), loans and mortgage-backed securities have had a significant effect on net income. In addition to interest paid on its interest-bearing liabilities, the Bank's principal expenses are operating expenses.
FISCAL 1994 COMPARED TO FISCAL 1993
REAL ESTATE
The following table sets forth, for the fiscal years ended September 30, 1994, 1993 and 1992, direct operating results for the Real Estate Trust's (i) shopping center and office properties, (ii) commercial properties portfolio, which presents the shopping center and office property results on a combined basis, and (iii) hotel properties. On August 26, 1993, the Real Estate Trust transferred its 22 shopping center properties and one of its office properties to Saul Holdings Partnership and a subsidiary limited partnership of Saul Holdings Partnership in exchange for a 21.5% limited partnership interest in Saul Holdings Partnership (the "Saul Centers Transaction"). See "Business - Real Estate - Investment in Saul Holdings Limited Partnership" and Note 2 to the Consolidated Financial Statements in this report. As a result of the Saul Centers Transaction, the fiscal 1994 operating results of commercial properties, which did not include the Transferred Properties, and the fiscal 1993 operating results, which included such commercial properties for less than the entire fiscal year, are not entirely comparable to the results of the prior corresponding periods.
The Real Estate Trust recorded a loss before depreciation and amortization of debt expense of $24.0 million and an operating loss of $34.3 million for fiscal 1994, compared to a loss before depreciation and amortization of debt expense of $29.0 million and an operating loss of $44.5 million for fiscal 1993. The improvement was largely attributable to the decline in interest expense resulting from refinancings and the Saul Centers Transaction and to the absence in fiscal 1994 of a charge comparable to the charge for abandoned development costs of $13.1 million in fiscal 1993.
Income after direct operating expenses from commercial properties, which included only office properties in fiscal 1994, decreased $22.2 million (69.3%) from such income in fiscal 1993, which included income from both shopping centers and office properties. Because of the Saul Centers Transaction, the Real Estate Trust received no income from shopping centers in the current year. Income after direct operating expenses from commercial properties in the portfolio during both years increased $61,000 (0.6%). The performance of the office portfolio in fiscal 1994 was adversely affected by a reduction in rental income during the first half of the year, although office rents largely recovered in the last two quarters. Income after direct operating expenses for office properties increased $442,000 (19.8%) in the fourth quarter of fiscal 1994 from the level in the prior corresponding period.
Income after direct operating expenses from hotel properties increased $284,000 (2.4%) in fiscal 1994. Room sales increased by $1,159,000 (3.8%) as a result of increases in average room rates. This increase was offset in part by a decrease in average occupancy rates. The lower occupancy rates contributed to a decrease of $526,000 (4.4%) in food and beverage sales. Total revenues increased by $661,000 (1.5%), while expenses were higher by $377,000 (1.1%).
Interest expense decreased $11.1 million (22.0%) in fiscal 1994, largely as result of the transfer of the mortgage debt associated with the properties conveyed in the Saul Centers Transaction. Primarily for the same reason, average balances of the Real Estate Trust's outstanding borrowings declined to $358.4 million in fiscal 1994 from $452.7 in the prior year.
Amortization of debt expense decreased $1.8 million (60.2%) and depreciation decreased $3.4 million (27.1%), primarily as a result of the transfer of properties in the Saul Centers Transaction.
Advisory, management and leasing fees paid to related parties declined $456,000 (6.3%) in fiscal 1994. The advisory fee in fiscal 1994 was $250,000 per month from October 1993 through March 1994 and $292,000 per month from April 1994 through September 1994, compared to $97,000 per month from October through December 1992 and $157,000 per month from January through September 1993. The effect of this increase was offset by decreases in management and leasing fees, which resulted principally from the transfer of properties in the Saul Centers Transaction.
General and administrative expense decreased $92,000 (4.3%) in fiscal 1994, largely because of a reduction in overhead expense. Legal expense increased slightly from the fiscal 1993 level.
The fiscal 1994 write-down of real estate to net realizable value reflects a $1.4 million reduction in the carrying value of a hotel property. The Real Estate Trust reduced the carrying value of the asset based on management's evaluation of the hotel's location, recent operating history and unlikely prospects for a near-term recovery.
Equity in earnings (losses) of unconsolidated entities represents the Real Estate Trust's share of earnings or losses in its partnership investments. For fiscal 1994, the Real Estate Trust recorded earnings of $1.7 million, compared to a loss of $0.7 million in the prior year.
BANKING
OVERVIEW. The Bank recorded operating income of $53.2 million for the year ended September 30, 1994 ("fiscal 1994"), compared to operating income of $63.8 million for the year ended September 30, 1993 ("fiscal 1993"). The decline in income for fiscal 1994 was primarily attributable to a $56.9 million increase in operating expenses, a $14.4 million decrease in total net interest income, a $10.6 million decrease in credit card fees and an $8.9 million decrease in gain on sale of investment securities. The decrease in income for the year was offset in part by a $29.3 million decrease in the provision for loan losses and a $29.8 million increase in other (non-interest) income resulting primarily from a $30.6 million increase in loan and deposit servicing fees and improved results on real estate held for investment or sale.
The Bank's net income for the 1994 period reflected a $6.3 million extraordinary loss, net of related income taxes, resulting from the Bank's redemption of $128.5 million principal amount of subordinated capital debentures in December 1993. See Note 23 to the Consolidated Financial Statements in this report.
The Bank adopted SFAS 109 effective October 1, 1993. The cumulative effect of this change in accounting principle of $5.1 million was recognized as a benefit in the operating results for fiscal 1994.
NET INTEREST INCOME. Net interest income, before the provision for loan losses, decreased $12.4 million (or 6.8%) in fiscal 1994, as the average yield on interest-earning assets decreased at a rate greater than the decrease in the average rate on interest-bearing liabilities. See "Financial Condition - Asset and Liability Management."
The Bank would have recorded interest income of $9.1 million in fiscal 1994 if the Bank's non-accrual assets and restructured loans had been current in accordance with their original terms. Interest income of $2.7 million was actually recorded on non-accrual assets and restructured loans during the fiscal year. The Bank's net interest income in future periods will continue to be adversely affected by the Bank's non-performing assets. See "Financial Condition - Asset Quality - Non-performing Assets."
The following table sets forth, for the periods indicated, information regarding the total amount of income from interest-earning assets and the resulting yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and rates, and the net interest spread and net yield on interest-earning assets.
Net Interest Margin Analysis (Dollars in thousands)
The following table presents certain information regarding changes in interest income and interest expense of the Bank during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); changes in rate (change in rate multiplied by old volume); and changes in rate and volume.
Volume and Rate Changes in Net Interest Income (In thousands)
Interest income in fiscal 1994 decreased $14.4 million from the level in fiscal 1993 as a result of lower average yields earned by the Bank on the principal categories of its interest-earning assets. The effect of the lower average yields on interest income was offset in part by higher average balances of loans receivable and, to a lesser extent, trading securities and other interest-earning assets.
The Bank's net interest spread declined to 4.42% in fiscal 1994 from 5.16% in fiscal 1993. The decline reflected the effects of marketing strategies which included the offering of lower introductory rates for certain loan products, primarily credit card and home equity credit line loans, and the increased origination of credit card loans; the higher level of asset securitization activities; and the downward adjustment of interest rates on certain of the Bank's adjustable-rate products to reflect previous declines in market interest rates to which the loan rates on such products are indexed.
Interest income on loans, the largest category of interest-earning assets, increased by $14.9 million (or 6.2%) from fiscal 1993. The increase in interest income on loans was attributable to higher average balances of the loan portfolio. Average balances of single-family residential permanent loans increased $326.7 million (or 33.0%) as a result of increased origination of such loans during the current year. Interest income on these loans increased $17.1 million (or 23.6%) from fiscal 1993. Average balances of credit card loans increased $82.3 million (or 9.9%)in fiscal 1994, largely as a result of new account originations in connection with the Bank's resumption of active national solicitation of credit card accounts. An increase of $11.1 million (or 132.0%) in interest income on consumer loans (other than credit card loans) was attributable to increased originations of automobile loans, which resulted in an increase in the average balances of such consumer loans to $236.5 million from $89.7 million. Average balances of commercial permanent loans increased $14.4 million (or 18.0%), primarily as a result of an increase in loans made to purchasers of certain of the Bank's REO in connection with the sales of such REO. Average balances of home equity credit line loans declined in fiscal 1994, largely as a result of the Bank's securitization and sale activity. The securitization and sale of $194.2 million, $146.2 million and $181.9 million of home equity credit line receivables in December 1992, September 1993 and September 1994, respectively, contributed to a decline of $19.5 million (or 12.6%) in average balances of home equity credit line receivables, which was largely responsible for a $1.5 million decline in interest income.
Lower average yields on the loan portfolio partially offset the effect of higher average balances. The average yield on the loan portfolio in fiscal 1994 decreased by 182 basis points (to 9.44% from 11.26%) from the average yield in fiscal 1993. Special introductory and promotional interest rates to new and existing credit card holders contributed to a decline in the average yield on credit card loans to 14.65% from 17.68% and to a decline of $13.2 million in interest income on these loans. The average yield on home equity credit line loans decreased to 6.96% from 7.05%, primarily as a result of introductory rates offered on new home equity credit line loans. The average yield on single-family residential loans declined to 6.81% from 7.33%, as customers continued to refinance higher rate mortgage loans into mortgage loans with lower rates.
Interest income on mortgage-backed securities decreased $24.1 million because of lower average interest rates and lower average balances. The reduced mortgage-backed security balances in fiscal 1994 reflected the effects of the sale of $127.8 million of such securities during fiscal 1993. Average interest rates on these securities declined to 5.77% from 6.30%, primarily as a result of the prepayment of higher rate mortgage-backed securities and the purchase of mortgage-backed securities with lower rates.
Interest income on investment securities decreased $7.8 million as a result of the sale in June 1993 of U.S. Government securities with a book balance of $172.9 million, which resulted in lower average balances of such securities in fiscal 1994.
Interest expense decreased $2.0 million (or 1.2%) for the year ended September 30, 1994 because of a decline of $5.1 million in interest expense on borrowings. The decrease in interest paid on borrowings was primarily attributable to a $4.2 million decrease in interest expense on repurchase agreement transactions and a $2.0 million decrease in interest expense on the Bank's subordinated debentures. A decrease of $160.8 million (or 60.6%) in the average balances of repurchase agreements contributed to the reduced interest expense on repurchase agreement transactions. The decline in interest expense on the Bank's subordinated debentures reflected the effects of the refinancing of two outstanding debenture issues in the first quarter of fiscal 1994 with the proceeds of a new, lower-rate debenture issue. As a result of such refinancing, the annual interest rate paid by the Bank on its debentures decreased to 10.02% in fiscal 1994 from 13.55% in fiscal 1993. See Note 23 to the Consolidated Financial Statements in this report.
The decrease in interest expense on borrowings was partially offset by a $3.1 million increase in interest expense on deposits, the largest category of interest-bearing liabilities. Interest expense on deposits increased principally as a result of an increase of $138.0 million in average deposit balances. See "Financial Condition - Asset and Liability Management."
PROVISION FOR LOAN LOSSES. The Bank's provision for loan losses decreased to $33.2 million in fiscal 1994 from $62.5 million in the prior fiscal year. The decrease was primarily attributable to a decrease of $20.3 million in the provision for losses on credit card loans. The lower provision resulted in part from a decline in net charge-offs of credit card loans in fiscal 1994. In addition, the securitization and sale of $850 million of credit card receivables in the fourth quarter of fiscal 1994 and of $200.0 million and $300.0 million of credit card receivables in the March 1994 and June 1994 quarters, respectively, reduced the amount of such receivables against which the Bank maintains the reserve. The provision for losses on real estate loans decreased $10.2 million, reflecting the Bank's implementation of SOP 92-3 during the December 1992 quarter. See "Financial Condition - Asset Quality - Reserves for Losses."
OTHER INCOME. The increase in other (non-interest) income to $160.0 million in fiscal 1994 from $130.8 million in fiscal 1993 was primarily attributable to an increase in loan and deposit servicing fees. In addition, the Bank recorded earnings on real estate held for investment or sale, compared to a loss in fiscal 1993. The positive effect of these items on other income was partially offset by a decrease in credit card fees and a decrease in gain on sale of investment securities.
An increase of $21.8 million in excess servicing fees and $4.4 million of servicing fees earned by the Bank for servicing its portfolios of securitized credit card loans contributed to an increase of $30.6 million (or 46.9%) in loan and deposit servicing fees. Such excess servicing fees and servicing fees have increased in recent periods as a result of greater securitization activity by the Bank. The increase in loan and deposit servicing fees also reflected a $4.6 million increase in excess servicing fees related to home equity credit line securitizations. The excess servicing fee level rose because of a decrease in the average prepayment rate with respect to the underlying home equity credit line receivables. See "Excess Servicing Assets" in "Summary of Significant Accounting Policies - The Bank" in the Notes to the Consolidated Financial Statements in this report.
The improved results on real estate held for investment or sale were primarily attributable to a decrease of $16.4 million in the provision for losses on such assets. The Bank's implementation of SOP 92-3 in the quarter ended December 31, 1992 resulted in $19.0 million of additional provisions for real estate losses in that period which was required to reduce the book value of the Bank's foreclosed assets to fair value. An increase of $2.0 million in the gain recorded on sales of the Bank's REO properties also contributed to the earnings on real estate held for investment or sale. These results were partially offset by a $3.0 million decrease in the operating income generated by the Bank's REO properties.
Credit card fees, consisting of membership fees, late charges, interchange fees and cash advance charges, decreased $10.6 million (41.1%) in fiscal 1994 from the level in fiscal 1993. The decrease was primarily attributable to a $12.9 million increase in rebate expense on credit card retail purchases, which the Bank incurred in connection with promotional activities undertaken beginning in 1993. The decrease was partially offset by an increase in interchange fees and cash advance charges as a result of increased account activity. The increased number of accounts reflected the increase in new account originations in connection with the Bank's resumption of active national solicitation of new credit card accounts.
Gain on sale of investment securities decreased by $8.9 million as a result of the sale in the June 1993 quarter of U.S. Government securities with a book value of $172.9 million.
OPERATING EXPENSES. Operating expenses for the year ended September 30, 1994 increased $56.9 million (30.6%) from the level in fiscal 1993. The main components of the higher operating expenses were increases in marketing expenses, salaries and employee benefits, and data processing expenses. The $34.1 million increase in marketing expenses was primarily incurred in connection with the Bank's expanded marketing program for its credit card products and services initiated in June 1993 with the resumption of active national solicitation of new credit card accounts. See "Business - Lending - Credit Card Lending." The $17.7 million increase in salaries and employee benefits resulted primarily from the addition of staff to the Bank's credit card operations and discretionary bonuses paid to substantially all employees in December 1993. The $8.5 million increase in data processing expense was principally attributable to an increase in the number of credit card accounts outstanding and the activity generated by such accounts during fiscal 1994. In order to take
advantage of additional opportunities to enhance profitability, the Bank may be required to incur increased expenditures for salaries and employee benefits, loan expenses and marketing expenses, which will contribute to higher operating expenses in future periods.
FISCAL 1993 COMPARED TO FISCAL 1992
REAL ESTATE
The Real Estate Trust recorded an operating loss of $44.5 million for the fiscal year ended September 30, 1993, which represented a $16.0 million increase from the $28.5 million operating loss recorded for fiscal 1992. Of the loss recorded by the Real Estate Trust in fiscal 1993, $15.5 million consisted of depreciation and amortization of debt expense. The operating results for fiscal 1993 reflected a $13.1 million write-off of previously capitalized costs on development projects which management has determined have no continuing value to the Real Estate Trust.
Income after direct operating expenses from commercial properties, which included both shopping center and office properties, decreased $5.0 million (13.6%) in fiscal 1993 from the prior fiscal year. Income from shopping centers after direct operating expenses declined by $2.6 million (1.2%) from the fiscal 1992 level, while income from office buildings declined by $2.4 million (7.6%). The decline in shopping center income and, to a lesser extent, office property income was primarily attributable to the transfer of 22 shopping centers and one office property in the Saul Centers Transaction, which effectively limited fiscal 1993 operating results for the major part of the commercial property portfolio to approximately 11 months of operations. The performance of the office portfolio also was adversely affected by a reduction in the leasing rate to 77% at September 30, 1993 from 81% at September 30,1992. The lower leasing rate generally reflected the recessionary economic conditions in the markets in which these properties are located, including the effects of the termination on March 31, 1993 of a lease for 134,000 square feet of space in one of the Real Estate Trust's office buildings in Atlanta.
Income after direct operating expenses from hotel properties decreased $0.8 million (6.1%) in fiscal 1993 from the prior fiscal year. Room sales declined $2.1 million (3.8%), reflecting continued softness in some of the hotel markets and a significant decrease in occupancy rates at one of the nine properties. Direct operating expenses, which include a number of variable costs tied to occupancy, decreased $0.5 million (1.4%) in the current year.
Interest expense declined $0.9 million (1.7%) in fiscal 1993 as a result of lower interest rates and lower average total indebtedness. Average balances of the Trust's outstanding borrowings declined to $452.7 million in fiscal 1993 from $478.9 million in fiscal 1992, primarily as a result of the transfer in the Saul Centers Transaction of the mortgage debt associated with the properties transferred to Saul Holdings Partnership.
Advisory, management and leasing fees paid to related parties increased $0.2 million (2.2%) in fiscal 1993 as result of an increase, effective January 1, 1993, in the monthly advisory fee to $157,000 from $97,000. The effect of this increase was partially offset by a decrease of $0.4 million in management and leasing fees as a result of lower rental and sales income on which these fees are based.
General and administrative expense decreased $2.1 million (49.9%) in fiscal 1993 from the level in the prior fiscal year. Such expense in fiscal 1992 reflected payment of a $1.3 million litigation judgment awarded against the Trust. Most of the balance of the decreased expenses in the current fiscal year was attributable to lower legal expense.
The $13.1 million write-off of abandoned development costs, which were incurred primarily before fiscal 1990, represents the expensing of costs capitalized in previous years by the Real Estate Trust on projects for various types of income-producing properties located in Georgia, Virginia, Kansas and Florida. Because of changed economic circumstances in those locations, management determined that it would not be in the best interests of the Trust to continue development and that the costs expended had no continuing value to the Real Estate Trust.
BANKING
OVERVIEW. The Bank recorded operating income of $63.8 million for fiscal 1993, compared to operating income of $43.4 million for the year ended September 30, 1992 ("fiscal 1992"). The increase in operating income for fiscal 1993 was primarily attributable to a $26.5 million decrease in the provision for loan losses, a $7.0 million increase in loan and deposit servicing fees, an $8.9 million increase in gain on sales of securities and a $37.9 million decrease in loss on real estate held for investment or sale. The positive effect of
these items was offset in part by a $7.0 million decrease in net interest income before provision for loan losses, an $8.2 million decrease in credit card fees, a $12.9 million decrease in gains on sales of credit card relationships, loans and mortgage-backed securities and a $29.5 million increase in operating expenses.
NET INTEREST INCOME. Net interest income, before the provision for loan losses, decreased $7.0 million (or 3.7%) in fiscal 1993, as the average yield on interest-earning assets decreased at a rate greater than the decrease in the average rate on interest-bearing liabilities. See "Financial Condition - Asset and Liability Management."
The Bank would have recorded additional net interest income of $7.4 million in fiscal 1993 if the Bank's non-accrual assets and restructured loans had been current in accordance with their original terms.
Interest income in fiscal 1993 decreased $54.2 million from the level in fiscal 1992 as a result of lower average yields on the loan portfolio and lower average balances of loans. The effect of the lower average yields on loans, which reflected a decline in market interest rates, and lower average loan balances was partially offset by higher average balances of certain interest-earning assets, principally mortgage-backed securities and, to a lesser extent, U.S. Government securities.
Interest income on loans, the largest category of the Bank's interest-earning assets, declined by $67.3 million (or 21.9%) due to lower average balances and decreased yields. The Bank's loan securitization and sale activity was the single largest factor in reducing loan balances. The securitization and sale of $194.2 million and $146.2 million of home equity credit line receivables in the first and fourth quarters of fiscal 1993, respectively, were reflected in a decrease of $27.5 million (or 15.0%) in average balances of this loan type. A decrease of $259.5 million in average credit card loan balances resulting from the securitization and sale of $200.0 million of credit card receivables in the fourth quarter of fiscal 1993 and $150.0 million and $280.0 million of credit card receivables in the March 1993 and 1992 quarters, respectively, contributed to a $51.9 million decrease in interest income from this category of loans. Average loan balances in the construction and ground loan categories decreased $49.6 million (or 42.5%) from the level in fiscal 1992 primarily as a result of loan principal repayments and the acquisition of the underlying collateral through foreclosure or categorization of the loans as in-substance foreclosed. Average loan balances of residential permanent loans increased $10.1 million as a
result of the Bank's increased origination of single-family residential loans during fiscal 1993.
A decrease of 150 basis points in the average yield on the loan portfolio for the year ended September 30, 1993 resulted primarily from a decrease to 7.33% from 8.62% in the average yield on residential permanent loans and a decrease to 7.05% from 8.51% in the average yield on home equity credit line loans. The Bank's residential permanent loans and home equity credit line loans generally bear interest at variable rates that adjust based on specified market interest rates, which declined from levels prevailing in fiscal 1992. See "Business - Lending Activities - Single-Family Residential Real Estate Lending."
Interest income on mortgage-backed securities increased $11.6 million primarily as a result of higher average balances of these assets. Average balances increased $393.0 million (or 35.2%) from the level in fiscal 1992 primarily as a result of increased purchases of mortgage-backed securities during the year. Mortgage-backed security balances increased primarily as result of management's desire to reduce its overall risk-based capital requirement. Management accomplished this objective by reinvesting proceeds from the securitization and sale of home equity credit line and credit card receivables securitizations, and to a lesser extent, early curtailments on its residential loans into government and mortgage-backed securities. The effects of the higher average balances were offset in part by lower average yields on these securities resulting from lower market interest rates.
Interest income on investment securities increased $3.9 million as a result of higher average balances of U.S. Government securities. As discussed above, the Bank's higher balances in U.S. Government securities was a result of management's desire to reduce risk-based capital requirements. Other interest income decreased $2.4 million during the year ended September 30, 1993 primarily because of lower average yields of interest bearing deposits, which declined to 2.2% from 3.8% (or 41.6%), and lower average yields and balances of federal funds sold, which declined to 3.0% from 4.1% and to $14.3 million from $25.9 million (or 44.9%), respectively. The Bank's decrease in federal funds sold, resulted primarily from the immediate reinvestment of various securitization proceeds into agency mortgage-backed securities rather than into federal funds.
Interest expense decreased $47.2 million (or 22.0%) for the year ended September 30, 1993 because of a decline of $53.8 million in interest expense on deposits, the largest category of interest-bearing liabilities. Interest expense
on deposits decreased primarily as a result of a decrease in average rates (to 3.35% from 4.45%), which reflected a decline in market interest rates, and secondarily to a decline of $266.6 million in average deposit balances. The decline in average deposit balances, which began in fiscal 1992, has been primarily attributable to two factors. First, thrifts and banks generally experienced a net outflow of deposits in 1992 and 1993 as a result of low market interest rates and the relative strength and attractiveness of bonds and equity securities as alternate investments. Second, the Bank pursued a more conservative strategy in fiscal 1992 than certain of its competitors in setting interest rates on deposits, particularly on more costly certificates of deposit and money market deposits. Interest on borrowings increased by $6.6 million, primarily because of higher average balances of short-term borrowings which replaced decreased deposit balances. The higher average balances of such borrowings were offset in part by lower average interest rates.
PROVISION FOR LOAN LOSSES. The Bank's provision for loan losses decreased to $62.5 million in fiscal 1993 from $89.1 million in the prior fiscal year. The decrease was primarily attributable to a decrease of $23.7 million in the provision for losses on credit card loans. The securitization and sale of $200.0 million of credit card receivables in the fourth quarter of fiscal 1993 and of $150.0 million and $280.0 million of credit card receivables in the March 1993 and 1992 quarters, respectively, reduced the amount of such receivables against which the Bank maintains the reserve. See "Financial Condition - Asset Quality - Reserves for Losses."
OTHER INCOME. The increase in other (non-interest) income to $130.8 million in fiscal 1993 from $100.4 million in fiscal 1992 was primarily attributable to an increase in loan and deposit servicing fees, an increase in the gain on sales of securities and a decrease in the loss on real estate held for investment or sale. These items were partially offset by decreases in credit card fees and in gain on sales of credit card relationships, loans and mortgage-backed securities.
Credit card fees, consisting of membership fees, late charges, interchange fees and cash advance charges, decreased $8.2 million in fiscal 1993 from the level in fiscal 1992. The decrease was attributable to a decrease in interchange fees, a decrease in late charges collected and a decrease in annual membership fees as a result of a lower number of accounts due primarily to credit card securitization activity.
Loan servicing fees increased $6.2 million in fiscal 1993. Higher levels of securitized receivables serviced by the Bank contributed to an increase of $6.9 million in credit card servicing fees, and higher levels of purchased mortgage servicing rights contributed to an increase of $2.6 million in residential single-family mortgage servicing fees. As the Bank securitizes and sells assets, purchases mortgage servicing rights, or sells mortgage loans and retains the servicing rights on those loans, servicing fee income levels increase. The level of servicing fee income declines upon repayment of assets previously securitized and sold and upon prepayment of mortgage loans serviced for others. The amortization of the excess servicing asset related to home equity credit line securitizations increased $3.8 million, primarily due to an increase in the average prepayment rate of the underlying receivables, which reflected continued high levels of loan prepayment activity.
The gain on sales of securities increased to $8.9 million as a result of the Bank's sale in June 1993 of its portfolio of five-year U.S. Government securities with a book value of $172.9 million. The Bank sold these securities primarily to permit increased mortgage loan origination activity which would otherwise have been limited under the asset growth limitations imposed on the Bank by the OTS. See "Financial Condition - Capital - Regulatory Action and Requirements."
The $37.9 million decrease in the loss on real estate held for investment or sale was primarily attributable to a decrease in the provision for losses on these assets of $30.2 million. See "Financial Condition - Asset Quality - Reserve for Losses."
Gain on sales of credit card relationships, loans and mortgage-backed securities in fiscal 1993 decreased $12.9 million from fiscal 1992 levels, primarily because of a decrease in the amount of mortgage-backed securities sold. In the June 1992 quarter, the Bank sold $438.4 million of long-term fixed-rate mortgage-backed securities, which resulted in a gain of $21.0 million, in order to mitigate the effects on the Bank's capital levels of an increase in the Bank's reserves for losses on real estate and real estate-related charge-offs taken in the same quarter. The decrease in the gain on sales of credit card relationships, loans and mortgage-backed securities was partially offset by a $4.8 million gain recognized on the sale of the Bank's portfolio of seven-year balloon fixed-rate mortgage-backed securities, totaling $127.8 million, in the March 1993 quarter. These securities were sold primarily to provide the Bank with flexibility under existing regulatory growth limits and to reduce the Bank's exposure to possible future
increases in long-term interest rates. In addition, the Bank recognized aggregate gains of aggregate $16.8 million on its securitization and sale of home equity credit line receivables in fiscal 1993 compared to gains of $15.1 million in fiscal 1992. See "Financial Condition - Capital - Regulatory Action and Requirements."
OPERATING EXPENSES. Operating expenses in fiscal 1993 increased $29.5 million (18.9%) from the level in fiscal 1992. This increase was primarily attributable to increases in salaries and employee benefits, loan expenses and advertising expenses. Salaries and employee benefits increased $7.0 million, of which $5.5 million resulted from staffing increases, primarily in the asset workout, loan origination support and marketing areas. The remaining increase was attributable to the increase in the level of the Bank's contributions to its employee profit sharing plan. The $10.5 million increase in marketing expenses was primarily attributable to increased direct mail solicitation by the Bank of its credit card products and services in connection with the resumption of active national solicitation of new credit card accounts. See "Business - Lending - Credit Card Lending." The $12.2 million increase in loan expenses was due primarily to a $10.6 million increase in the amortization of purchased mortgage servicing rights, which resulted from the amortization of the purchase price of approximately $1.2 billion principal amount of residential single- family mortgage servicing rights acquired by the Bank during fiscal 1993 and the increased prepayments of the underlying loans. See "Business - Lending - Loan Servicing."
ITEM 8.


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION
CONTENTS
PAGE
(a) Reports of Independent Public Accountants . . . . . . . . . . . . .
(b) Consolidated Balance Sheets September 30, 1994 and 1993 . . . . . . . . . . . . . . . . . . . .
(c) Consolidated Statements of Operations - Three Years Ended September 30, 1994, 1993 and 1992 . . . . . . . . . . . . . .
(d) Consolidated Statements of Shareholders' Deficit - Three Years Ended September 30, 1994, 1993 and 1992 . . . . . . . . . . .
(e) Consolidated Statements of Cash Flows - Three Years Ended September 30, 1994, 1993 and 1992 . . . . . . . . . . . . . .
(f) Notes to Consolidated Financial Statements. . . . . . . . . . . . .
The selected quarterly financial data included in Note 34 of Notes to the Consolidated Financial Statements referred to above are incorporated herein by reference.
Summary financial information with respect to the Bank is also included in Part I, Item I.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust:
We have audited the accompanying consolidated balance sheet of B.F. Saul Real Estate Investment Trust (the "Trust") and subsidiaries as of September 30, 1994, and the related consolidated statement of operations, shareholders' deficit and cash flows for the year then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of B.F. Saul Real Estate Investment Trust and subsidiaries as of September 30, 1994, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles.
As explained in the Organization and Summary of Significant Accounting Policies in the notes to the financial statements, effective October 1, 1993, the Trust changed its method of accounting for income taxes, impaired loans and investments in securities and mortgage-backed securities.
Washington, D.C. ARTHUR ANDERSEN LLP December 19, 1994
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust:
We have audited the accompanying consolidated balance sheet of B.F. Saul Real Estate Investment Trust as of September 30, 1993, and the related consolidated statements of operations, shareholders' deficit, and cash flows for the years ended September 30, 1993 and 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of B.F. Saul Real Estate Investment Trust as of September 30, 1993, and the results of its operations and its cash flows for the years ended September 30, 1993 and 1992, in conformity with generally accepted accounting principles.
As explained in Summary of Significant Accounting Policies--the Bank, effective December 31, 1992, the Bank changed its method of accounting for foreclosed assets.
STOY, MALONE & COMPANY, P.C.
Bethesda, Maryland November 4, 1993
CONSOLIDATED BALANCE SHEETS B. F. SAUL REAL ESTATE INVESTMENT TRUST
The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF OPERATIONS B. F. SAUL REAL ESTATE INVESTMENT TRUST
The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' DEFICIT B. F. SAUL REAL ESTATE INVESTMENT TRUST
The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS B. F. SAUL REAL ESTATE INVESTMENT TRUST
The Notes to Consolidated Financial Statements are an integral part of these statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
B.F. Saul Real Estate Investment Trust and its wholly owned subsidiaries (collectively, the "Real Estate Trust") operate as a Maryland real estate investment trust. The principal business activity of the Real Estate Trust is the ownership and development of income-producing properties. The properties owned by the Real Estate Trust are located predominantly in the Mid-Atlantic and Southeastern regions of the United States and consist principally of office projects, hotels and various undeveloped land parcels.
B.F. Saul Real Estate Investment Trust also owns 80% of the outstanding common stock of Chevy Chase Bank, F.S.B., and its subsidiaries (the "Bank" or the "Corporations"), whose assets accounted for approximately 93% of the consolidated assets of the B.F. Saul Real Estate Investment Trust and its consolidated subsidiaries (the "Trust") at September 30, 1994. The Bank is a federally chartered and federally insured stock savings bank. The B. F. Saul Real Estate Investment Trust is a thrift holding company by virtue of its ownership of a majority interest in the Bank and is subject to regulation by the Office of Thrift Supervision ("OTS"). The accounting and reporting practices of the Trust conform to generally accepted accounting principles and, as appropriate, predominant practices within the real estate and banking industries.
PRINCIPLES OF CONSOLIDATION
The accompanying financial statements include the accounts of the the Real Estate Trust and the Bank. Accordingly, the accompanying financial statements reflect the assets, liabilities, operating results, and cash flows for two business segments: Real Estate and Banking. All significant intercompany balances and transactions have been eliminated.
INCOME TAXES
The Real Estate Trust files a consolidated federal income tax return which includes operations of all 80% or more owned subsidiaries.
In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 establishes financial accounting and reporting standards for the effects of income taxes that result from the Trust's activities during the current and preceding years. It requires an asset and liability approach in accounting for income taxes versus the deferred method previously used under Accounting Principals Board Opinion No. 11, "Accounting for Income Taxes" ("APB 11"). The Trust adopted SFAS 109 on October 1, 1993 and recorded a cumulative effect of a change in accounting principle of approximately $36.3 million.
Under SFAS 109, deferred income taxes are recorded using enacted tax laws and rates for the years in which taxes are expected to be paid. To the extent that realization of such assets is more likely than not, SFAS 109 provides for the recognition of deferred tax assets based on tax loss and tax credit carryforwards. At September 30, 1994, the Trust's net deferred tax asset, after $7.0 million in valuation allowances, was $55.2 million.
Income tax provisions for fiscal years 1993 and 1992 were determined under APB 11 and have not been restated to reflect adoption of SFAS 109.
NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is determined by dividing net income (loss), after deducting preferred share dividend requirements, by the weighted average number of common shares outstanding during the year. For fiscal years 1994, 1993 and 1992, the weighted average number of shares used in the calculation was 4,826,910.
RECLASSIFICATIONS
Certain reclassifications have been made to the consolidated financial statements for the years ended September 30, 1993 and 1992 to conform with the presentation used for the year ended September 30, 1994.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - REAL ESTATE TRUST
CASH EQUIVALENTS
The Real Estate Trust considers all highly liquid, temporary investments with an original maturity of three months or less to be cash equivalents.
PROPERTIES
Income-producing properties are stated at the lower of depreciated cost (except those which were acquired through foreclosure or equivalent proceedings, the carrying amounts of which are based on the lower of cost or fair value at the time of acquisition) or net realizable value based on management's intent and ability to hold such properties on a long term basis. Under the net realizable value approach, management evaluates, on an ongoing basis, the recoverability of the investment in each property by analyzing cash flow after capital improvements to determine that such cash flow is sufficient to recover the recorded investment in the property over its expected useful life.
Interest, real estate taxes and other carrying costs are capitalized on projects under construction. Once construction is completed and the assets are placed in service, rental income, direct operating expenses, and depreciation associated with such properties are included in current operations. Expenditures for repairs and maintenance are charged to operations as incurred.
In the initial rental operations of development projects, the Real Estate Trust considers a project to be substantially complete and held available for occupancy upon completion of tenant improvements, but no later than one year from the cessation of major construction activity. Subtantially completed portions of a project are accounted for as separate projects.
Depreciation is calculated using the straight-line method and estimated useful lives of 31.5 to 47 years for buildings and up to 20 years for certain other improvements. Tenant improvements are amortized over the lives of the related leases using the straight-line method.
INCOME RECOGNITION
Rental and interest income are accrued as earned except when doubt exists as to their collectibility, in which case accrual is discontinued. When rentals vary from a straight-line basis due to free rent periods or scheduled increases, income is recognized on a straight-line basis. Additional rental income based on tenants' gross revenues ("overage rent") is accrued on the basis of the prior year's overage rents adjusted to give effect to currently available sales data.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments.
CASH AND CASH EQUIVALENTS
The carrying amount approximates fair value because of the short-term maturity of these instruments.
LIABILITIES
The carrying amount of Mortgage notes payable approximates their fair value since most of the debt has been financed in recent periods at prevailing market interest rates. The fair value of Notes payable -- unsecured is based on the rates currently offered by the Real Estate Trust for similar notes. At September 30, 1994 and 1993 the fair value of Notes payable - unsecured was $42.1 and $41.6 million, respectively.
The Real Estate Trust and certain of its subsidiaries are obligated to reimburse the partners of certain partnerships, including a partnership in which the Real Estate Trust has an equity interest, in an amount up to $116.1 million if those partnerships fail to make payments with respect to specified debt. The operations of those partnerships are presently adequate to service that debt. Accordingly, as of the balance sheet date, the Real Estate Trust has determined that the fair value of this contingent obligation was zero. See Note 2.
C. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - THE BANK
The Bank is a federally chartered and federally insured stock savings bank and, as such, is subject to comprehensive regulation, examination and supervision by the Office of Thrift Supervision ("OTS") and by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is principally engaged in the business of attracting deposits from the public and using such deposits, together with borrowings and other funds, to make loans secured by real estate, primarily residential mortgage loans, and various types of consumer loans, primarily credit card loans.
CASH AND CASH EQUIVALENTS:
For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits, federal funds sold and securities purchased under agreements to resell.
The Bank is required to maintain reserve balances with the Federal Reserve Bank. Average reserves maintained at the Federal Reserve Bank were $20.6, $21.8 and $30.2 million during the years ended September 30, 1994, 1993 and 1992, respectively.
LOANS HELD FOR SALE:
The Corporations engage in mortgage banking activities. At September 30, 1994 and 1993, loans held for sale are composed of single-family residential loans originated or purchased for sale in the secondary market and are carried at aggregate cost which is lower than aggregate market value. Single-family residential loans held for sale will either be sold or will be exchanged for mortgage-backed securities and then sold. Gains and losses on sales of whole loans held for sale are determined using the specific identification method. See "Trading Securities" and Note 28.
LOANS HELD FOR SECURITIZATION AND SALE:
The Corporations periodically sell receivables through asset-backed securitizations, in which receivables are transferred to a trust, and the Corporations sell certificates to investors representing ownership interests in the trust.
The amount of asset-backed securitizations contemplated to occur during the six-month period subsequent to the balance sheet date is classified as held for securitization and sale to the extent that such amounts are outstanding. Such assets held for securitization and sale are reported at the lower of aggregate cost or aggregate market value for each asset type.
INVESTMENT SECURITIES AND MORTGAGE-BACKED SECURITIES:
Effective October 1, 1993, the Bank adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") which was issued in May 1993. SFAS 115 requires institutions to classify and account for debt and equity securities in one of three categories as follows:
1. Debt securities that an institution has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost.
2. Debt and equity securities that are purchased and held principally for the purpose of selling them in the near term and mortgage-backed securities held for sale in conjunction with mortgage banking activities are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. See "Trading Securities."
3. Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a net amount in a separate component of stockholders' equity, net of the related income tax effect.
At September 30, 1994, all investment securities and mortgage-backed securities held by the Bank are classified as available-for-sale and recorded at fair value. At September 30, 1994, net unrealized holding losses in the amount of $14.1 million, net of the related income tax effect, are included as a separate component of stockholders' equity. See Notes 9 and 10.
Premiums and discounts on investment securities and mortgage-backed securities available-for-sale are amortized or accreted using the level-yield method. Realized gains and losses are determined using the specific identification method.
Prior to October 1, 1993, the Bank's investment and mortgage-backed securities were held for investment and stated at cost, adjusted for amortization of premiums and accretion of discounts. These securities were carried at amortized cost because the Bank had the ability to hold such securities until maturity and it was management's intent to hold such securities for the foreseeable future. When management determined that certain securities might be sold in response to changes in interest rates, changes in prepayment risks or the need to increase regulatory capital, such securities were transferred from the held for investment category to the held for sale category. Such held for sale securities were transferred in and carried at the lower of aggregate cost or aggregate market value. Gains and losses resulting from the sale of investment and mortgage-backed securites were determined using the specific identification method.
Prior to October 1, 1993, securities to be held for indefinite periods of time, including securities that management intended to use as part of its asset-liability management, or that could be sold in response to changes in interest rates, changes in prepayment risks, the need to increase regulatory capital or other similar factors, were classified as held for sale and were carried at the lower of aggregate cost or aggregate market value. Gains and losses on sales of securities held for sale were determined using the specific identification method.
TRADING SECURITIES:
As part of its mortgage banking activities, the Corporations exchange loans held for sale for mortgage-backed securities and then sell the mortgage-backed securities to third party investors in the month of issuance. In accordance with SFAS 115, these mortgage-backed securities are classified as trading securities. Proceeds from sales of trading securities were $688.8 million during the year ended September 30, 1994. The Bank realized net gains on the sale of trading securities of $1.7 million for the year ended September 30, 1994. Gains and losses on sales of trading securities are determined using the specific identification method. There were no securities classified as trading securities at September 30, 1994.
LOAN ORIGINATION AND COMMITMENT FEES:
Nonrefundable loan fees, such as origination and commitment fees, and incremental loan origination costs relating to loans originated or purchased are deferred. Net deferred fees (costs) related to loans held for investment are amortized over the life of the loan using the level-yield or straight-line method. Net fees (costs) related to loans held for sale are deferred until such time as the loan is sold, at which time the net deferred fees (costs) become a component of the gain or loss on sale.
CREDIT CARD FEES AND COSTS:
Credit card membership fees are deferred and recognized as income on a straight-line basis over the period the fee entitles the cardholder to use the card, which is one year. Credit card origination costs are deferred and recognized as a reduction of income on a straight-line basis over the privilege period which is generally one year.
IMPAIRED LOANS:
Effective October 1, 1993, the Bank adopted, on a prospective basis, Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"), which was issued in May 1993, and Statement of Financial Accounting Standards No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures, an amendment of FASB Statement No. 114", which was issued in October 1994. Under SFAS 114, a loan is impaired when, based on all current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the agreement, including all scheduled principal and interest payments. SFAS 114 requires that impaired loans be measured based on the present value of expected future cash flows, discounted at the loan's effective interest rate. As a practical expedient, impairment may be measured based on the loan's observable market price, or, if the loan is collateral-dependent, the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. In addition, SFAS 114 changes the method of accounting for loans for which foreclosure is probable and requires that such impaired loans be accounted for as loans. The Bank also classifies certain credit card loans for which customers have agreed to modified payment terms, as impaired loans in accordance with SFAS 114.
The Bank evaluates each impaired real estate loan individually to determine the income recognition policy. Generally, payments received are applied in accordance with the contractual terms of the note or as a reduction of principal.
The Bank recognizes interest income on impaired credit card loans using the current interest rate of the loan and the accrual method. When loans become 90 days past due, all accrued interest is reserved and the loan is placed on non-accrual status. Interest income on non-accrual credit card loans is recognized when received by the Bank.
At September 30, 1994, the Bank had no impaired real estate loans and had impaired credit card loans with a carrying value of $35.3 million, before reserves for losses of $3.5 million on all such impaired credit card loans. The Bank calculates its reserve for losses on all credit card loans based upon historical charge-offs and repayment experience and the age of the portfolio. The average recorded investment in impaired real estate and credit card loans for the year ended September 30, 1994 was $39.0 million. The Bank recognized interest income of $2.4 million on its impaired loans for the year ended September 30, 1994.
RESERVES FOR LOSSES:
Management reviews the loan, real estate held for investment and real estate held for sale portfolios to establish reserves for estimated losses. The reserves for losses are reviewed periodically, and reserves are provided after consideration of the borrower's financial condition and/or the estimated value of collateral, including estimated selling and holding costs. Reserves are also provided by management after considering such factors as the economy in lending areas, delinquency statistics, past loss experience and estimated future loss experience.
The reserves for losses are based on estimates, and ultimate losses may vary from current estimates. As adjustments to the reserves become necessary, provisions for losses are reported in operations in the periods they are determined to be necessary.
ACCRUED INTEREST RECEIVABLE ON LOANS:
Loans are reviewed on a monthly basis and are placed on a non-accrual status when, in the opinion of management, the full collection of principal or interest has become unlikely. Uncollectible accrued interest receivable on non-accrual loans is charged against current period interest income.
REAL ESTATE HELD FOR INVESTMENT OR SALE:
REAL ESTATE HELD FOR INVESTMENT:
Real estate held for investment consists of an office building, apartment buildings, developed land and investments in limited partnerships all of which are owned by one of the Bank's subsidiaries. Real estate held for investment is carried at the lower of aggregate cost or net realizable value. Also included in real estate held for investment is a loan to a developer with a 50% profit participation feature. This investment in a real estate venture, which was non-performing at September 30, 1994, is accounted for as an acquisition, development and construction ("ADC") arrangement.
REAL ESTATE HELD FOR SALE:
Real estate held for sale consists of real estate acquired in settlement of loans ("REO") and is recorded at the lower of cost or fair value at acquisition. Prior to December 31, 1992, real estate acquired in settlement of loans was carried at the lower of adjusted cost or net realizable value. Effective December 31, 1992, real estate acquired in settlement of loans is carried at the lower of adjusted cost or fair value (less estimated selling costs). Costs relating to the development and improvement of property, including interest, are capitalized, whereas costs relating to the holding of property are expensed. Capitalized interest amounted to $4.4, $10.2 and $13.2 million for the years ended September 30, 1994, 1993 and 1992, respectively.
Prior to October 1, 1993 and the implementation of SFAS 114, real estate held for sale also included in-substance foreclosures. In-substance foreclosures included those investments for which the Bank had determined that (i) the debtor had little or no equity in the collateral, considering the current fair value of the collateral (ii) proceeds for repayment of the loan could be expected to come only from the operation or sale of the collateral and (iii) the debtor had either formally or effectively abandoned control to the Bank or retained control of the collateral but, because of the current financial condition of the debtor, or the economic prospects for the debtor and/or the collateral, it was doubtful that the debtor would be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future.
Effective December 31, 1992, OTS regulations required that foreclosed assets be carried at the lower of cost or fair value which required the Bank to adopt Statement of Position 92-3, "Accounting for Foreclosed Assets" ("SOP 92-3"), issued by the Accounting Standards Division of the American Institute of Certified Public Accountants. SOP 92-3 requires that foreclosed assets held for sale, including assets classified as in-substance foreclosed (prior to the implementation of SFAS 114), be carried at the lower of fair value (less estimated selling costs) or cost. Under SOP 92-3, the Bank's real estate acquired in settlement of loans is considered to be held for sale. The adoption of SOP 92-3 caused the Bank to revise its method of accounting for real estate held for sale. Based on management's internal calculations and preliminary information with respect to certain appraisals, the Bank recorded valuation allowances against its foreclosed assets at December 31, 1992 of approximately $40.5 million to reduce the book balance of foreclosed assets to fair value. Because the increase in the Bank's reserves during the year ended September 30, 1992 reduced the effects of SOP 92-3, $21.5 million of valuation allowances previously provided partially offset the valuation allowances required by SOP 92-3.
PROPERTY AND EQUIPMENT:
Property and equipment is stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method which allocates the cost of the applicable assets over their estimated useful lives. Major improvements and alterations to Bank premises and leaseholds are capitalized. Leasehold improvements are amortized over the shorter of the terms of the respective leases (including renewal options that are expected to be exercised) or 20 years. Maintenance and repairs are charged to operating expenses as incurred.
COST IN EXCESS OF NET ASSETS ACQUIRED:
Cost in excess of net assets acquired is stated net of accumulated amortization and is being amortized using the straight-line method generally over a period of 15 years. Accumulated amortization was $31.0 and $28.2 million at September 30, 1994 and 1993, respectively.
MORTGAGE SERVICING RIGHTS:
Purchased mortgage servicing rights, which are stated net of accumulated amortization, are being amortized in proportion to the estimated remaining net revenues from the mortgage servicing rights purchased. Amortization of these assets amounted to $6.1, $12.1 and $1.6 million for the years ended September 30, 1994, 1993 and 1992, respectively. Accumulated amortization was $37.7 and $31.6 million at September 30, 1994 and 1993, respectively. During fiscal 1994, 1993 and 1992, the Bank capitalized $0.9, $20.7 and $1.6 million, respectively, related to the acquisition of mortgage servicing rights. In fiscal 1993, the Bank sold approximately $1.2 million of rights to service mortgage loans with principal balances of approximately $76.1 million and recognized a loss of $0.4 million. There were no sales of previously purchased mortgage servicing rights during the years ended September 30, 1994 and 1992.
In fiscal 1994, 1993 and 1992, the Bank sold the rights to service mortgage loans with principal balances of approximately $383.9, $476.1, and $255.7 million, respectively, which were originated by the Corporations in connection with mortgage banking activities, and recognized gains of $5.8, $5.2 and $3.8 million, respectively.
Management periodically evaluates the carrying value of purchased mortgage servicing rights taking into consideration current portfolio factors such as prepayment rates. The Bank's analyses are performed on a discounted basis based on pools of loans with similar characteristics. Any adjustments to the carrying value of such rights as a result of this evaluation are included in the amortization for the respective period.
EXCESS SERVICING ASSETS:
When loans are sold with the servicing rights retained by the Bank, the net present value of estimated future servicing income in excess of normal servicing income is recorded as an adjustment to the sales price of the loans. Estimated future losses are deducted in the computation of such excess servicing income. The resulting assets are amortized using the level-yield ("interest") method over the estimated lives of the underlying loans. Amortization of these assets amounted to $13.5, $21.4 and $20.0 million for the years ended September 30, 1994, 1993 and 1992, respectively. Accumulated amortization was $65.9 and $52.5 million at September 30, 1994 and 1993, respectively. Excess servicing assets capitalized in fiscal 1994, 1993 and 1992 of $11.1, $19.5 and $16.9 million respectively, were the result of the servicing retained upon the securitization and sale of home equity credit line receivables. See Note 15.
Management periodically evaluates the carrying value of excess servicing assets taking into consideration current portfolio factors such as prepayment rates. The Bank's analyses are performed on a discounted basis based on pools of loans with similar characteristics. Any adjustments to the carrying value of such assets as a result of this evaluation are included in the amortization for the respective period.
ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED:
Statement of Financial Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments" ("SFAS 119"), was issued in October 1994. SFAS 119 requires companies to disclose the amount, nature and terms of derivative financial instruments. Because SFAS 119 addresses only disclosure related issues, its adoption will not have an impact on the financial condition or results of operations of the Bank. Adoption of SFAS 119 is required for fiscal years ending after December 15, 1994. The Bank will be required to adopt SFAS 119 by September 30, 1995.
1. LIQUIDITY AND CAPITAL RESOURCES - REAL ESTATE TRUST
Historically, the Real Estate Trust's total cash requirements have exceeded the cash generated by its operations. As described below, this condition persisted in 1994 and is expected to continue for the foreseeable future. The Real Estate Trust's internal sources of funds, primarily cash flow generated by its income-producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding unsecured notes ("Unsecured Notes") sold to the public (see Note 4), interest payable on the Senior Secured Notes (as defined below), and the payment of capital improvement costs. In the past, the Real Estate Trust has funded such shortfalls through a combination of external funding sources, primarily new financings (including sale of Unsecured Notes), refinancings of maturing mortgage debt, asset sales and tax sharing payments from the Bank.
The Real Estate Trust had negative cash flow from operating activities of $10.9, $3.1, $0.9 and $16.4 million in fiscal 1994, 1993, 1992 and 1991, respectively, before tax sharing payments from the Bank of $9.6, $5.0 and $29.6 million in fiscal 1994, 1993 and 1991, respectively. The Real Estate Trust's ability to meet its liquidity needs, including debt service payments, will depend in significant part on its receipts of tax sharing payments from the Bank (pursuant to the tax sharing agreement dated June 28, 1990, as amended, among the Trust, the Bank and their subsidiaries) and dividends from the Bank. The availability and amount of dividends and tax sharing payments in future periods, however is dependent upon, among other things, the Bank's operating performance and income, regulatory restrictions on such payments and (in the case of tax sharing payments) the continued consolidation of the Bank and the Bank's subsidiaries with the Trust for federal income tax purposes.
Management anticipates that the Trust will continue to file a consolidated federal income tax return and that the Bank will operate in a profitable manner sufficient to generate tax sharing payments. Based on recent activity, management anticipates that such tax sharing payments will be approved by the OTS sufficient to enable the Real Estate Trust to meet its debt service and other liquidity needs. As of September 30, 1994, the Bank owed the Real Estate Trust $12.0 million in tax sharing payments of which $5.0 million was paid in October 1994 with the approval of the OTS. Nonetheless, should further tax sharing payments not be paid during the next twelve months, management estimates that the Real Estate Trust has adequate liquidity including unencumbered cash balances and debt service escrow balances related to the Senior Secured Notes and Unsecured Notes sufficient to fund its cash flow requirements including debt service.
The Real Estate Trust's liquidity position was positively affected by the issuance on March 30, 1994 of $175.0 million aggregate principal amount of 11 5/8% Senior Secured Notes due 2002 (the "Senior Secured Notes"). After paying offering expenses of $8.9 million, third-party mortgage indebtedness of $74.1 million, and affiliate indebtedness of $8.9 million, the Real Estate Trust retained $83.1 million of the net proceeds of the offering for application to general corporate purposes, including a loan to an affiliate of $15.0 million. Of this amount, approximately $25.8 million was deposited with the Trustee for the Senior Secured Notes to satisfy one of the initial collateral requirements with respect to such securities. See Note 4. Concurrently with the application of the net proceeds of the offering to repay third-party mortgage indebtedness, the terms of certain of the mortgage loans repaid in part were modified to waive deferred interest, reduce interest rates and extend maturities. After the application of such net proceeds and the modification of such loans, the final maturity of loans with total balances of $111.1 million was 12 years and the final maturity of a loan with a balance of $15.1 million was 15 years.
During the third and fourth quarters of fiscal 1994, the Trust purchased 573,500 shares of common stock of Saul Centers, Inc. (representing 4.8% of such company's outstanding common stock) for approximately $10.3 million. These shares have been deposited with the Trustee for the Senior Secured Notes to satisfy in part the collateral requirements for those securities, thereby permitting release to the Trust of a portion of the cash on deposit with the Trustee.
The Senior Secured Notes are secured, general obligations of the Trust ranking pari passu with all other unsubordinated obligations of the Trust, including the Unsecured Notes. The Senior Secured Notes are secured by a first-priority perfected security interest in 80% of the issued and outstanding common stock of the Bank, which 80% is owned by the Trust. The Indenture pursuant to which the Senior Secured Notes were issued contains convenants that, among other things, restrict the ability of the Trust and/or its subsidiaries (excluding, in most cases, the Bank and the Bank's subsidiaries) to incur additional indebtedness, make investments, sell assets or pay dividends and make other distributions to holders of the Trust's capital stock.
The Real Estate Trust's current program of public Unsecured Note sales was initiated in the 1970's as a vehicle for supplementing other external funding sources. Unsecured Note sales were suspended in June 1990, but resumed in November 1992. The Real Estate Trust is currently selling Unsecured Notes principally to pay outstanding Unsecured Notes as they mature. In paying maturing Unsecured Notes with proceeds of new Unsecured Note sales, the Real Estate Trust effectively is refinancing its outstanding Unsecured Notes with similar new unsecured debt at lower interest rates currently prevailing in today's market. To the degree that the Real Estate Trust does not sell new Unsecured Notes in an amount sufficient to finance completely the scheduled repayment of outstanding Unsecured Notes as they mature, it will be required to finance such repayments from other sources of funds.
The Bank has agreed not to make any additional tax sharing payments to the Real Estate Trust without the prior approval of the OTS. In April 1993, the Bank successfully completed a $75 million offering of preferred stock, which significantly strengthened the Bank's regulatory capital ratios. This capital infusion, together with the Bank's improved operating results, should enhance the prospects of the Real Estate Trust to receive tax sharing payments and dividends from the Bank in the future. In June 1993, after receiving approval of the OTS, the Bank made a $5.0 million payment to the Real Estate Trust pursuant to the tax sharing agreement between the Bank and the Real Estate Trust. OTS approval of this payment was conditioned on a pledge by or on behalf of the Real Estate Trust of certain assets to secure certain of its obligations under the tax sharing agreement. Following execution of the pledge, the OTS approved, and the Bank made during the period October 1, 1993 through September 30, 1994, additional tax sharing payments of $9.6 million to the Real Estate Trust. As of September 30, 1994, the estimated tax sharing payment due to the Real Estate Trust from the Bank was $12.0 million.
The Real Estate Trust has never received cash dividends from the Bank. Its ability to receive cash dividends in the future will depend on the Bank's earnings and regulatory capital levels, among other factors. The Bank's written agreement with the OTS was amended in October 1993 to eliminate the requirement that the Bank obtain the written approval of the OTS before declaring or paying any dividends on its common stock. Nonetheless, the OTS must be notified regarding dividends declared or paid.
As the owner, directly and through a wholly owned subsidiary, of a 21.5% limited partnership interest in Saul Holdings Limited Partnership (see Note 2), the Real Estate Trust will share in cash distributions from operations and from capital transactions involving the sale or refinancing of the properties of Saul Holdings Limited Partnership. The partnership agreement of Saul Holdings Limited Partnership provides for quarterly cash distributions to the partners out of net cash flow. During fiscal 1994, the Real Estate Trust received total cash distributions in the amount of 4.6 million from Saul Holdings Limited Partnership.
While the Real Estate Trust's ability to satisfy its liquidity requirements is contingent on future events, which include the sale of new Notes in an amount sufficient to finance scheduled maturities of outstanding unsecured Notes and the Bank's ability to pay tax sharing payments and dividends, the Real Estate Trust believes it will be able to consummate the transactions described above as well as explore other financing opportunities in order to raise sufficient proceeds to fund its liquidity requirements.
2. SAUL HOLDINGS LIMITED PARTNERSHIP - REAL ESTATE TRUST
In late August 1993, the Real Estate Trust entered into a series of transactions undertaken in connection with an initial public offering of common stock of a newly organized corporation, Saul Centers, Inc. ("Saul Centers"). The Real Estate Trust transferred its 22 shopping centers and one of its office properties together with the debt associated with such properties to a newly formed partnership, Saul Holdings Limited Partnership ("Saul Holdings"), in which the Real Estate Trust owns (directly or through one of its wholly owned subsidiaries) a 21.5% interest, other entities affiliated with the Real Estate Trust own a 5.5% interest, and Saul Centers owns a 73.0% interest. B. Francis Saul II, Chairman of the Board of Trustees of the Trust, is also Chairman of the Board of Directors and Chief Executive Officer of Saul Centers, which is the sole general partner of Saul Holdings. The Real Estate Trust has pledged 62% of its interest in Saul Holdings to the Bank.
In connection with the transfer of its properties to Saul Holdings, the Real Estate Trust was relieved of approximately $196 million in mortgage debt and deferred interest. Pursuant to a reimbursement agreement among the partners of Saul Holdings and its subsidiary limited partnerships (collectively, the "Partnerships"), the Real Estate Trust and those of its subsidiaries that are partners in the Partnerships have agreed to reimburse Saul Centers and the other partners in the event the Partnerships fail to make payments with respect to certain portions of the Partnerships' debt obligations and Saul Centers or any such other partners personally make payments with respect to such debt obligations. At the date of transfer as well as at September 30, 1994, the maximum potential obligations of the Real Estate Trust and its subsidiaries under this agreement totalled approximately $116.1 million.
The fair market value of each of the properties contributed to the Partnerships by the Real Estate Trust and its subsidiaries at the date of transfer (the "FMV" of each such property) exceeded the tax basis of such property (with respect to each property, such excess is referred to as the "FMV-Tax Difference"). In the event Saul Centers, as general partner of the Partnerships, causes the Partnerships to dispose of one or more of such properties, a disproportionately large share of the total gain for federal income tax purposes would be allocated to the Real Estate Trust or its subsidiaries as a result of the property disposition. In general, if the gain recognized by the Partnerships on a property disposition is less than or equal to the FMV-Tax Difference for such property (as previously reduced by the amounts of special tax allocations of depreciation deductions to the partners), an amount of gain equal to the FMV-Tax Difference (as adjusted) will be allocated to the Real Estate Trust or its subsidiaries. To the extent the gain recognized by the Partnerships on the property disposition exceeds the FMV-Tax Difference (as adjusted), such excess generally will be allocated among all the partners in Saul Holdings based on their relative percentage interests. In general, the amount of gain allocated to the Real Estate Trust or its subsidiaries in the event of such a property disposition is likely to exceed, perhaps substantially, the amount of cash, if any, distributable to the Real Estate Trust or its subsidiaries as a result of the property disposition. In addition, future reductions in the level of the Partnerships' debt, or any release of the guarantees of such debt by the Real Estate Trust or its subsidiaries, could cause the Real Estate Trust or its subsidiaries to have taxable constructive distributions without the receipt of any corresponding amounts of cash. Currently, management does not intend to seek a release of or a reduction in the guarantees or to convert its limited partner units in Saul Holdings into shares of Saul Centers common stock.
At the date of transfer of the Real Estate Trust properties to Saul Holdings, liabilities exceeded assets transferred by approximately $104.3 million on an historical cost basis. The assets and liabilities were recorded by Saul Holdings and Saul Centers at their historical cost rather than market value because of affiliated ownership and common management and because the assets and liabilities were the subject of the business combination between Saul Centers and Saul Holdings, newly formed entities with no prior operations.
Immediately subsequent to the business combination and initial public offering of common stock by Saul Centers, Saul Centers had total owners' equity of approximately $16.4 million of which approximately $3.5 million related to the Real Estate Trust's 21.5% ownership interest. Recognition by the Real Estate Trust of the change in its investment in the properties of approximately $107.8 million, from a deficit of $104.3 million to $3.5 million, has been deferred due to the Real Estate Trust's guarantee of $116.1 million under the Saul Centers reimbursement agreement. The deferred gain of $107.8 million is included in "Deferred gains - real estate" in the financial statements. The gain will be recognized in future periods to the extent the Real Estate Trust's obligations are terminated under the reimbursement agreement.
The management of Saul Centers has adopted a strategy of maintaining a ratio of total debt to total asset value, as estimated by management, of fifty percent or less. The management of Saul Centers has concluded at September 30, 1994 that the total debt of Saul Centers remains below fifty percent of total asset value. As a result, the Real Estate Trust has concluded at September 30, 1994 that fundings under the reimbursement agreement are remote.
In addition to the deferred gains, as of September 30, 1994, the Real Estate Trust's investment in the consolidated entities of Saul Centers consisted of the following.
The $7.5 million balance is included in "Other assets" in the financial statements.
The Condensed Consolidated Balance Sheet at September 30, 1994 and 1993, and the Condensed Consolidated Statement of Operations for October 1, 1993 through September 30, 1994 and for August 27, 1993 through September 30, 1993 of Saul Centers follow.
SAUL CENTERS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS)
SAUL CENTERS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (IN THOUSANDS)
3. INVESTMENT PROPERTIES - REAL ESTATE TRUST
The following table summarizes the cost basis of income-producing properties and land parcels together with their related debt.
4. DEBT - REAL ESTATE TRUST
Mortgage notes payable are secured by various income-producing properties and land parcels. Almost all mortgage notes are payable in monthly installments, have maturity dates ranging to 2009 and accrue interest at annual rates from 6.6% to 10.0%. Certain mortgages contain a number of restrictions, including cross default provisions.
The Real Estate Trust obtained a $5.0 million secured loan from an affiliate in August 1992. Interest accrued at prime plus 1.5%. The loan was repaid during fiscal 1994.
In December 1992, the Trust completed the sale to an institutional investor, for $25 million, of 100% of the preferred stock of a newly organized Trust subsidiary to which the Trust contributed certain real estate and other assets. The assets contributed included six shopping centers and one office building, several parcels of unencumbered raw land, and a capital note in the amount of $58 million secured by a junior lien on 30% of the Bank's stock. The net proceeds of the transaction were lent by the subsidiary to the Trust in exchange for notes of the Trust secured by specified real estate properties and other assets of the Trust (the "Trust Notes"). Such proceeds were applied by the Trust for its general corporate purposes, with approximately $2.3 million of such proceeds being reserved for capital improvements to certain of the real estate properties contributed to the new subsidiary. In late August 1993, the Real Estate Trust was relieved of approximately $196 million in mortgage debt and deferred interest in connection with the formation of Saul Holdings (See Note 2). As a part of this transaction, the preferred stock issued to the institutional investor was redeemed in exchange for the Trust Notes and the pledge of all of the stock of the Trust subsidiary, together with $60 million, at their then-market value, of the Real Estate Trust's partnership interests in Saul Holdings. During fiscal 1994, the Trust Notes were repaid and the collateral was released.
On March 30, 1994, the Real Estate Trust issued $175.0 million aggregate principal amount of its Senior Secured Notes. The Senior Secured Notes are general obligations of the Real Estate Trust ranking pari passu with all other unsubordinated obligations of the Trust and are secured by a first priority perfected security interest in 80% (8,000 shares) of the issued and outstanding common stock of the Bank and by certain other assets of the Trust as described herein. After paying offering expenses of $8.9 million, third-party mortgage indebtedness of $74.1 million, and affiliate indebtedness of $8.9 million, the Real Estate Trust retained $83.1 million of the net proceeds of the offering for application to general corporate purposes, including a loan to an affiliate of $15.0 million. Of the remaining amount, approximately $25.8 million was deposited with the Trustee for the Senior Secured Notes to satisfy one of the initial collateral requirements with respect to such securities. This collateral requirement, which will remain in effect as long as any Senior Secured Notes are outstanding, will be recalculated each calendar quarter based on the estimated amount of one year's interest payments on then outstanding Senior Secured Notes and Unsecured Notes. Concurrently with the application of the net proceeds of the offering to repay third-party mortgage indebtedness, the terms of certain of the mortgage loans repaid in part were modified to waive deferred interest, reduce interest rates and extend maturities. After the application of such net proceeds and the modification of such loans, the final maturity of loans with total balances of $111.1 million was 12 years and the final maturity of a loan with a balance of $15.1 million was 15 years. During the third and fourth quarters of fiscal 1994, the Real Estate Trust purchased 573,500 shares of common stock of Saul Centers (representing 4.8% of such company's outstanding stock) for approximately $10.3 million. These shares have been deposited with the Trustee for the Senior Secured Notes to satisfy in part the collateral requirements for those securities, thereby permitting release to the Trust of a portion of the cash on deposit with the Trustee.
Notes payable - unsecured includes notes which have been sold by the Real Estate Trust directly to investors at varying interest rates with maturities of one to ten years. These notes do not contain any provisions for conversion, sinking fund or amortization. Notes sold after November 14, 1986, are subject to a provision permitting the Real Estate Trust to call them prior to maturity. The weighted average interest rates at September 30, 1994 and 1993 were 11.1% and 12.7%, respectively. During fiscal 1993 and fiscal 1994, the Real Estate Trust sold notes amounting to approximately $11.9 and $15.7 million, respectively.
The maturity schedule for the Real Estate Trust's outstanding debt at September 30, 1994 for the fiscal years commencing October 1, 1994 is set forth in the following table.
Debt Maturity Schedule (In thousands)
5. LONG-TERM LEASE OBLIGATIONS - REAL ESTATE TRUST
The Real Estate Trust has one noncancelable long-term lease which provides for periodic adjustments of the basic annual rent. This lease will expire in 2061. The minimum future rental commitments under this lease amount to $101,000 per year for the next five fiscal years; thereafter, the total commitment is $6.1 million.
The Consolidated Statements of Operations contain minimum ground rent expense of $102,000, $286,000 and $312,000 in fiscal 1994, 1993 and 1992, respectively. In addition to the minimum ground rent payments, real estate taxes on the land are an obligation of the Real Estate Trust.
6. INCOME FROM COMMERCIAL PROPERTIES - REAL ESTATE TRUST
This income classification includes minimum and overage rent arising from noncancelable commercial leases. Minimum rent for fiscal years 1994, 1993, and 1992 amounted to $15.9, $38.0 and $41.7 million, respectively. Overage rent for these periods amounted to $0.3, $2.7 and $3.0 million, respectively. Future minimum rentals as of September 30, 1994 under noncancelable leases are as follows:
7. TRANSACTIONS WITH RELATED PARTIES - REAL ESTATE TRUST
TRANSACTIONS WITH B. F. SAUL COMPANY AND ITS SUBSIDIARIES
The Real Estate Trust is managed by B. F. Saul Advisory Company (the "Advisor"), a wholly-owned subsidiary of B. F. Saul Company ("Saul Co."). All of the Real Estate Trust officers and three Trustees of the Trust are also officers and/or directors of Saul Co. and/or its subsidiary corporations. The Advisor is paid a fixed monthly fee which is subject to annual review by the Trustees. The monthly fee was $97,000 during the period October 1991 through December 1992, $157,000 during the period January 1993 through September 1993, $250,000 during the period October 1993 through March 1994, and $292,000 during the period April 1994 through September 1994. The advisory contract has been extended until September 30, 1995, and will continue thereafter unless cancelled by either party at the end of any contract year. Certain loan agreements prohibit termination of this contract.
Saul Co. and Franklin Property Company ("Franklin"), a wholly-owned subsidiary of Saul Co., provide services to the Real Estate Trust in the areas of commercial property management and leasing, hotel management, development and construction management, and acquisitions, sales and financings of real property. The fee schedules for providing those services by Saul Co. and Franklin are reviewed and approved by the Trustees after comparison with rates charged by competitive firms for comparable services in the various market areas. Fees paid to Saul Co. and Franklin amounted to $4.5, $7.7 and $8.7 million in fiscal 1994, 1993 and 1992, respectively. The Real Estate Trust reimburses the Advisor and Franklin for costs and expenses incurred in connection with the acquisition and development of real property on behalf of the Real Estate Trust, in-house legal expenses and for all travel expenses incurred in connection with the affairs of the Real Estate Trust.
The Real Estate Trust pays the Advisor 1% of the principal amount of the unsecured notes as they are issued to offset its costs of administering the program. These payments amounted to $157,000 and $118,000 in fiscal 1994 and 1993, respectively. There were no such payments in fiscal 1992.
A subsidiary of Saul Co. is a general insurance agency which receives commissions and countersignature fees in connection with the Real Estate Trust's insurance program. Such commissions and fees amounted to approximately $157,000, $221,000 and $229,000 in fiscal 1994, 1993 and 1992, respectively.
The Real Estate Trust had a working capital loan from the Saul Co. of approximately $3.3 million as of September 30, 1993, bearing interest of 1/2 percent over prime per annum. The funds were used for general operating purposes and the loan was satisfied in March 1994. Interest paid on this loan in fiscal 1994, 1993, and 1992 amounted to $139,000, $365,000 and $15,000, respectively. In April 1994 the Real Estate Trust made a loan to the Saul Company of $15.0 million bearing interest at 1/2 percent over prime and due on demand. Subsequent to year-end the loan balance was reduced to $12.7 million. Interest received on this loan in fiscal 1994 amounted to $565,000.
TRANSACTIONS WITH OTHER AFFILIATES
The Real Estate Trust obtained a $5.0 million secured loan from The Klingle Corporation in August 1992. The loan was repaid during fiscal 1994. It accrued interest at a rate of prime plus 1.5%. The Real Estate Trust incurred interest expense of $193,000, $365,000, and $15,000 during fiscal 1994, 1993, and 1992, respectively.
REMUNERATION OF TRUSTEES AND OFFICERS
For fiscal years 1994, 1993, and 1992, the Real Estate Trust paid the Trustees $76,000, $79,000 and $88,000, respectively, for their services. No compensation was paid to the officers of the Real Estate Trust for acting as such; however, one Trustee was paid by the Bank for his services as Chairman and Chief Executive Officer of the Bank, and two received payments for their services as directors of the Bank. Three of the Trustees and all of the officers of the Real Estate Trust receive compensation from Saul Co. and/or its subsidiary corporations as directors or officers thereof.
LEGAL SERVICES
The law firm in which one of the Trustees is a partner received $1.3, $1.2 and $2.1 million, excluding expense reimbursements, during fiscal 1994, 1993, and 1992, respectively, for legal services to the Real Estate Trust and its consolidated subsidiaries.
SALE OF AVENEL BUSINESS PARK-PHASE I
In 1984, the Real Estate Trust sold Avenel Business Park-Phase I to an affiliate, Avenel Associates Limited Partnership (the"Partnership"), for $8.9 million based on an independent appraisal. The managing general partner of the Partnership was a subsidiary of Saul Co., and a subsidiary of the Bank owned a 45% interest in the Partnership. The Real Estate Trust received the sales price for the property in the form of cash, a purchase money note in the amount of $1,735,000 and the assumption of a first trust loan. The net gain realized upon the sale was $3,023,000, after deducting a $781,000 discount of the purchase money note due to its below market interest rate. The Real Estate Trust has continued to defer recognition of this gain pending a sale of the property to an unaffiliated entity.
In late August 1993, the Partnership sold Avenel Business Park-Phase I to Saul Holdings and redeemed the purchase money note held by the Real Estate Trust. The gain has continued to be deferred in accordance with the accounting policy for gain recognition described in Note 2.
SAUL HOLDINGS LIMITED PARTNERSHIP
See Note 2 for a description of this partnership. The Real Estate Trust accounts for this investment under the equity method. The Real Estate Trust's share of earnings for fiscal 1994 was $2.4 million. The Real Estate Trust's share of losses for Saul Holdings for its initial period of operations, August 27, 1993 through September 30, 1993, was $467,000.
OTHER TRANSACTIONS
The Real Estate Trust leases space to the Bank, Franklin and Saul Co. at several of its income-producing properties. Minimum rents and recoveries paid by these affiliates amounted to approximately $51,000, $460,000 and $533,000, in fiscal 1994, 1993 and 1992, respectively.
8. LOANS HELD FOR SECURITIZATION AND SALE - THE BANK
At September 30, 1994 and 1993, loans held for securitization and sale are composed of credit card receivables.
9. INVESTMENT SECURITIES - THE BANK
At September 30, 1994, all investment securities are classified as available-for-sale in accordance with SFAS 115. Gross unrealized holding gains and losses on the Bank's investment securities at September 30, 1994 are as follows:
As discussed in Summary of Significant Accounting Policies - The Bank, at September 30, 1993, investment securities were carried at amortized cost. Gross unrealized gains and losses for the Bank's investment securities at September 30, 1993 were as follows:
A comparison of amortized cost and fair value for investment securities, along with the contractual maturity dates, by category of investments at September 30, 1994, is as follows:
Proceeds from sales of investment securities, including securities held for sale, during fiscal 1993 were $181.8 million. Gross gains of $8.9 million and gross losses of $0 were realized on sales for fiscal 1993. There were no sales of investment securities during the years ended September 30, 1994 and 1992.
At September 30, 1994, certain investment securities were pledged as collateral for certain letters of credit. See Note 28.
10. MORTGAGE-BACKED SECURITIES - THE BANK
At September 30, 1994, all mortgage-backed securities are classified as available-for-sale in accordance with SFAS 115. Gross unrealized holding gains and losses on the Bank's mortgage-backed securities at September 30, 1994 are as follows:
As discussed in Summary of Significant Accounting Policies -- The Bank, at September 30, 1993, mortgage-backed securities were carried at amortized cost. The amortized cost and estimated market values for the Bank's mortgage-backed securities at September 30, 1993 were as follows:
Gross unrealized gains were $27.1 million and gross unrealized losses were $0.2 million at September 30, 1993.
Proceeds from sales of mortgage-backed securities, including mortgage-backed securities held for sale, were $810.8 and $834.2 million during the years ended September 30, 1993 and 1992, respectively. Gross gains of $10.2 and $23.0 million and gross losses of $4.4 and $3.0 million were realized on the sale of mortgage-backed securities, including mortgage-backed securities held for sale, during the years ended September 30, 1993 and 1992, respectively. There were no sales of mortgage-backed securities during the year ended September 30, 1994.
Accrued interest receivable on mortgage-backed securities totaled $6.3 and $8.9 million at September 30, 1994 and 1993, respectively, and is included in other assets in the Consolidated Statements of Financial Condition.
At September 30, 1994, certain mortgage-backed securities were pledged as collateral for securities sold under repurchase agreements, other short-term borrowings and other recourse arrangements. See Notes 19 and 28. Other mortgage-backed securities with a book value of $23.8 million were pledged as collateral primarily for credit card settlement obligations.
11. LOANS RECEIVABLE - THE BANK
Loans receivable is composed of the following:
The Bank serviced loans owned by others amounting to $3,943.8, $3,423.6 and $2,379.1 million at September 30, 1994, 1993 and 1992, respectively.
Accrued interest receivable on loans totaled $17.1 and $16.0 million at September 30, 1994 and 1993, respectively, and is included in other assets in the Consolidated Balance Sheets.
12. REAL ESTATE HELD FOR INVESTMENT OR SALE - THE BANK
Real estate held for investment or sale is composed of the following:
Earnings (loss) on real estate held for investment or sale is composed of the following:
At September 30, 1994, the Corporations have an ADC arrangement with, and hold a partnership interest in, a limited partnership. The partnership and ADC arrangement were formed for the purpose of acquiring, developing, operating and selling real estate and are accounted for under the equity method with profits and losses allocated proportionately among the partnership interests. At September 30, 1994, there were no outstanding commitments, lines of credit or other arrangements between the Corporations and the partnership relating to these investments other than reflected below. Combined, condensed financial information for the partnerships and ADC arrangement is presented below:
BALANCE SHEETS
STATEMENTS OF OPERATIONS
With respect to the ADC arrangement, the limited partnership classifies the Bank's investment in the real estate project as a liability payable to the Bank rather than as equity.
During fiscal 1994, the Bank sold its interests in three limited partnerships to other partners at an aggregate amount that exceeded the net carrying values of these assets.
13. RESERVES FOR LOSSES - THE BANK
Activity in the reserves for losses on loans receivable and real estate held for investment or sale is summarized as follows:
The reserves for losses at September 30, 1994 are based on management's estimates of the amount of reserves required to reflect the risks in the loan and real estate portfolios based on circumstances and conditions known at the time. The Bank's primary lending and real estate investment market is the Washington, D.C. metropolitan area, which was adversely affected by the downturn in recent years in the local real estate market. The ultimate impact of these economic developments, the absence of a continued recovery in the real estate markets and the effect of general market conditions on the Bank's borrowers could result in difficulties in certain borrowers meeting their obligations to the Bank and the Bank's ability to dispose of its real estate properties. As a result, the Bank may incur additional provisions for losses.
14. NON-PERFORMING ASSETS - THE BANK
Non-performing assets are composed of the following at September 30, 1994:
Approximately 18.9% of the Bank's non-performing credit card loans are located in the Washington, D.C. metropolitan area. In general, the Bank's remaining non-performing assets are located in the Washington, D.C. metropolitan area, including approximately 57.3% located in Loudoun County, Virginia.
The ultimate collection or realization of the Bank's non-performing assets will be primarily dependent on the general economic conditions in the Washington, D.C. metropolitan area. Based upon current economic conditions and other factors, the Bank has provided loss reserves and initial write-downs for real estate acquired in settlement of loans. See Note 13. As circumstances change, it may be necessary to provide additional reserves based on new information.
At September 30, 1994 and 1993, the Bank had $29.1 and $36.7 million, respectively, of loans accounted for as troubled debt restructurings, all of which were included as performing loans. At September 30, 1994, the Bank had commitments to lend $2.5 million of additional funds on loans which have been restructured.
The amount of interest income that would have been recorded if non-accrual assets and restructured loans had been current in accordance with their original terms was $9.1, $10.5 and $16.3 million for the years ended September 30, 1994, 1993 and 1992, respectively. The amount of interest income that was recorded on these loans was $2.7, $3.0 and $5.0 million for the years ended September 30, 1994, 1993 and 1992, respectively.
15. SIGNIFICANT SALES TRANSACTIONS - THE BANK
The Bank periodically sells credit card receivables through asset-backed securitizations, in which credit card receivables are transferred to trusts, and the Bank sells certificates to investors representing ownership interests in the trusts. The Bank sold and received gross proceeds of $1,350.0, $350.0 and $280.0 million for these asset-backed certificates for the years ended September 30, 1994, 1993 and 1992, respectively. No gains or losses were recorded on the transactions; however, excess servicing fees are recognized over the related lives of the transactions. Outstanding trust certificate balances related to these and previous securitizations were $1,953.8 and $841.8 million at September 30, 1994 and 1993, respectively. The related receivable balances contained in the trusts were $2,330.9 and $1,232.8 million at September 30, 1994 and 1993, respectively. The Bank continues to service the underlying loans and is contingently liable under various letters of credit or surety bonds that were issued in connection with these transactions. See Note 28.
During fiscal 1994 and 1992, the Bank sold credit card relationships with related outstanding receivable balances of $96.5 and $14.9 million, respectively. Gains of $16.9 and $1.5 million were recorded in connection with these sales for the years ended September 30, 1994 and 1992, respectively, and the Bank will no longer service these relationships. No such sales occurred during the year ended September 30, 1993.
In fiscal 1994, 1993 and 1992, the Bank sold home equity credit line receivables through asset-backed securitizations, in which home equity credit line receivables were transferred to trusts, and the Bank sold certificates to investors representing ownership interests in the trusts. The amount of receivables sold and gross proceeds received was $181.9, $340.4 and $253.6 million, respectively. Gains recognized on these transactions were $9.5, $16.8 and $15.1 million, respectively, and the Bank continues to service the underlying loans. The outstanding trust certificate balances and the related receivable balances contained in the trusts were $485.4 and $530.1 million at September 30, 1994 and 1993, respectively. The Bank is contingently liable under various surety bonds issued in connection with these transactions. See Note 28.
In September 1991, the Bank sold automobile loan receivables through an asset-backed securitization, in which automobile loan receivables were transferred to a trust, and the Bank sold certificates to investors representing ownership interests in the trust. The Bank continues to service the underlying loans. The outstanding trust certificate balances and the related receivable balances contained in the trust were $9.5 and $29.6 million at September 30, 1994 and 1993, respectively. The Bank is contingently liable under a surety bond issued in connection with this transaction. See Note 28.
16. PROPERTY AND EQUIPMENT - THE BANK
Property and equipment is composed of the following:
Depreciation expense amounted to $18.5, $14.8 and $14.5 million for the years ended September 30, 1994, 1993 and 1992, respectively.
17. LEASES - THE BANK
The Corporations have noncancelable, long-term leases for office premises and retail space, which have a variety of terms expiring from 1995 to 2019 and ground leases which have terms expiring from 2029 to 2080. These leases are accounted for as operating leases. Some of the leases are subject to rent adjustments in the future based upon changes in the Consumer Price Index and some also contain renewal options. The following is a schedule by years of future minimum lease payments required at September 30, 1994:
Rent expense totaled $9.7, $9.2 and $9.0 million for the years ended September 30, 1994, 1993 and 1992, respectively.
18. DEPOSIT ACCOUNTS - THE BANK
An analysis of deposit accounts and the related weighted average effective interest rates at year-end are as follows:
Interest expense on deposit accounts is composed of the following:
Outstanding certificate accounts at September 30, 1994 mature in the years indicated as follows:
At September 30, 1994, certificate accounts of $100 or more have contractual maturities as indicated below:
19. SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER SHORT-TERM BORROWINGS - THE BANK
Short-term borrowings are summarized as follows:
The investment and mortgage-backed securities underlying the repurchase agreements were delivered to the dealers who arranged the transactions. The dealers may have loaned such securities to other parties in the normal course of their operations and agreed to resell to the Bank the identical securities at the maturities of the agreements.
At September 30, 1994, the Bank had pledged mortgage-backed securities with a book value of $11.6 million to secure certain other borrowings.
20. BONDS PAYABLE - THE BANK
Bonds payable represent bonds (term and serial) issued through a local housing finance agency secured by land and two residential apartment buildings having an aggregate net book value of $25.7 and $26.4 million at September 30, 1994 and 1993, respectively. The assets securing these bonds are included in real estate held for investment or sale.
The term bonds amounting to $23.7 million mature November 1, 2006, and currently bear interest at 9.7%. On November 1, 1995, November 1, 1998, November 1, 2001 and November 1, 2004, the interest rate on the outstanding term bonds will be adjusted to be equal to the rate at which such bonds could be sold at par on such date. The term bonds are not redeemable prior to November 1, 1995. On or after such date, the term bonds will be redeemable, in whole or in part, at the option of the Corporations, at a redemption price equal to the principal amount redeemed plus accrued interest to the redemption date. Beginning May 1, 1995, and continuing each November 1 and May 1 thereafter, the term bonds will be subject to mandatory sinking fund redemption payments. Such payments will retire approximately 55.0% of the principal amount of the term bonds prior to November 1, 2006.
Serial bonds amounting to $0.3 million mature on November 1, 1994. Interest rates on these bonds are 9.3%.
The aggregate principal payments on the bonds payable outstanding at September 30, 1994 for the next five years are summarized as follows:
Deferred debt issuance costs, net of accumulated amortization, amounted to $0.5 and $0.8 million at September 30, 1994 and 1993, respectively, and are included in other assets in the Consolidated Balance Sheets. These amounts are being amortized using the level-yield method over the life of the related debt.
At September 30, 1994, $3.0 million of bond proceeds were held in a restricted cash account by the trustee for the purpose of paying principal and interest on the bonds in the event that the Corporations are unable to fund payments. This amount is included in interest-bearing deposits in the Consolidated Balance Sheets.
21. NOTES PAYABLE - THE BANK
Notes payable bear interest at rates ranging from 8.9% to 13.0% and are due in varying installments through 2004.
Scheduled repayments of notes payable at September 30, 1994 are as follows:
22. FEDERAL HOME LOAN BANK ADVANCES - THE BANK
At September 30, 1994, the Bank had a $100.0 million advance from the Federal Home Loan Bank of Atlanta ("FHLB") with an interest rate of 4.77% which adjusts quarterly based on the three-month London Interbank Offered Rate ("LIBOR") and maturing in August 1996.
Under a Specific Collateral Agreement with the FHLB, advances are secured by all of the Bank's FHLB stock, qualifying first mortgage loans with a total principal balance of $433.6 million and mortgage-backed securities with a book value of $131.7 million. The FHLB requires that members maintain qualifying collateral at least equal to 100% of the member's outstanding advances at all times. The collateral held by the FHLB in excess of the September 30, 1994 advances is available to secure additional advances from the FHLB, subject to its collateralization guidelines.
23. CAPITAL NOTES - SUBORDINATED - THE BANK
Capital notes, which are subordinated to the interest of deposit account holders, are composed of the following:
On November 23, 1993, the Bank sold $150.0 million 9 1/4% Subordinated Debentures due 2005 (the "1993 Debentures"). The Bank received net proceeds of $143.6 million from the sale of the 1993 Debentures, of which approximately $134.2 million was used to redeem $78.5 million of debentures due in 2002 and $50.0 million of debentures due in 2003 on December 23, 1993 and December 24, 1993, respectively. The remaining net proceeds were used for general corporate purposes. The Bank incurred a loss of $6.3 million, after related income taxes, in connection with the redemption of these debentures. The OTS has approved the inclusion of the principal amount of the 1993 Debentures in the Bank's supplementary capital for regulatory capital purposes.
The indenture pursuant to which the 1993 Debentures were sold ("the Indenture") provides that the Bank may not pay dividends on its capital stock unless, after giving effect to the dividend, no event of default shall have occurred and be continuing and the Bank is in compliance with its regulatory capital requirements. In addition, the amount of the proposed dividend may not exceed the sum of (i) $15.0 million, (ii) 66 2/3% of the Bank's consolidated net income (as defined in the Indenture) accrued on a cumulative basis commencing on October 1, 1993 and (iii) the aggregate net cash proceeds received by the Bank after October 1, 1993 from the sale of qualified capital stock or certain debt securities, minus the aggregate amount of any restricted payments made by the Bank. Notwithstanding the above restrictions on dividends, provided no event of default has occurred or is continuing, the Indenture does not restrict the payment of dividends on the Preferred Stock or any payment-in-kind preferred stock issued in lieu of cash dividends on the Preferred Stock or the redemption of any such payment-in-kind preferred stock.
Deferred debt issuance costs, net of accumulated amortization, amounted to $6.2 and $4.9 million at September 30, 1994 and 1993, respectively, and are included in other assets in the Consolidated Balance Sheets.
24. PREFERRED STOCK - THE BANK
In April 1993, the Bank sold $75.0 million of its Noncumulative Perpetual Preferred Stock, Series A ("Preferred Stock") in a private offering. Cash dividends on the Preferred Stock are payable quarterly in arrears at an annual rate of 13%. If the Board of Directors does not declare the full amount of the noncumulative cash dividend accrued in respect of any quarterly dividend period, in lieu thereof the Board of Directors will be required to declare (subject to regulatory and other restrictions) a stock dividend in the form of a new series of payment-in-kind preferred stock of the Bank.
The OTS has approved the inclusion of the Preferred Stock as tier 1 or core capital and has approved the payment of dividends on the Preferred Stock, provided certain conditions are met. The Preferred Stock is not redeemable until May 1, 2003 and is redeemable thereafter at the option of the Bank. The holders of the Preferred Stock have no voting rights, except in certain limited circumstances.
Holders of the Preferred Stock will be entitled to receive a liquidating distribution in the amount of $25 per share, plus accrued and unpaid dividends for the then-current dividend period in the event of any voluntary liquidation of the Bank, after payment of the deposit accounts and other liabilities of the Bank, and out of the assets available for distribution to shareholders. The Preferred Stock ranks superior and prior to the issued and outstanding common stock of the Bank with respect to dividend and liquidation rights.
25. RETIREMENT PLAN - THE BANK
The Corporations participate in a defined contribution profit sharing retirement plan (the "Plan") which covers those full-time employees who meet the requirements as specified in the Plan. The Plan, which can be modified or discontinued at any time, requires participating employees to contribute 2.0% of their compensation. Corporate contributions, which are discretionary, were equal to the employee contribution from October 1, 1991 to June 30, 1992 and three times the employee contribution subsequent to June 30, 1992. Corporate contributions were $3.5, $3.1 and $1.5 million for the years ended September 30, 1994, 1993 and 1992, respectively. There are no past service costs associated with the Plan and the Corporations have no liability under the Plan other than their current contributions. The Plan owns 4.0% of the Bank's common stock.
26. REGULATORY MATTERS - THE BANK
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the Bank's regulatory capital requirements at September 30, 1994 were a 1.5% tangible capital requirement, a 3.0% core capital requirement and an 8.0% total risk-based capital requirement. Under the OTS "prompt corrective action" regulations, the Bank must maintain minimum leverage, tier 1 risk-based and total risk-based capital ratios of 4.0%, 4.0% and 8.0%, respectively, to meet the ratios established for "adequately-capitalized" institutions. At September 30, 1994, the Bank was in compliance with its tangible, core and risk-based regulatory capital requirements. In addition, on the basis of its balance sheet at September 30, 1994, the Bank met the FIRREA-mandated fully phased-in capital requirements. The information below is based upon the Bank's understanding of the applicable FIRREA and "prompt corrective action" regulations and related interpretations.
In November 1994, the OTS announced its policy to exclude net unrealized holding gains (losses) on debt securities classified as available-for-sale from regulatory capital for purposes of computing regulatory capital ratios. Savings associations are required to adopt the revised policy by June 1995, but may elect to adopt the revised policy beginning December 1994. This decision reversed the interim OTS policy issued in August 1993, which required net unrealized holding gains (losses) to be fully includable in tier 1 capital for regulatory capital purposes.
At September 30, 1994, the Bank had $27.2 million in loans to and investments in subsidiaries engaged in activities impermissible for national banks ("non-includable subsidiaries") which are required to be phased-out from all three capital requirements according to the following schedule (which reflects OTS approval of the Bank's use of a delayed phase-in period pursuant to legislation enacted in October 1992): 40% beginning July 1, 1994; 60% beginning July 1, 1995 and 100% beginning July 1, 1996. At September 30, 1994, the Bank also had $38.6 million in equity investments which were fully phased-out from total risk-based capital.
As of September 30, 1994, the Bank had $48.3 million in supervisory goodwill, of which $17.3 million was included in core capital subject to a limitation of 0.375% of tangible assets. The percentage includable in core capital declines to 0% of tangible assets effective January 1, 1995.
OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property (through bulk sales or otherwise) prior to the end of its applicable five-year holding period and is unable to obtain an extension of such five-year holding period from the OTS, the Bank would be required to deduct the then-current book value of such REO property from risk-based capital. Although there can be no assurances, management believes that it will be able to receive the necessary extensions. The following table sets forth the Bank's REO at September 30, 1994, after valuation allowances of $109.1 million, by the fiscal year in which the property was acquired through foreclosure.
Under the OTS "prompt corrective action" regulations, an institution is categorized as "well-capitalized" if it has a leverage ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%. The Bank's regulatory capital ratios exceeded the requirements for a well-capitalized institution at September 30, 1994. On a fully phased-in basis at September 30, 1994, the Bank's regulatory capital ratios would meet the ratios established for "adequately-capitalized" institutions.
The Bank is subject to a written agreement with the OTS dated September 30, 1991. The agreement, which was amended on October 29, 1993, addresses, among other things, transactions with affiliates, reductions of real estate acquired in settlement of loans and asset quality. Specifically, the Bank agreed that, without receiving the prior approval of the OTS, it would not increase its investment in certain real estate projects beyond specified levels. In addition, the Bank must provide the OTS with 15 days notice prior to selling certain significant business assets.
27. TRANSACTIONS WITH RELATED PARTIES - THE BANK
LOANS RECEIVABLE:
From time to time, in the normal course of business, the Bank may make loans to executive officers and directors, their immediate family members or companies with which they are affiliated. These loans are on substantially the same terms as similar loans with unrelated parties. An analysis of activity with respect to these loans for the year ended September 30, 1994 is as follows:
SERVICES:
B. F. Saul Company, which is a shareholder of the Trust, and its subsidiaries provide certain services to the Corporations. These services include property management, cafeteria management, insurance brokerage and leasing. Fees for these services were $0.5, $0.6 and $0.6 million for the years ended September 30, 1994, 1993 and 1992, respectively.
The law firm in which one director of the Bank is a partner received $2.4, $2.7 and $3.0 million for legal services rendered to the Corporations during the years ended September 30, 1994, 1993 and 1992, respectively.
For the years ended September 30, 1994, 1993 and 1992, one of the directors of the Bank was paid $30,000 $28,000 and $25,000, respectively, for consulting services rendered to the Bank. Another director of the Bank was paid total fees of $50,000 for the year ended September 30, 1994 for consulting services.
A director of the Bank and his wife are entitled to $125,000 per year in supplemental retirement benefits under an agreement entered into by the Bank in 1990 in connection with the director's former employment as a Vice Chairman of the Bank. The director also receives compensation under an agreement for ongoing services provided to the Bank. Amounts paid to the director under these agreements totaled $167,000 and $165,000 in fiscal 1994 and 1993.
TAX SHARING AGREEMENT:
The Bank and the other companies in the Trust's affiliated group entered into a tax sharing agreement dated June 28, 1990 (the "Tax Sharing Agreement"). The Tax Sharing Agreement provides for payments to be made by members of the Trust's affiliated group to the Real Estate Trust based on their separate company tax liabilities. The Tax Sharing Agreement also provides that, to the extent net operating losses or tax credits of a particular member are used to reduce the overall tax liability of the Trust's affiliated group, such member will be reimbursed by the other members of the affiliated group that have taxable income in an amount equal to such tax reduction. The Bank paid $9.6 and $5.0 million to the Real Estate Trust during fiscal 1994 and 1993, respectively, under the Tax Sharing Agreement. There were no tax sharing payments made to the Real Estate Trust during the year ended September 30, 1992. OTS approval of the tax sharing payments during fiscal 1994 and 1993 was conditioned on a pledge by the Real Estate Trust of certain assets to secure certain of its obligations under the Tax Sharing Agreement. After receipt of OTS approval, the Bank made an additional tax sharing payment of $5.0 million to the Real Estate Trust subsequent to September 30, 1994. Under the terms of the Bank's written agreement with the OTS dated September 30, 1991, as amended, the Bank has agreed not to make any tax sharing payments to the Real Estate Trust unless such payments are approved by the OTS. However, the Bank continues to account for income taxes in accordance with the Tax Sharing Agreement. At September 30, 1994 and 1993, the estimated tax sharing payment payable to the Real Estate Trust by the Bank was $12.0 and $21.9 million, respectively.
OTHER:
The Corporations paid $3.9, $3.5 and $3.4 million for office space leased from or managed by companies affiliated with the Bank or its directors during the years ended September 30, 1994, 1993 and 1992, respectively.
The Corporations owned approximately 45% of Avenel Associates Limited Partnership ("Avenel"), which owned a commercial property. The general partner in the partnership was a subsidiary of the B. F. Saul Company. In August 1993, Avenel sold this property and the Bank sold two real estate properties to Saul Holdings, a newly formed partnership in which the Trust owns a 21.5% interest, other affiliated entities of the Trust own a 5.5% interest and public shareholders own a 73% interest. These assets were sold at amounts that exceeded their net carrying values. During fiscal 1994, upon payment of a final distribution to its partners, Avenel was dissolved.
The Trust, the B. F. Saul Company and Chevy Chase Lake Corporation, an affiliate of the Bank, from time to time maintain interest-bearing deposit accounts with the Bank. Those accounts totaled $46.8 million at September 30, 1994. The Bank paid interest on the accounts amounting to $1.1 million in fiscal 1994.
During fiscal 1994, the Bank sold 12.70 acres of retail land to Saul Holdings at an amount equal to its net carrying value.
28. FINANCIAL INSTRUMENTS - THE BANK:
The Bank, in the normal course of business, is a party to financial instruments with off-balance-sheet risk. These financial instruments include commitments to extend credit, letters of credit and assets sold with limited recourse.
The contract or notional amounts of these instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bank's exposure to credit loss in the event of nonperformance by the other party is represented by the contractual notional amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
COMMITMENTS TO EXTEND CREDIT:
The Bank had $7,451.4 million of outstanding commitments to extend credit at September 30, 1994. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments are subject to the Bank's normal underwriting and credit evaluation policies and procedures.
Loans approved but not closed are commitments for fixed or adjustable-rate residential loans which are secured by real estate. The Bank currently requires borrowers to obtain private mortgage insurance on all loans where the loan-to-value ratio exceeds 80%.
To manage the potentially adverse impact of interest rate movements on its fixed-rate mortgage loan pipeline, the Bank hedges its pipeline by entering into whole loan and mortgage-backed security forward sale commitments. At September 30, 1994, the Bank had whole loan and mortgage-backed security forward sale commitments of $5.2 and $41.9 million, respectively. In addition, at September 30, 1994, the Bank had $1.8 million in mortgage-backed security forward purchase commitments related to its hedging activities.
LETTERS OF CREDIT:
Letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. At September 30, 1994, the Bank had written letters of credit in the amount of $62.6 million, of which $55.7 million were issued to guarantee the performance of and irrevocably assure payment by customers under construction projects and $6.9 million were issued to assure payment of specified financial obligations of customers.
Of the total, $31.3 million will expire in fiscal 1995 and the remainder will expire over time through fiscal 1999. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. Investment and mortgage-backed securities with a book value of $9.5 million were pledged as collateral for certain of these letters of credit at September 30, 1994.
RECOURSE ARRANGEMENTS:
The Bank is obligated under various recourse provisions (primarily related to credit losses) related to the securitization and sale of credit card, home equity credit line and automobile loan receivables through the asset-backed securitizations described in Note 15. At September 30, 1994, the primary recourse to the Bank was $65.9 million. As a result of these recourse provisions, the Bank maintained restricted cash accounts amounting to $73.1 and $125.8 million, at September 30, 1994 and 1993, respectively, which are included in other assets in the Consolidated Balance Sheets.
The Bank is obligated under various recourse provisions related to the swap of single-family residential loans for participation certificates and mortgage-backed securities issued to the Bank by FHLMC and FNMA. At September 30, 1994, recourse to the Bank under these arrangements was $5.9 million. As security for the payment of funds due under certain of the FHLMC recourse obligations, the Bank is required to post collateral. At September 30, 1994, mortgage-backed securities pledged as collateral under these obligations had a book value of $6.2 million.
CONCENTRATIONS OF CREDIT:
The Bank's principal real estate lending market is the metropolitan Washington, D.C. area. In addition, approximately 17.8% of the Bank's outstanding credit card loans at September 30, 1994 were generated by cardholders residing in the metropolitan Washington, D.C. area. Service industries and Federal, state and local governments employ a significant portion of the Washington, D.C. area labor force. Adverse changes in economic conditions could have a direct impact on the timing and amount of payments by borrowers.
29. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS - THE BANK
The majority of the Bank's assets and liabilities are financial instruments; however, certain of these financial instruments lack an available trading market. Significant estimates, assumptions and present value calculations were therefore used for the purposes of the following disclosure, resulting in a great degree of subjectivity inherent in the indicated fair value amounts. Comparability among financial institutions may be difficult due to the wide range of permitted valuation techniques and the numerous estimates and assumptions which must be made. The estimated fair values of the Bank's financial instruments at September 30, 1994 and 1993 are as follows:
The following methods and assumptions were used to estimate the fair value amounts at September 30, 1994 and 1993:
CASH, DUE FROM BANKS, INTEREST-BEARING DEPOSITS AND FEDERAL FUNDS SOLD: Carrying amount approximates fair value.
LOANS HELD FOR SALE: Fair value is determined using quoted prices for loans, or securities backed by loans with similar characteristics, or outstanding commitment prices from investors.
LOANS HELD FOR SECURITIZATION AND SALE: The carrying value of credit card loans held for securitization and sale approximates fair value because such receivables are sold at face value.
INVESTMENT SECURITIES: Fair value is based on quoted market prices.
MORTGAGE-BACKED SECURITIES: Fair value is based on quoted market prices, dealer quotes or estimates using dealer quoted market prices for similar securities.
LOANS RECEIVABLE, NET OF RESERVE: Fair value of certain homogeneous groups of loans (e.g., single-family residential, non-credit card consumer loans and fixed-rate commercial and multifamily loans) is estimated using discounted cash flow analyses based on contractual repayment schedules. The discount rates used in these analyses are based on either the interest rates paid on U.S. Treasury securities of comparable maturities adjusted for credit risk and non-interest operating costs, or the interest rates currently offered by the Bank for loans with similar terms to borrowers of similar credit quality. For loans which reprice frequently at market rates (e.g., home equity, variable-rate commercial and multifamily, real estate construction and ground loans), the carrying amount approximates fair value. Because credit card receivables are generally sold at face value through the Bank's securitization program, such face value is used as the estimated fair value of these receivables. The fair value of the Bank's loan portfolio as presented above does not include the value of established credit card and home equity credit line customer relationships, or the value relating to estimated cash flows from future receivables and the associated fees generated from existing customers.
OTHER FINANCIAL ASSETS: The carrying amount of Federal Home Loan Bank stock, accrued interest receivable, excess servicing assets, interest-bearing deposits maintained pursuant to various asset securitizations and other short-term receivables approximates fair value. The fair value of an investment is based on quoted market prices.
DEPOSIT ACCOUNTS WITH NO STATED MATURITIES: Deposit liabilities payable on demand, consisting of NOW accounts, money market deposits, statement savings and other deposit accounts, are assumed to have an estimated fair value equal to carrying value. The indicated fair value does not consider the value of the Bank's established deposit customer relationships.
DEPOSIT ACCOUNTS WITH STATED MATURITIES: Fair value of fixed-rate certificates of deposit is estimated based on discounted cash flow analyses using the remaining maturity of the underlying accounts and interest rates currently offered on certificates of deposit with similar maturities.
BORROWINGS: These instruments consist of securities sold under repurchase agreements and other short-term borrowings, bonds payable, notes payable and Federal Home Loan Bank advances. For borrowings which either reprice frequently to market interest rates or are short-term in duration, the carrying amount approximates fair value. Fair value of the remaining amounts borrowed is estimated based on discounted cash flow analyses using interest rates currently charged by the lender for comparable borrowings with similar remaining maturities.
CAPITAL NOTES-SUBORDINATED: Fair value of the 1993 Debentures is based on quoted market prices. The carrying amount of the $10.0 million private placement capital note approximates fair value.
OTHER FINANCIAL LIABILITIES: The carrying amount of custodial accounts, amounts due to banks, accrued interest payable and other short-term payables approximates fair value.
OFF-BALANCE SHEET INSTRUMENTS: There is no market value associated with the Bank's commitments to extend credit and letters of credit because any prices charged by the Bank are consistent with the prices charged by other companies for similar agreements. Fair value of forward commitments is based on the estimated amount that the Bank would pay to terminate the arrangements at the reporting date, taking into account the remaining terms of the arrangements and the counterparties' credit standing, where applicable.
30. LITIGATION - THE BANK
During the normal course of business, the Corporations are involved in certain litigation, including litigation arising out of the collection of loans, the enforcement or defense of the priority of their security interests, and the continued development and marketing of certain of their real estate properties. Although the amounts claimed in some of these suits in which the Corporations are defendants are material, the Corporations deny liability and, in the opinion of management, litigation which is currently pending will not have a material impact on the financial condition or future operations of the Corporations.
31. COMMITMENTS AND CONTINGENCIES - THE TRUST
The Trust is involved in a number of lawsuits arising from the normal course of its business. On the basis of consultations with counsel, management does not believe that any material loss will result.
32. INCOME TAXES - THE TRUST
The Trust voluntarily terminated its qualification as a real estate investment trust under the Internal Revenue Code during fiscal 1978.
As discussed in Organization and Summary of Significant Accounting Policies, the Trust adopted SFAS 109 effective October 1, 1993, which had the effect of increasing the Trust's net deferred tax asset by approximately $36.3 million. For fiscal years 1993 and 1992, the Trust accounted for income taxes in accordance with APB 11. The provision for income taxes for the years ended September 30, 1994, 1993 and 1992, consists of the following:
The tax effect of each timing difference resulting in a deferred income tax benefit is as follows:
On August 10, 1993, Congress passed the Tax Revenue Reconciliation Act of 1993, retroactively increasing the Federal corporate income tax rate from 34% to 35% effective January 1, 1993. As a result, the Trust's income tax rate for fiscal years 1994, 1993 and 1992 was 35.00%, 34.75% and 34.00%, respectively.
The Trust's effective income tax rate varies from the statutory Federal income tax rate as a result of the following factors:
Under SFAS 109, the components of the net deferred tax asset were as follows:
Under SFAS 109, a valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. Management has established a valuation allowance in part to reduce the net deferred tax asset for net operating loss carryforwards related to state taxes. Historically, the Bank has generated taxable income while the Real Estate Trust has generated taxable losses. Net operating loss carryforwards are realizable through future taxable income of the Bank since the Trust files a consolidated tax return for federal purposes. The net operating loss carryforwards are not expected to be realizable for state tax purposes since a consolidated return is not filed with state tax authorities.
In the opinion of management, the net deferred tax asset of $55.2 million will be realized through future taxable income primarily attributable to the Bank. In order to realize the portion of the net deferred tax asset related to net operating loss carryforwards, the Bank will need to generate future taxable income of approximately $40.0 million in excess of annual taxable losses of the Real Estate Trust. The Real Estate Trust generated a net taxable loss of approximately $22 million in fiscal 1994.
Based on the Trust's historical consolidated net income of $23.1, $4.5 and $5.9 million in fiscal years 1994, 1993 and 1992, respectively, in the opinion of management, it is more likely than not that the Trust will realize the benefit of the federal net operating loss carryforward before expiration. Furthermore management believes the existing net deductible temporary differences will reverse during periods in which the Bank generates taxable income in excess of Real Estate Trust taxable losses. Management believes that the positive consolidated earnings trend will continue as a result of continued improvement in Bank earnings. In addition, management believes that the losses from the Real Estate Trust will stabilize as a result of recent transactions that either eliminated or reduced debt service requirements. See further discussion in Notes 2 and 3.
TAX SHARING AGREEMENT
The Trust's affiliated group, including the Bank, entered into a tax sharing agreement dated June 28, 1990. This agreement provides that payments be made by members of the affiliated group to the Trust based on their respective allocable shares of the overall federal income tax liability of the affiliated group for taxable years and partial taxable years beginning on or after that date. Allocable shares of the overalll tax liability are prorated among the members with taxable income calculated on a separate return basis. The agreement also provides that, to the extent net operating losses or tax credits of a particular member are used to reduce overall tax liability of the Trust's affiliated group, such member will be reimbursed on a dollar-for-dollar basis by the other members of the affiliated group that have taxable income in an amount equal to such tax reduction. Under the tax sharing agreement, the Bank paid $9.6 and $5.0 million, respectively, to the Trust during fiscal 1994 and 1993. Subsequent to September 30, 1994, the OTS approved and the Bank made a tax sharing payment of $5.0 million. The Bank made no payments during fiscal 1992. Effective June 30, 1991, the Bank agreed with the OTS not to make any further tax sharing payments to the Trust without permission of the OTS.
In recent years, the operations of the Trust have generated net operating losses while the Bank has reported net income. It is anticipated that the Trust's consolidation of the Bank's operations into the Trust's federal income tax return will result in the use of the Trust's net operating losses to reduce the federal income taxes the Bank would otherwise owe. If in any future year, the Bank has taxable losses or unused credits, the Trust would be obligated to reimburse the Bank for the greater of (i) the tax benefit to the group using such tax losses or unused tax credits in the group's consolidated Federal income tax returns or (ii) the amount of tax refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated Federal income tax return of the group.
As of September 30, 1994, the federal tax net operating loss carryforwards and alternative minimum tax carryforwards were $39.9 and $2.0 million, respectively. The net operating losses will begin to expire in the year 2004.
33. SHAREHOLDERS' EQUITY - THE TRUST
In June 1990, the Trust acquired from affiliated companies an additional equity interest in the Bank, which raised the Trust's ownership share of the Bank to 80%. In exchange for the interest acquired, the Trust issued 450,000 shares of a new class of $10.50 cumulative preferred shares of beneficial interest with a par value of $1 ("preferred shares"). The transaction has been accounted for at historical cost in a manner similar to the pooling of interests method because the entities are considered to be under common control. In addition, the Trust acquired two real estate properties from an affiliate in exchange for 66,000 preferred shares.
At September 30, 1994, 1993, and 1992, the amount of dividends in arrears on the preferred shares was $21,226,500 ($41.14 per share), $15,808,500 ($30.64 per share) and $10,390,500 ($20.14 per share), respectively.
34. QUARTERLY FINANCIAL DATA (UNAUDITED) - THE TRUST
35. INDUSTRY SEGMENT INFORMATION - THE TRUST
Industry segment information with regard to the Real Estate Trust is presented below. For information regarding the Bank please refer to the "Banking" sections of the accompanying financial statements.
36. CONDENSED FINANCIAL STATEMENTS - THE TRUST
These condensed financial statements reflect the Real Estate Trust and all its consolidated subsidiaries except for the Bank which has been reflected on the equity method.
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF OPERATIONS
CONDENSED STATEMENTS OF CASH FLOWS
MANAGEMENT'S STATEMENT ON RESPONSIBILITY
The Consolidated Financial Statements and related financial information in this report have been prepared by the Advisor (management) in accordance with generally accepted accounting principles, based on best estimates and judgments, with consideration given to materiality.
The Trust maintains a system of internal accounting controls supported by documentation to provide reasonable assurance that the books and records reflect authorized transactions of the Trust and that the assets of the Trust are safeguarded.
The Board of Trustees exercises its responsibility for the Trust's financial statements through its Audit Committee, which is composed of two outside Trustees who meet periodically with the Trust's independent accountants and management. The Committee considers the audit scope, discusses financial and reporting subjects, and reviews management actions on these matters. The independent accountants have full access to the Audit Committee.
The independent accountants are recommended by the Audit Committee and confirmed by the Board of Trustees. They provide an objective assessment of the fairness and accuracy of the financial statements, consider the adequacy of the system of internal accounting controls and perform such tests and other procedures as they deem necessary to express an opinion on the fairness of the financial statements. Management believes that the policies and procedures it has established provide reasonable assurance that its operations are conducted in conformity with law and a high standard of business conduct.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
In accordance with the requirements of rules promulgated under the Securities Exchange Act of 1934, the Trust filed a Current Report on Form 8-K with the Securities and Exchange Commission on May 23, 1994 with respect to the appointment of Arthur Andersen LLP as the Trust's independent public accountants.
PART III
ITEM 10.



ITEM 10. TRUSTEES AND EXECUTIVE OFFICERS OF THE TRUST
The Trust's Declaration of Trust provides that there shall be no fewer than three nor more than twelve Trustees, as determined from time to time by the Trustees in office. The Board of Trustees has fixed its membership at five Trustees divided into three classes with overlapping three-year terms. The term of each class expires at the annual meeting of shareholders, which is usually held on the last Friday of January.
The following list sets forth the name, age, position with the Trust, present principal occupation or employment and material occupations, positions, offices or employments during the past five years of each Trustee and executive officer of the Trust. Unless otherwise indicated below, the business address of each Trustee or executive officer of the Trust is 8401 Connecticut Avenue, Chevy Chase, Maryland 20815 and, unless otherwise indicated, each individual has held an office with the Trust for at least the past five years.
CLASS TWO TRUSTEE --TERM ENDS AT 1995 ANNUAL MEETING
George M. Rogers, Jr., age 61, has served as a Trustee since 1969. His professional corporation is a partner in the law firm of Shaw, Pittman, Potts & Trowbridge, Washington, D.C., which serves as counsel to the Trust and
the Bank. Mr. Rogers serves as a Director of B. F. Saul Company, Chevy Chase Property Company, the Bank, Westminster Investing Corporation, and Chevy Chase Lake Corporation. His business address is 2300 N Street, N.W., Washington, D.C. 20037.
CLASS THREE TRUSTEES--TERMS END AT 1996 ANNUAL MEETING
Garland J. Bloom, Jr., age 63, has served as a Trustee since 1964. He is currently a real estate consultant. He was formerly Executive Vice President and Principal, GMB Associates, Inc. (a real estate finance and management firm) from 1988 to 1990 and Vice Chairman and Chief Operating Officer of Smithy- Braedon Company (a real estate finance and management firm) from 1985 to 1987.
John R. Whitmore, age 61, has served as a Trustee since 1984. He also serves as Director, President and Chief Executive Office of The Bessemer Group, Incorporated and its Bessemer Trust Company subsidiaries with which he has been associated since 1975 (a financial management and banking group) and as a Director of Bessemer Securities Corporation, Chevy Chase Property Company, B. F. Saul Company and Saul Centers, Inc. His business address is 630 Fifth Avenue, New York, New York 10111.
CLASS ONE TRUSTEES --TERMS END AT 1997 ANNUAL MEETING
Gilbert M. Grosvenor, age 63, has served as a Trustee since 1971. He also serves as President and Chairman of the Board of Trustees of the National Geographic Society and as a Director of the Bank, Saul Centers, Inc., Marriott International Corp., Chesapeake and Potomac Telephone Company, Ethyl Corporation and Charles Allmon Trust, Inc. His business address is 1145 17th Street, N.W., Washington, D.C. 20036.
B. Francis Saul II, age 62, has served as Chairman and Chief Executive Officer of the Trust since 1969 and as a Trustee since 1964. He also serves as President and Chairman of the Board of Directors of B. F. Saul Company, B. F. Saul Advisory Company, Chevy Chase Property Company, Westminster Investing Corporation, and Chevy Chase Lake Corporation, as Chairman of the Board of the Bank and Saul Centers, Inc., and as a Trustee of the National Geographic Society and the Brookings Institute.
EXECUTIVE OFFICERS OF THE TRUST WHO ARE NOT DIRECTORS
Philip D. Caraci, age 56, serves as Senior Vice President and Secretary of the Trust, Executive Vice President of B. F. Saul Company, Senior Vice President of
B. F. Saul Advisory Company, President of Franklin Property Company and a Director and President of Saul Centers, Inc.
Stephen R. Halpin, Jr., age 39, was appointed Vice President and Chief Financial Officer of the Trust in fiscal 1994. He also serves as Senior Vice President and Chief Financial Officer of the Bank and B. F. Saul Company.
Ross E. Heasley, age 55, serves as Vice President of the Trust, B. F. Saul Company, B. F. Saul Advisory Company, Franklin Property Company and Saul Centers, Inc.
Henry Ravenel, Jr., age 60, serves as Vice President of the Trust, B. F. Saul Company, B. F. Saul Advisory Company and Saul Centers, Inc.
William K. Albright, age 63, serves as Vice President and Treasurer of the Trust, B. F. Saul Company, Franklin Property Company and B. F. Saul Advisory Company, and Vice President of Saul Centers, Inc.
COMMITTEES OF THE BOARD OF TRUSTEES
The Board of Trustees met three times during fiscal 1994. Each member of the Board attended at least 75% of the aggregate number of meetings of the Board and of the Committees of the Board on which he served.
The Board of Trustees has three standing committees: the Audit Committee, the Executive Committee, and the Nominating Committee.
The Audit Committee is composed of Messrs. Bloom and Grosvenor. Its duties include nominating the Trust's independent auditors, discussing with them the scope of their examination of the Trust, reviewing with them the financial statements and accompanying report, and being generally available to receive their recommendations regarding internal controls and related matters. This Committee met four times during fiscal 1994.
The Executive Committee is composed of Messrs. Rogers, Saul and Whitmore. It is empowered to oversee day-to-day actions of the Advisor and Franklin in connection with the operations of the Trust, including the acquisition, administration, sale or disposition of investments. This Committee did not meet during fiscal 1994.
The Nominating Committee is composed of Messrs. Rogers and Whitmore. Its function is to screen and make recommendations to the Board of Trustees regarding potential candidates for membership on the Board and to perform such
other duties as may be assigned to it from time to time. This Committee did not meet during fiscal 1994.
Trustees of the Trust are currently paid an annual retainer of $12,500 and a fee of $600 for each Board or committee meeting attended. Trustees from outside the Washington, D.C. area are also reimbursed for out-of-pocket expenses in connection with their attendance at meetings. Mr. Saul is not paid for attending Executive Committee meetings. For the fiscal year ended September 30, 1994, the Real Estate Trust paid total compensation of $76,000 to the Trustees, including $14,300 to Mr. Saul.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
The Trust pays no compensation to its executive officers for their services in such capacity. Mr. Saul receives compensation from the Bank for his services as the Bank's Chairman of the Board of Directors and Chief Executive Officer and Mr. Halpin, who became an executive officer of the Trust in fiscal 1994, receives compensation from the Bank for his services as Senior Vice President and Chief Financial Officer of the Bank. No other executive officers of the Trust received any compensation from the Trust or its subsidiaries with respect to any one of the fiscal years ended September 30, 1994, 1993 or 1992.
The following table sets forth the cash compensation paid by the Bank to Mr. Saul for or with respect to the fiscal years ended September 30, 1994, 1993 and 1992 and the cash compensation paid by the Bank to Mr. Halpin for or with respect to the fiscal year ended September 30, 1994 for all capacities in which they served during such fiscal years.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information, as of December 1, 1994, concerning beneficial ownership of Common Shares and Preferred Shares of Beneficial Interest ("Preferred Shares") by Trustees and executive officers of the Trust.
Except as noted above, no other Trustee or executive officer of the Trust owned any Common or Preferred Shares as of December 1, 1994.
The Preferred Shares were issued in June 1990 in connection with the transaction in which the Trust increased its ownership of the Bank's common stock from 60% to 80%. The dividend rate on the Preferred Shares is $10.50 per share per annum. Dividends are cumulative and are payable annually or at such other times as the Trustees may determine, as and when declared by the Trustees out of any assets legally available therefor. The Preferred Shares have a liquidation preference of $100 per share. Subject to limits in certain of the Trust's loan agreements, the Preferred Shares are subject to redemption at the option of the Trust at any time on or after the fifth anniversary of their issuance at a redemption price equal to their liquidation preference. Except as otherwise required by applicable law, the holders of Preferred Shares are entitled to
vote only in certain limited situations, such as the merger of the Trust or a sale of all or substantially all of the assets of the Trust.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
REAL ESTATE
TRANSACTIONS WITH B. F. SAUL COMPANY AND ITS SUBSIDIARIES. The Real Estate Trust is managed by the Advisor, a wholly owned subsidiary of the Saul Company. All of the officers of the Trust and B. Francis Saul II, George M. Rogers, Jr. and John R. Whitmore, each of whom is a Trustee of the Trust, are also officers and/or directors of the Saul Company and/or its subsidiary corporations. The Advisor is paid a monthly fee subject to review by the Trustees. The monthly fee was $250,000 for the period October 1993 through March 1994 and $292,000 for the period April 1994 through September 1994. The advisory contract has been extended until September 30, 1995, and will continue thereafter unless canceled by either party at the end of any contract year. Certain loan agreements prohibit termination of this contract.
The Saul Company and Franklin, a wholly-owned subsidiary of the Saul Company, provide services to the Real Estate Trust in the areas of commercial property management and leasing, hotel management, development and construction management, and acquisitions, sales and financings of real property. The fee schedules of the Saul Company and Franklin are reviewed and approved by the Trustees. The Trustees believe that these fees are as favorable to the Real Estate Trust as would be obtainable from unaffiliated sources. Fees to the Saul Company and Franklin amounted to $4.5 million in fiscal 1994.
The Real Estate Trust reimburses the Advisor and Franklin for costs and expenses incurred in connection with the acquisition and development of real property on behalf of the Real Estate Trust, in-house legal expenses and for all travel expenses incurred in connection with the affairs of the Real Estate Trust.
The Real Estate Trust pays the Advisor 1% of the principal amount of publicly offered Unsecured Notes as they are issued to offset the Advisor's costs of administering the program. The Advisor received $157,000 in such fees in fiscal 1994.
B. F. Saul Insurance Agency of Maryland, Inc., a subsidiary of the Saul Company, is a general insurance agency that receives commissions and counter- signature fees in connection with the Real Estate Trust's insurance program. Such commissions and fees amounted to $157,000 in fiscal 1994.
The Saul Company made a working capital loan in fiscal 1992 to the Real Estate Trust which was repaid during fiscal 1994 with the proceeds of the offering of Senior Secured Notes. At September 30,
1993, the balance of this loan was $3.3 million, and the highest balance of the loan in fiscal 1994 was $5.9 million. The loan accrued interest at a rate of prime plus 1/2%. The Real Estate Trust incurred interest expense of $139,000 on the loan during fiscal 1994.
The Real Estate Trust obtained a $5.0 million secured loan from The Klingle Corporation in August 1992. This loan was repaid during fiscal 1994 with the proceeds of the offering of Senior Secured Notes. The loan accrued interest at a rate of prime plus 1.5%. The Real Estate Trust incurred interest expense of $193,000 on the loan during fiscal 1994.
In April 1994, the Real Estate Trust made a $15.0 million demand loan to the Saul Company. This loan accrues interest at a rate of prime plus 1/2%. During fiscal 1994, interest received on the loan amounted to $565,000. Subsequent to September 30, 1994, the principal amount was reduced to $12.7 million.
REMUNERATION OF TRUSTEES AND OFFICERS. For fiscal 1994, the Real Estate Trust paid the Trustees $76,000 for their services. See "Trustees and Executive Officers of the Trust." No compensation was paid to the officers of the Real Estate Trust for acting as such; however, Mr. Saul was paid by the Bank for his services as the Bank's Chairman and Chief Executive Officer and Mr. Halpin was paid by the Bank for his services as Senior Vice President and Chief Financial Officer of the Bank. See "Executive Compensation." Messrs. Grosvenor, Rogers, and Saul receive compensation for their services as directors of the Bank and Messrs. Rogers, Saul and Whitmore and all of the officers of the Real Estate Trust receive compensation from the Saul Company and/or its affiliated corporations for their services as directors or officers thereof.
LEGAL SERVICES. For legal services to the Real Estate Trust and its subsidiaries, the law firm in which the professional corporation of George M. Rogers, Jr., a Trustee of the Trust, is a partner received $1.3 million in fiscal 1994, excluding expense reimbursements.
OTHER TRANSACTIONS. The Real Estate Trust leases space to Franklin at one of its income-producing properties. Minimum rents and recoveries paid by this affiliate amounted to $51,000 in fiscal 1994.
BANKING
Set forth below are certain transactions between the Bank and executive officers and directors of the Trust and certain of their affiliates. Management believes that the transactions with related parties described herein have been conducted on substantially the same terms as similar transactions with unrelated parties.
SERVICES. The Saul Company and its subsidiaries provide certain
services to the Bank and its subsidiaries. These services have included property management, cafeteria management, leasing, insurance brokerage and data processing. The Bank paid the Saul Company fees for these services totaling $548,000 in fiscal 1994. Subject to certain restrictions under applicable OTS conflict of interest rules, the Bank intends to continue using the Saul Company and its subsidiaries for many of these services, provided that the fees remain competitive with fees charged for similar services by unrelated parties.
LEGAL SERVICES. The law firm of Shaw, Pittman, Potts & Trowbridge, in which the professional corporation of Mr. Rogers is a partner, has rendered legal services to the Bank, for which the firm received $2.4 million during fiscal 1994, excluding expense reimbursements.
OTHER TRANSACTIONS. The Bank or a wholly-owned subsidiary leases certain branch offices from affiliates of which Mr. Saul is an officer, director and may be deemed to own beneficially more than 10% of the equity. In fiscal 1994, total payments under such leases were $811,000.
The Bank leases its operations center from Chevy Chase Lake Corporation ("Lake"), an affiliate of which Mr. Saul is an officer, director and may be deemed to own beneficially more than 10% of the equity. Payments under this lease totaled approximately $1.4 million in fiscal 1994.
Lake, the Trust and the Saul Company from time to time maintain interest-bearing deposit accounts with the Bank. Those accounts totaled $46.8 million at September 30, 1994. The Bank paid interest on the accounts amounting to $1.1 million in fiscal 1994.
During fiscal 1994, the Bank sold 12.70 acres of retail land at an amount equal to its net carrying value to Saul Holdings Partnership, of whose corporate general partner Mr. Saul is an officer and director.
The Bank traditionally has offered home mortgage loans, home equity credit line loans, automobile loans and credit card loans to its executive officers and directors and to executive officers and directors of its subsidiaries. Management does not believe these loans involve more than the normal risk of collectibility. Each loan bears interest at prevailing market rates. All such loans are currently made to executive officers and directors of the Bank on substantially the same terms prevailing at the time for comparable transactions with unrelated parties. FIRREA imposes certain limits on loans, including prohibitions on preferential loans, by the Bank to its directors, executive officers, principal shareholders and their related interests.
As of September 30, 1994, the aggregate dollar amount of the indebtedness to the Bank of executive officers and directors of the
Bank and their immediate family members or companies with which they are affiliated was $4.2 million. This amount represented 1.5% of the Bank's stockholders' equity as of that date.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements
The following consolidated Financial Statements of the Trust are incorporated by reference in Part 11, Item 8.
(a) Reports of Independent Public Accountants.
(b) Consolidated Balance Sheets - September 30, 1994 and 1993.
(c) Consolidated Statements of Operations - Three Years Ended September 30, 1994, 1993 and 1992.
(d) Consolidated Statements of Shareholders' Deficit - Three Years Ended September 30, 1994, 1993 and 1992.
(e) Consolidated Statements of Cash Flows - Three Years Ended September 30, 1994, 1993 and 1992.
(f) Notes to Consolidated Financial Statements.
2. Financial Statement Schedules and Supplementary Data
(a) Selected Quarterly Financial Data for the Real Estate Trust are incorporated by reference in Part II, Item 8.
(b) Reports of Independent Public Accountants.
(c) Schedules of the Real Estate Trust:
Schedule III - Condensed Financial Information - Three Years Ended September 30, 1994, 1993 and 1992.
Schedule X - Consolidated Schedule of Supplementary Income Statement Information - Three Years Ended September 30, 1994, 1993 and 1992.
Schedule XI - Consolidated Schedule of Investment Properties - September 30, 1994.
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
(b) Reports on Form 8-K.
None.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust:
We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of B.F. Saul Real Estate Investment Trust (the "Trust") and have issued our report thereon dated December 19, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Trust's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements, and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Washington, D.C. Arthur Andersen LLP December 19, 1994
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Trustees and Shareholders of B.F. Saul Real Estate Investment Trust:
We have audited the consolidated financial statements of B.F. Saul Real Estate Investment Trust as of September 30, 1993, and for the years ended September 30, 1993 and 1992, and have issued our report thereon dated November 4, 1993; such consolidated financial statements and report are included elsewhere in this Form 10-K. Our audits also included the consolidated financial statement schedules of B.F. Saul Real Estate Investment Trust for the years ended September 30, 1993 and 1992, listed in Item 14. These financial statement schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules for the years ended September 30, 1993 and 1992, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
STOY, MALONE & COMPANY, P.C.
Bethesda, Maryland November 4, 1993
B.F. SAUL REAL ESTATE INVESTMENT TRUST CONDENSED FINANCIAL INFORMATION (RULE 12-04) SCHEDULE III
(a) Required condensed financial information on the Trust is disclosed in the audited consolidated financial statements included herewith.
(b) Amounts of cash dividends paid to the Trust by consolidated subsidiaries were as follows:
Year Ended September 30 ------------------------------------- 1994 1993 1992 ------------------------------------- None None None
Schedule X
CONSOLIDATED SCHEDULE OF SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED SEPTEMBER 30 (In thousands)
Schedule XI Consolidated Schedule of Investment Properties - Real Estate Trust September 30, 1994 (Dollars in Thousands)
Schedule XI-Continued Consolidated Schedule of Investment Properties - Real Estate Trust (Continued) September 30, 1994 (Dollars in Thousands)
Schedule XI (cont'd)
CONSOLIDATED SCHEDULE OF INVESTMENT PROPERTIES - REAL ESTATE TRUST
NOTES:
(1) See Summary of Significant Accounting Policies for basis of recording investment properties and computing depreciation. Investment properties are discussed in Note 3 of Notes to Consolidated Financial Statements.
(2) A reconciliation of the basis of investment properties and accumulated depreciation follows.
BASIS OF INVESTMENT PROPERTIES (In thousands)
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Trust has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
B.F. Saul Real Estate Investment Trust
December 29, 1994 /s/ B. FRANCIS SAUL II ---------------------- B. Francis Saul II Chairman of the Board (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates shown.
Signature Title Date --------- ----- ----
Trustee, Chairman /s/ B. FRANCIS SAUL II of the Board and December 29, 1994 - ------------------------- Principal Executive B. Francis Saul II Officer
Vice President and /s/ STEPHEN R. HALPIN, JR. Chief Financial Officer December 29, 1994 - ------------------------- (Principal Financial Stephen R. Halpin, Jr. Officer)
/s/ ROSS E. HEASLEY Principal Accounting December 29, 1994 - ------------------------- Officer Ross E. Heasley
/s/ GARLAND J. BLOOM, JR. Trustee December 29, 1994 - ------------------------- Garland J. Bloom, Jr.
/s/ GILBERT M. GROSVENOR Trustee December 29, 1994 - ------------------------- Gilbert M. Grosvenor
/s/ GEORGE M. ROGERS, JR. Trustee December 29, 1994 - ------------------------- George M. Rogers, Jr.
/s/ JOHN R. WHITMORE Trustee December 29, 1994 - ------------------------- John R. Whitmore