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 September 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

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

24,437,163 common shares ($1.00 par value per share)
outstanding as of October 31, 2006

 

 

TABLE OF CONTENTS

		Page
Part I FINANCIAL INFORMATION:
Item 1 Financial Statements
Unaudited consolidated statements of financial condition at September 30, 2006 and December 31, 2005			1
Unaudited consolidated statements of income for the quarters and nine-month periods ended September 30, 2006 and 2005			2
Unaudited consolidated statements of changes in stockholders’ equity for the nine-month periods ended September 30, 2006 and 2005			3
Unaudited consolidated statements of comprehensive income for the quarters and nine-month periods ended September 30, 2006 and 2005			4
Unaudited consolidated statements of cash flows for the nine-month periods ended September 30, 2006 and 2005			5
Notes to unaudited consolidated financial statements			6
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations			22
Item 3 Quantitative and Qualitative Disclosures About Market Risk			39
Item 4 Controls and Procedures			41
PART II OTHER INFORMATION:
Item 1 Legal Proceedings			42
Item 1A Risk Factors			42
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds			42
Item 3 Defaults Upon Senior Securities			43
Item 4 Submissions of Matters to a Vote of Security Holders			43
Item 5 Other Information			43
Item 6 Exhibits			43
Signatures			44
Certifications			45
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

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 local 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.

PART — I FINANCIAL INFORMATION

ITEM — I FINANCIAL STATEMENTS

UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

     (In thousands, except per share data)

		September 30,				December 31,
		2006				2005
ASSETS
Cash and due from banks		$	14,734			$	13,789
Money market investments			19,318				3,480
Cash and cash equivalents			34,052				17,269
Investments:
Time deposits with other banks			5,000				60,000
Trading securities, at fair value with amortized cost of $349 (December 31, 2005 - $144)			347				146
Investment securities available-for-sale, at fair value with amortized cost of $1,058,283 (December 31, 2005 - $1,069,649)
Securities pledged that can be repledged			788,508				558,719
Other investment securities			246,824				488,165
Total investment securities available-for-sale			1,035,332				1,046,884
Investment securities held-to-maturity, at amortized cost with fair value of $2,141,020 (December 31, 2005 - $2,312,832)
Securities pledged that can be repledged			1,936,372				1,917,805
Other investment securities			246,240				428,450
Total investment securities held-to-maturity			2,182,612				2,346,255
Federal Home Loan Bank (FHLB) stock, at cost			12,847				20,002
Total investments			3,236,138				3,473,287
Securities sold but not yet delivered			87,487				44,009
Loans:
Mortgage loans held-for-sale, at lower of cost or market			8,582				8,946
Loans receivable, net of allowance for loan losses of $7,645 (December 31, 2005 - $6,630)			1,169,869				894,362
Total loans, net			1,178,451				903,308
Accrued interest receivable			28,661				29,067
Premises and equipment, net			19,797				14,828
Deferred tax asset, net			12,698				12,222
Foreclosed real estate			3,825				4,802
Other assets			61,221				48,157
Total assets		$	4,662,330			$	4,546,949
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand deposits		$	136,717			$	146,623
Savings accounts			213,042				82,641
Certificates of deposit			943,683				1,069,304
Total deposits			1,293,442				1,298,568
Borrowings:
Federal funds purchased and other short term borrowings			45,070				4,455
Securities sold under agreements to repurchase			2,692,173				2,427,880
Advances from FHLB			165,000				313,300
Term notes			15,000				15,000
Subordinated capital notes			72,166				72,166
Total borrowings			2,989,409				2,832,801
Securities purchased but not yet received			702				43,354
Accrued expenses and other liabilities			27,064				30,435
Total liabilities			4,310,617				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; 25,378,732 shares issued (December 31, 2005 - 25,350,125 shares)			25,379				25,350
Additional paid-in capital			208,670				208,454
Legal surplus			37,523				35,863
Retained earnings			49,702				52,340
Treasury stock, at cost 868,322 shares (December 31, 2005 - 770,472 shares)			(11,521	)			(10,332	)
Accumulated other comprehensive loss, net of tax of $1,314 (December 31, 2005 - $1,810)			(26,040	)			(37,884	)
Total stockholders’ equity			351,713				341,791
Total liabilities and stockholders’ equity		$	4,662,330			$	4,546,949

See notes to unaudited consolidated financial statements.

UNAUDITED CONSOLIDATED STATEMENTS OF INCOME

  (In thousands, except per share data)

		Quarter Ended September 30,								Nine-Month Period Ended September 30,
		2006				2005				2006				2005
						(As Restated)								(As Restated)
Interest income:
Loans		$	20,819			$	15,218			$	55,384			$	43,575
Mortgage-backed securities			26,030				21,655				74,416				69,055
Investment securities			13,715				13,265				42,188				33,601
Short term investments			301				675				1,764				1,031
Total interest income			60,865				50,813				173,752				147,262
Interest expense:
Deposits			11,931				9,589				33,575				25,909
Securities sold under agreements to repurchase			36,035				20,132				93,525				54,101
Advances from FHLB, term notes and other borrowings			2,551				2,551				7,741				6,739
Subordinated capital notes			1,395				1,213				4,036				3,487
Total interest expense			51,912				33,485				138,877				90,236
Net interest income			8,953				17,328				34,875				57,026
Provision for loan losses			870				951				2,918				2,461
Net interest income after provision for loan losses			8,083				16,377				31,957				54,565
Non-interest income:
Financial service revenues			3,986				3,919				11,303				10,515
Banking service revenues			2,025				2,244				6,712				6,064
Investment banking revenues			592				5				3,153				167
Net gain (loss) on:
Mortgage banking activities			1,122				1,068				2,191				3,310
Securities available-for-sale			2,174				341				2,193				2,864
Derivatives			(1,571	)			(50	)			(713	)			(3,188	)
Trading securities			281				4				303				(49	)
Other			1,276				294				1,216				680
Total non-interest income, net			9,885				7,825				26,358				20,363
Non-interest expenses:
Compensation and employee benefits			6,241				6,260				18,042				13,955
Occupancy and equipment			2,867				2,976				8,549				8,508
Advertising and business promotion			1,148				1,350				3,514				4,257
Professional and service fees			1,804				1,693				5,029				5,307
Communication			419				413				1,261				1,199
Loan servicing expenses			525				446				1,490				1,277
Taxes, other than payroll and income taxes			440				597				1,613				1,531
Electronic banking charges			489				388				1,451				1,448
Printing, postage, stationery and supplies			259				259				803				676
Insurance			220				185				652				560
Other			733				823				2,409				2,714
Total non-interest expenses			15,145				15,390				44,813				41,432
Income before income taxes			2,823				8,812				13,502				33,496
Income tax expense (benefit)			446				391				557				(1,903	)
Net income			2,377				8,421				12,945				35,399
Less: Dividends on preferred stock			(1,200	)			(1,200	)			(3,601	)			(3,601	)
Income available to common shareholders		$	1,177			$	7,221			$	9,344			$	31,798
Income per common share:
Basic		$	0.05			$	0.29			$	0.38			$	1.28
Diluted		$	0.05			$	0.29			$	0.38			$	1.25
Average common shares outstanding			24,564				24,926				24,600				24,791
Average potential common shares-options			97				351				124				714
			24,661				25,277				24,724				25,505
Cash dividends per share of common stock		$	0.14			$	0.14			$	0.42			$	0.42

See notes to unaudited consolidated financial statements.

UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

     (In thousands)

		Nine-Month Period Ended September 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			29				720
Balance at end of period			25,379				25,321
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				10,928
Stock options exercised			200				2,129
Common stock issuance cost			—				(8	)
Balance at end of period			208,670				212,695
Legal surplus:
Balance at beginning of period			35,863				31,280
Transfer from retained earnings			1,660				3,636
Balance at end of period			37,523				34,916
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			12,945				35,399
Cash dividends declared on common stock			(10,322	)			(10,410	)
Cash dividends declared on preferred stock			(3,601	)			(3,601	)
Transfer to legal surplus			(1,660	)			(3,636	)
Balance at end of period			49,702				49,433
Treasury stock:
Balance at beginning of period			(10,332	)			(91	)
Stock used to match defined contribution plan 1165(e)			171				251
Stock purchased			(1,360	)			(8,191	)
Balance at end of period			(11,521	)			(8,031	)
Accumulated other comprehensive income (loss), net of tax:
Balance at beginning of period			(37,884	)			(37,023	)
Other comprehensive income for the period, net of tax			11,844				1,121
Balance at end of period			(26,040	)			(35,902	)
Total stockholders’ equity		$	351,713			$	346,432

See notes to unaudited consolidated financial statements.

UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

     (In thousands)

		Quarter Ended September 30,								Nine-Month Period Ended September 30,
COMPREHENSIVE INCOME		2006				2005				2006				2005
						(As Restated)								(As Restated)
Net income		$	2,377			$	8,421			$	12,945			$	35,399
Other comprehensive income (loss):
Unrealized (loss) gain on securities available-for-sale arising during the period			25,039				(8,978	)			3,689				(17,250	)
Realized gain on investment securities available-for-sale included in net income			(2,174	)			(341	)			(2,193	)			(2,864	)
Unrealized gain (loss) on derivatives designated as cash flows hedges arising during the period			(18,454	)			11,006				10,131				17,629
Realized loss on derivatives designated as cash flow hedges included in net income			1,571				50				713				3,188
Income tax effect related to unrealized loss (gain) on securities available-for-sale			(2,067	)			744				(496	)			418
Other comprehensive income for the period, net of tax			3,915				2,481				11,844				1,121
Comprehensive income		$	6,292			$	10,902			$	24,789			$	36,520

See notes to unaudited consolidated financial statements.

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

     (In thousands)

		Nine-Month Period Ended September 30,
		2006				2005
						(As Restated)
Cash flows from operating activities:
Net income		$	12,945			$	35,399
Adjustments to reconcile net income to net cash used in operating activities:
Amortization of deferred loan origination fees, net of costs			(1,006	)			(1,420	)
Amortization of premiums, net of accretion of discounts on investment securities			1,317				7,679
Depreciation and amortization of premises and equipment			3,998				4,738
Deferred income tax expense (benefit)			(972	)			159
Equity in earnings of investment in limited liability partnership			(658	)			(466	)
Provision for loan losses			2,918				2,461
Stock-based compensation (benefit)			16				(6,281	)
Loss (gain) on:
Sale of securities available-for-sale			(2,193	)			(4,397	)
Mortgage banking activities			(2,191	)			(3,309	)
Derivatives			713				4,720
Sale of foreclosed real estate			(169	)			—
Sale of premises and equipment			(253	)			—
Originations of loans held-for-sale			(62,434	)			(155,129	)
Proceeds from sale of loans held-for-sale			28,963				37,018
Net decrease (increase) in:
Trading securities			(201	)			927
Accrued interest receivable			406				(4,889	)
Other assets			(4,810	)			(8,572	)
Net increase (decrease) in:
Accrued interest on deposits and borrowings			231				11,270
Other liabilities			(993	)			10,556
Net cash used in operating activities			(24,373	)			(69,536	)
Cash flows from investing activities:
Net decrease (increase) in time deposits with other banks			55,000				(60,000	)
Purchases of:
Investment securities available-for-sale			(443,229	)			(735,767	)
Investment securities held-to-maturity			(6,500	)			(336,399	)
Equity options and put options			—				(902	)
Maturities and redemptions of:
Investment securities available-for-sale			26,490				423,948
Investment securities held-to-maturity			170,049				217,588
FHLB stock			7,155				1,102
Proceeds from sales of:
Investment securities available-for-sale			380,653				514,837
Foreclosed real estate			2,522				2,965
Premises and equipment			2,644				3,355
Loan production:
Origination and purchase of loans, excluding loans held-for-sale			(342,782	)			(227,199	)
Principal repayment of loans			63,987				174,583
Additions to premises and equipment			(11,358	)			(4,138	)
Net cash used in investing activities			(95,369	)			(26,027	)
Cash flows from financing activities:
Net increase (decrease) in:
Deposits			(3,084	)			223,243
Securities sold under agreements to repurchase			262,177				(128,979	)
Federal funds purchased			40,615				11,641
Proceeds from:
Advances from FHLB			2,977,225				1,508,071
Exercise of stock options, net			229				2,849
Repayments of advances from FHLB			(3,125,525	)			(1,508,071	)
Common stock used to match defined contribution plan 1165(e)			171				(7,819	)
Repurchase of treasury stock			(1,360	)			—
Dividends paid on common and preferred stocks			(13,923	)			(14,010	)
Net cash provided by financing activities			136,525				86,925
Net change in cash and cash equivalents			16,783				(8,638	)
Cash and cash equivalents at beginning of period			17,269				34,955
Cash and cash equivalents at end of period		$	34,052			$	26,317
Cash and cash equivalents include:
Cash and due from banks		$	14,734			$	15,930
Money market investments			19,318				10,387
		$	34,052			$	26,317
Supplemental Cash Flow Disclosure and Schedule of Noncash Activities:
Interest paid		$	142,560			$	78,965
Income taxes paid		$	82			$	1,108
Mortgage loans securitized into mortgage-backed securities		$	36,023			$	71,226
Investment securities available for sale transferred to held to maturity		$	—			$	60,460
Securities sold but not yet delivered		$	43,478			$	707
Securities and loans purchased but not yet received		$	42,652			$	100,000
Transfer from loans to foreclosed real estate		$	1,376			$	2,972

See notes to unaudited consolidated financial statements.

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 September 30, 2006 and December 31, 2005, and the results of operations, and the cash flows for the nine-month periods ended September 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 nine-month periods ended September 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 wholly-owned subsidiaries, Oriental Bank and Trust (the “Bank”), Oriental Financial Services Corp. (“Oriental Financial Services”), Oriental Insurance, Inc. (“Oriental Insurance”), and Caribbean Pension Consultants, Inc. (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

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.

Loans and Allowance for Loan Losses

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, unamortized discount related to mortgage servicing rights (“MSR”) sold and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees and costs and premiums and discounts on loans purchased are deferred and amortized over the estimated life of the loans as an adjustment of their yield through interest income using a method that approximates the interest method.

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.

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.

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 September 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 September 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 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 September 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 nine-month period ended September 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

the Group and its subsidiaries did not generate net taxable income for the year 2005, this additional tax imposition did not apply and, therefore, it did not affect on the Group’s consolidated operational results.

Stock Option Plans

At September 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 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 nine-month period ended September 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 September 30, 2006, was approximately $206,000 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:

		Nine-Month
		Period Ended
(In thousands, except for per share data)		September 30, 2005
Net income, as reported		$	35,399
Deduct: Shared-based compensation reduction included in reported earnings			(6,287	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards			(716	)
Pro forma net income			28,396
Less: Dividends on preferred stock			(3,601	)
Pro forma income available to common shareholders		$	24,795
Earnings per share:
Basic — as reported		$	1.28
Basic — pro forma		$	1.00
Diluted — as reported		$	1.25
Diluted — pro forma		$	0.97
Average common shares outstanding			24,791
Average potential common share-options			714
			25,505

The average fair value of each option granted during the nine-month period ended September 30, 2006 and 2005 was $3.95 and $4.34, 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:

		Nine-Month Period Ended
		September 30,
		2006				2005
Weighted Average Assumptions:
Dividend yield			3.92	%			3.71	%
Expected volatility			34.32	%			41.59	%
Risk-free interest rate			4.18	%			3.93	%
Expected life (in years)			8.5				8.5

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.

NOTE 2 — INVESTMENT SECURITIES:

The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the investment securities as of September 30, 2006 and December 31, 2005, were as follows:

		September 30, 2006 (In thousands)
						Gross				Gross								Weighted
		Amortized				Unrealized				Unrealized				Fair				Average
		Cost				Gains				Losses				Value				Yield
Available-for-sale
US Treasury securities		$	99,839			$	—			$	3,245			$	96,594				3.55	%
Puerto Rico Government and agency obligations			21,379				65				936				20,508				5.66	%
Corporate bonds and other			150,637				276				3,156				147,757				4.59	%
Total investment securities			271,855				341				7,337				264,859
FNMA and FHLMC certificates			453,293				1,358				13,080				441,571				4.47	%
GNMA certificates			30,745				316				249				30,812				5.59	%
Collateralized mortgage obligations (CMO’s)			302,390				112				4,412				298,090				5.13	%
Total mortgage-backed-securities and CMO’s			786,428				1,786				17,741				770,473
Total securities available-for-sale			1,058,283				2,127				25,078				1,035,332				4.65	%
Held-to-maturity
US Treasury securities			15,038				—				209				14,829				2.71	%
Obligations of US Government sponsored agencies			1,028,310				25				19,884				1,008,451				3.74	%
Puerto Rico Government and agency obligations			55,273				—				5,081				50,192				5.29	%
Total investment securities			1,098,621				25				25,174				1,073,472
FNMA and FHLMC certificates			737,570				232				13,346				724,456				5.06	%
GNMA certificates			190,761				264				2,562				188,463				5.36	%
Collateralized mortgage obligations			155,660				157				1,188				154,629				5.13	%
Total mortgage-backed-securities and CMO’s			1,083,991				653				17,096				1,067,548
Total securities held-to-maturity			2,182,612				678				42,270				2,141,020				4.46	%
Total		$	3,240,895			$	2,805			$	67,348			$	3,176,352				4.52	%

		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 September 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								Amortized
		Cost				Fair Value				Cost				Fair Value
Investment securities
Due within one year		$	43,950			$	41,897			$	349,855			$	347,117
Due after 1 to 5 years			151,350				147,223				312,403				305,590
Due after 5 to 10 years			1,890				1,866				281,248				272,963
Due after 10 years			74,665				73,873				155,115				147,802
			271,855				264,859				1,098,621				1,073,472
Mortgage-backed securities
Due within one year			216				216				—				—
Due after 1 to 5 years			7,661				7,716				—				—
Due after 5 to 10 years			2,893				2,764				—				—
Due after 10 years			775,658				759,777				1,083,991				1,067,548
			786,428				770,473				1,083,991				1,067,548
		$	1,058,283			$	1,035,332			$	2,182,612			$	2,141,020

Proceeds from the sale of investment securities available-for-sale during the nine-month period ended September 30, 2006 totaled $380.7 million (2005 — $514.8 million). Gross realized gains and losses on those sales during the nine-month period ended September 30, 2006 were $4.7 million and $2.6 million, respectively (2005 – gains of $4.9 million and losses of $5,000).

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 September 30, 2006.

Available-for-sale

		Less than 12 months
		Amortized				Unrealized				Fair
		Cost				Loss				Value
US Treasury securities		$	—			$	—			$	—
Puerto Rico Government and agency obligations			3,509				(28	)			3,481
Corporate bonds and other			68,947				(2,652	)			66,295
Mortgage-backed securities and CMO’s			151,726				(460	)			151,266
			224,182				(3,140	)			221,042

		12 months or more
		Amortized				Unrealized				Fair
		Cost				Loss				Value
US Treasury securities			99,840				(3,245	)			96,595
Puerto Rico Government and agency obligations			14,189				(908	)			13,281
Corporate bonds and other			25,040				(504	)			24,536
Mortgage-backed securities and CMO’s			544,733				(17,281	)			527,452
			683,802				(21,938	)			661,864

		Total
		Amortized				Unrealized				Fair
		Cost				Loss				Value
US Treasury securities			99,840				(3,245	)			96,595
Puerto Rico Government and agency obligations			17,698				(936	)			16,762
Corporate bonds and other			93,987				(3,156	)			90,831
Mortgage-backed securities and CMO’s			696,459				(17,741	)			678,718
		$	907,984			$	(25,078	)		$	882,906