ORIENTAL FINANCIAL GROUP, INC.
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANG ACT OF 1934
For the transition period from                      to                     
Commission File Number 001-12647
Oriental Financial Group Inc.
     
Incorporated in the Commonwealth of Puerto Rico,   IRS Employer Identification No. 66-0538893
Principal Executive Offices:
997 San Roberto Street
Oriental Center 10th Floor
Professional Offices Park
San Juan, Puerto Rico 00926
Telephone Number: (787) 771-6800
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
     Yes o   No þ
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
     Large Accelerated Filer o   Accelerated Filer þ   Non-Accelerated Filer o
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
     Yes o   No þ
Number of shares outstanding of the registrant’s common stock, as of the latest practicable date:
24,572,557_common shares ($1.00 par value per share)
outstanding as of September 30, 2006
 
 

 


 

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Certifications
    45   
 EX-10.1 CHANGE IN CONTROL COMPENSATION AGREEMENT/MARI EVELYN RODRIGUEZ
 EX-31.1 SECTION 302 CERTIFICATION OF CEO
 EX-31.2 SECTION 302 CERTIFICATION OF CFO
 EX-32.1 SECTION 906 CERTIFICATION OF CEO
 EX-32.2 SECTION 906 CERTIFICATION OF CFO

 


Table of Contents

FORWARD-LOOKING STATEMENTS
When used in this Form 10-Q or future filings by Oriental Financial Group Inc. (the “Group”) with the Securities and Exchange Commission (the “SEC”), in the Group’s press releases or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimated,” “project,” “believe,” “should” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.
The future results of the Group could be affected by subsequent events and could differ materially from those expressed in forward-looking statements. If future events and actual performance differ from the Group’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements.
The Group wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made and are based on management’s current expectations, and to advise readers that various factors, including regional and national economic conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities, competitive, and regulatory factors, legislative changes and accounting pronouncements, could affect the Group’s financial performance and could cause the Group’s actual results for future periods to differ materially from those anticipated or projected. The Group does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

 


Table of Contents

PART — I   FINANCIAL INFORMATION
ITEM — I    FINANCIAL STATEMENTS
UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30, 2006 AND DECEMBER 31, 2005

(In thousands, except share data)
                 
    June 30,     December 31,  
    2006     2005  
ASSETS
               
 
               
Cash and due from banks
  $ 35,237     $ 13,789  
 
           
Investments:
               
Time deposits with other banks
    30,000       60,000  
Money market investments
    5,722       3,480  
 
           
Short term investments
    35,722       63,480  
 
           
Trading securities, at fair value with amortized cost of $362 (December 31, 2005 - $144)
    368       146  
 
           
Investment securities available-for-sale, at fair value with amortized cost of $1,245,907 (December 31, 2005 - $1,069,649)
               
Securities pledged that can be repledged
    974,763       558,719  
Other investment securities
    225,481       488,165  
 
           
Total investment securities available-for-sale
    1,200,244       1,046,884  
 
           
Investment securities held-to-maturity, at amortized cost with fair value of $2,158,770 (December 31, 2005 - $2,312,832)
               
Securities pledged that can be repledged
    1,960,268       1,917,805  
Other investment securities
    282,951       428,450  
 
           
Total investment securities held-to-maturity
    2,243,219       2,346,255  
 
           
Federal Home Loan Bank (FHLB) stock, at cost
    18,269       20,002  
 
           
Total investments
    3,497,822       3,476,767  
 
           
 
Securities sold but not yet delivered
    710       44,009  
 
           
 
               
Loans:
               
Mortgage loans held-for-sale, at lower of cost or market
    9,564       8,946  
Loans receivable, net of allowance for loan losses of $7,501 (December 31, 2005 - $6,630)
    1,144,374       894,362  
 
           
Total loans, net
    1,153,938       903,308  
 
           
 
Accrued interest receivable
    31,313       29,067  
Premises and equipment, net
    17,358       14,828  
Deferred tax asset, net
    14,861       12,222  
Foreclosed real estate
    4,379       4,802  
Other assets
    77,044       48,157  
 
           
Total assets
  $ 4,832,662     $ 4,546,949  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
Deposits:
               
Demand deposits
  $ 141,260     $ 146,623  
Savings accounts
    171,034       82,641  
Certificates of deposit
    901,553       1,069,304  
 
           
Total deposits
    1,213,847       1,298,568  
 
           
 
               
Borrowings:
               
Federal funds purchased and other short term borrowings
    17,098       4,455  
Securities sold under agreements to repurchase
    2,856,361       2,427,880  
Advances from FHLB
    285,500       313,300  
Term notes
    15,000       15,000  
Subordinated capital notes
    72,166       72,166  
 
           
Total borrowings
    3,246,125       2,832,801  
 
           
 
Securities purchased but not yet received
    6,539       43,354  
Accrued expenses and other liabilities
    25,868       30,435  
 
           
Total liabilities
    4,492,379       4,205,158  
 
           
 
               
Commitments and Contingencies
               
 
               
Stockholders’ equity:
               
Preferred stock, $1 par value; 5,000,000 shares authorized; $25 liquidation value; 1,340,000 shares of Series A and 1,380,000 shares of Series B issued and outstanding
    68,000       68,000  
Common stock, $1 par value; 40,000,000 shares authorized; 25,369,875 shares issued (December 31, 2005 - 25,350,125 shares)
    25,370       25,350  
Additional paid-in capital
    208,620       208,454  
Legal surplus
    37,114       35,863  
Retained earnings
    52,368       52,340  
Treasury stock, at cost 807,713 shares (December 31, 2005 - 770,472 shares)
    (10,779 )     (10,332 )
Accumulated other comprehensive loss, net of tax of $3,381 (December 31, 2005 - $1,810)
    (40,410 )     (37,884 )
 
           
Total stockholders’ equity
    340,283       341,791  
 
           
Total liabilities and stockholders’ equity
  $ 4,832,662     $ 4,546,949  
 
           
See notes to unaudited consolidated financial statements.

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Table of Contents

UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
FOR THE QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(In thousands, except per share data)
                                 
    Quarter Ended June 30,     Six-Month Period Ended June 30,  
    2006     2005     2006     2005  
            (As Restated)             (As Restated)  
 
                               
Interest income:
                               
Loans
  $ 18,311     $ 14,934     $ 34,564     $ 28,357  
Mortgage-backed securities
    23,887       22,626       48,387       47,401  
Investment securities
    13,973       11,037       28,473       20,335  
Short term investments
    723       279       1,462       355  
 
                       
Total interest income
    56,894       48,876       112,886       96,448  
 
                       
 
                               
Interest expense:
                               
Deposits
    11,146       8,697       21,644       16,320  
Securities sold under agreements to repurchase
    31,128       17,583       57,491       33,969  
Advances from FHLB, term notes and other borrowings
    2,568       2,143       5,190       4,188  
Subordinated capital notes
    1,344       1,165       2,641       2,273  
 
                       
Total interest expense
    46,186       29,588       86,966       56,750  
 
                       
 
Net interest income
    10,708       19,288       25,920       39,698  
Provision for loan losses
    947       850       2,048       1,510  
 
                       
Net interest income after provision for loan losses
    9,761       18,438       23,872       38,188  
 
                       
 
                               
Non-interest income:
                               
Financial service revenues
    4,066       3,249       7,317       6,419  
Banking service revenues
    2,511       2,064       4,687       3,893  
Investment banking revenues
    852       162       2,561       339  
Net gain (loss) on:
                               
Mortgage banking activities
    634       1,168       1,070       2,241  
Securities available-for-sale
          1,420       19       4,056  
Derivatives
    (23 )     (1,866 )     859       (4,670 )
Trading securities
    (8 )     (42 )     21       (53 )
Other
    (511 )     282       (60 )     311  
 
                       
Total non-interest income, net
    7,521       6,437       16,474       12,536  
 
                       
 
                               
Non-interest expenses:
                               
Compensation and employee benefits
    5,627       4,402       11,801       7,697  
Occupancy and equipment
    2,793       3,066       5,682       5,532  
Advertising and business promotion
    1,300       1,420       2,366       2,907  
Professional and service fees
    1,601       1,777       3,225       3,614  
Communication
    395       410       843       786  
Loan servicing expenses
    509       430       964       831  
Taxes, other than payroll and income taxes
    573       471       1,173       934  
Electronic banking charges
    494       543       962       1,060  
Printing, postage, stationery and supplies
    359       207       544       416  
Insurance
    219       188       432       375  
Other
    914       979       1,675       1,888  
 
                       
Total non-interest expenses
    14,784       13,893       29,667       26,040  
 
                       
 
Income before income taxes
    2,498       10,982       10,679       24,684  
Income tax expense (benefit)
    (21 )     377       110       (2,294 )
 
                       
Net income
    2,519       10,605       10,569       26,978  
Less: Dividends on preferred stock
    (1,201 )     (1,202 )     (2,401 )     (2,401 )
 
                       
Income available to common shareholders
  $ 1,318     $ 9,403     $ 8,168     $ 24,577  
                         
Income per common share:
                               
Basic
  $ 0.05     $ 0.38     $ 0.33     $ 1.00  
 
                       
Diluted
  $ 0.05     $ 0.37     $ 0.33     $ 0.96  
 
                       
 
Average common shares outstanding
    24,599       24,847       24,608       24,571  
Average potential common shares-options
    106       601       128       1,104  
 
                       
 
    24,705       25,448       24,736       25,675  
 
                       
 
Cash dividends per share of common stock
  $ 0.14     $ 0.14     $ 0.28     $ 0.28  
 
                       
See notes to unaudited consolidated financial statements.

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Table of Contents

UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(In thousands)
                 
    Six-Month Period Ended June 30,  
CHANGES IN STOCKHOLDERS’ EQUITY:   2006     2005  
            (As Restated)  
 
               
Preferred stock:
               
 
           
Balance at beginning and end of period
  $ 68,000     $ 68,000  
 
           
 
Common stock:
               
Balance at beginning of period
    25,350       24,601  
Stock options exercised
    20       503  
 
           
Balance at end of period
    25,370       25,104  
 
           
 
Additional paid-in capital:
               
Balance at beginning of period — as previously reported
            186,405  
Prior period adjustment
            13,241  
 
             
Balance at beginning of period — as restated
    208,454       199,646  
Stock-based compensation expense
    16       6,261  
Stock options exercised
    150       905  
Common stock issuance cost
          (8 )
 
           
Balance at end of period
    208,620       206,804  
 
           
 
Legal surplus:
               
Balance at beginning of period
    35,863       31,280  
Transfer from retained earnings
    1,251       2,613  
 
           
Balance at end of period
    37,114       33,893  
 
           
 
Retained earnings:
               
Balance at beginning of period — as previously reported
            59,884  
Prior period adjustment
            (28,203 )
 
             
Balance at beginning of period — as restated
    52,340       31,681  
Net income
    10,569       26,978  
Cash dividends declared on common stock
    (6,889 )     (6,940 )
Cash dividends declared on preferred stock
    (2,401 )     (2,401 )
Transfer to legal surplus
    (1,251 )     (2,613 )
 
           
Balance at end of period
    52,368       46,705  
 
           
 
Treasury stock:
               
Balance at beginning of period
    (10,332 )     (91 )
Stock used to match defined contribution plan 1165(e)
    135       235  
Stock purchased
    (582 )     (3,512 )
 
           
Balance at end of period
    (10,779 )     (3,368 )
 
           
 
Accumulated other comprehensive income (loss), net of tax:
               
Balance at beginning of period
    (37,884 )     (37,023 )
Other comprehensive income (loss), net of tax
    (2,526 )     (1,360 )
 
           
Balance at end of period
    (40,410 )     (38,383 )
 
           
 
Total stockholders’ equity
  $ 340,283     $ 338,755  
 
           
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(In thousands)
                                 
    Quarter Ended June 30,     Six-Month Period Ended June 30,  
COMPREHENSIVE INCOME   2006     2005     2006     2005  
            (As Restated)             (As Restated)  
 
Net income
  $ 2,519     $ 10,605     $ 10,569     $ 26,978  
 
                       
Other comprehensive income (loss):
                               
Unrealized (loss) gain on securities available-for-sale arising during the period
    (9,788 )     6,717       (21,351 )     (8,991 )
Realized (gain) loss on investment securities available-for-sale included in net income
    (19 )     832       (19 )     (1,804 )
Unrealized gain (loss) on derivatives designated as cash flows hedges arising during the period
    8,106       (6,565 )     18,022       7,018  
Realized loss (gain) on derivatives designated as cash flow hedges included in net income
          820       (749 )     2,743  
Income tax effect related to unrealized loss on securities available-for-sale
    992       (405 )     1,571       (326 )
 
                       
 
Other comprehensive (loss) income for the period, net of tax
    (709 )     1,399       (2,526 )     (1,360 )
 
                       
 
Comprehensive income
  $ 1,810     $ 12,004     $ 8,043     $ 25,618  
 
                       
See notes to unaudited consolidated financial statements.

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Table of Contents

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(In thousands)
                 
    Six-Month Period Ended June 30,  
    2006     2005  
            (As Restated)  
Cash flows from operating activities:
               
Net income
  $ 10,569     $ 26,978  
 
           
Adjustments to reconcile net income to net cash used in operating activities:
               
Amortization of deferred loan origination fees, net of costs
    (760 )     (982 )
Amortization of premiums, net of accretion of discounts on investment securities
    1,045       4,987  
Depreciation and amortization of premises and equipment
    2,672       3,143  
Deferred income tax expense (benefit)
    (1,068 )     205  
Equity in losses (earnings) of investment in limited liability partnership
    271       (247 )
Provision for loan losses
    2,048       1,510  
Stock-based compensation (benefit)
    16       (6,287 )
Loss (gain) on:
               
Sale of securities available-for-sale
    (19 )     (4,056 )
Mortgage banking activities
    (1,070 )     (2,241 )
Derivatives
    (859 )     4,670  
Sale of foreclosed real estate
    (115 )      
Sale of premises and equipment
    (8 )      
Originations of loans held-for-sale
    (33,830 )     (107,035 )
Proceeds from sale of loans held-for-sale
    13,525       28,893  
Net decrease (increase) in:
               
Trading securities
    (222 )     850  
Accrued interest receivable
    (2,246 )     (2,446 )
Other assets
    (7,375 )     (10,454 )
Net increase (decrease) in:
               
Accrued interest on deposits and borrowings
    (2,492 )     3,329  
Other liabilities
    (2,030 )     7,351  
 
           
Net cash used in operating activities
    (21,948 )     (51,832 )
 
           
 
               
Cash flows from investing activities:
               
Net decrease (increase) in time deposits with other banks
    30,000       (30,000 )
Purchases of:
               
Investment securities available-for-sale
    (278,566 )     (623,529 )
Investment securities held-to-maturity
    (6,500 )     (236,399 )
Equity options and put options
          (739 )
FHLB stock
    (9,733 )      
Maturities and redemptions of:
               
Investment securities available-for-sale
    73,173       400,720  
Investment securities held-to-maturity
    108,975       100,340  
FHLB stock
    11,466       1,102  
Proceeds from sales of:
               
Investment securities available-for-sale
    57,130       449,622  
Foreclosed real estate
    2,142       2,149  
Premises and equipment
          3,355  
Loan production:
               
Origination and purchase of loans, excluding loans held-for-sale
    (321,068 )     (164,269 )
Principal repayment of loans
    68,474       108,314  
Additions to premises and equipment
    (5,194 )     (2,340 )
 
           
Net cash provided by (used in) investing activities
    (269,701 )     8,326  
 
           
 
               
Cash flows from financing activities:
               
Net increase (decrease) in:
               
Deposits
    (85,449 )     178,064  
Securities sold under agreements to repurchase
    425,516       (146,070 )
Federal funds purchased and other short term borrowings
    12,643       12,310  
Proceeds from:
               
Advances from FHLB
    1,322,995       917,570  
Exercise of stock options, net
    170       1,408  
Repayments of advances from FHLB
    (1,350,795 )     (917,570 )
Common stocks used to match defined contribution plan 1165(e)
    135       (3,157 )
Repurchase of treasury stocks
    (582 )      
Dividends paid
    (9,294 )     (9,321 )
 
           
Net cash provided by financing activities
    315,339       33,234  
 
           
 
               
Net change in cash and cash equivalents
    23,690       (10,272 )
Cash and cash equivalents at beginning of period
    17,269       34,955  
 
           
Cash and cash equivalents at end of period
  $ 40,959     $ 24,683  
 
           
 
               
Cash and cash equivalents include:
               
Cash and due from banks
  $ 35,237     $ 14,892  
Money market investments
    5,722       9,791  
 
           
 
  $ 40,959     $ 24,683  
 
           
Supplemental Cash Flow Disclosure and Schedule of Noncash Activities:
               
Interest paid
  $ 90,826     $ 53,421  
 
           
Income taxes paid
  $     $ 554  
 
           
Mortgage loans securitized into mortgage-backed securities
  $ 20,447     $ 33,662  
 
           
Accrued dividend payable
  $ 3,441     $ 3,487  
 
           
Other comprehensive loss for the period
  $ 2,526   $ 1,360
 
           
Securities sold but not yet delivered
  $ 710     $ 1,034  
 
           
Securities and loans purchased but not yet received
  $ 6,539     $ 22,772  
 
           
Transfer from loans to foreclosed real estate
  $ 1,604     $ 1,937  
 
           
See notes to unaudited consolidated financial statements.

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ORIENTAL FINANCIAL GROUP INC.
Notes to Unaudited Consolidated Financial Statements
NOTE 1 — BASIS OF PRESENTATION:
The accounting and reporting policies of Oriental Financial Group Inc. (the “Group” or “Oriental”) conform with U.S. generally accepted accounting principles (“GAAP”) and to financial services industry practices.
The unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, these consolidated financial statements include all adjustments necessary, all of which are of normal recurring nature, to present fairly the consolidated financial condition as of June 30, 2006 and December 31, 2005, and the results of operations, and the cash flows for the six-month periods ended June 30, 2006 and 2005. All significant intercompany balances and transactions have been eliminated in the accompanying unaudited consolidated financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules and regulations. Management believes that the disclosures made are adequate to make the information presented not misleading. Financial information as of December 31, 2005 has been derived from the Group’s audited consolidated financial statements. The results of operations and cash flows for the six-month periods ended June 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto for the transition period ended December 31, 2005, included in the Group’s Form 10-K.
Nature of Operations
Oriental is a diversified, publicly-owned financial holding company incorporated under the laws of the Commonwealth of Puerto Rico. It has four direct subsidiaries, Oriental Bank and Trust (the “Bank”), Oriental Financial Services Corp. (“Oriental Financial Services”), Oriental Insurance, Inc. (“Oriental Insurance”), and Caribbean Pension Consultants, Inc., which is located in Boca Raton, Florida. The Group also has two special purpose entities, Oriental Financial (PR) Statutory Trust I (the “Statutory Trust I”) and Oriental Financial (PR) Statutory Trust II (the “Statutory Trust II”). Through these subsidiaries and its divisions, the Group provides a wide range of financial services such as mortgage, commercial and consumer lending, financial planning, insurance sales, money management and investment banking and brokerage services, as well as corporate and individual trust services. Note 9 to the unaudited consolidated financial statements present further information about the operations of the Group’s business segments.
The main offices of the Group and its subsidiaries are located in San Juan, Puerto Rico. The Group is subject to examination, regulation and periodic reporting under the U.S. Bank Holding Company Act of 1956, as amended, which is administered by the Board of Governors of the Federal Reserve System.
The Bank operates through twenty-four branches located throughout Puerto Rico and is subject to the supervision, examination and regulation of the Office of the Commissioner of Financial Institutions of Puerto Rico and the Federal Deposit Insurance Corporation (“FDIC”). The Bank offers banking services such as commercial and consumer lending, saving and time deposit products, financial planning, and corporate and individual trust services, and capitalizes on its commercial banking network to provide mortgage lending products to its clients. The Bank also operates two international banking entities (“IBEs”) pursuant to the International Banking Center Regulatory Act of Puerto Rico, as amended (the “IBE Act”): O.B.T. International Bank, which is a unit of the Bank, and Oriental International Bank Inc., which is a wholly-owned subsidiary of the Bank. On January 1, 2004, the Group transferred most of the assets and liabilities of O.B.T. International Bank to Oriental International Bank Inc. The IBE offers the Bank certain Puerto Rico tax advantages and its services are limited under Puerto Rico law to persons and assets/liabilities located outside of Puerto Rico.
Oriental Financial Services is subject to the supervision, examination and regulation of the National Association of Securities Dealers, Inc., the SEC, and the Office of the Commissioner of Financial Institutions of Puerto Rico. Oriental Insurance is subject to the supervision, examination and regulation of the Office of the Commissioner of Insurance of Puerto Rico.
Change of Fiscal Year
On August 30, 2005, the Group’s Board of Directors (the “Board”) approved an amendment to Section 1 of Article IX of the Group’s By-Laws to change its fiscal year to a calendar year. The Group’s fiscal year was from July 1 of each year to June 30 of the following year. The Group’s transition period was from July 1, 2005 to December 31, 2005.
Significant Accounting Policies
The unaudited consolidated financial statements of the Group are prepared in accordance with GAAP and with the general practices within the financial services industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of

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revenues and expenses during the reporting period. Actual results could differ from those estimates. The Group believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses based on losses that are estimated to occur. Loan losses are charged against the allowance when the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The Group follows a systematic methodology to establish and evaluate the adequacy of the allowance for loan losses. This methodology consists of several key elements. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
Larger commercial loans that exhibit potential or observed credit weaknesses are subject to individual review and grading. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Group.
Included in the review of individual loans are those that are impaired, as provided in the Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan.” A loan is considered impaired when, based on current information and events, it is probable that the Group will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, at the observable market price of the loan or the fair value of the collateral, if the loan is collateral dependent. Loans are individually evaluated for impairment, except large groups of small balance homogeneous loans that are collectively evaluated for impairment and loans that are recorded at fair value or at the lower of cost or market. The Group measures for impairment all commercial loans over $250,000. The portfolios of mortgage and consumer loans are considered homogeneous, and are evaluated collectively for impairment.
For loans that are not individually graded, the Group uses a methodology that follows a loan credit risk rating process that involves dividing loans into risk categories. The following are the credit risk categories: pass, special mention, substandard, doubtful and loss.
The Group, using an aged-based rating system, applies an overall allowance percentage to each loan portfolio category based on historical credit losses adjusted for current conditions and trends. This delinquency-based calculation is the starting point for management’s determination of the required level of the allowance for loan losses. Other data considered in this determination includes: the overall historical loss trends and other information including underwriting standards and economic trends.
Loan loss ratios and credit risk categories are updated quarterly and are applied in the context of GAAP and the importance of depository institutions having prudent, conservative, but not excessive loan allowances that fall within an acceptable range of estimated losses. While management uses available information in estimating possible loan losses, future changes to the allowance may be necessary based on factors beyond the Group’s control, such as factors affecting general economic conditions.
Financial Instruments
Certain financial instruments including derivatives, hedged items, trading securities and investment securities available-for-sale are recorded at fair value and unrealized gains and losses are recorded in other comprehensive income or other gains and losses as appropriate. Fair values are based on listed market prices, if available. If listed market prices are not available, fair value is determined based on other relevant factors, including price quotations for similar instruments. The fair values of certain derivative contracts are derived from pricing models that consider current market and contractual prices for the underlying financial instruments as well as time value and yield curve or volatility factors underlying the positions.
Impairment of Investment Securities
The Group evaluates its securities available-for-sale and held-to-maturity for impairment. An impairment charge in the consolidated statements of income is recognized when the decline in the fair value of investments below their cost basis is judged to be other-than-temporary. The Group considers various factors in determining whether it should recognize an impairment charge, including, but not limited to the length of time and extent to which the fair value has been less than its cost basis, and the Group’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. For debt securities, the Group also considers, among other factors, the investors repayment ability on its debt obligations and its cash and capital generation ability.

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Income Taxes
In preparing the consolidated financial statements, the Group is required to estimate income taxes. This involves an estimate of current income tax expense together with an assessment of temporary differences resulting from differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The determination of current income tax expense involves estimates and assumptions that require the Group to assume certain positions based on its interpretation of current tax laws and regulations. Changes in assumptions affecting estimates may be required in the future and estimated tax assets or liabilities may need to be increased or decreased accordingly. The accrual for tax contingencies is adjusted in light of changing facts and circumstances, such as the progress of tax audits, case law and emerging legislation. The Group’s effective tax rate includes the impact of tax contingency accruals and changes to such accruals, including related interest and surcharges, as considered appropriate by management. When particular matters arise, a number of years may elapse before such matters are audited and finally resolved. Favorable resolution of such matters could be recognized as a reduction to the Group’s effective rate in the year of resolution. Unfavorable settlement of any particular issue could increase the effective rate and may require the use of cash in the year of resolution.
The Group maintained an effective tax rate lower than the maximum marginal statutory rate of 43.5% as of June 30, 2006, mainly due to the interest income arising from investments exempt from Puerto Rico income taxes, net of expenses attributable to the exempt income. Exempt interest relates mostly to interest earned on obligations of the United States and Puerto Rico governments and certain mortgage-backed securities, including securities held by the Bank’s international banking entities.
The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of the Group’s net deferred tax assets assumes that the Group will be able to generate sufficient future taxable income based on estimates and assumptions. If these estimates and related assumptions change in the future, the Group may be required to record valuation allowances against its deferred tax assets resulting in additional income tax expense in the consolidated statements of income.
Management evaluates the realizability of the deferred tax assets on a regular basis and assesses the need for a valuation allowance. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Changes in valuation allowance from period to period are included in the Group’s tax provision in the period of change. As of June 30, 2006, a valuation allowance of approximately $2.0 million was recorded to offset deferred tax assets from loss carry forwards that the Group considers it will not be realized in future periods.
Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the projections of future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Group will realize the benefits of these deductible differences, net of the existing valuation allowances at June 30, 2006. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carry forward period are reduced.
On August 1, 2005 the Puerto Rico Legislature approved Act No. 41 that imposes an additional tax of 2.5% on taxable income exceeding $20,000. The law is effective for tax years beginning after December 31, 2004 and ending on or before December 31, 2006. This additional tax imposition did not have a material effect on the Group’s consolidated operational results for the six-month period ended June 30, 2006 due to the tax exempt composition of the Group’s investments.
On May 13, 2006, the Puerto Rico Governor signed into law Act No. 89 to (i) increase the recapture tax that is imposed on corporations and partnerships generating taxable income in excess of $500,000 with the purpose of increasing the maximum marginal corporate income tax rate for these entities from 39% to 41.5%, and (ii) to impose an additional tax of 2% on the taxable income of banking corporations covered under the Puerto Rico the Group’s investments.
On May 16, 2006, the Puerto Rico Governor also signed into law Act No. 98 to impose a one-time 5% extraordinary tax that is imposed on an amount equal to the net taxable income of non-exempt corporations and partnerships for the last taxable year ended on or before December 31, 2005. On July 31, 2006 Act No. 137 was signed into law to amend various provisions of Act No. 98. The payment of this extraordinary tax constitutes, in effect, a prepayment, as the taxpayer will be allowed to credit the amount so paid against its Puerto Rico income tax liability for taxable years beginning after July 31, 2006 provided the credit claimed in any taxable year does not exceed 25% of the extraordinary tax paid. Since no member of the Group generated taxable income for the year 2005, this additional tax imposition will not apply and, therefore, it will not affect on the Group’s consolidated operational results.
Stock Option Plans
At June 30, 2006, the Group had three stock-based employee compensation plans: the 1996, 1998, and 2000 Incentive Stock Option Plans. These plans offer key officers, directors and employees an opportunity to purchase shares of the Group’s common stock. The Compensation Committee of the Board of Directors has sole authority and absolute discretion as to the number of stock options to be granted to any officer, director or employee, their vesting rights, and the options’ exercise

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prices. The plans provide for a proportionate adjustment in the exercise price and the number of shares that can be purchased in case of merger, consolidation, combination, exchange of shares, other reorganization, recapitalization, reclassification, stock dividend, stock split or reverse stock split in which the number of shares of common stock of the Group as a whole are increased, decreased, changed into or exchanged for a different number or kind of shares or securities. Stock options vest upon completion of specified years of service.
Up to June 30, 2005, the Group accounted for its stock compensation award plans under the recognition and measurement principles of the Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations. Compensation expense for option awards with traditional terms was generally recognized for any excess of the quoted market price of the Group’s stock at measurement date over the amount an employee must pay to acquire the stock. No stock-based employee compensation cost was reflected for the awards with traditional terms as the options had an exercise price equal to the market value of the underlying common stock on the date of grant. The Financial Accounting Standards Board (“FASB”) Interpretation No. 28 “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (“FIN 28”) an interpretation of APB 25 clarifies aspects of accounting for compensation related to stock appreciation rights and other variable stock option or award plans. With regards to stock option awards with anti-dilution provisions, where the terms are such that the number of shares that the employee is entitled to receive and the purchase price depends on events occurring after the date of the grant, compensation is measured at the end of each period as the amount by which the quoted market value of the shares of the enterprise’s stock covered by a grant exceeds the option price and is accrued as a charge to expense over the periods the employee performs the related services. Changes in the quoted market value are reflected as an adjustment of accrued compensation and compensation expense in the periods in which the changes occur.
On June 30, 2005, the Compensation Committee of the Group’s Board of Directors approved the acceleration of the vesting of all outstanding options to purchase shares of common stock of the Group that were held by employees, officers and directors as of that date. As a result, options to purchase 1,219,333 shares became exercisable. The purpose of the accelerated vesting was to enable the Group to avoid recognizing in its income statement compensation expense associated with these options in future periods, upon adoption of FASB Statement No. 123(R).
Effective July 1, 2005, the Group adopted SFAS No. 123R “Share-Based Payment” (“SFAS 123R”), an amendment of SFAS 123 “Accounting for Stock-Based Compensation” using the modified prospective transition method. SFAS 123R requires measurement of the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award with the cost to be recognized over the service period. SFAS 123R is effective for financial statements as of the beginning of the first interim or annual reporting period of the first fiscal year that began after June 15, 2005. SFAS No. 123R applies to all awards unvested and granted after this effective date and awards modified, repurchased, or cancelled after that date.
The Group recorded approximately $16,000 during the six-month period ended June 30, 2006 related to compensation expense for options issued subsequent to the adoption of SFAS 123R. The remaining unrecognized compensation cost related to unvested awards as of June 30, 2006, was approximately $249,000 and the weighted average period of time over which this cost will be recognized is approximately 7 years.
Had the estimated fair value of the options granted been included in compensation expense for the period indicated below, the Group’s net earnings and earnings per share would have been as follows:

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            Six-month  
    Quarter Ended     Period Ended  
    June 30, 2005     June 30, 2005  
(In thousands, except for per share data)
               
Net income, as reported
  $ 10,605     $ 26,978  
Deduct: Shared-based compensation reduction included in reported earnings
    (2,964 )     (6,287 )
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards
    (303 )     (716 )
 
           
Pro forma net income
    7,338       19,975  
Less: Dividends on preferred stock
    (1,202 )     (2,401 )
 
           
Pro forma income available to common shareholders
  $ 6,136     $ 17,574  
 
           
 
               
Earnings per share:
               
Basic — as reported
  $ 0.38     $ 1.00  
 
           
Basic — pro forma
  $ 0.25     $ 0.72  
 
           
 
               
Diluted — as reported
  $ 0.37     $ 0.96  
 
           
Diluted — pro forma
  $ 0.24     $ 0.68  
 
           
 
               
Average common shares outstanding
    24,847       24,571  
Average potential common share-options
    601       1,104  
 
           
 
    25,448       25,675  
 
           
The average fair value of each option granted during the six-month period ended June 30, 2006 and 2005 was $4.05 and $15.32, respectively. The average fair value of each option granted was estimated at the date of the grant using the Black-Scholes option pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Group’s employee options. Use of an option valuation model, as required by GAAP, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant.
The following assumptions were used in estimating the fair value of the options granted:
                 
    Six-month period ended
    June 30,
    2006   2005
Weighted Average Assumptions:
               
Dividend yield
    3.87 %     3.71 %
Expected volatility
    34.26 %     42.33 %
Risk-free interest rate
    4.19 %     3.92 %
Expected life (in years)
    8.5       7  
The expected term of share options granted represents the period of time that share options granted are expected to be outstanding. Expected volatilities are based on historical volatility of the Group’s shares over the most recent period equal to the expected term of the share option.

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NOTE 2 — INVESTMENT SECURITIES:
The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the investment securities as of June 30, 2006 and December 31, 2005, were as follows:
                                         
    June 30, 2006 (In thousands)  
            Gross     Gross             Weighted  
    Amortized     Unrealized     Unrealized     Fair     Average  
    Cost     Gains     Losses     Value     Yield  
     
Available-for-sale
                                       
 
                                       
US Treasury securities
  $ 199,746     $     $ 9,144     $ 190,602       3.64 %
Puerto Rico Government and agency obligations
    28,396       76       1,355       27,117       5.59 %
Corporate bonds and other
    112,383             3,112       109,271       4.51 %
 
                               
Total investment securities
    340,525       76       13,611       326,990          
 
                               
 
                                       
FNMA and FHLMC certificates
    567,958             22,054       545,904       4.71 %
GNMA certificates
    48,587       281       543       48,325       5.58 %
Collateralized mortgage obligations (CMO’s)
    288,837       6       9,818       279,025       5.11 %
 
                               
Total mortgage-backed-securities and CMO’s
    905,382       287       32,415       873,254          
 
                               
 
                                       
Total securities available-for-sale
  $ 1,245,907     $ 363     $ 46,026     $ 1,200,244       4.67 %
 
                             
 
                                       
Held-to-maturity
                                       
 
                                       
US Treasury securities
    40,059             375       39,684       2.52 %
Obligations of U.S. government sponsored entities
    1,028,246             37,261       990,985       3.74 %
Puerto Rico Government and agency obligations
    55,284             5,886       49,398       5.29 %
 
                               
Total investment securities
    1,123,589             43,522       1,080,067          
 
                               
 
                                       
FNMA and FHLMC certificates
    763,141             29,956       733,185       5.03 %
GNMA certificates
    198,057             6,690       191,367       5.33 %
Collateralized mortgage obligations
    158,432             4,281       154,151       5.13 %
 
                               
Total mortgage-backed-securities and CMO’s
    1,119,630             40,927       1,078,703          
 
                               
 
                                       
Total securities held-to-maturity
    2,243,219             84,449       2,158,770       5.03 %
 
                             
 
                                       
Total
  $ 3,489,126     $ 363     $ 130,475     $ 3,359,014       4.85 %
 
                             

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    December 31, 2005 (In thousands)  
            Gross     Gross             Weighted  
    Amortized     Unrealized     Unrealized     Fair     Average  
    Cost     Gains     Losses     Value     Yield  
     
Available-for-sale
                                       
US Treasury securities
  $ 174,836     $     $ 5,599     $ 169,237       3.45 %
Puerto Rico Government and agency obligations
    28,356       183       340       28,199       5.29 %
Corporate bonds and other
    92,005             1,468       90,537       4.75 %
 
                               
Total investment securities
    295,197       183       7,407       287,973          
 
                               
 
FNMA and FHLMC certificates
    488,356             12,193       476,163       5.17 %
GNMA certificates
    36,799       630       129       37,300       5.83 %
Collateralized mortgage obligations (CMO’s)
    249,297       552       4,401       245,448       5.47 %
 
                               
Total mortgage-backed-securities and CMO’s
    774,452       1,182       16,723       758,911          
 
                               
Total securities available-for-sale
    1,069,649       1,365       24,130       1,046,884       4.95 %
 
                             
 
Held-to-maturity
                                       
US Treasury securities
    60,168             818       59,350       2.84 %
Obligations of US Government sponsored agencies
    1,021,634       77       19,661       1,002,050       4.09 %
Puerto Rico Government and agency obligations
    62,084             2,987       59,097       5.32 %
 
                               
Total investment securities
    1,143,886       77       23,466       1,120,497          
 
                               
 
FNMA and FHLMC certificates
    822,870       1,238       10,389       813,719       5.05 %
GNMA certificates
    216,237       1,371       1,196       216,412       5.52 %
Collateralized mortgage obligations
    163,262       129       1,187       162,204       5.42 %
 
                               
Total mortgage-backed-securities and CMO’s
    1,202,369       2,738       12,772       1,192,335          
 
                               
Total securities held-to-maturity
    2,346,255       2,815       36,238       2,312,832       4.65 %
 
                             
 
Total
  $ 3,415,904     $ 4,180     $ 60,368     $ 3,359,716       4.75 %
 
                             
The amortized cost and fair value of the Group’s investment securities available-for-sale and held-to-maturity at June 30, 2006, by contractual maturity, are shown in the next table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
                                 
    (In thousands)
    Available-for-sale   Held-to-maturity
    Amortized Cost   Fair Value   Amortized Cost   Fair Value
         
Investment securities
                               
Due within one year
  $ 5,000     $ 4,975     $ 274,860     $ 272,055  
Due after 1 to 5 years
    295,202       283,026       412,359       398,674  
Due after 5 to 10 years
    1,890       1,835       281,241       264,817  
Due after 10 years
    38,433       37,154       155,129       144,521  
         
 
    340,525       326,990       1,123,589       1,080,067  
         
Mortgage-backed securities
                               
Due within one year
    228       228              
Due after 1 to 5 years
    10,242       10,262              
Due after 5 to 10 years
    3,327       3,163              
Due after 10 years
    891,585       859,601       1,119,630       1,078,703  
         
 
    905,382       873,254       1,119,630       1,078,703  
         
 
  $ 1,245,907     $ 1,200,244     $ 2,243,219     $ 2,158,770  
         
Proceeds from the sale of investment securities available-for-sale during the six-month period ended June 30, 2006 totaled approximately $57,130,000 (2005 — approximately $449,622,000). Gross realized gains on those sales during the six-month period ended June 30, 2006 were approximately $19,000 (2005 — gains of approximately $4.6 million and losses of approximately $500,000).
The following table shows the Group’s gross unrealized losses and fair value of investment securities available-for-sale and held-to-maturity, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2006.

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Available-for-sale
 
(In thousands)
                         
    Less than 12 months
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
  $ 24,895     $ (131 )   $ 24,764  
Puerto Rico Government and agency obligations
    18,696       (853 )     17,843  
Corporate bonds and other
    92,135       (3,040 )     89,095  
Mortgage-backed securities and CMO’s
    364,510       (5,695 )     358,815  
 
 
    500,236       (9,719 )     490,517  
 
                         
    12 months or more
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
    174,852       (9,013 )     165,839  
Puerto Rico Government and agency obligations
    4,207       (502 )     3,705  
Corporate bonds and other
    91       (72 )     19  
Mortgage-backed securities and CMO’s
    524,814       (26,720 )     498,094  
 
 
    703,964       (36,307 )     667,657  
 
                         
    Total
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
    199,747       (9,144 )     190,603  
Puerto Rico Government and agency obligations
    22,903       (1,355 )     21,548  
Corporate bonds and other
    92,226       (3,112 )     89,114  
Mortgage-backed securities and CMO’s
    889,324       (32,415 )     856,909  
 
 
  $ 1,204,200     $ (46,026 )   $ 1,158,174  
 
Held-to-maturity
 
(In thousands)
                         
    Less than 12 months
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
  $ 331,086     $ (12,441 )   $ 318,645  
Puerto Rico Government and agency obligations
    9,966       (791 )     9,175  
Mortgage-backed securities and CMO’s
    774,431       (23,321 )     751,110  
 
 
    1,115,483       (36,553 )     1,078,930  
 
                         
    12 months or more
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
    737,219       (25,195 )     712,024  
Puerto Rico Government and agency obligations
    45,318       (5,095 )     40,223  
Mortgage-backed securities and CMO’s
    345,199       (17,606 )     327,593  
 
 
    1,127,736       (47,896 )     1,079,840  
 
                         
    Total
    Amortized   Unrealized   Fair
    Cost   Loss   Value
US Treasury securities
    1,068,305       (37,636 )     1,030,669  
Puerto Rico Government and agency obligations
    55,284       (5,886 )     49,398  
Mortgage-backed securities and CMO’s
    1,119,630       (40,927 )     1,078,703  
 
 
  $ 2,243,219     $ (84,449 )   $ 2,158,770  
 
Securities in an unrealized loss position at June 30, 2006 are mainly composed of securities issued or backed by U.S. government agencies. The vast majority of them are rated the equivalent of AAA by nationally recognized rating organizations. The investment portfolio is structured primarily with highly liquid securities, which have a large and efficient secondary market. Valuations are performed on a monthly basis using a third party provider and dealer quotes. Management believes that the unrealized losses in the investment portfolio at June 30, 2006 are mainly related to market interest rate fluctuations and not to deterioration in the creditworthiness of the issuers. The Group is a well capitalized financial institution, which has the ability to hold the investment securities with unrealized losses until maturity or until the unrealized losses are recovered, and expects to continue its pattern of holding the securities until the forecasted recovery of fair value.

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NOTE 3 — LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES:
Loans Receivable
The Group’s credit activities are mainly with customers located in Puerto Rico. The Group’s loan transactions are encompassed within three main categories: mortgage, commercial and consumer. The composition of the Group’s loan portfolio at June 30, 2006, and December 31, 2005, was as follows:
                 
    (In thousands)  
    June 30, 2006     December 31, 2005  
     
 
               
Residential mortgage loans
  $ 848,473     $ 599,163  
Home equity loans and secured personal loans
    39,147       41,034  
Commercial loans, mainly secured by real estate
    228,008       228,163  
Consumer
    39,074       35,482  
 
           
Loans receivable, gross
    1,154,702       903,842  
Less: deferred loan fees, net
    (2,827 )     (2,850 )
 
           
Loans receivable
    1,151,875       900,992  
Allowance for loan losses
    (7,501 )     (6,630 )
 
           
Loans receivable, net
    1,144,374       894,362  
Mortgage loans held-for-sale
    9,564       8,946  
     
Total loans, net
  $ 1,153,938     $ 903,308  
     
Allowance for Loan Losses
The Group maintains an allowance for loan losses at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent risks. The Group’s allowance for loan losses policy provides for a detailed quarterly analysis of probable losses. The analysis includes a review of historical loan loss experience, value of underlying collateral, current economic conditions, financial condition of borrowers and other pertinent factors.
While management uses available information in estimating probable loan losses, future additions to the allowance may be required based on factors beyond the Group’s control. Refer to Table 4 of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the changes in the allowance for loan losses for the quarters and six-month periods ended June 30, 2006 and December 31, 2005.
The Group evaluates all loans, some individually and other as homogeneous groups, for purposes of determining impairment. At June 30, 2006 and December 31, 2005, the total investment in impaired loans was $1.8 million and $3.6 million, respectively. The impaired loans were measured based on the fair value of collateral. The Group determined that no specific impairment allowance was required for such loans.

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NOTE 4 — PLEDGED ASSETS
At June 30, 2006, residential mortgage loans amounting to $349,712,000 and investment securities with fair values amounting to $15,663,000 were pledged to secure advances and borrowings from the FHLB. Investment securities with fair values totaling $2,902,985,000, $135,282,000 and $15,860,000 at June 30, 2006, were pledged to secure securities sold under agreements to repurchase, public fund deposits, and term notes, respectively. Also, investment securities with fair value totaling $803,000 at June 30, 2006, were pledged to the Puerto Rico Treasury Department.
As of June 30, 2006, investment securities available-for-sale and held-to-maturity not pledged amounted to $143,215,000 and $71,435,000 respectively. As of June 30, 2006, mortgage loans not pledged amounted to $547,471,000.
NOTE 5 — OTHER ASSETS
Other assets at June 30, 2006 and December 31, 2005 include the following:
                 
    (In thousands)  
    June 30, 2006     December 31, 2005  
 
               
Investment in equity options
  $ 25,999     $ 22,054  
Derivative asset
    20,347       2,509  
Deferred charges
    2,814       3,213  
Prepaid expenses
    2,763       2,698  
Investment in Statutory Trusts
    2,169       2,169  
Goodwill
    2,006       2,006  
Investment in limited partnership
    10,814       11,085  
Accounts receivable and other assets, net
    10,132       2,423  
 
           
 
  $ 77,044     $ 48,157  
 
           
NOTE 6 — SUBORDINATED CAPITAL NOTES
Subordinated capital notes amounted to $72,166,000 at June 30, 2006 and December 31, 2005.
In October 2001 and August 2003, the Statutory Trust I and the Statutory Trust II, respectively, special purpose entities of the Group, were formed for the purpose of issuing trust redeemable preferred securities. In December 2001 and September 2003, $35.0 million of trust redeemable preferred securities were issued each by the Statutory Trust I and the Statutory Trust II, as part of pooled underwriting transactions. Pooled underwriting involves participating with other bank holding companies in issuing the securities through a special purpose pooling vehicle created by the underwriters.
The proceeds from these issuances were used by the Statutory Trust I and the Statutory Trust II to purchase a like amount of floating rate junior subordinated deferrable interest debentures (“subordinated capital notes”) issued by the Group. The first of these subordinated capital notes has a par value of $36.1 million, bears interest based on 3 month LIBOR plus 360 basis points (9.00% at June 30, 2006; 8.10% at December 31, 2005), provided, however, that prior to December 18, 2006, this interest rate shall not exceed 12.5%, payable quarterly, and matures on December 23, 2031. The second one, has a par value of $36.1 million, bears interest based on 3 month LIBOR plus 295 basis points (8.35% at June 30, 2006; December 31, 2005 — 7.45%), payable quarterly, and matures on September 17, 2033. Both subordinated capital notes may be called at par after five years (Statutory Trust I — December 2006; Statutory Trust II — September 2008). The trust redeemable preferred securities have the same maturity and call provisions as the subordinated capital notes. The subordinated deferrable interest debentures issued by the Group are accounted for as a liability denominated as subordinated capital notes on the unaudited consolidated statements of financial condition.
The subordinated capital notes are treated as Tier 1 capital for regulatory purposes. On March 4, 2005, the Federal Reserve Board issued a final rule that continues to allow trust preferred securities to be included in Tier I regulatory capital, subject to stricter quantitative and qualitative limits. Under this rule, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability.
NOTE 7 — OTHER BORROWINGS
At June 30, 2006, securities underlying agreements to repurchase were delivered to, and are being held by, the counterparties with whom the repurchase agreements were transacted. The counterparties have agreed to resell to the Group the same or similar securities at the maturity of the agreements.
Securities sold under agreements to repurchase at June 30, 2006 mature as follows:

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    (In thousands)  
    Balance  
 
       
Due within 30 days
  $ 1,391,111  
Due after 30 to 90 days
    1,365,109  
Due after 90 to 120 days
    100,141  
 
     
 
  $ 2,856,361  
 
     
At June 30, 2006, the contractual maturities of advances from the FHLB and term notes by year are as follows:
                 
    (In thousands)  
June 30,   Advances from FHLB     Term Notes  
 
               
2007
  $ 210,500     $  
2008
    25,000       15,000  
2009
    50,000        
 
           
 
  $ 285,500     $ 15,000  
 
           
NOTE 8 — DERIVATIVES ACTIVITIES
The Group utilizes various derivative instruments for hedging purposes as part of its asset and liability management. These transactions involve both credit and market risks. The notional amounts are amounts on which calculations, payments, and the value of the derivatives are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received or paid, if any. The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties. The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.
The Group generally uses interest rate swaps and options in managing its interest rate risk exposure. Certain swaps were entered into to convert the forecasted rollover of short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating thirty or ninety-day payment based on LIBOR. Floating rate payments received from the swap counterparties partially offset the interest payments to be made on the forecasted rollover of short-term borrowings.
In August 2004, the Group entered into a $35.0 million notional amount interest rate swap to fix the cost of the subordinated capital notes of the Statutory Trust I. This swap was fixed at a rate of 2.98% and matures on December 18, 2006.
The Group’s swaps, including those not designated as a hedge, and their maturity terms at June 30, 2006 and December 31, 2005 are set forth in the table below:
                 
    (Dollars in thousands)
    June 30,   December 31,
    2006   2005
 
               
Swaps:
               
Pay fixed swaps notional amount
  $ 1,350,000     $ 1,275,000  
Weighted average pay rate — fixed
    4.48 %     3.90 %
Weighted average receive rate — floating
    5.24 %     4.39 %
Maturity in months
    3 to 54       1 to 60  
Floating rate as a percent of LIBOR
    100 %     100 %
The Group offers its customers certificates of deposit with an option tied to the performance of the Standard & Poor’s 500 stock market index. At the end of five years depositors receive a return equal to the greater of 15% of the principal in the account or 125% of the average increase in the month-end value of the index. The Group uses option agreements with major broker-dealer companies to manage its exposure to changes in this index. Under the terms of the option agreements, the Group receives the average increase in the month-end value of the index in exchange for a fixed premium. The changes in fair value of the option agreements used to manage the exposure in the stock market in the certificates of deposit are recorded in earnings in accordance with SFAS No. 133, as amended.
Derivative instruments are generally negotiated over-the-counter (“OTC”) contracts. Negotiated OTC derivatives are generally entered into between two counterparties that negotiate specific contractual terms, including the underlying instrument, amount, exercise price and maturity.

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Derivatives designated as a hedge consist of interest rate swaps primarily used to hedge securities sold under agreements to repurchase with notional amounts of $1.315 billion and $1.240 billion as of June 30, 2006 and December 31, 2005, respectively. Derivatives not designated as a hedge consist of purchased options used to manage the exposure to the stock market on stock indexed deposits with notional amounts of $146,090,000 and $173,280,000 as of June 30, 2006 and December 31, 2005, respectively; embedded options on stock indexed deposits with notional amounts of $137,995,000 and $164,651,000 as of June 30, 2006 and December 31, 2005, respectively; and interest rate swaps with notional amounts of $35 million as of June 30, 2006 and December 31, 2005.
During the six-month periods ended June 30, 2006 and 2005, gains (losses) of $859,000 and ($4.7 million), respectively, were credited (charged) to earnings and reflected as “Derivatives Activities” in the unaudited consolidated statements of income. During the six-month periods ended June 30, 2006 and 2005, unrealized gains of $18.0 million and unrealized losses of $7.0 million, respectively, on derivatives designated as cash flow hedges were included in other comprehensive income (loss).
At June 30, 2006 and December 31, 2005, the fair value of derivatives was recognized as either assets or liabilities in the unaudited consolidated statements of financial condition as follows: the fair value of the interest rate swaps to fix the cost of the forecasted rollover of short-term borrowings represented an asset of $20.3 million and $2.5 million, as of June 30, 2006 and December 31, 2005, respectively, presented in other assets; the purchased options used to manage the exposure to the stock market on stock indexed deposits represented an asset of $26.0 million and $22.1 million, respectively, also presented in other assets; the options sold to customers embedded in the certificates of deposit represented a liability of $24.6 million and $21.1 million, respectively, recorded in deposits.
The Group’s Asset and Liability Management Committee (“ALCO”) decided in July 2006 to unwind interest rate swaps with an aggregate notional amount of $640 million, which had been designated as cash flow hedges and had maturity dates ranging from September 2010 to December 2010. Management concluded that it was beneficial to Oriental to lock-in the fair value of these swaps at approximately $11 million. The net gain of $11 million on this transaction will continue to be included in other comprehensive income, and will be reclassified into earnings during the originally remaining term of the swaps, starting in the September 2006 quarter and through December 2010, by reducing the interest expense on borrowings.
NOTE 9 — SEGMENT REPORTING:
The Group segregates its businesses into the following major reportable segments: Banking, Treasury, and Financial Services. Management established the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as the Group’s organization, nature of products, distribution channels and economic characteristics of the products were also considered in the determination of the reportable segments. The Group measures the performance of these reportable segments based on pre-established goals of different financial parameters such as net income, net interest income, loan production and fees generated. During this quarter, Management decided to reclassify and present investment banking revenues in the Treasury segment rather than into the Financial Services segment. This reclassification was retroactively presented in the disclosure.
Banking includes the Bank’s branches and mortgage banking, with traditional banking products such as deposits and mortgage, commercial and consumer loans. Mortgage banking activities are carried out by the Bank’s mortgage banking division, whose principal activity is to originate mortgage loans for the Group’s own portfolio. From time to time, if conditions so warrant, the Group may sell loans directly into the secondary market or securitize conforming loans into mortgage-baked securities certificates. The Group outsourced the servicing of mortgages included in the resulting mortgage-backed securities pools, as well as loans maintained in portfolio.
The Treasury segment encompasses all of the Group’s assets and liability management activities such as: purchases and sales of investment securities, interest rate risk management, derivatives, and borrowings as well as investment banking revenues on public offerings and private placement of debt and equity securities.
Financial services is comprised of the Bank’s trust division (Oriental Trust), the brokerage subsidiary (Oriental Financial Services Corp.), the insurance agency subsidiary (Oriental Insurance, Inc.), and the pension plan administration subsidiary (Caribbean Pension Consultants, Inc.). The core operations of this segment are financial planning, money management and investment brokerage services, insurance sales, corporate and individual trust and retirement services, as well as pension plan administration services.
Intersegment sales and transfers, if any, are accounted for as if the sales or transfers were to third parties, that is, at current market prices. The accounting policies of the segments are the same followed by the Group, which are described in the “Summary of Significant Accounting Policies” included in the Group’s Form 10-K. Following are the results of operations and the selected financial information by operating segment for the quarters and six-month periods ended June 30, 2006 and 2005:

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Unaudited — quarters ended June 30, (Dollars in thousands)
 
                                                 
                    Financial   Total           Consolidated
    Banking   Treasury   Services   Segments   Eliminations   Total
June 30, 2006
                                               
Interest income
  $ 18,653     $ 38,191     $ 50     $ 56,894           $ 56,894  
Interest expense
    (6,831 )     (39,355 )           (46,186 )           (46,186 )
               
     
Net interest income
    11,822       (1,164 )     50       10,708             10,708  
Non-interest income
    4,111       112       3,298       7,521             7,521  
Non-interest expenses
    (12,082 )     (314 )     (2,388 )     (14,784 )           (14,784 )
Intersegment revenue
    576                   576       (576 )      
Intersegment expense
            (240 )     (336 )     (576 )     576        
Provision for loan losses
    (947 )                 (947 )           (947 )
               
Income before income taxes
  $ 3,480     $ (1,606 )   $ 624     $ 2,498     $     $ 2,498  
               
 
                                               
 
                                               
               
Total Assets as of June 30, 2006
  $ 1,583,909     $ 3,667,383     $ 12,265     $ 5,263,557     $ (430,895 )   $ 4,832,662  
               
 
                                               
June 30, 2005
                                               
Interest income
  $ 15,006     $ 33,857     $ 13     $ 48,876           $ 48,876  
Interest expense
    (5,386 )     (24,202 )           (29,588 )           (29,588 )
               
Net interest income
    9,620       9,655       13       19,288             19,288  
Non-interest income
    4,348       (430 )     2,519       6,437             6,437  
Non-interest expenses
    (10,163 )     (596 )     (3,134 )     (13,893 )           (13,893 )
Intersegment revenue
    1,193                   1,193       (1,193 )      
Intersegment expense
          (347 )     (846 )     (1,193 )     1,193        
Provision for loan losses
    (850 )                 (850 )           (850 )
               
Income before income taxes
  $ 4,148     $ 8,282     $ (1,448 )   $ 10,982     $     $ 10,982  
               
 
                                               
               
Total Assets as of June 30, 2005
  $ 973,296     $ 3,655,649     $ 9,582     $ 4,638,527     $ (391,662 )   $ 4,246,865  
               

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Unaudited — six-months period ended June 30, (Dollars in thousands)
 
                                                 
                    Financial   Total           Consolidated
    Banking   Treasury   Services   Segments   Eliminations   Total
June 30, 2006
                                               
Interest income
  $ 35,253     $ 77,547     $ 86     $ 112,886           $ 112,886  
Interest expense
    (12,833 )     (74,133 )           (86,966 )           (86,966 )
               
             
Net interest income
    22,420       3,414       86       25,920             25,920  
Non-interest income
    7,544       3,062       5,868       16,474             16,474  
Non-interest expenses
    (24,247 )     (697 )     (4,723 )     (29,667 )           (29,667 )
Intersegment revenue
    1,189                   1,189       (1,189 )      
Intersegment expense
          (407 )     (782 )     (1,189 )     1,189        
Provision for loan losses
    (2,048 )                 (2,048 )           (2,048 )
               
             
Income before income taxes
  $ 4,858     $ 5,372     $ 449     $ 10,679     $     $ 10,679  
               
 
                                               
               
Total Assets as of June 30, 2006
  $ 1,583,909     $ 3,667,383     $ 12,265     $ 5,263,557     $ (430,895 )   $ 4,832,662  
               
 
                                               
June 30, 2005
                                               
Interest income
  $ 28,577     $ 67,833     $ 38     $ 96,448           $ 96,448  
Interest expense
    (10,471 )     (46,279 )           (56,750 )           (56,750 )
               
Net interest income
    18,106       21,554       38       39,698             39,698  
Non-interest income
    6,617       794       5,125       12,536             12,536  
Non-interest expenses
    (20,035 )     (1,128 )     (4,877 )     (26,040 )           (26,040 )
Intersegment revenue
    1,954                     1,954       (1,954 )      
Intersegment expense
            (541 )     (1,413 )     (1,954 )     1,954        
Provision for loan losses
    (1,510 )                   (1,510 )           (1,510 )
               
Income before income taxes
  $ 5,132     $ 20,679     $ (1,127 )   $ 24,684     $     $ 24,684  
               
 
                                               
               
Total Assets as of June 30, 2005
  $ 973,296     $ 3,655,649     $ 9,582     $ 4,638,527     $ (391,662 )   $ 4,246,865  
               
NOTE 10 — RECENT ACCOUNTING DEVELOPMENTS:
SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140”
In February 2006, FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” This statement amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS No. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155:
    Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation;
 
    Clarifies, which interest-only strips and principal-only strips are not subject to the requirements of Statement 133;
 
    Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation;
 
    Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives;
 
    Amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of SFAS 155 may also be applied upon adoption of this statement for hybrid financial instruments that had been bifurcated under paragraph 12 of SFAS No. 133 prior to the adoption of SFAS No. 155. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year.

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Provisions of this statement may be applied to instruments that an entity holds at the date of adoption on an instrument-by-instrument basis.
At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative-effect adjustment to beginning retained earnings. An entity should separately disclose the gross gains and losses that make up the cumulative-effect adjustment, determined on an instrument-by-instrument basis. Prior periods should not be restated.
The Group is evaluating the impact that this recently issued accounting pronouncement may have on its financial condition and results of operations.
SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment of FASB Statements No. 133 and 140”
In March 2006, FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets — an amendment to SFAS No. 140”, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” to (1) require the recognition of a servicing asset or servicing liability under specified circumstances, (2) require that, if practicable, all separately recognized servicing assets and liabilities be initially measured at fair value, (3) create a choice for subsequent measurement of each class of servicing assets or liabilities by applying either the amortization method or the fair value method, and (4) permit the one-time reclassification of securities identified as offsetting exposure to changes in fair value of servicing assets or liabilities from available-for-sale securities to trading securities under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. In addition, SFAS No. 156 amends SFAS No. 140 to require significantly greater disclosure concerning recognized servicing assets and liabilities. SFAS No. 156 is effective for all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006, with early adoption permitted.
The adoption of SFAS No. 156 is not expected to have a material effect on the Group’s consolidated financial position or results of operations.
FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes
During July 2006, the Financial Accounting Standards Board adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 was issued to clarify the requirements of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”, relating to the recognition of income tax benefits. FIN 48 provides a two-step approach to recognizing and measuring tax benefits when the benefits’ realization is uncertain. The first step is to determine whether the benefit is to be recognized; the second step is to determine the amount to be recognized:
    Income tax benefits should be recognized when, based on the technical merits of a tax position, the entity believes that if a dispute arose with the taxing authority and were taken to a court of last resort, it is more likely than not (i.e. a probability of greater than 50 percent) that the tax position would be sustained as filed.
 
    If a position is determined to be more likely-than not of being sustained, the reporting enterprise should recognize the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with the taxing authority.
FIN 48 is applicable to the Group beginning in the first quarter of 2007. The cumulative effect of applying the provisions of FIN 48 upon adoption must be reported as an adjustment to beginning retained earnings. Management is assessing the effect of the adoption of FIN 48 on the Group.
SFAS No. 157, “Fair Value Measurements”
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.
This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. Management is assessing the effect of the adoption of SFAS 157 on the Group.

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NOTE 11 — RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
Subsequent to the issuance of the Group’s June 30, 2005 consolidated financial statements, the Group’s management determined that the accounting treatment for certain mortgage-related transactions previously treated as purchases under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, and the treatment of certain employee stock option awards as fixed awards instead of variable awards did not conform to GAAP, as discussed below. As a result, the accompanying unaudited consolidated financial statements as of June 30, 2005 have been restated from the amounts previously reported to correct the accounting for these transactions. Refer to Note 2 to the consolidated financial statements for the transition period ended December 31, 2005, included in the Group’s Form 10-K.
A summary of the significant effects of the restatement as of June 30, 2005 is as follows:
                                 
    Quarter Ended June 30, 2005   Six-Month Period Ended June 30, 2005
    (Unaudited)   (Unaudited)
    As Previously           As Previously    
    Reported   As Restated   Reported   As Restated
 
                               
Non-interest expenses:
                               
Compensation and employees’ benefits
  $ 7,366     $ 4,402     $ 13,984     $ 7,697  
Total non-interest expenses
    16,857       13,893       32,327       26,040  
 
                               
Income before income taxes
    8,018       10,982       18,397       24,684  
Net income
  $ 7,641     $ 10,605     $ 20,691     $ 26,978  
 
                               
Income per common share:
                               
Basic
  $ 0.26     $ 0.38     $ 0.74     $ 1.00  
Diluted
  $ 0.26     $ 0.37     $ 0.72     $ 0.96  

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SELECTED FINANCIAL DATA
FOR THE QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(dollars in thousands)
                                                 
    Quarter Ended June 30,     Six-Month Period Ended June 30,  
    2006     2005     Variance %     2006     2005     Variance %  
 
                                               
Interest income
  $ 56,894     $ 48,876       16.4 %   $ 112,886     $ 96,448       17.0 %
Interest expense
    46,186       29,588       56.1 %     86,966       56,750       53.2 %
 
                                   
Net interest income
    10,708       19,288       -44.5 %     25,920       39,698       -34.7 %
Provision for loan losses
    947       850       11.4 %     2,048       1,510       35.6 %
 
                                   
Net interest income after provision for loan losses
    9,761       18,438       -47.1 %     23,872       38,188       -37.5 %
Non-interest income
    7,521       6,437       16.8 %     16,474       12,536       31.4 %
Non-interest expenses
    14,784       13,893       6.4 %     29,667       26,040       13.9 %
 
                                   
Income before taxes
    2,498       10,982       -77.3 %     10,679       24,684       -56.7 %
Income tax (benefit) expense
    (21 )     377       -105.6 %     110       (2,294 )     -104.8 %
 
                                   
Net income
    2,519       10,605       76.2 %     10,569       26,978       -60.8 %
Less: Dividends on preferred stock
    (1,201 )     (1,202 )     -0.1 %     (2,401 )     (2,401 )     0.0 %
 
                                   
Net income available to common shareholders
  $ 1,318     $ 9,403       -86.0 %   $ 8,168     $ 24,577       -66.8 %
 
                                   
 
                                               
Per share data:
                                               
Basic
  $ 0.05     $ 0.38       -86.8 %   $ 0.33     $ 1.00       -67.0 %
 
                                   
Diluted
  $ 0.05     $ 0.37       -86.5 %   $ 0.33     $ 0.96       -65.6 %
 
                                   
 
                                               
Average common shares outstanding
    24,599       24,847       -1.0 %     24,608       24,571       0.2 %
Average potential common share-options
    106       601       82.4 %     128       1,104       -88.4 %
 
                                   
Average shares and shares equivalents
    24,705       25,448       -2.9 %     24,736       25,675       -3.7 %
 
                                   
 
                                               
Selected Financial Ratios:
                                               
Return on average assets (ROA)
    0.22 %     1.01 %             0.92 %     1.29 %        
 
                                       
Return on average equity (ROE)
    1.94 %     13.86 %             7.93 %     18.22 %        
 
                                       
Efficiency ratio
    78.76 %     53.58 %             71.39 %     49.52 %        
 
                                       
Expense ratio
    0.60 %     0.71 %             0.63 %     0.65 %        
 
                                       
Interest rate spread
    0.70 %     1.68 %             0.89 %     1.75 %        
 
                                       
Interest rate margin
    0.96 %     1.89 %             1.16 %     1.95 %        
 
                                       
Number of financial centers
                            24       23          
 
                                           
PERIOD END BALANCES AND CAPITAL RATIOS:
                         
    June 30,     December 31,        
    2006     2005     Variance %  
 
                       
Investments and loans
                       
Investment securities
  $ 3,497,822     $ 3,476,767       0.6 %
Loans and leases (including loans held-for-sale), net
    1,153,938       903,308       27.7 %
Securities sold but not yet delivered
    710       44,009       -98.4 %
 
                 
 
  $ 4,652,470     $ 4,424,084       5.2 %
 
                 
 
                       
Deposits and Borrowings
                       
Deposits
  $ 1,213,847     $ 1,298,568       -6.5 %
Repurchase agreements
    2,856,361       2,427,880       17.6 %
Other borrowings
    389,764       404,921       -3.7 %
Securities purchased but not yet received
    6,539       43,354       -84.9 %
 
                 
 
  $ 4,466,511     $ 4,174,723       7.0 %
 
                 
 
                       
Stockholders’ equity
                       
Preferred equity
  $ 68,000     $ 68,000       0.0 %
Common equity
    272,283       273,791       -0.6 %
 
                 
 
  $ 340,283     $ 341,791       -0.4 %
 
                 
Capital ratios
                       
Leverage capital
    9.39 %     10.13 %     -7.3 %
 
                 
Tier 1 risk-based capital
    29.60 %     34.70 %     -14.7 %
 
                 
Total risk-based capital
    30.11 %     35.22 %     -14.5 %
 
                 
Common shares outstanding
    24,562       24,580       -0.1 %
 
                 
 
                       
Trust assets managed
  $ 1,933,912     $ 1,875,300       3.1 %
Broker-dealer assets gathered
    1,172,726       1,132,286       3.6 %
 
                 
Assets managed
    3,106,638       3,007,586       3.3 %
Assets owned
    4,832,662       4,546,949       6.3 %
 
                 
Total financial assets managed and owned
  $ 7,939,300     $ 7,554,535       5.1 %
 
                 
OVERVIEW OF FINANCIAL PERFORMANCE
Introduction
The Group’s diversified mix of businesses and products generates both the interest income traditionally associated with a banking institution and non-interest income traditionally associated with a financial services institution (generated by such businesses as securities brokerage, fiduciary services, investment banking, insurance and pension administration). Although all of these businesses, to varying degrees, are affected by interest rate and financial markets fluctuations and other external factors, the Group’s commitment is to produce a balanced and growing revenue stream.

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During the quarter and six-month period ended June 30, 2006, the Group continued to implement the Oriental Way program to deliver world-class products and services, targeting the personal and commercial needs of Puerto Rico’s mid net-worth individuals, professionals and owners of small and mid-sized businesses. The results of these efforts included continued growth in commercial loans and tight control over non-interest expenses.
Change of Fiscal Year
On August 30, 2005, the Group’s Board of Directors approved an amendment to Section 1 of Article IX of the Group’s By-Laws to change its fiscal year to a calendar year. The Group’s fiscal year was from July 1 of each year to June 30 of the following year. The Group’s transition period was from July 1, 2005 to December 31, 2005.
Net Income
For the quarter and six-month period ended June 30, 2006, the Group’s net income available to common shareholders totaled $1.3 million and $8.2 million, respectively, compared to $9.4 million and $24.6 million in the comparable year ago periods. Earnings per common share fully diluted was $0.05 compared to $0.37 in the year-ago quarter and $0.33 compared to $0.96 in the year ago six-month period. As a result of the Group’s previously disclosed restatement, the year ago quarter and six-month period included a $3.0 million and $6.3 million reduction, respectively, in non-cash compensation expense. These reductions increased income available to common shareholders by $0.12 and $0.25 per common share fully diluted in the quarter and six-month period, respectively.
Return on Assets and Common Equity
Return on common equity (ROE) and return on assets (ROA) for the quarter and six-month period ended June 30, 2006 were 1.94%, 0.22%, 7.93% and 0.92%, respectively, which represent decreases of 86.0% and 56.5% in ROE from 13.86% and 18.22% for the quarter and six-month period ended June 30, 2005, and a decrease of 78.2% and 28.7% in ROA from 1.01% and 1.29% for the quarter and six-month period ended June 30, 2005, mainly due to reduced net income available to common shareholders.
Net Interest Income after Provision for Loan Losses
Net interest income after provision for loan losses decreased 47.1% and 37.5% for the quarter and six-month period ended June 30, 2006, totaling $9.8 million and $23.9 million, compared with $18.4 million and $38.2 million for the same periods in the previous year. Increases of 16.4% and 17.0% in interest income for the quarter and six-month period ended June 30, 2006 as compared to same periods last year was mainly due to higher loan volume, and higher average yields on both investment securities and loans. These increases were more than offset by higher interest rates and increased volume on borrowings. Net interest margin for the June 30, 2006 quarter and six-month period was 0.96% and 1.16%, respectively compared to 1.89% and 1.95% for the quarter and six-month period. Investment yields increased despite the Group’s continued repositioning of its portfolio, shifting into short-term government securities and away from long-term, mortgage-backed securities. Interest income from commercial and consumer loans also increased on both increased volume and yields.
Non-Interest Income
Total non-interest income was $7.5 million and $16.5 million, an increase of 16.8% and 31.4% over the June 2005 quarter and six-month period, respectively. Financial service revenues totaled $4.1 million and $7.3 million compared to $3.2 million and $6.4 million in the year ago quarter and six-month period, respectively, while banking service revenues totaled $2.5 million and $4.7 million versus $2.1 million and $3.9 million in the June 2005 quarter and six-month period then ended, respectively. Investment banking revenues totaled $0.9 million and $2.6 million, versus $0.2 million and $0.3 million in the June 2005 quarter and six-month period, respectively. Mortgage banking activities totaled $0.6 million and $1.1 million, versus $1.2 million and $2.2 million in the June 2005 quarter and six-month period then ended, respectively. Combined (losses) gains from net (loss) gain on sale of securities, derivatives and other totaled ($0.5 million) and $0.8 million, versus ($0.2 million) and ($0.4 million) in the June 2005 quarter and six-month period, respectively. Improvements of both items reflect the SWAP program mark to market valuation of financial instruments put in place last year to offset partially the effect of rising rates on interest expense.
Non-Interest Expenses
Non-interest expenses totaled $14.8 million and $29.7 million, compared to $13.9 million and $26.0 million, in the June 2005 quarter and six-month period, respectively. The June 2006 quarter reflected sequential declines in compensation expense (excluding non-cash compensation reduction); advertising and business promotion expenses; professional and service fees; and other costs. Even though these expenses declined, non-interest expenses did include higher accounting fees related to the Group’s change in its fiscal year; start-up expenses related to new and expanded branches; and acceleration of amortization of existing leasehold improvements related to the Group’s May 2006 move to new corporate offices, where most non-branch operations have been consolidated for increased efficiencies. Compensation and employee

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benefit expense for the last year’s quarter and six-month period includes reduction in non-cash compensation expense of $3.0 million and $6.3 million, respectively, due to the Group’s previously disclosed restatement.
Income Tax Expense
The income (benefit) tax expense was ($21,000) and $110,000 for the quarter and six-month period June 30, 2006, respectively, compared to $377,000 and ($2.3 million) for the same periods ended June 30, 2005. The current income tax provision is lower than the provision based on the statutory tax rate for the Group, which is 43.5%, due to the high level of tax-advantaged interest income earned on certain investments and loans, net of the disallowance of related expenses attributable to the exempt income. Exempt interest relates principally to interest earned on obligations of the United States and Puerto Rico governments and certain mortgage-backed securities, including securities held by the Group’s international banking entities. The tax benefit for the quarter ended June 30, 2005 takes into account, among other things, the expiration of certain tax contingencies.
Group’s Financial Assets
The Group’s total financial assets include owned assets and the assets managed by the trust division, the securities broker-dealer subsidiary, and the private pension plan administration subsidiary. At June 30, 2006, total financial assets reached $7.940 billion compared to $7.555 billion at December 31, 2005, reflecting a 5.1% increase. There was 3.3% increase in assets managed by the trust division and broker-dealer subsidiary when compared to December 31, 2005. Owned assets, the Group’s largest financial asset component, are approximately 99% owned by the Group’s banking subsidiary.
The Group’s second largest financial asset component is assets managed by the trust division and the retirement plan administration subsidiary. The Group’s trust division offers various types of individual retirement accounts (“IRA”) and manages 401(K) and Keogh retirement plans and custodian and corporate trust accounts, while Caribbean Pension Consultants, Inc. (“CPC”) manages the administration of private pension plans. At June 30, 2006, total assets managed by the Group’s trust division and CPC amounted to $1.934 billion, compared to the $1.875 billion reported at December 31, 2005. The other financial asset component is assets gathered by the securities broker-dealer. The Group’s securities broker-dealer subsidiary offers a wide array of investment alternatives to its client base such as tax-advantaged fixed income securities, mutual funds, stocks, bonds and money management wrap-fee programs. At June 30, 2006, total assets gathered by the securities broker-dealer from its customer investment accounts, increased to $1.173 billion compared to $1.132 billion as of December 31, 2005. Both financial asset components reflect the Group’s success attracting financial assets, as well as improved equity market conditions.
Interest Earning Assets
The investment portfolio amounted to $3.498 billion as of June 30, 2006, a 0.6% increase compared to $3.477 billion as of December 31, 2005, while the loan portfolio increased 27.7% to $1.154 billion as of June 30, 2006, compared to $903.3 million as of December 31, 2005. The nominal sequential change in investment securities reflects the Group’s strategy of growing loans faster than investment securities.
Mortgage loans totaled $897.2 million as of June 30, 2006, a 38.2% increase from $649.1 million at December 31, 2005, and 38.8% increase from $646.4 million a year ago. Mortgage loan production totaled $70.8 million and $134.0 million, a 9.1% and 4.6% decrease compared to the same quarter and six-month period of the prior fiscal year, excluding purchases from third party originators. Mortgage loans purchased amounted to $174.2 million and $181.8 million for the quarter and six-month period ended June 30, 2006, respectively, compared to $22.2 million and $37.8 million for the June 2005 periods.
Interest Bearing Liabilities
Deposits of $1.214 billion at June 30, 2006 decreased 6.5% compared to December 31, 2005, reflecting reduced IRA CD balances as the Group’s customers transferred funds into Oriental’s Diversified Growth IRA investment product, partially offset by the success of Oriental’s new savings account products. Borrowings at June 30, 2006 totaled $3.246 billion, an increase of 14.6% from December 31, 2005, primarily due to the Group’s use of repurchase agreements. While the Group’s long-term strategy is to use deposits rather than borrowings to fund asset growth, from time to time it is more cost effective for the Group to use repurchase agreements.
Stockholders’ Equity
Stockholders’ equity as of June 30, 2006, was $340.3 million, slightly lower than the $341.8 million as of December 31, 2005.

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On August 30, 2005, the Board of Directors of the Group approved a program for the repurchase of up to $12.1 million of the Group’s outstanding shares of common stock, which replaced the former program. On June 20, 2006, the Board of Directors approved an increase of $3.0 million to the initial amount, for the repurchase of up to $15.1 million. During the quarter and six-month period ended June 30, 2006, the Group repurchased 46,600 of its shares of common stock in the open market, at a total cost of $582,000.
The Group continues to be well-capitalized, with ratios significantly above regulatory capital adequacy guidelines. At June 30, 2006, Tier 1 Leverage Capital Ratio was 9.39% (more than 2.3 times the minimum of 4.00%), Tier 1 Risk-Based Capital Ratio was 29.60% (more than 7.4 times the minimum of 4.00%), and Total Risk-Based Capital Ratio was 30.11% (more than 3.7 times the minimum of 8.00%).
Dividends
During the quarter and six-month period ended June 30, 2006, the Group declared cash dividends of $3.4 million and $1.2 million and $6.9 million and $2.4 million on its common and preferred stocks, respectively, similar to the $3.5 million and $1.2 million and $6.9 million and $2.4 million declared for the same periods a year ago.

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TABLE 1 — QUARTERLY ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
FOR THE QUARTERS ENDED JUNE 30, 2006 AND 2005
(Dollars in thousands)
                                                                         
    Interest   Average rate   Average balance
                    Variance                   Variance                   Variance
    2006   2005   in %   2006   2005   in BP   2006   2005   in %
 
                                                                       
A — TAX EQUIVALENT SPREAD
                                                                       
 
                                                                       
Interest-earning assets
  $ 56,894     $ 48,876       16.4 %     5.08 %     4.78 %     30     $ 4,480,608     $ 4,091,543       9.5 %
Tax equivalent adjustment
    13,051       10,523       24.0 %     1.17 %     1.03 %     14                   0.0 %
                   
Interest-earning assets — tax equivalent
    69,945       59,399       17.8 %     6.25 %     5.81 %     44       4,480,608       4,091,543       9.5 %
Interest-bearing liabilities
    46,186       29,588       56.1 %     4.38 %     3.10 %     128       4,215,139       3,814,410       10.5 %
                   
Tax equivalent net interest income / spread
  $ 23,759     $ 29,811       -20.3 %     1.87 %     2.71 %     (84 )   $ 265,469     $ 277,133       -4.2 %
                   
Tax equivalent interest rate margin
                            2.13 %     2.92 %     (79 )                        
                   
 
                                                                       
B — NORMAL SPREAD
                                                                       
 
                                                                       
Interest-earning assets:
                                                                       
Investments:
                                                                       
Investment securities
  $ 38,251     $ 34,153       12.0 %     4.44 %     4.32 %     12     $ 3,443,554     $ 3,165,901       8.8 %
Investment management fees
    (395 )     (495 )     -20.2 %     -0.05 %     -0.06 %     1                   0.0 %
                   
Total investment securities
    37,856       33,658       12.5 %     4.40 %     4.25 %     15       3,443,554       3,165,901       8.8 %
Trading securities
    4       5       -20.0 %     7.34 %     5.99 %     135       218       334       -34.7 %
Money market investments
    723       279       159.1 %     4.72 %     2.97 %     175       61,269       37,583       63.0 %
                   
 
    38,583       33,942       13.7 %     4.40 %     4.24 %     16       3,505,041       3,203,818       9.4 %
                   
 
                                                                       
Loans:
                                                                       
Mortgage
    13,003       11,030       17.9 %     7.28 %     7.05 %     23       714,649       625,556       14.2 %
Commercial
    4,202       3,190       31.7 %     7.55 %     5.43 %     212       222,574       235,023       -5.3 %
Consumer
    1,106       714       54.9 %     11.54 %     10.52 %     102       38,344       27,146       41.3 %
                   
 
    18,311       14,934       22.6 %     7.51 %     6.73 %     78       975,567       887,725       9.9 %
                   
 
    56,894       48,876       16.4 %     5.08 %     4.78 %     30       4,480,608       4,091,543       9.5 %
                   
 
                                                                       
Interest-bearing liabilities:
                                                                       
Deposits:
                                                                       
Non-interest bearing deposits
                0.0 %                 0       39,897       64,573       -38.2 %
Now Accounts
    214       232       -7.8 %     1.07 %     1.05 %     2       80,077       88,357       -9.4 %
Savings
    1,014       236       329.7 %     2.87 %     1.01 %     186       141,139       93,705       50.6 %
Certificates of Deposit
    9,918       8,229       20.5 %     4.12 %     3.41 %     71       961,794       964,839       -0.3 %
                   
 
    11,146       8,697       28.2 %     3.65 %     2.87 %     78       1,222,907       1,211,474       0.9 %
                   
 
                                                                       
Borrowings:
                                                                       
Repurchase agreements
    32,932       16,598       98.4 %     5.04 %     3.01 %     203       2,616,058       2,202,757       18.8 %
Interest rate risk management
    (1,930 )     819       -335.7 %     -0.30 %     0.15 %     (45 )                 0.0 %
Financing fees
    126       166       -24.1 %     0.02 %     0.03 %     (1 )                 0.0 %
                   
Total repurchase agreements
    31,128       17,583       77.0 %     4.76 %     3.19 %     157       2,616,058       2,202,757       18.8 %
FHLB advances
    2,248       2,001       12.3 %     3.22 %     2.60 %     62       279,497       308,389       -9.4 %
Subordinated capital notes
    1,344       1,166       15.3 %     7.45 %     6.46 %     99       72,166       72,166       0.0 %
Term Notes
    159       107       48.6 %     4.24 %     2.85 %     139       15,000       15,000       0.0 %
Other borrowings
    161       34       373.5 %     6.77 %     2.98 %     379       9,511       4,624       105.7 %
                   
 
    35,040       20,891       67.7 %     4.68 %     3.21 %     147       2,992,232       2,602,936       15.0 %
                   
 
    46,186       29,588       56.1 %     4.38 %     3.10 %     128       4,215,139       3,814,410       10.5 %
                   
Net interest income / spread
  $ 10,708     $ 19,288       -44.5 %     0.70 %     1.68 %     (98 )                        
                   
Interest rate margin
                            0.96 %     1.89 %     (93 )                        
                   
Excess of average interest-earning assets over average interest-bearing liabilities
                                                  $ 265,469     $ 277,133       -4.2 %
                   
Average interest-earning assets over average interest-bearing liabilities ratio
                                                    106.30 %     107.27 %        
                         
                         
C. Changes in net interest income due to:
  Volume   Rate   Total
 
                       
Interest Income:
                       
Investments
    13,617       (8,976 )     4,641  
Loans
  $ 1,884     $ 1,493     $ 3,377  
     
 
    15,501       (7,483 )     8,018  
     
 
                       
Interest Expense:
                       
Deposits
  $ 325       2,124       2,449  
Repurchase agreements
    9,187       4,358       13,545  
Other borrowings
    (833 )     1,437       604  
     
 
    8,679       7,919       16,598  
     
 
                       
Net Interest Income
  $ 6,822     $ (15,402 )   $ (8,580 )
     

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Table of Contents

TABLE 1A — FISCAL YEAR-TO-DATE ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE
FOR THE SIX-MONTHS RERIOD ENDED JUNE 30, 2006 AND 2005
(Dollars in thousands)
                                                                         
    Interest   Average rate   Average balance
                    Variance                   Variance                   Variance
    2006   2005   in %   2006   2005   in BP   2006   2005   in %
             
 
                                                                       
A — TAX EQUIVALENT SPREAD
                                                                       
 
                                                                       
Interest-earning assets
  $ 112,886     $ 96,448       17.0 %     5.06 %     4.74 %     32     $ 4,461,132     $ 4,072,091       9.6 %
Tax equivalent adjustment
    26,773       21,244       26.0 %     1.20 %     1.04 %     16                   0.0 %
                   
Interest-earning assets — tax equivalent
    139,659       117,692       18.7 %     6.26 %     5.78 %     48       4,461,132       4,072,091       9.6 %
Interest-bearing liabilities
    86,966       56,750       53.2 %     4.17 %     2.99 %     118       4,168,052       3,795,220       9.8 %
                   
Tax equivalent net interest income / spread
  $ 52,693     $ 60,942       -13.5 %     2.09 %     2.79 %     (70 )   $ 293,080     $ 276,871       5.9 %
                   
Tax equivalent interest rate margin
                            2.36 %     2.99 %     (63 )                        
                                                       
 
                                                                       
B — NORMAL SPREAD
                                                                       
 
                                                                       
Interest-earning assets:
                                                                       
Investments:
                                                                       
Investment securities
  $ 77,570     $ 68,671       13.0 %     4.50 %     4.31 %     19     $ 3,447,122     $ 3,189,098       8.1 %
Investment management fees
    (714 )     (941 )     -24.1 %     -0.04 %     -0.06 %     2                   0.0 %
                   
Total investment securities
    76,856       67,730       13.5 %     4.46 %     4.25 %     21       3,447,122       3,189,098       8.1 %
Trading securities
    3       6       -50.0 %     3.30 %     3.50 %     (20 )     182       343       -46.9 %
Money market investments
    1,463       355       312.6 %     4.50 %     2.23 %     227       65,019       31,787       104.5 %
                   
 
    78,322       68,091       15.0 %     4.46 %     4.23 %     23       3,512,323       3,221,228       9.0 %
                   
 
                                                                       
Loans:
                                                                       
Mortgage
    24,201       21,494       12.6 %     6.75 %     6.63 %     12       716,601       648,321       10.5 %
Commercial
    8,298       5,560       49.2 %     8.51 %     6.30 %     221       194,913       176,474       10.4 %
Consumer
    2,065       1,303       58.5 %     11.08 %     10.00 %     108       37,295       26,068       43.1 %
                   
 
    34,564       28,357       21.9 %     7.29 %     6.67 %     62       948,809       850,863       11.5 %
                   
 
                                                                       
 
    112,886       96,448       17.0 %     5.06 %     4.74 %     32       4,461,132       4,072,091       9.6 %
                   
 
                                                                       
Interest-bearing liabilities:
                                                                       
Deposits:
                                                                       
Non-interest bearing deposits
                0.0 %                 0       40,965       59,314       -30.9 %
Now Accounts
    433       462       -6.4 %     1.05 %     1.04 %     1       82,617       88,627       -6.8 %
Savings
    1,271       469       171.0 %     2.24 %     1.00 %     124       113,717       93,824       21.2 %
Certificates of Deposit
    19,940       15,389       29.6 %     4.01 %     3.36 %     65       993,618       916,577       8.4 %
                   
 
    21,644       16,320       32.6 %     3.52 %     2.82 %     70       1,230,917       1,158,342       6.3 %
                   
 
                                                                       
Borrowings:
                                                                       
Repurchase agreements
    60,487       30,890       95.8 %     4.75 %     2.76 %     199       2,548,638       2,240,004       13.8 %
Interest rate risk management
    (3,250 )     2,742       -218.5 %     -0.26 %     0.24 %     (50 )                 0.0 %
Financing fees
    254       337       -24.6 %     0.02 %     0.03 %     (1 )                 0.0 %
                   
Total repurchase agreements
    57,491       33,969       69.2 %     4.51 %     3.03 %     148       2,548,638       2,240,004       13.8 %
FHLB advances
    4,597       3,960       16.1 %     3.15 %     2.58 %     57       292,213       307,383       -4.9 %
Subordinated capital notes
    2,641       2,273       16.2 %     7.32 %     6.30 %     102       72,166       72,166       0.0 %
Term Notes
    316       194       62.9 %     4.21 %     2.59 %     180       15,000       15,000       21.2 %
Other borrowings
    277       34       714.7 %     6.08 %     2.92 %     362       9,118       2,325       155.1 %
                   
 
    65,322       40,430       61.6 %     4.45 %     3.07 %     138       2,937,135       2,636,878       11.4 %
                   
 
                                                                       
 
    86,966       56,750       53.2 %     4.17 %     2.99 %     118       4,168,052       3,795,220       9.8 %
                   
 
                                                                       
Net interest income / spread
  $ 25,920     $ 39,698       -34.7 %     0.89 %     1.75 %     (86 )                        
                                     
 
                                                                       
Interest rate margin
                            1.16 %     1.95 %     (79 )                        
                                                       
 
                                                                       
Excess of average interest-earning assets over average interest-bearing liabilities   $ 293,080     $ 276,871       5.9 %
                                                       
 
                                                                       
Average interest-earning assets over average interest-bearing liabilities ratio     107.03 %     107.30 %        
                                                               
                         
C. Changes in net interest income due to:   Volume   Rate   Total
 
 
                       
Interest Income:
                       
Investments
    28,060       (17,829 )     10,231  
Loans
  $ 19,398     $ (13,191 )   $ 6,207  
       
 
    47,458       (31,020 )     16,438  
       
 
                       
Interest Expense:
                       
Deposits
  $ 3,747       1,577       5,324  
Repurchase agreements
    15,125       8,397       23,522  
Other borrowings
    (556 )     1,926       1,370  
       
 
    18,316       11,900       30,216  
       
 
                       
Net Interest Income
  $ 29,142     $ (42,920 )   $ (13,778 )
       

-26-


Table of Contents

Net interest income is a function of the difference between rates earned on the Group’s interest-earning assets and rates paid on its interest-bearing liabilities (interest rate spread) and the relative amounts of its interest-earning assets and interest-bearing liabilities (interest rate margin). Typically, bank liabilities re-price in line with changes in short-term rates, while many asset positions are affected by longer-term rates. The Group constantly monitors the composition and re-pricing of its assets and liabilities to maintain its net interest income at adequate levels.
For the quarter and six-month period ended June 30, 2006, net interest income amounted to $10.7 million and $25.9 million, respectively, a 44.5% and 34.8% decrease from $19.3 million and $39.7 million in the same period of the previous year. The decrease for the quarter reflects a 16.4% increase in interest income, due to a $15.5 million positive volume variance and a $7.5 million negative rate variance, more than offset by an increase of 56.1% in interest expense, caused by an increase of $8.7 million from borrowings volume and $7.9 million due to interest rate changes. The decrease for the six-month period reflects a 17.0% increase in interest income, due to a $47.5 million positive volume variance and a $31.0 million negative interest rate variance, offset by an increase of 53.2% in interest expense, caused by an increase of $18.3 million from borrowings volume and $11.9 million attributable to interest rate changes. Interest rate spread dropped 98 basis points, to 0.70% from 1.68% in the June 2005 quarter, and 86 basis points to 0.89% from 1.75% in the six-month period ended June 2005. This decline was due to an increase of 30 and 32 basis points, respectively, in the combined average yield of investments and loans for the quarters and six-month periods and an increase of 128 and 118 basis points, respectively, caused by an increase in the average cost of funds.
For the quarter and six-month period ended June 30, 2006, the average balance of total interest-earnings assets grew 9.5% to $4.481 billion versus $4.092 billion and 9.6% to $4.461 billion compared to $4.072 billion for the same periods of the previous year. The increase in the average balance reflects growth of 9.4% in the investment portfolio to $3.505 billion and a 9.9%in loans, to $975.6 million for the quarter, and 9.0% in the investment portfolio to $3.512 billion, and 11.5% in loans, to $948.8 million for the six-month period. Most of the dollar increase in loans came from the residential mortgage loan portfolio average balance, which increased by 14.2% to $714.6 million for the quarter ended June 30, 2006 from $625.6 million for the quarter ended June 30, 2005 and 10.5% to $716.6 million for the six-month period ended June 30, 2006 from $648.3 million a year ago.
For the quarter and six-month period ended June 30, 2006, the average yield on interest-earning assets was 5.08%and 5.06%, respectively, compared to 4.78% and 4.74% in the comparable year ago periods. Higher average yields were due to increases in both of the investments and loan portfolio yields. The investment portfolio yield increased to 4.40% in the quarter ended June 30, 2006, versus 4.24% in the corresponding year ago quarter and to 4.46% in the six-month period ended June 30, 2006, versus 4.23% in the corresponding period a year ago, due to additions of higher yield investments. The increase of 78 basis points in the yield of the loan portfolio for the quarter and 62 basis points for the six-month period was due to higher rates on mortgage, commercial and consumer loans new production reflecting higher rates on variable rate loans due to the higher interest rate environment for lending.
For the quarter and six-month period ended June 30, 2006, interest expense increased 56.1% to $46.2 million from $29.6 million for the year ago quarter and 53.2% to $87.0 million from $56.8 million for the year ago six-month period, both resulting from higher volume and rate variances due to the increased interest earnings asset portfolio.
For the quarter and six-month period ended June 30, 2006, the cost of deposits increased 78 basis points to 3.65% as compared to 2.87% in the year ago quarter and 70 basis points to 3.52% as compared to 2.82% in the year ago six-month period. The increase reflects higher average rates paid on higher balances, specifically in savings accounts. For the quarter and six-month period ended June 30, 2006, the cost of borrowings increased 147 basis points to 4.68% as compared to 3.21% in the year ago quarter and 138 basis points to 4.45% as compared to 3.07% in the year ago six-month period. The increase was mainly the result of higher average rates paid on increased volume of repurchase agreements. Repurchase agreements increased 203 basis points, to 5.04% from 3.01% for the quarter ended June 30, 2005 and 199 basis points to 4.75% as compared to 2.76% in the year ago six-month period, reflecting the effect of interest rate increases by the Board of Governors of the Federal Reserve System of 300 basis points since December 2004. The cost of repurchase agreements was offset by a 45 basis point reduction in the Group’s hedging costs for the quarter ended June 30, 2006 and 50 basis points for the six-month period, as the Group’s use of interest rate swaps in a rising interest rate environment partially offset rising borrowing costs. The cost of FHLB advances increased 62 basis points to 3.22% versus 2.60% for the quarter ended June 30, 2005, and 57 basis points to 3.15% as compared to 2.58% in the year ago six-month period.

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TABLE 2 — NON-INTEREST INCOME SUMMARY:
FOR THE QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(Dollars in thousands)
                                                 
    Quarter Ended June 30,   Six-Month Period Ended June 30,    
    2006     2005     Variance %     2006     2005     Variance %  
                       
 
Mortgage banking activities
  $ 634     $ 1,168       -45.7 %   $ 1,070     $ 2,241       -52.3 %
Commissions and fees from broker, insurance activities
    4,066       3,249       25.1 %     7,317       6,419       14.0 %
Investment banking revenues
    852       162       425.9 %     2,561       339       655.5 %
 
                                   
Non-banking service revenues
    5,552       4,579       21.2 %     10,948       8,999       21.7 %
 
                                   
 
                                               
Fees on deposit accounts
    1,315       1,233       6.7 %     2,734       2,392       14.3 %
Bank service charges and commissions
    656       367       78.7 %     1,275       929       37.2 %
Other operating revenues
    540       464       16.2 %     678       572       18.5 %
                                     
Bank service revenues
    2,511       2,064       21.6 %     4,687       3,893       20.4 %
 
                                   
 
                                               
Securities net gain
          1,420       -100.0 %     19       4,056       -99.5 %
Trading net (loss) gain
    (8 )     (42 )     -81.0 %     21       (53 )     -139.6 %
Derivatives net (loss) gain
    (23 )     (1,866 )     -98.8 %     859       (4,670 )     -118.4 %
 
                                   
Securities, derivatives and trading activities
    (31 )     (488 )     -93.6 %     899       (667 )     234.8 %
 
                                   
 
                                               
Other income (loss)
    (511 )     282       -281.2 %     (60 )     311       -119.3 %
 
                                   
Other non-interest income
    (511 )     282       -281.2 %     (60 )     311       -119.3 %
 
                                   
 
                                               
Total non-interest income
  $ 7,521     $ 6,437       16.8 %   $ 16,474     $ 12,536       31.4 %
 
                                   
Non-interest income, the second largest source of earnings, is affected by the amount of securities and trading transactions, the level of trust assets under management, transactions generated by the gathering of financial assets by the securities broker-dealer subsidiary, the level of investment and mortgage banking activities, and the fees generated from loans, deposit accounts, and insurance.
Non-interest income totaled $7.5 million and $16.5 million in the quarter and six-months ended June 30, 2006, respectively a 16.8% and 31.4% increase when compared to $6.4 million and $12.5 million in the same periods of the previous year. Performance in the quarter and six-months ended June 30, 2006, reflects increases in commissions and fees from brokerage investment banking, and insurance activities reflecting increased activities from the financial services area, as well as higher banking service revenues. This was partially offset by less mortgage banking activities, primarily reflecting the Group’s strategy, initiated during the quarter ended June 30, 2005, to retain more mortgages for their recurring interest income rather than selling the loans for a gain.
Non-banking service revenues, generated from trust, mortgage banking, investment banking, brokerage, and insurance activities, is one of the principal components of non-interest income. For the quarter and six-month period ended June 30, 2006, these revenues increased 21.2% and 21.7% to $5.6 million and $10.9 million, respectively, from $4.6 million and $9.0 million for the year ago periods. Mortgage banking activities decreased 45.7%, to $634,000 from $1.2 million in the year ago quarter and 52.3%, to $1.1 million from $2.2 million in the year ago six-month period. Commissions and fees from brokerage and insurance activities increased 25.1% to $4.1 million from $3.2 million in the year ago quarter and 14.0%, to $7.3 million from $6.4 million in the year ago six-month period. Growth reflected the general improvement in the equity markets and increased underwriting activities. Investment banking revenues increased to $852,000 from $162,000 the year ago quarter and to $2.6 million from $339,000 the year ago six-month period.
Banking service revenues, another major component of non-interest income, consists primarily of fees generated by deposit accounts, electronic banking services, and bank service commissions. For the quarter and six-month period ended June 30, 2006, these revenues increased 21.6% to $2.5 million compared to the year ago quarter and 20.4% to $4.7 million the year ago six-month period, primarily due to increase in fee income on deposit accounts, mainly overdraft fees, and the ongoing success of the Group’s product and service marketing programs. Fees on deposit accounts increased 6.7% to $1.3 million from $1.2 million in the year ago quarter and 14.3% to $2.7 million from $2.4 million in the year ago six-month period. Bank service charges and commissions increased 78.7% to $656,000 from $367,000 in the year ago quarter and 37.2% to $1.3 million from $929,000 in the year ago reflecting higher transactional volume in the Bank’s debit and credit cards.
For the quarter ended June 30, 2006, (losses) gains from securities, derivatives and trading activities was ($31,000) compared to ($488,000) for the year ago quarter and $899,000 compared to ($667,000) for the year ago six-month period. The improvement for both periods was primarily due to higher mark to market valuation of financial instruments used to partially offset the effect of rising rates on interest expense.

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TABLE 3 — NON-INTEREST EXPENSES SUMMARY
FOR THE QUARTER AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(Dollars in thousands)
                                                 
    Quarter Ended June 30,     Six-Month Period Ended June 30,  
    2006     2005     Variance %     2006     2005     Variance %  
 
                                               
Compensation and employee benefits
  $ 5,627     $ 4,402       27.8 %   $ 11,801     $ 7,697       53.3 %
Occupancy and equipment
    2,793       3,066       -8.9 %     5,682       5,532       2.7 %
Advertising and business promotion
    1,300       1,420       -8.5 %     2,366       2,907       -18.6 %
Professional and service fees
    1,601       1,777       -9.9 %     3,225       3,614       -10.8 %
Communications
    395       410       -3.7 %     843       786       7.3 %
Loan servicing expenses
    509       430       18.4 %     964       831       16.0 %
Taxes, other than payroll and income taxes
    573       471       21.7 %     1,173       934       25.6 %
Electronic banking charges
    494       543       -9.0 %     962       1,060       -9.2 %
Printing, postage, stationery and supplies
    359       207       73.4 %     544       416       30.8 %
Insurance, including deposits insurance
    219       188       16.5 %     432       375       15.2 %
Other operating expenses
    914       979       -6.6 %     1,675       1,888       -11.3 %
 
                                   
Total non-interest expenses
  $ 14,784     $ 13,893       6.4 %   $ 29,667     $ 26,040       13.9 %
 
                                   
 
                                               
Relevant ratios and data:
                                               
Compensation and benefits to non-interest expenses
    38.1 %     31.7 %             39.8 %     29.6 %        
 
                                       
Compensation to total assets
    0.47 %     0.41 %             0.49 %     0.36 %        
 
                                       
Average compensation per employee (annualized)
  $ 42.4     $ 33.8             $ 44.6     $ 28.9          
 
                                       
Average number of employees
    531       521               529       532          
 
                                       
Bank assets per employee
  $ 9,101     $ 8,151             $ 9,177     $ 7,983          
 
                                       
Total work force:
                            537       519          
 
                                           
Non-interest expenses for the quarter and six-month period ended June 30, 2006, were $14.8 million and $29.7 million, respectively, compared to $13.9 million and $26.0 million in the year ago periods, with an efficiency ratio of 78.76% compared to 53.58% in the quarter ended June 30, 2005 and 71.39% compared to 49.52% for the six-month period ended June 30, 2005. The efficiency ratio measures how much of a company’s revenue is used to pay operating expenses. The Group computes its efficiency ratio by dividing operating expenses by the sum of its net interest income and recurring non-interest income, but excluding gains on sale of investments securities, derivatives gains or losses and other income.
The Group has been successful in limiting expense growth to those areas that directly contribute to increase efficiency, service quality, and profitability. Non-interest expenses increased 6.4% and 13.9%, respectively, compared to the year ago quarter and six months ended June 30, 2005, which included a non-cash compensation benefit of $3.0 million and $6.3 million, respectively, as a result of the Group’s previously disclosed restatement. Excluding the year ago non-cash compensation benefit, non interest expense declined 12.3% and 8.2%, respectively, from the comparable year ago periods.
Compensation and employee benefits, the largest non-interest expense category accounted for 38.1% and 39.8% of the total non-interest expense, for the quarter and six-month period ended June 30, 2006, respectively. Total compensation and employee benefits amounted to $5.6 million and $11.8 million, respectively, for the quarter and six-month period ended June 30, 2006, compared to $4.4 million and $11.8 million, in the comparable year ago periods, which benefited from the previously mentioned non-cash variable accounting reduction.
Occupancy and equipment expenses amounted to $2.8 million and $5.7 million, decreasing 8.9% from $3.1 million for the quarter ended June 30, 2005 and increasing 2.7% from $5.5 million for the six-month period ended June 30, 2005. The variation is mainly due to the acceleration of leasehold improvements amortization expense due to the relocation in May 2006 of the Group’s main offices to a new financial center building, where most non-branch operations have been consolidated for increased efficiencies.
Taxes, other than payroll and income taxes, increased 21.6% to $573,000 from $471,000 for the last quarter and 25.6% to $1.2 million from $934,000 for the six-month period a year ago, mainly due to the increase in revenues and income subject to volume of business tax.
The total decrease in advertising and business promotion, professional and service fees, and electronic banking charges was principally due to effective cost controls.

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TABLE 4 — ALLOWANCE FOR LOAN LOSSES SUMMARY
FOR THE QUARTERS AND SIX-MONTH PERIODS ENDED JUNE 30, 2006 AND 2005
(Dollars in thousands)
                                                 
    Quarter Ended June 30,     Change in     Six-Month Period Ended June 30,     Change in  
    2006     2005     %     2006     2005     %  
 
                                               
Beginning balance
  $ 7,160     $ 6,980       2.6 %   $ 6,630     $ 7,565       -12.4 %
Provision for loan losses
    947       850       11.4 %     2,048       1,510       35.6 %
Net credit losses — see Table 5
    (606 )     (1,335 )     -54.6 %     (1,177 )     (2,580 )     -54.4 %
 
                                   
Ending balance
  $ 7,501     $ 6,495       15.5 %   $ 7,501     $ 6,495       15.5 %
 
                                   
 
                                               
Selected Data and Ratios:
                                               
Outstanding gross loans at June 30,
                          $ 1,161,439     $ 910,099       27.6 %
 
                                         
Recoveries to charge-offs
                            18.4 %     9.9 %     85.9 %
 
                                         
Allowance coverage ratio
                                               
Total loans
                            0.65 %     0.71 %     -8.5 %
 
                                         
Non-performing loans
                            25.55 %     21.05 %     21.4 %
 
                                         
Non-mortgage non-performing loans
                            213.52 %     139.02 %     53.6 %
 
                                         
TABLE 5 — NET CREDIT LOSSES STATISTICS
(Dollars in thousands)
                                                 
    Quarter Ended June 30,     Change in     Six-Month Period Ended June 30,     Change in  
    2006     2005     %     2006     2005     %  
 
                                               
Mortgage
                                               
Charge-offs
  $ (178 )   $ (911 )     -80.5 %   $ (377 )   $ (1,663 )     -77.3 %
Recoveries
                0.0 %                 0.0 %
 
                                   
 
    (178 )     (911 )     -80.5 %     (377 )     (1,663 )     -77.3 %
 
                                   
 
                                               
Commercial
                                               
Charge-offs
    (196 )     (170 )     15.3 %     (220 )     (485 )     -54.6 %
Recoveries
    76       11       590.9 %     83       14       492.9 %
 
                                   
 
    (120 )     (159 )     -24.5 %     (137 )     (471 )     -70.9 %
 
                                   
 
                                               
Consumer
                                               
Charge-offs
    (389 )     (378 )     2.9 %     (845 )     (715 )     18.2 %
Recoveries
    81       113       -28.3 %     182       269       -32.3 %
 
                                   
 
    (308 )     (265 )     16.2 %     (663 )     (446 )     48.7 %
 
                                   
 
                                               
Net credit losses
                                               
Total charge-offs
    (763 )     (1,459 )     -47.7 %     (1,442 )     (2,863 )     -49.6 %
Total recoveries
    157       124       26.6 %     265       283       -6.4 %
 
                                   
 
  $ (606 )   $ (1,335 )     -54.6 %   $ (1,177 )   $ (2,580 )     -54.4 %
 
                                   
 
                                               
Net credit losses to average outstanding (1):
                                               
Mortgage
    0.10 %     0.58 %             0.11 %     0.95 %        
 
                                       
Commercial
    0.22 %     0.27 %             0.14 %     0.53 %        
 
                                       
Consumer
    3.21 %     3.90 %             3.56 %     3.42 %        
 
                                       
Total
    0.25 %     0.60 %             0.25 %     0.61 %        
 
                                       
 
                                               
Average loans:
                                               
Mortgage
  $ 714,649     $ 625,556       14.2 %   $ 716,601     $ 648,321       10.5 %
Commercial
    222,574       235,023       -5.3 %     194,913       176,474       10.4 %
Consumer
    38,344       27,146       41.3 %     37,295       26,068       43.1 %
 
                                   
Total
  $ 975,567     $ 887,725       9.9 %   $ 948,809     $ 850,863       11.5 %
 
                                   
 
(1)   Annualized ratios

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TABLE 6 — ALLOWANCE FOR LOSSES BREAKDOWN
(Dollars in thousands)
                                 
    June 30,     December 31,     Change in     June 30,  
    2006     2005     %     2005  
 
Allowance for loan losses breakdown:
                               
Mortgage
  $ 3,463     $ 3,185       8.7 %   $ 3,167  
Commercial
    1,721       1,723       -0.1 %     1,714  
Consumer
    2,088       1,417       47.4 %     1,335  
Unallocated allowance
    229       305       -24.9 %     279  
 
                       
 
  $ 7,501     $ 6,630       13.1 %   $ 6,495  
 
                       
 
                               
Allowance composition:
                               
Mortgage
    46.2 %     48.0 %             48.7 %
Commercial
    22.9 %     26.0 %             26.4 %
Consumer
    27.8 %     21.4 %             20.6 %
Unallocated allowance
    3.1 %     4.6 %             4.3 %
 
                         
 
    100.0 %     100.0 %             100.0 %
 
                         
The provision for loan losses for the quarter and six-month period ended June 30, 2006, totaled $947,000, an 11.4% increase from the $850,000 reported for the same quarter of the previous year, and $2.0 million, an 35.6% increase from the $1.5 million reported for the same six-month period of the previous year. Based on an analysis of the credit quality and composition of its loan portfolio, the Group determined that the provision for the first six months of the current year was adequate in order to maintain the allowance for loan losses at an appropriate level.
Net credit losses for the quarter and six-month period decreased 54.6%, from $1.3 million in the quarter ended June 30, 2005, to $606,000 in the quarter ended June 30, 2006 and 54.4%, from $2.6 million in the six-month period ended June 30, 2005, to $1.2 million in the six-month period ended June 30, 2006. The decreases were primarily due to reductions in net credit losses for mortgage of $729,000 for the quarter and $1.4 million for the six-month period, respectively, when compared to the same periods in the previous year. For the quarter and six-month period of the current year, the net credit losses average ratio was 0.25% for both periods, compared to 0.60% and 0.61%, respectively reported for the same periods of the prior fiscal year. Non-performing loans of $29.4 million as of June 30, 2006 were 4.8% lower than the $30.9 million as of June 30, 2005, and 3.3% higher than the $28.4 million reported as of December 31, 2005 (Table 9).
At June 30, 2006, the Group’s allowance for loan losses amounted to $7.5 million (0.65% of total loans) compared to $6.6 million (0.73% of total loans) reported at December 31, 2005. Consumer and mortgage loan allowances increased by 47.4% and 8.7%, or $671,000 and $278,000, respectively, when compared with balances recorded at December 31, 2005. Commercial loans allowance decreased 0.1% or $2,000, when compared to December 31, 2005. Unallocated allowance decreased 25.0%, or $76,000, when compared to December 31, 2005.
The Group maintains an allowance for loan losses at a level that management considers adequate to provide for potential losses based upon an evaluation of known and inherent risks. The Group’s allowance for loan losses policy provides for a detailed quarterly analysis of possible losses.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical loss experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
The Group uses a methodology that follows a loan credit risk rating process that involves dividing loans into risk categories. The following are the credit risk categories used:
1.   Pass — loans considered highly collectible due to their repayment history or current status.
 
2.   Special Mention — loans with potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects of the loan.
 
3.   Substandard — loans inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

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4.   Doubtful — loans that have all the weaknesses inherent in substandard, with the added characteristic that collection or liquidation in full is highly questionable and improbable.
 
5.   Loss — loans considered uncollectible and of such little value that their continuance as bankable assets is not warranted.
Larger commercial loans that exhibit potential or observed credit weaknesses are subject to individual review and grading. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Group.
Included in the review of individual loans are those that are impaired. A loan is considered impaired when, based on current information and events, it is probable that the Group will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, at the observable market price of the loan or the fair value of the collateral, if the loan is collateral dependent.
The Group evaluates all loans, some individually and others as homogeneous groups, for purposes of determining impairment. The portfolios of mortgages and consumer loans are considered homogeneous and are evaluated collectively for impairment. For the commercial loans portfolio, all loans over $250,000 are evaluated for impairment. At June 30, 2006, the total investment in impaired loans was $1.8 million, a 50% reduction from the $3.6 million at December 31, 2005, mainly due to certain commercial loans collected during the quarter ended June 30, 2006. Impaired loans are measured based on the fair value of collateral. The Group determined that no specific impairment allowance was required for such loans.
The Group, using an aged-based rating system, applies an overall allowance percentage to each loan portfolio category based on historical credit losses adjusted for current conditions and trends. This delinquency-based calculation is the starting point for management’s determination of the required level of the allowance for loan losses. Other data considered in this determination includes:
  1.   Overall historical loss trends; and
  2.   Other information including underwriting standards, economic trends and unusual events
Loan loss ratios and credit risk categories are updated quarterly and are applied in the context of GAAP and the Joint Interagency Guidance on the importance of depository institutions having prudent, conservative, but not excessive loan loss allowances that fall within an acceptable range of estimated losses. While management uses available information in estimating possible loan losses, future changes to the allowance may be necessary, based on factors beyond the Group’s control, such as factors affecting general economic conditions.
An unallocated allowance is established recognizing the estimation risk associated with the aged-based rating system and with the specific allowances. It is based upon management’s evaluation of various conditions, the effects of which are not directly measured in determining the aged-based rating system and the specific allowances. These conditions include then-existing general economic and business conditions affecting our key lending areas; credit quality trends, including trends in non-performing loans expected to result from existing conditions, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, regulatory examination results, and findings by the Group’s management. The evaluation of the inherent loss regarding these conditions involves a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.

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FINANCIAL CONDITION
TABLE 7 — ASSETS SUMMARY AND COMPOSITION
(Dollars in thousands)
                                 
    June 30,     December 31,     Variance     June 30,  
    2006     2005     %     2005  
 
                               
Investments:
                               
Mortgage-backed securities
  $ 1,993,034     $ 1,961,285       1.6 %   $ 1,959,760  
U.S. Government and agency obligations
    1,258,975       1,251,058       0.6 %     1,029,980  
P.R. Government and agency obligations
    82,474       90,333       -8.7 %     108,968  
Other investment securities
    109,348       90,609       20.7 %     66,023  
Short-term investments
    35,722       63,480       -43.7 %     39,791  
FHLB stock
    18,269       20,002       -8.7 %     27,058  
 
                       
 
    3,497,822       3,476,767       0.6 %     3,231,580  
 
                       
 
                               
Loans:
                               
Mortgage
    884,671       637,318       38.8 %     735,971  
Commercial, mainly secured by real estate
    227,744       227,846       0.0 %     129,670  
Consumer
    39,460       35,828       10.1 %     30,282  
 
                       
Loans receivable
    1,151,875       900,992       27.8 %     895,923  
Allowance for loan losses
    (7,501 )     (6,630 )     13.1 %     (6,495 )
 
                       
Loans receivable, net
    1,144,374       894,362       28.0 %     889,428  
Mortgage loans held for sale
    9,564       8,946       6.9 %     17,963  
 
                       
Total loans receivable, net
    1,153,938       903,308       27.7 %     907,391  
 
                       
Securities sold but not yet delivered
    710       44,009       -98.4 %     1,034  
 
                       
 
                               
Total securities and loans
    4,652,470       4,424,084       5.2 %     4,140,005  
 
                       
 
                               
Other assets:
                               
Cash and due from banks
    35,237       13,789       155.5 %     14,892  
Accrued interest receivable
    31,313       29,067       7.7 %     23,735  
Premises and equipment, net
    17,358       14,828       17.1 %     15,269  
Deferred tax asset, net
    14,861       12,222       21.6 %     6,191  
Foreclosed real estate, net
    4,379       4,802       -8.8 %     4,186  
Other assets
    77,044       48,157       60.0 %     46,374  
 
                       
Total other assets
    180,192       122,865       46.7 %     110,647  
 
                       
 
                               
Total assets
  $ 4,832,662     $ 4,546,949       6.3 %   $ 4,250,652  
 
                       
 
                               
Investment portfolio composition:
                               
Mortgage-backed securities
    56.9 %     56.4 %             60.6 %
U.S. Government and agency obligations
    36.0 %     36.0 %             31.9 %
P.R. Government and agency obligations
    2.4 %     2.6 %             3.4 %
FHLB stock, short term investments and debt securities
    4.7 %     5.0 %             4.1 %
 
                         
 
    100.0 %     100.0 %             100.0 %
 
                         
 
                               
Loan portfolio composition:
                               
Mortgage
    77.0 %     71.0 %             82.5 %
Commercial, mainly secured by real estate
    19.6 %     25.0 %             14.2 %
Consumer
    3.4 %     4.0 %             3.3 %
 
                         
 
    100.0 %     100.0 %             100.0 %
 
                         
At June 30, 2006, the Group’s total assets amounted to $4.833 billion, an increase of 6.3%, when compared to $4.547 billion at December 31, 2005. At June 30, 2006, interest-earning assets were $4.652 billion, a 5.2% increase compared to $4.424 billion at December 31, 2005.
Investments are the Group’s largest interest-earning assets component. Investments principally consist of money market instruments, U.S. government bonds, mortgage-backed securities, collateralized mortgage obligations, and Puerto Rico government bonds. At June 30, 2006, the investment portfolio increased 0.6% to $3.498 billion, from $3.477 billion as of December 31, 2005. The increase reflects additional mortgage-backed securities investments. The Group maintains its strategy in a rising interest rate environment of investing in fixed and variable rate, short-term and medium-term government securities, and the sale of long-term mortgage-backed securities.

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At June 30, 2006, the Group’s loan portfolio, the second largest category of the Group’s interest-earning assets, increased by 27.7% to $1.154 billion when compared to $903.3 million at December 31, 2005. This was principally due to increased production and purchases of mortgage and commercial loans. Mortgage and consumer loans grew by 38.8% and 10.1%, respectively, to $884.7 million and $39.5 million, when compared to $637.3 million and $35.8 million at December 31, 2005. Such increases reflect the Group’s strategy to expand its loan portfolios. During the quarter and six-month period ended June 30, 2006, total loan production amounted to $262.2 million and $354.9, respectively, an increase of 118.0% and 26.7% over the year ago periods. During the quarter and six-month period ended June 30, 2006, the Group purchased $174.2 million and $181.8 million, respectively in real estate mortgage loans. During the six-month ended June 30, 2005, the Group granted $46.8 million in a commercial real estate loan backed by real estate mortgages.
TABLE 8 — NON-PERFORMING ASSETS
(Dollars in thousands)
                                 
    June 30,     December 31,     Change in     June 30,  
    2006     2005     %     2005  
 
                               
Non-performing assets:
                               
Non- Accruing Loans
  $ 15,096     $ 18,986       -20.5 %   $ 21,859  
Accruing Loans
    14,264       9,447       60.0 %     8,997  
 
                       
Total Non-performing loans
    29,360       28,433       3.3 %     30,856  
Foreclosed real estate
    4,379       4,802       -8.8 %     4,186  
 
                       
 
  $ 33,739     $ 33,235       1.5 %   $ 35,042  
 
                       
 
                               
Non-performing assets to total assets
    0.70 %     0.73 %             0.83 %
 
                         
TABLE 9 — NON-PERFORMING LOANS
(Dollars in thousands)
                                 
    June 30,     December 31,     Change in     June 30,  
    2006     2005     %     2005  
 
                               
Non-performing loans:
                               
Mortgage
  $ 25,847     $ 23,535       9.8 %   $ 26,184  
Commercial, mainly secured by real estate
    2,930       4,600       -36.3 %     4,549  
Consumer
    583       298       95.6 %     123  
 
                       
Total
  $ 29,360     $ 28,433       3.3 %   $ 30,856  
 
                       
 
                               
Non-performing loans composition:
                               
Mortgage
    88.0 %     82.8 %             84.9 %
Commercial, mainly secured by real estate
    10.0 %     16.2 %             14.7 %
Consumer
    2.0 %     1.0 %             0.4 %
 
                         
Total
    100.0 %     100.0 %             100.0 %
 
                         
Non-performing loans to:
                               
Total loans
    2.53 %     3.12 %     -18.9 %     3.39 %
 
                       
Total assets
    0.61 %     0.63 %     -3.2 %     0.73 %
 
                       
Total capital
    8.63 %     8.32 %     3.7 %     9.11 %
 
                       
At June 30, 2006, the Group’s non-performing assets totaled $33.7 million (0.70% of total assets) versus $33.2 million (0.73% of total assets) at December 31, 2005. Foreclosed real estate properties decreased 8.8% to $4.4 million, when compared to $4.8 million reported as of December 31, 2005.
Non-performing consumer loans increased to $583,000 as of June 30, 2006, from $298,000 as of December 31, 2005, mainly due to the higher charge-offs due to current economical conditions. Non-performing mortgage loans increased 9.8% to $25.8 million as of June 30, 2006, when compared to December 31, 2005 non-performing level of $23.5 million, and non-performing commercial loans decreased by 36.3% to $2.9 million as of June 30, 2006 compared to $4.6 million at December 31, 2005.

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At June 30, 2006, the allowance for loan losses to non-performing loans coverage ratio was 25.55%. Detailed information concerning each of the items that comprise non-performing assets follows:
  Mortgage loans are placed on a non-accrual basis when they become 365 days or more past due and are written-down, if necessary, based on the specific evaluation of the collateral underlying the loan. At June 30, 2006, the Group’s non-performing mortgage loans totaled $25.8 million (88.0% of the Group’s non-performing loans), a 9.8% increase from the $23.5 million (82.8% of the Group’s non-performing loans) reported at December 31, 2005. Non-performing loans in this category are primarily residential mortgage loans. Based on the value of the underlying collateral, the loan-to-value ratios and credit loss experience, management considers that no significant losses will be incurred on this portfolio.
 
  Commercial loans are placed on non-accrual status when they become 90 days or more past due and are written-down, if necessary, based on the specific evaluation of the underlying collateral, if any. At June 30, 2006, the Group’s non-performing commercial loans amounted to $2.9 million (10.0% of the Group’s non-performing loans), a 36.3% decrease from $4.6 million reported at December 31, 2005 (16.2% of the Group’s non-performing loans). Most of this portfolio is collateralized by real estate and no significant losses are expected.
 
  Consumer loans are placed on non-accrual status when they become 90 days past due and written-off when payments are delinquent 120 days in personal loans and 180 days in credit cards and personal lines of credit. At June 30, 2006, the Group’s non-performing consumer loans amounted to $583,000 (2.0% of the Group’s total non-performing loans), which increased from the $298,000 reported at December 31, 2005 (1% of total non-performing loans).
 
  Foreclosed real estate is initially recorded at the lower of the related loan balance or fair value at the date of foreclosure. Any excess of the loan balance over the fair market value of the property is charged against the allowance for loan losses. Subsequently, any excess of the carrying value over the estimated fair market value less disposition cost is charged to operations.
At June 30, 2006, the Group’s total liabilities were $4.492 billion, 6.8% higher than the $4.205 billion reported at December 31, 2005. Deposits and borrowings, the Group’s funding sources, amounted to $4.460 billion at June 30, 2006, an increase of 8.0% when compared to $4.131 billion reported at December 31, 2005. At June 30, 2006, borrowings represented 73% of interest-bearing liabilities and deposits represented 27%, versus 69% and 31%, respectively, at December 31, 2005.
Borrowings is the Group’s largest interest-bearing liability component. It consists mainly of diversified funding sources through the use of repurchase agreements, FHLB advances, subordinated capital notes, term notes, and lines of credit. At June 30, 2006, borrowings amounted to $3.246 billion, 14.6% greater than the $2.833 billion at December 31, 2005, mainly due to an increase of 17.6% in repurchase agreements, reflecting the funding needed to finance the Group’s investment and loan portfolios.
The FHLB system functions as a source of credit to financial institutions that are members of a regional Federal Home Loan Bank. As a member of the FHLB, the Group can obtain advances from the FHLB, secured by the FHLB stock owned by the Group, as well as by certain of the Group’s mortgages and investment securities. FHLB advances totaled $285.5 million at June 30, 2006, and $313.3 million at December 31, 2005. The Group has the capacity to expand FHLB funding up to a maximum of $288.6 million based on the current $18.3 million capital contribution by the Group to the FHLB.
At June 30, 2006, deposits, the second largest category of the Group’s interest-bearing liabilities, reached $1.214 billion, down 6.5%, compared to the $1.299 billion reported as of December 31, 2005. Deposits reflected a quarterly decrease of 15.5% in certificates of deposit, to $896.6 million primarily due to a decrease in brokered deposits, partially offset by an increase in savings accounts of 107.0%, to $171.0 million as of June 30, 2006 from $82.6 million as of December 31, 2005.

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TABLE 10 — LIABILITIES SUMMARY AND COMPOSITION
(Dollars in thousands)
                                 
    June 30,     December 31,              
    2006     2005     Variance %     June 30, 2005  
Deposits:
                               
Non-interest bearing deposits
  $ 62,266     $ 61,473       1.3 %   $ 62,205  
Now accounts
    78,970       85,119       -7.2 %     89,930  
Savings accounts
    171,030       82,640       107.0 %     93,920  
Certificates of deposit
    896,571       1,061,401       -15.5 %     1,002,908  
 
                       
 
    1,208,837       1,290,633       -6.3 %     1,248,963  
Accrued interest payable
    5,010       7,935       -36.9 %     3,934  
 
                       
 
    1,213,847       1,298,568       -6.5 %     1,252,897  
 
                       
 
                               
Borrowings:
                               
Repurchase agreements
    2,856,361       2,427,880       17.6 %     2,191,756  
Advances from FHLB
    285,500       313,300       -8.9 %     300,000  
Subordinated capital notes
    72,166       72,166       0.0 %     72,166  
Term notes
    15,000       15,000       0.0 %     15,000  
Federal funds purchased and other short term borrowings
    17,098       4,455       283.8 %     12,310  
 
                       
 
    3,246,125       2,832,801       14.6 %     2,591,232  
 
                       
 
                               
Total deposits and borrowings
    4,459,972       4,131,369       8.0 %     3,844,129  
Securities purchased but not yet received
    6,539       43,354       -84.9 %     22,772  
Other liabilities
    25,868       30,435       -15.0 %     42,584  
 
                       
Total liabilities
  $ 4,492,379     $ 4,205,158       6.8 %   $ 3,909,485  
 
                       
 
                               
Deposits portfolio composition percentages:
                               
Non-interest bearing deposits
    5.2 %     4.8 %             5.0 %
Now accounts
    6.5 %     6.6 %             7.2 %
Savings accounts
    14.1 %     6.4 %             7.5 %
Certificates of deposit
    74.2 %     82.2 %             80.3 %
 
                         
 
    100.0 %     100.0 %             100.0 %
 
                         
 
                               
Borrowings portfolio composition percentages:
                               
Repurchase agreements
    88.0 %     85.7 %             84.6 %
Advances from FHLB
    8.8 %     11.1 %             11.6 %
Subordinated capital notes
    2.2 %     2.5 %             2.8 %
Term notes
    0.5 %     0.5 %             0.6 %
Federal funds purchased and other short term borrowings
    0.5 %     0.2 %             0.4 %
 
                         
 
    100.0 %     100.0 %             100.0 %
 
                         
 
                               
Repurchase agreements
                               
Amount outstanding at quarter-end
  $ 2,856,361     $ 2,427,880             $ 2,191,756  
 
                         
Daily average outstanding balance
  $ 2,548,638     $ 2,270,145             $ 2,174,312  
 
                         
Maximum outstanding balance at any month-end
  $ 2,856,361     $ 2,427,880             $ 2,398,861  
 
                         
Stockholders’ Equity
Stockholders’ equity as of June 30, 2006 was $340.3 million, a 0.4% decrease from $341.8 million as of December 31, 2005. This decrease reflects dividend payments and stock repurchased under the Group’s stock repurchase program, partially offset by the impact of earnings retention and the improvement in derivatives valuation from December 31, 2005.
On August 30, 2005, the Board of Directors of the Group approved a new stock repurchase program pursuant to which the Group is authorized to purchase in the open market of up to $12.1 million of its outstanding shares of common stock. The program superseded the program established in March 2003. On June 20, 2006, the Board of Directors approved an increase of $3.0 million to the initial amount, for the repurchase of up to $15.1 million. The shares of common stock so repurchased are to be held by the Group as treasury shares. During the quarter and six-month period ended June 30, 2006, the Group purchased 46,600 of its shares of common stock in the open market, at a total cost of $582,000, under such program.
The Group’s common stock is traded on the New York Stock Exchange (NYSE) under the symbol OFG. At June 30, 2006, the Group’s market capitalization for its outstanding common stock was $313.6 million ($12.76 per share).

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Under the regulatory framework for prompt corrective action, banks that meet or exceed a Tier I capital risk-based ratio of 6%, a total capital risk-based ratio of 10% and a leverage ratio of 5% are considered well capitalized. The Bank exceeds those regulatory capital requirements.
The following are the consolidated capital ratios of the Group at June 30, 2006 and December 31, 2005:
TABLE 11 — CAPITAL, DIVIDENDS AND STOCK DATA
(In thousands, except for per share data)
                                 
    June 30,     December 31,     Variance     June 30,  
    2006     2005     %     2005  
Capital data:
                               
Stockholders’ equity
  $ 340,283     $ 341,791       -0.4 %   $ 338,755  
 
                       
 
                               
Regulatory Capital Ratios data:
                               
Leverage Capital Ratio
    9.39 %     10.13 %     -7.3 %     10.59 %
 
                       
Minimum Leverage Capital Ratio Required
    4.00 %     4.00 %             4.00 %
 
                           
Actual Tier 1 Capital
  $ 435,973     $ 447,669       -2.6 %   $ 445,131  
 
                       
Minimum Tier 1 Capital Required
  $ 185,712     $ 176,790       5.0 %   $ 168,080  
 
                       
 
Tier 1 Risk-Based Capital Ratio
    29.60 %     34.70 %     -14.7 %     36.97 %
 
                       
Minimum Tier 1 Risk-Based Capital Ratio Required
    4.00 %     4.00 %             4.00 %
 
                           
Actual Tier 1 Risk-Based Capital
  $ 435,973     $ 447,669       -2.6 %   $ 445,131  
 
                       
Minimum Tier 1 Risk-Based Capital Required
  $ 58,912     $ 51,602       14.2 %   $ 48,163  
 
                       
 
Total Risk-Based Capital Ratio
    30.11 %     35.22 %     -14.5 %     37.51 %
 
                       
Minimum Total Risk-Based Capital Ratio Required
    8.00 %     8.00 %             8.00 %
 
                           
Actual Total Risk-Based Capital
  $ 443,474     $ 454,299       -2.4 %   $ 451,626  
 
                       
Minimum Total Risk-Based Capital Required
  $ 117,825     $ 103,204       14.2 %   $ 96,327  
 
                       
 
                               
Stock data:
                               
Outstanding common shares, net of treasury
    24,562       24,580       0.0 %     24,876  
 
                       
Book value
  $ 11.09     $ 11.14       -0.5 %   $ 10.88  
 
                       
Market Price at end of period
  $ 12.76     $ 12.36       3.2 %   $ 15.26  
 
                       
Market capitalization
  $ 313,615     $ 303,809       3.2 %   $ 379,608  
 
                       
                         
    June 30,     June 30,     Variance  
    2006     2005     %  
Common dividend data:
                       
Cash dividends declared
  $ 6,889     $ 6,940       -0.7 %
 
                 
Cash dividends declared per share
  $ 0.28     $ 0.28       0.0 %
 
                 
Payout ratio
    84.34 %     28.24 %     198.7 %
 
                 
Dividend yield
    4.24 %     2.57 %     65.0 %
 
                 
The following provides the high and low prices and dividend per share of the Group’s stock for each quarter of the last three periods. Common stock prices and cash dividend per share were adjusted to give retroactive effect to the stock dividend declared on the Group’s common stock.
                         
                    Cash  
    Price     Dividend  
    High     Low     Per share  
2006
                       
June 30, 2006
  $ 13.99     $ 11.96     $ 0.14  
 
                 
March 31, 2006
  $ 14.46     $ 12.41     $ 0.14  
 
                 
 
                       
2005
                       
December 31, 2005
  $ 13.12     $ 10.16     $ 0.14  
 
                 
September 30, 2005
  $ 15.98     $ 11.91     $ 0.14  
 
                 
June 30, 2005
  $ 23.47     $ 13.66     $ 0.14  
 
                 
March 31, 2005
  $ 28.94     $ 22.97     $ 0.14  
 
                 
 
                       
2004
                       
December 31, 2004
  $ 28.41     $ 24.37     $ 0.14  
 
                 
September 30, 2004
  $ 26.64     $ 22.76     $ 0.13  
 
                 
June 30, 2004
  $ 29.77     $ 23.26     $ 0.13  
 
                 
March 31, 2004
  $ 29.55     $ 22.45     $ 0.13  
 
                 
 
                       

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk and Asset/Liability Management
The Group’s interest rate risk and asset/liability management is the responsibility of the ALCO, which is composed of members of the Group’s senior management. The principal objective of ALCO is to enhance profitability while maintaining an appropriate level of interest rate and liquidity risks. ALCO is also involved in formulating economic projections and strategies used by the Group in its planning and budgeting process. In addition, ALCO oversees the Group’s sources, uses and pricing of funds.
Interest rate risk can be defined as the exposure of the Group’s operating results or financial position to adverse movements in market interest rates, which mainly occur when assets and liabilities reprice at different times and at different rates. This difference is commonly referred to as a “maturity mismatch” or “gap”. The Group employs various techniques to assess its degree of interest rate risk.
The Group is liability sensitive due to its fixed rate and medium to long-term asset composition being funded with shorter-term repricing liabilities. As a result, the Group utilizes various derivative instruments for hedging credit and market risk. The notional amounts are amounts from which calculations and payments are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amount to be received and paid, if any. The actual risk of loss is the cost of replacing, at market, these contracts in the event of default by the counterparties. The Group controls the credit risk of its derivative financial instrument agreements through credit approvals, limits, monitoring procedures and collateral, when considered necessary.
The Group generally uses interest rate swaps and interest rate options in managing its interest rate risk exposure. The swaps were entered into to convert short-term borrowings into fixed rate liabilities for longer periods and provide protection against increases in short-term interest rates. Under these swaps, the Group pays a fixed monthly or quarterly cost and receives a floating monthly or quarterly payment based on LIBOR. Floating rate payments received from the swap counterparties correspond to the floating rate payments made on the short-term borrowings thus resulting in a net fixed rate cost to the Group. Please refer to Note 8-Derivatives Activities of the accompanying unaudited consolidated financial statements for more information related to the Group’s swaps, including derivatives used to manage exposure to the stock market on the certificates of deposit with an option tied to the performance of the Standard & Poor’s 500 stock market index.
During the quarter and six-month period ended June 30, 2006, (losses) gains of ($23,000) and $859,000, respectively, compared to ($1.9 million) and ($4.7 million) for the same periods a year ago, were charged to earnings and reflected as “Derivatives Activities” in the consolidated statements of income. For the quarter and six-month period ended June 30, 2006 unrealized gains of $8.1 million and $18.0 million, respectively, on derivatives designated as cash flow hedges were included in other comprehensive income (loss).
At June 30, 2006 and December 31, 2005, the fair value of derivatives was recognized as either assets or liabilities in the unaudited consolidated statements of financial condition as follows: the fair value of the interest rate swaps to fix the cost of the forecasted rollover of short-term borrowings represented an asset of $20.3 million and $2.5 million, as of June 30, 2006 and December 31, 2005, respectively, presented in other assets; the purchased options used to manage the exposure to the stock market on stock indexed deposits represented an asset of $26.0 million and $22.1 million, respectively also presented in other assets; the options sold to customers embedded in the certificates of deposit represented a liability of $24.6 million and $21.1 million, respectively, recorded in deposits.
The Group’s ALCO decided in July 2006 to unwind interest rate swaps with an aggregate notional amount of $640 million, which had been designated as cash flow hedges and had maturity dates ranging from September 2010 to December 2010. Management concluded that it was beneficial to Oriental to lock-in the fair value of these swaps at approximately $11 million. The net gain of $11 million on this transaction will continue to be included in other comprehensive income, and will be reclassified into earnings during the originally remaining term of the swaps, starting in the September 2006 quarter and through December 2010, by reducing the interest expense on borrowings.
The Group is exposed to a reduction in the level of net interest income (“NII”) in a rising interest rate environment. NII will fluctuate with changes in the levels of interest rates, affecting interest-sensitive assets and liabilities. The hypothetical rate scenarios as of June 30, 2006 consider a gradual change of plus and minus 200 basis points during a forecasted twelve-month period. The hypothetical rate scenarios as of December 31, 2005 consider a gradual change of plus 200 and minus 100 basis points during a forecasted twelve-month period. If (1) the rates in effect at year-end remain constant, or increase or decrease on instantaneous and sustained changes in the amounts presented for each forecasted period, and (2) all scheduled repricing, reinvestments and estimated prepayments, and reissuances are constant, or increase or decrease accordingly; NII will fluctuate as shown on the following table:

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(Dollars in thousands)  
Change in   Expected     Amount     Percent  
Interest rate   NII     Change     Change  
 
                       
June 30, 2006:
                       
Base Scenario
                       
Flat
  $ 34,805     $       0.0 %
 
                 
+ 200 Basis points
  $ 13,395     $ (21,410 )     -61.5 %
 
                 
- 200 Basis points
  $ 59,085     $ 24,280       69.8 %
 
                 
 
                       
December 31, 2005:
                       
Base Scenario
                       
Flat
  $ 56,798     $       0.0 %
 
                 
+ 200 Basis points
  $ 38,043     $ (18,755 )     -33.0 %
 
                 
- 100 Basis points
  $ 65,168     $ 8,370       14.7 %
 
                 
Liquidity Risk Management
The objective of the Group’s asset and liability management function is to maintain consistent growth in net interest income within the Group’s policy limits. This objective is accomplished through management of the Group’s balance sheet composition, liquidity, and interest rate risk exposure arising from changing economic conditions, interest rates and customer preferences.
The goal of liquidity management is to provide adequate funds to meet changes in loan demand or unexpected deposit withdrawals. This is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufficient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. As of June 30, 2006, the Group had approximately $313.7 million in investments available to cover liquidity needs. Additional asset-driven liquidity is provided by securitizable loan assets. These sources, in addition to the Group’s 9.39% average equity capital base, provide a stable funding base.
In addition to core deposit funding, the Bank also accesses a variety of other short-term and long-term funding sources. Short-term funding sources mainly include securities sold under agreements to repurchase. Borrowing funding source limits are determined annually by each counterparty and depend on the Bank’s financial condition and delivery of acceptable collateral securities. The Bank may be required to provide additional collateral based on the fair value of the underlying securities. The Group also uses the FHLB as a funding source, issuing notes payable, such as advances, through its FHLB member subsidiary, the Bank. This funding source requires the Bank to maintain a minimum amount of qualifying collateral with a fair value of at least 110% of the outstanding advances. At June 30, 2006, the Group has an additional borrowing capacity with the FHLB of $3.1 million.
In addition, the Bank utilizes the National Certificate of Deposit (“CD”) Market as a source of cost effective deposit funding in addition to local market deposit inflows. Depositors in this market consist of credit unions, banking institutions, CD brokers and some private corporations or non-profit organizations. The Bank’s ability to acquire brokered deposits can be restricted if it becomes in the future less than well capitalized. An adequately-capitalized bank, by regulation, may not accept deposits from brokers unless it applies for and receives a waiver from the FDIC.
As of June 30, 2006, the Bank had line of credit agreement with other financial institutions permitting the Bank to borrow a maximum aggregate amount of $15.0 million (no borrowings were made during the six-month period ended June 30, 2006 and December 31, 2005 under such lines of credit). The agreements provide for unsecured advances to be used by the Group on an overnight basis. Interest rates are negotiated at the time of the transaction. The credit agreements are renewable annually.
The Group’s liquidity targets are reviewed monthly by ALCO and are based on the Group’s commitment to make loans and investments and its ability to generate funds.
The principal source of funds for the Group is dividends from the Bank. The ability of the Bank to pay dividends is restricted by regulatory authorities (see “Dividend Restrictions” under “Regulation and Supervision” in Item 1). Primarily, through such dividends the Group meets its cash obligations and pays dividends to its common and preferred stockholders. Management believes that the Group will continue to meet its cash obligations as they become due and pay dividends as they are declared.
Changes in statutes and regulations, including tax laws and rules
The Group, as a Puerto Rico-chartered financial holding company, and its subsidiaries, are each subject to extensive federal and local governmental supervision and regulation relating to its banking, securities, and insurance business. The Group also

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benefits from favorable tax treatment under regulations relating to the activities of its international banking entities. In addition, there are laws and other regulations that restrict transactions between the Group and its subsidiaries. Any change in such tax or other regulations, whether by applicable regulators or as a result of legislation subsequently enacted by the Congress of the United States or the Legislature of Puerto Rico, could have an effect on the Group’s results of operations and financial condition.
Puerto Rico international banking entities, or IBEs, are currently exempt from taxation under Puerto Rico law. The IBE Act, as amended, imposes income taxes at normal statutory rates on each IBE that operates as a unit of a bank if the IBE’s net income exceeds 20 percent of the bank’s net income in taxable years commencing on July 1, 2005 and thereafter. It does not impose income taxation on an IBE that operates as a subsidiary of a bank.
The Group has an IBE that operates as a unit of the Bank. In November 2003, the Group organized a new IBE that operates as a subsidiary of the Bank. The Bank transferred as of January 1, 2004, substantially all of the Bank’s IBE assets to the new IBE subsidiary. Although this transfer of IBE assets allows the Group to continue enjoying tax benefits, there cannot be any assurance that the IBE Act will not be modified in the future in a manner to reduce the tax benefits available to the IBE subsidiary.
On August 1, 2005 the Puerto Rico Legislature approved Act No. 41, known as the “Act for the Educational Future of the Puerto Rican Children.” This law imposes an additional tax of 2.5% on taxable net income. This law is applicable to all corporations and partnerships with a taxable net income over $20,000, according to part (a) of Section 1015 of the Puerto Rico Internal Revenue Code of 1994, as amended. The law is effective for tax years beginning after December 31, 2004 and ending on or before December 31, 2006. Although the effectiveness of this law was subject to the final approval of the Legislature’s Joint Resolution No. 445, concerning the Commonwealth’s General Budget of the 2005-2006 fiscal year, which Joint Resolution was vetoed by the Puerto Rico Governor, the Puerto Rico Treasury Department has taken the position that the law is in effect.

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On October 20, 2005, the Puerto Rico Legislature approved a new tax bill. This bill imposes an additional tax of 1% on the net taxable income of banks. This bill is applicable to all banking corporations covered under the Puerto Rico Banking Act of 1933, as amended. The additional funds expected to be obtained from this tax will be assigned to the Department of Education of Puerto Rico. The additional tax is effective for the tax years commencing after June 30, 2005 and ending on or before December 31, 2006.
On May 13, 2006, the Puerto Rico Governor signed into law Act No. 89, which amends the Puerto Rico Internal Revenue Code of 1994, as amended, to impose an additional tax of 2% on the taxable income exceeding $20,000 of banking corporations covered under the Puerto Rico Banking Act of 1933, as amended. The law is effective for taxable years beginning after December 31, 2005 and ending on or before December 31, 2006. This additional tax imposition is not expected to have a material effect on the Group’s consolidated operational results due to the tax exempt composition of the Group’s investments.
On May 16, 2006, the Puerto Rico Governor also signed into law Act No. 98 to impose a one-time extraordinary tax on the net available income of non-exempt corporations and partnerships for the last taxable year ended on or before December 31, 2005. This extraordinary tax constitutes, in effect, a prepayment, as the taxpayer will be allowed to credit the amount so paid against its Puerto Rico income tax liability for taxable years beginning after December 31, 2005; any “unused credit” can be claimed by the taxpayer in four equal installments, beginning on the taxable year following that in which the extraordinary tax is paid. This additional tax imposition is not expected to have a material effect on the Group’s consolidated operational results due to the tax exempt composition of the Group’s investments.
Item 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this quarterly report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of the Group’s management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Group’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon such evaluation, the CEO and the CFO have concluded that, as of the end of such period, the Group’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Group in the reports that it files or submits under the Exchange Act.
Internal Control over Financial Reporting
During the quarter ended June 30, 2006, the Group enhanced its internal controls to address the material weaknesses identified in management’s report on internal control over financial reporting included in the Group’s Form 10-K for the transition period ended December 31, 2005. Specifically, the Group has strengthened its review and documentation procedures over significant non-routine transactions in order to identify and consider all relevant terms and conditions for the proper accounting treatment. These enhanced controls have been applied to certain non-routine transactions that have taken place during and after the quarter ended June 30, 2006, and their operating effectiveness has been tested accordingly. The Group will continue to monitor the design and operating effectiveness of these controls as part of the current year’s management assessment of internal controls over financial reporting.
PART — II OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
On August 14, 1998, as a result of a review of its accounts in connection with the admission by a former Group officer of having embezzled funds and manipulated bank accounts and records, the Group became aware of certain irregularities. The Group notified the appropriate regulatory authorities and commenced an intensive investigation with the assistance of forensic accountants, fraud experts, and legal counsel. The investigation determined losses of $9.6 million, resulting from dishonest and fraudulent acts and omissions involving several former Group employees. These losses were submitted to the Group’s fidelity insurance policy (the “Policy”) issued by Federal Insurance Company, Inc. (“FIC”). In the opinion of the Group’s management, its legal counsel and experts, the losses determined by the investigation were covered by the Policy. However, FIC denied all claims for such losses. On August 11, 2000, the Group filed a lawsuit in the United States District Court for the District of Puerto Rico against FIC, a stock insurance corporation organized under the laws of the State of Indiana, for breach of insurance contract, breach of covenant of good faith and fair dealing and damages, seeking payment of the Group’s $9.6 million insurance claim loss and the payment of consequential damages of no less than $13.0 million resulting from FIC capricious, arbitrary fraudulent and without cause denial of the Group’s claim. The losses resulting from such dishonest and fraudulent acts and omissions were expensed in prior years. On October 3, 2005, a jury rendered a verdict of $7.5 million in favor of the Group and against FIC, the defendant. The jury granted the Group $453,219 for fraud and loss documentation in connection with its Accounts Receivable Returned Checks Account. However, the jury could not reach a decision on the Group’s claim for $3.4 million in connection with fraud in its Cash Accounts, thus forcing a new trial on this issue. The jury denied the Group’s claim for $5.6 million in connection with fraud in the Mortgage Loans Account, but the jury determined that FIC had acted in bad faith and with malice. It, therefore, awarded the Group $7.1 million in consequential damages. The court decided not to enter a final judgment for the aforementioned awards until a new trial on

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the fraud in the Cash Accounts claim is held. After a final judgment is entered, the parties would be entitled to exhaust their post-judgment and appellate rights. The Group has not recognized any income on this claim since the appellate rights have not been exhausted and the amount to be collected has not been determined. The Group expects to request and recover prejudgment interest, costs, fees and expenses related to its prosecution of this case. However, no specific sum can be anticipated as they are subject to the discretion of the court. To date, the court has not scheduled this new trial.
In addition, the Group and its subsidiaries are defendants in a number of legal proceedings incidental to their business. The Group is vigorously contesting such claims. Based upon a review by legal counsel and the development of these matters to date, management is of the opinion that the ultimate aggregate liability, if any, resulting from these claims will not have a material adverse effect on the Group’s financial condition or results of operations.
Item 1A. RISK FACTORS
Except as noted below, there have been no material changes to the risk factors as previously disclosed under Item 1A. in the Group’s Form 10-K for the transition period ended December 31, 2005.
Puerto Rico’s current economic condition may have an adverse effect in our loan portfolio and other revenue sources
The economic uncertainty that exists in Puerto Rico, our primary market, caused in part by the disagreements of the legislative and executive branches of the Puerto Rico government regarding the tax and fiscal reform and the budget approval, has resulted in an economic slowdown in the Island. Also, increases in the price of petroleum and other consumer goods and services, coupled with a recently approved sales tax of 7%, are additional concerns impacting the Island’s economic situation. Puerto Rico economic growth remains subdued, with an apparent reduction in private sector employment. Tax and fiscal reforms were recently signed into law by the Puerto Rico government, including the government’s budget for fiscal year 2007.
The above economic concerns and uncertainty in the private and public sectors may also have an adverse effect in the credit quality of our loan portfolios, as delinquency rates may increase in the short-term, until the economy stabilizes. Also, potential reduction in consumer spending may also impact growth in our other interest and non-interest revenue sources.
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  a)   None
 
  b)   Not applicable
 
  c)   Purchases of equity securities by the issuer and affiliated purchasers
On August 30, 2005, the Board of Directors of the Group approved a program for the repurchase of up to $12.1 million of the Group’s outstanding shares of common stock, which replaced the former program. On June 20, 2006, the Board of Directors approved an increase of $3.0 million to the initial amount, for the repurchase of up to $15.1 million. During May 2006, the Group purchased 46,600 of its shares of common stock in the open market, at an average price of $12.50, for a total cost of $582,000. The approximate dollar value of shares that may yet be purchased under this program amounted to $10.3 million at June 30, 2006.
Item 3. DEFAULTS UPON SENIOR SECURITIES
     None
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
     None

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Item 5. OTHER INFORMATION
  a)   None
 
  b)   None
Item 6. EXHIBITS
     
10.1
  Change in Control Compensation Agreement between Oriental Financial Group Inc. and Mari Evelyn Rodriguez
 
   
31.1
  Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31.2
  Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
32.1
  Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ORIENTAL FINANCIAL GROUP INC.
(Registrant)
             
By:
  /s/ José Rafael Fernández
 
José Rafael Fernández
President and Chief Executive Officer
      Dated: October 17, 2006 
 
           
By:
  /s/ Norberto González
 
Norberto González
Executive Vice President and Chief Financial Officer
      Dated: October 17, 2006 

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