Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


(Mark One)

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

For the quarterly period ended September 30, 2006

or

 

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

Commission file number 1-11921

 


E*TRADE Financial Corporation

(Exact name of Registrant as Specified in its Charter)

 

Delaware   94-2844166

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

135 East 57th Street, New York, New York 10022

(Address of Principal Executive Offices and Zip Code)

(646) 521-4300

(Registrant’s Telephone Number, including Area Code)

 


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  x    No  ¨

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  x   Accelerated filer  ¨  

Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of November 3, 2006, there were 426,951,622 shares of common stock outstanding.

 



Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended September 30, 2006

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION

    

Item 1.

  Consolidated Financial Statements    3

Consolidated Statement of Income

   35

Consolidated Balance Sheet

   36

Consolidated Statement of Comprehensive Income

   37

Consolidated Statement of Shareholders’ Equity

   38

Consolidated Statement of Cash Flows

   39

Notes to Consolidated Financial Statements (Unaudited)

   41

Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies

   41

Note 2—Discontinued Operations

   43

Note 3—Facility Restructuring and Other Exit Activities

   44

Note 4—Operating Interest Income and Operating Interest Expense

   45

Note 5—Available-for-Sale Mortgage-Backed and Investment Securities

   46

Note 6—Loans, Net

   49

Note 7—Brokerage Receivables, Net and Brokerage Payables

   49

Note 8—Accounting for Derivative Financial Instruments and Hedging Activities

   50

Note 9—Equity Method Investments

   54

Note 10—Goodwill

   55

Note 11—Deposits

   55

Note 12—Asset Securitization

   55

Note 13—Earnings per Share

   57

Note 14—Share Repurchases

   58

Note 15—Employee Share-Based Payments and Other Benefits

   58

Note 16—Regulatory Requirements

   59

Note 17—Commitments, Contingencies and Other Regulatory Matters

   60

Note 18—Segment Information

   63

Note 19—Subsequent Events

   67

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    3

Overview

   3

Earnings Overview

   7

Segment Results Review

   18

Balance Sheet Overview

   21

Liquidity and Capital Resources

   26

Summary of Critical Accounting Policies and Estimates

   27

Required Financial Data

   28

Glossary of Terms

   30

Item 3.

  Quantitative and Qualitative Disclosures about Market Risk    33

Item 4.

  Controls and Procedures    68

PART II—OTHER INFORMATION

    

Item 1.

  Legal Proceedings    69

Item 1A.

  Risk Factors    70

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds    70

Item 3.

  Defaults Upon Senior Securities    70

Item 4.

  Submission of Matters to a Vote of Security Holders    71

Item 5.

  Other Information    71

Item 6.

  Exhibits    71

Signatures

   72

 


Unless otherwise indicated, references to “the Company,” “We,” “Us,” “Our” and “E*TRADE” mean E*TRADE Financial Corporation or its subsidiaries.

E*TRADE, E*TRADE Financial, E*TRADE Bank (“Bank”), ClearStation, Equity Edge, Equity Resource, OptionsLink and the Converging Arrows logo are registered trademarks of E*TRADE Financial Corporation in the United States and in other countries.

 

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Table of Contents

ITEM 1.    CONSOLIDATED FINANCIAL STATEMENTS

This information is set forth immediately following Item 3, “ Quantitative and Qualitative Disclosures about Market Risk.”

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document.

FORWARD-LOOKING STATEMENTS

Certain statements made in this document are forward-looking statements that are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may sometimes be identified by words such as “expect,” “may,” “looking forward,” “we plan,” “we believe,” “are planned,” “could be” or “currently anticipate.” Although we believe these statements to be true, we give no assurance that any such plans, intentions or expectations will be achieved. Actual results, performance or achievements may differ materially from those contemplated, expressed or implied by any forward-looking statements, and we caution that we do not undertake to update forward-looking statements. Important factors that may cause actual results to differ materially from any forward-looking statements are set forth in our 2005 Form 10-K filed with the Securities and Exchange Commission (“SEC”) under the heading “Risk Factors.”

We further caution that there may be risks associated with owning our securities other than those discussed in such filings.

GLOSSARY OF TERMS

In analyzing and discussing our business, we utilize certain metrics, ratios and other terms that are defined in the “Glossary of Terms,” which is located at the end of Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

OVERVIEW

Strategy

Our strategy centers on strengthening and growing our retail business and leveraging that growth in our institutional business. We strive to further develop our retail business by acquiring, expanding and retaining our relationships with global retail customers. We offer our retail and institutional customers a suite of investing, trading, banking and lending products. We plan to grow those relationships by using technology to deliver an attractive combination of product, service and price to the value-driven customer. We also intend to grow, where appropriate, through targeted acquisitions which leverage our existing business platform.

As we expand our global customer base, and increase the retail customer cash and credit products we hold on our balance sheet, we believe that our business will benefit. As our institutional business manages our balance sheet on an enterprise-wide basis, we become less dependent on revenue from market-driven customer trading activity, and our income, while still positioned to benefit from a strong equity market, becomes more recurring in nature. As a result, net operating interest income has become our leading category of revenue, and we anticipate this trend will continue.

Key Factors Affecting Financial Performance

Our financial performance is affected by a number of factors outside of our control, including:

 

    customer demand for our products and services;

 

    competitors’ pricing on similar products and services;

 

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    interest rates and the shape of the interest rate yield curve; and

 

    the performance of the equity and capital markets.

In addition to the items noted above, our success in the future will depend upon, among other things:

 

    continuing our success in the acquisition, growth and retention of customers;

 

    deepening customer acceptance of our investing, trading, banking and lending products, including E*TRADE Complete;

 

    disciplined expense control and improved operational efficiency;

 

    maintaining strong overall asset quality; and

 

    prudent risk and capital management.

Management monitors a number of metrics in evaluating the Company’s performance. The most significant of these are shown in the table and discussed in the text below:

 

     As of or for the
Three Months Ended
September 30,
    Variance     As of or for the
Nine Months Ended
September 30,
    Variance  
     2006     2005     2006 vs. 2005     2006     2005     2006 vs. 2005  
Customer Activity Metrics:             

Retail client assets (dollars in billions)(1)

   $ 184.8     $ 106.4     74  %   $ 184.8     $ 106.4     74  %

Customer cash and deposits (dollars in billions)(1)

   $ 31.6     $ 19.4     63  %   $ 31.6     $ 19.4     63  %

Daily average revenue trades

     135,130       93,876     44  %     160,589       87,599     83  %

Average commission per trade

   $ 11.95     $ 13.94     (14 )%   $ 12.10     $ 14.24     (15 )%

Products per customer

     2.1       2.0     5  %     2.1       2.0     5  %
Company Financial Metrics:             

Net revenue growth(2)

     39 %     27 %   12  %     46 %     13 %   33  %

Enterprise net interest spread (basis points)

     286       252     13  %     288       246     17  %

Enterprise interest-earning assets (average in billions)

   $ 46.4     $ 32.7     42  %   $ 44.0     $ 31.3     40  %

Operating margin(3)

     38 %     36 %   2  %     41 %     36 %   5  %

Compensation and benefits as a % of revenue

     19 %     25 %   (6 )%     20 %     23 %   (3 )%

(1)   Customer cash and deposits, as well as retail client assets, have been re-presented to account for a methodology change in the metric to settlement date from trade date reporting as of December 31, 2005, which reduced both metrics by $564 million. This is not a methodology change in accounting policy and does not impact the reporting of these items on our balance sheet.
(2)   Revenue growth is the difference between the current and prior comparable period total net revenue divided by the prior comparable period total net revenue.
(3)   Percentage of net revenue that goes to net income before other income (expense), income taxes, minority interest, discontinued operations and cumulative effect of accounting change. It is calculated by dividing our income before other income (expense), income taxes, minority interest, discontinued operations and cumulative effect of accounting change by our total net revenue.

Customer Activity Metrics

 

    Retail client assets are an indicator of the value of our relationship with the customer. An increase in retail client assets generally indicates that the use of our products and services by existing and new customers is expanding. Changes in this metric are also driven by changes in the valuations of our customers’ underlying securities.

 

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    Customer cash and deposits are an indicator of a deepening engagement with our customers and a key driver of net operating interest income.

 

    Daily average revenue trades (“DARTs”) are the predominant driver of commission revenue from our retail customers.

 

    Average commission per trade is impacted by the mix between our retail domestic and international businesses. This is an indicator of changes in our customer mix, product mix or product pricing.

 

    Products per customer is an indicator of our customer engagement and how well our suite of products and services appeal to our customer base. We believe increases to this measure represent better overall customer engagement with our products and services.

Company Financial Metrics

 

    Net revenue growth is an indicator of our overall financial well-being and our ability to execute on our strategy. When coupled with operating margin, the two provide information about the general success of our business.

 

    Enterprise net interest spread is a broad indicator of our ability to generate net operating interest income.

 

    Enterprise interest-earning assets are an indicator of our ability to generate net operating interest income, and growth in these assets, in conjunction with net operating interest spread, indicates our ability to grow net operating interest income.

 

    Operating margin is an indicator of the profitability of our operations.

 

    Compensation and benefits as a percentage of revenue is an indicator of our productivity. In recent periods, we have grown our revenue faster than our compensation expense. This ratio coupled with operating margin is an indictor of our increasing efficiency.

Significant Events in the Third Quarter of 2006

Acquired Retirement Advisors of America (“RAA”)

We completed the purchase of RAA, a Dallas, Texas-based investment advisor managing over $1 billion in assets. We believe this acquisition strengthens our regional advisor business, which delivers localized wealth management services and advice to retail clients with a minimum of $250,000 in assets.

Increased Ownership of IL&FS Investsmart Limited (“Investsmart”)(1)

We increased our ownership stake in Investsmart and now meet the criteria required to exercise significant influence, which now categorizes Investsmart as an equity method investment. In addition, we have made an open offer to purchase an additional 20% of Investsmart’s outstanding shares, which, if successful, would increase our ownership percentage to as much as 48%.

E*TRADE Canada Pricing Change

E*TRADE Canada announced it will offer a flat fee on Canadian equity commissions to retail customers who hold $50,000 or more in combined assets, or who conduct 30 or more trades per quarter. With this pricing change, E*TRADE Canada is one of the first Canadian brokers to offer flat pricing to both Mass Affluent and Active Traders.

E*TRADE Germany Website Launch and Flat Fee Offer

E*TRADE Germany launched an updated website with new products and functionalities which supports both the English and German languages and introduces E*TRADE Germany as the first broker in Germany to offer a flat fee on trading.

 

(1)   Investsmart is an India-based financial services organization providing individuals and corporations with customized financial management solutions.

 

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Upgraded Credit Rating

Two credit agencies, Standard & Poors (“S&P”) and Dominion Bond Rating Service (“DBRS”), upgraded our senior unsecured debt rating during the third quarter of 2006. S&P upgraded our rating to BB- (stable) from B+ (positive) and DBRS upgraded our rating by two increments to BB (high) from BB (low). DBRS also upgraded the long-term deposit rating of E*TRADE Bank to BBB (low) from BB. These increases are consistent with Moody’s Investor Service upgrades on our senior unsecured debt rating from B1 to Ba2 and the long-term deposit rating of E*TRADE Bank from Ba2 to Baa3 that occurred during the second quarter of 2006. We believe that our improved profitability and the diversity of our business model were key factors in receiving these upgrades and that these upgrades are an important acknowledgement of the progress we have made as a company.

Enhanced Distribution Network

We enhanced our distribution network by opening a new E*TRADE Financial center during the period. With the addition of the King of Prussia, PA center, we increased the number of our nationwide financial centers to a total of 21.

Summary Financial Results

Income Statement Highlights for the Three and Nine Months Ended September 30, 2006 (dollars in millions, except per share amounts)

 

     Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
         2006             2005         2006 vs. 2005     2006     2005     2006 vs. 2005  

Total net revenue

   $ 581.8     $ 419.8     39 %   $ 1,791.5     $ 1,224.9     46 %

Net income

   $ 153.2     $ 107.5     43 %   $ 452.2     $ 301.1     50 %

Diluted net earnings per share

   $ 0.35     $ 0.28     25 %   $ 1.03     $ 0.79     30 %

Operating margin(1)

   $ 223.2     $ 152.0     47 %   $ 727.7     $ 445.5     63 %

Operating margin (%)(2)

     38 %     36 %   2 %     41 %     36 %   5 %

(1)   Income before other income (expense), income taxes, minority interest, discontinued operations and cumulative effect of accounting change.
(2)   Percentage of net revenue that goes to operating margin. It is calculated by dividing operating margin by our total net revenue.

During the third quarter of 2006, despite a decline in overall market activity, we continued to strengthen our operating and financial performance. Total net revenue and net income increased 39% and 43%, respectively, when compared to the corresponding period in the prior year. We believe these increases were driven both by our acquisitions of Harrisdirect LLC (“Harrisdirect”) and J.P. Morgan Invest, LLC (“BrownCo”) as well as by our ability to grow customer cash and deposits, margin receivables and DARTs. The growth in customer cash and deposits and margin receivables were the primary drivers of our increase in net operating interest income, and the growth in DARTs was the primary driver of our increase in commission revenue. We were able to achieve this growth while increasing our operating margin to 38% in the third quarter of 2006 from 36% when compared to the same period in the prior year. We believe this growth in operating margin reflects increasing efficiencies in our operations.

Net operating interest income after provision for loan losses increased 68% to $342.6 million for the three months ended September 30, 2006, compared with the same period in 2005. Net operating interest income benefited from increases in customer cash and deposits coupled with growth in enterprise interest-earning assets. Customer cash and deposits, our lowest cost sources of funds, increased $12.2 billion compared to the same period in 2005. The increase in customer cash and deposits resulted both from our acquisitions, which added $8.0 billion of customer cash and deposits, and from organic growth, which added $4.2 billion. We believe our

 

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organic growth is a result, in part, of the Intelligent Cash Optimizer within E*TRADE Complete, which continues to drive growth in customer cash and deposit balances. Average enterprise interest-earning assets increased by $13.7 billion in the third quarter of 2006 compared to the same period in 2005, partially driven by our acquisitions which added $3.9 billion of margin receivables to our balance sheet.

Commission revenue increased 17% to $133.6 million for the three months ended September 30, 2006, compared with the same period in 2005. The primary driver of this growth was an increase in DARTs to 135,130, an increase of 44% compared to the same quarter in 2005. Our U.S. DART volume increased 47% from the prior year, driven by both our acquisitions of BrownCo and Harrisdirect as well as organic customer growth and engagement. Our international DARTs grew by 28% compared to the same quarter in 2005, driven entirely by organic growth. Our international operations continue to be a strong growth contributor within our retail trading business, and we believe that over time it will become a significant component of our entire business. In addition, option-related DARTs further increased as a percentage of our total U.S. DARTs and now represent 13% of trading volume versus 10% a year ago.

Balance Sheet Highlights (dollars in billions)

 

     September 30,
2006
    December 31,
2005
    Variance  
         2006 vs. 2005  

Total assets

   $ 51.5     $ 44.6     16 %

Total enterprise interest-earning assets

   $ 46.4     $ 41.1     13 %

Average loans, net and margin receivables as a percentage of enterprise interest-earning assets(1)(2)

     64 %     61 %   3 %

Average retail deposits and free credits as a percentage of enterprise interest-bearing liabilities(1)(2)

     61 %     54 %   7 %

(1)   The table data on average enterprise interest-earning assets, loans, net and margin receivables, retail deposits and free credits has been prepared on the same basis as our disclosures with respect to the Bank under the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies”.
(2)   Percentages calculated reflect data for the three months ended September 30, 2006 and December 31, 2005.

The increase in total assets was primarily attributable to increases of $3.9 billion in loans, net and $2.6 billion in available-for-sale mortgage-backed and investment securities. The increase, in loans, net was principally due to growth in our real estate loan portfolio. We continue to focus our efforts on growing our residential mortgage loan portfolios, including one- to four-family and home equity loans, and allowing our consumer loan portfolio to decline.

Retail deposits and free credits were $27.9 billion, up 31% or $6.7 billion during the first nine months of 2006. The increase related to the Harrisdirect conversion, as well as organic growth in checking, money market and certificates of deposit accounts. Retail deposits and free credits are two of our lowest cost sources of funding and are important contributors to our net operating interest income growth. In addition to acquired customer growth, we experienced organic growth which we believe is a result, in part, of the E*TRADE Complete Intelligent Cash Optimizer, as well as an overall focus on price, functionality and service for our global retail customers.

EARNINGS OVERVIEW

Net income from continuing operations increased 38% to $150.2 million and 40% to $449.9 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. We experienced strong growth in customer cash and deposits as well as in DARTs. We also experienced growth in customer margin balances. In addition, we were able to achieve this growth while increasing our operating margin to 38% in the third quarter of 2006 from 36% when compared to the same period in the prior year. We believe this growth in operating margin is reflective of increasing efficiencies in our operations.

 

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During the nine month period ended September 30, 2006, we modified the format of our consolidated income statement to a format that we believe provides a clearer picture of our financial performance and is more consistent with the common presentation found in the financial services industry. We re-ordered the revenue section by placing net operating interest income, which we previously referred to as net interest income, first, and non-interest income second. In addition, we updated our expense presentation to eliminate the remaining bank/brokerage lines. In conjunction with this change, we created a new expense category, “Clearing and servicing.” This new category includes trade clearing-related expense, previously included in “Commissions, clearance and floor brokerage,” and most expenses previously included in “Servicing and other banking expenses.” We also consolidated “Fair value adjustments of financial derivatives” into the “Other” expense category. Information related to fair value adjustments of financial derivatives is detailed in Note 8 to the consolidated financial statements.

In particular, we report corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Our operating interest income and operating interest expense is generated from the operations of the Company and is a broad indicator of our success in our banking, lending and balance sheet management businesses. Our corporate debt, which is the primary source of our corporate interest expense, has been used primarily to finance acquisitions, such as Harrisdirect and BrownCo, and generally has not been downstreamed to any of our operating subsidiaries.

Similarly, we report gain on sales and impairment of investments separately from gain on sales of loans and securities, net. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Gain on sales of loans and securities, net are the result of activities in our operations, namely our lending and balance sheet management businesses. Gain on sales and impairment of investments relates to historical equity investments of the Company at the corporate level and are not related to the ongoing business of our operating subsidiaries.

The following sections describe in detail the changes in key operating factors and other changes and events that have affected our consolidated net revenue, expense excluding interest, other income (expense), income tax expense, discontinued operations and cumulative effect of accounting change.

Revenue

The components of net revenue and the resulting variances are as follows (dollars in thousands):

 

    Three Months Ended
September 30,
    Variance   Nine Months Ended
September 30,
    Variance
      2006 vs. 2005     2006 vs. 2005
    2006     2005     Amount         %       2006     2005     Amount         %    

Revenue:

               

Operating interest income

  $ 731,429     $ 424,114     $ 307,315     72 %   $ 1,986,096     $ 1,148,384     $ 837,712     73 %

Operating interest expense

    (376,293 )     (207,101 )     (169,192 )   82 %     (961,569 )     (535,532 )     (426,037 )   80 %
                                                   

Net operating interest income

    355,136       217,013       138,123     64 %     1,024,527       612,852       411,675     67 %

Provision for loan losses

    (12,547 )     (12,909 )     362     (3)%     (33,014 )     (37,946 )     4,932     (13)%
                                                   

Net operating interest income after provision for loan losses

    342,589       204,104       138,485     68 %     991,513       574,906       416,607     72 %
                                                   

Commission

    133,606       114,278       19,328     17 %     476,771       323,111       153,660     48 %

Service charges and fees

    33,910       32,893       1,017     3 %     99,540       100,639       (1,099 )   (1)%

Principal transactions

    22,697       23,793       (1,096 )   (5)%     84,979       75,547       9,432     12 %

Gain on sales of loans and securities, net

    16,003       21,850       (5,847 )   (27)%     38,738       84,121       (45,383 )   (54)%

Other revenue

    32,961       22,918       10,043     44 %     99,932       66,596       33,336     50 %
                                                   

Total non-interest income

    239,177       215,732       23,445     11 %     799,960       650,014       149,946     23 %
                                                   

Total net revenue

  $ 581,766     $ 419,836     $ 161,930     39 %   $ 1,791,473     $ 1,224,920     $ 566,553     46 %
                                                   

 

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Net operating interest income after provision for loan losses continues to be our largest source of revenue and now represents 59% and 55% of total net revenue for the three and nine months ended September 30, 2006, respectively. This reflects our focus on retaining retail customer cash and deposits and retail credit balances. Net operating interest income is earned primarily through holding credit balances, which includes margin, real estate and consumer loans, and by holding customer cash and deposits, which are a low cost source of funding. The table below presents each revenue component as a percentage of total net revenue.

 

     Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
     2006     2005     2006 vs. 2005     2006     2005     2006 vs. 2005  

Revenue:

            

Net operating interest income after provision for loan losses

   59 %   49 %   10  %   55 %   47 %   8  %

Commission

   23     27     (4 )   27     26     1  

Service charges and fees

   6     8     (2 )   6     8     (2 )

Principal transactions

   4     6     (2 )   5     6     (1 )

Gain on sales of loans and securities, net

   3     5     (2 )   2     7     (5 )

Other revenue

   5     5     —       5     6     (1 )
                                    

Total net revenue

   100 %   100 %   —    %   100 %   100 %   —     %
                                    

Net Operating Interest Income After Provision for Loan Losses

Net operating interest income after provision for loan losses increased 68% to $342.6 million and 72% to $991.5 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase in net operating interest income primarily is due to growth in enterprise interest-earning assets coupled with an increase in enterprise net interest spread. The growth in enterprise interest-earning assets was driven by increases in both loans, net and margin receivables. The increase in enterprise net interest spread was driven by changes in our mix of lending and funding sources. Average loans, net and margin receivables as a percentage of average enterprise interest-earning assets increased 5% to 64% and 10% to 63% for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Average retail deposits and free credits as a percentage of average enterprise interest-bearing liabilities increased 8% to 61% and 10% to 63% for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005.

 

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The following table presents enterprise average balance sheet data and enterprise income and expense data for our operations, as well as the related net interest spread, and has been prepared on the same basis as our disclosures with respect to E*TRADE Bank under the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in thousands):

 

    Three Months Ended September 30,  
    2006     2005  
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield/Cost
 

Enterprise interest-earning assets:

           

Loans, net

  $ 22,955,022     $ 364,744     6.36 %   $ 17,024,600   $ 232,004   5.45 %

Margin receivables

    6,645,017       123,855     7.39 %     2,267,918     37,844   6.62 %

Mortgage-backed and related available-for-sale securities

    12,068,052       159,199     5.28 %     9,059,130     97,537   4.31 %

Available-for-sale investment securities

    3,220,054       51,885     6.44 %     1,937,276     25,888   5.35 %

Trading securities

    114,806       2,600     9.06 %     186,377     2,792   5.99 %

Cash and cash equivalents(1)

    974,738       11,272     4.59 %     1,793,028     14,950   3.31 %

Stock borrow and other

    422,010       8,690     8.17 %     422,076     5,654   5.31 %
                               

Total enterprise interest-earning assets

  $ 46,399,699       722,245     6.22 %   $ 32,690,405     416,669   5.10 %
                               

Enterprise interest-bearing liabilities:

           

Retail deposits

  $ 20,992,962       141,035     2.67 %   $ 13,095,471     57,710   1.75 %

Brokered certificates of deposit

    618,681       7,453     4.78 %     540,575     4,815   3.53 %

Free credits

    5,794,586       18,326     1.25 %     3,406,685     4,733   0.55 %

Repurchase agreements and other borrowings

    11,586,260       150,837     5.09 %     9,510,214     91,520   3.77 %

Federal Home Loan Bank (“FHLB”) advances

    3,583,663       43,950     4.80 %     4,093,294     40,914   3.91 %

Stock loan and other

    1,283,026       11,617     3.59 %     426,729     2,025   1.88 %
                               

Total enterprise interest-bearing liabilities

  $ 43,859,178       373,218     3.36 %   $ 31,072,968     201,717   2.58 %
                               

Enterprise net interest income/spread

    $ 349,027     2.86 %     $ 214,952   2.52 %
                     

Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):

 

    Three Months Ended
September 30,
                     
    2006     2005                      

Enterprise net interest income(2)

  $     349,027     $     214,952          

Taxable equivalent interest adjustment

    (5,246 )     (2,599 )        

Stock conduit, net(3)

    14       339          

Customer cash held by third parties(4)

    11,341       4,321          
                       

Net operating interest income

  $     355,136     $     217,013          
                       

(1)   Includes segregated cash balances.
(2)   Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense, stock conduit interest income and expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net operating interest income generated by our operations.
(3)   Net operating interest income earned on average stock conduit assets of $0.03 billion and $0.7 billion for the quarters ended September 30, 2006 and 2005, respectively.
(4)   Includes interest earned on average customer assets of $3.6 billion and $1.7 billion for the quarters ended September 30, 2006 and 2005, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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    Nine Months Ended September 30,  
    2006     2005  
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield/Cost
 

Enterprise interest-earning assets:

           

Loans, net

  $ 20,994,403     $ 949,513     6.03 %   $ 14,517,416   $ 569,191   5.23 %

Margin receivables

    6,702,436       352,149     7.02 %     2,216,424     101,110   6.10 %

Mortgage-backed and related available-for-sale securities

    11,451,932       432,077     5.03 %     9,139,878     285,366   4.16 %

Available-for-sale investment securities

    2,931,914       136,561     6.21 %     2,957,416     112,115   5.05 %

Trading securities

    131,885       8,194     8.28 %     308,240     9,631   4.17 %

Cash and cash equivalents(1)

    1,259,239       40,592     4.31 %     1,717,698     38,837   3.02 %

Stock borrow and other

    481,809       25,215     7.00 %     438,029     14,957   4.57 %
                               

Total enterprise interest-earning assets

  $ 43,953,618       1,944,301     5.90 %   $ 31,295,101     1,131,207   4.82 %
                               

Enterprise interest-bearing liabilities:

           

Retail deposits

  $ 19,664,315       346,602     2.36 %   $ 12,407,871     147,570   1.59 %

Brokered certificates of deposit

    539,508       18,262     4.53 %     429,568     10,818   3.37 %

Free credits

    6,319,950       51,656     1.09 %     3,320,539     11,861   0.48 %

Repurchase agreements and other borrowings

    10,680,195       391,460     4.83 %     9,995,414     261,492   3.45 %

FHLB advances

    3,161,930       108,696     4.53 %     3,026,553     86,358   3.76 %

Stock loan and other

    1,031,071       24,301     3.15 %     453,485     4,630   1.37 %
                               

Total enterprise interest-bearing liabilities

  $ 41,396,969       940,977     3.02 %   $ 29,633,430     522,729   2.36 %
                               

Enterprise net interest income/spread

    $ 1,003,324     2.88 %     $ 608,478   2.46 %
                     

Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):

 

    Nine Months Ended
September 30,
                     
    2006     2005                      

Enterprise net interest income(2)

  $     1,003,324     $     608,478          

Taxable equivalent interest adjustment

    (12,944 )     (7,869 )        

Stock conduit, net(3)

    408       873          

Customer cash held by third parties(4)

    33,739       11,370          
                       

Net operating interest income

  $     1,024,527     $     612,852          
                       

(1)   Includes segregated cash balances.
(2)   Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense, stock conduit interest income and expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net operating interest income generated by our operations.
(3)   Net operating interest income earned on average stock conduit assets of $0.4 billion and $0.6 billion for the nine months ended September 30, 2006 and 2005, respectively.
(4)   Includes interest earned on average customer assets of $3.5 billion and $2.1 billion for the nine months ended September 30, 2006 and 2005, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

Despite the flat to inverted yield curve during the period, enterprise net interest spread increased by 34 basis points to 2.86% and by 42 basis points to 2.88% for the three and nine months ended September 30, 2006, respectively, compared to same periods in 2005. This increase was primarily the result of our ability to grow low-cost deposits and free credits during these periods, which in turn funded our growth in loans, net and margin receivables.

Average enterprise interest-earning assets increased 42% to $46.4 billion and 40% to $44.0 billion for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Average

 

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loans, net and margin receivables grew 53% to $29.6 billion and 66% to $27.7 billion for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Average loans, net grew as a result of our focus on mortgage loan products, specifically our home equity lines of credit (“HELOC”) portfolio. The margin loan portfolio grew, in part, as a result of our acquisitions of Harrisdirect and BrownCo, as well as organic growth.

Average enterprise interest-bearing liabilities increased 41% to $43.9 billion and 40% to $41.4 billion for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase in average enterprise interest-bearing liabilities was primarily in low-cost customer cash and deposits. Average retail deposits and free credits increased 62% to $26.8 billion and 65% to $26.0 billion for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Increases in average retail deposits and free credits were driven by our acquisitions of Harrisdirect and BrownCo, as well as by organic growth.

Our interest rate risk is impacted by external factors such as the level and shape of the interest rate yield curve and the impact of the competitive environment on our pricing. We utilize interest rate derivatives to manage this risk. In recent years, we have managed our interest rate risk to achieve a minimum to moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations.

Provision for Loan Losses

Provision for loan losses decreased 3% to $12.5 million and 13% to $33.0 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The decrease in the provision for loan losses is primarily related to a lower provision for our consumer loan portfolio in connection with the decline in the overall consumer loan portfolio. However, we anticipate that the provision for our mortgage portfolio will increase as we grow our mortgage portfolio and we expect the provision for the mortgage portfolio to increase at a higher rate than the decline in the provision for our consumer portfolio.

Commission

Commission revenue increased 17% to $133.6 million and 48% to $476.8 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The primary factors that affect our commission revenue are DARTs and average commission per trade, which is impacted by both trade types and the mix between our domestic and international businesses. Each business has a different pricing structure, unique to its customer base and local market practices, and as a result, a change in the executed trades between these businesses impacts average commission per trade. Each business also has different trade types (e.g. equities, options, fixed income and mutual funds) that can have different commission rates. As a result, changes in the mix of trade types within either of these businesses may impact average commission per trade.

Average commission per trade decreased 14% to $11.95 and 15% to $12.10 for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The decrease primarily was a function of the mix of customers. Main Street Investors, who generally have a higher commission per trade, traded less during the period which resulted in a heavier weighting of Active Traders, who generally have a lower commission per trade. In addition, we extended a conversion-related free trade offer to Harrisdirect customers during the first three months of the year.

Retail commission revenue increased $17.1 million and $128.6 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005 due to higher volumes (DARTs), offset by lower average commission per trade. The increase in DART volumes was the result of the Harrisdirect and BrownCo acquisitions as well as strong organic and overall market growth in domestic equity, international equity and option trades.

Due to the factors described above, our 44% and 83% growth in DARTs for the three and nine months ended September 30, 2006, respectively, equated to a 20% and 55% increase in retail commission revenue during

 

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the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005; however, our business model derives revenue not only from trades but also from other aspects of the relationship we have with our customers, especially those who maintain deposits, free credit and lending balances with us. Our average customer uses at least 2 products or services from our suite of retail products, which is the main driver in our diversification of revenue. For the three and nine months ended September 30, 2006, retail commission revenue represents 17% and 20% of total net revenue, respectively.

Institutional commission revenue increased $2.2 million and $25.1 million for the three and nine months ended September 30, 2006 compared to the same periods in 2005. These increases were due to a more favorable trading environment and to the continued leveraging of our integrated institutional model with higher retail order flow. We provide institutional customers with global execution and settlement services, as well as worldwide access to research provided by third parties, in exchange for commissions based on negotiated rates, which differ by customer.

Service Charges and Fees

Service charges and fees increased 3% to $33.9 million for the three months ended September 30, 2006, and decreased 1% to $99.5 million for the nine months ended September 30, 2006, compared to the same periods in 2005. The increase in service charges and fees for the third quarter primarily was due to an increase in the advisory service fee income. For the nine months ended September 30, 2006, however, this increase was offset by a decrease in account maintenance fees as our retail customers became more engaged and a greater number of customers exceeded the minimum activity levels required to avoid account maintenance fees. We expect our account maintenance fee income to continue to decline over time; however, we expect our advisory service fee income, which is not currently a significant portion of service charges and fees, to increase over time as we focus on growing this product.

Principal Transactions

Principal transactions decreased 5% to $22.7 million for the three months ended September 30, 2006, and increased 12% to $85.0 million for the nine months ended September 30, 2006, compared to the same periods in 2005. The decrease in principal transactions for the third quarter primarily resulted from a decline in market trading volumes during the period. For the nine months ended September 30, 2006, the increase in principal transactions resulted from higher trading volumes and market volatility which were offset slightly by a decrease in the average revenue earned per trade. Our principal transactions revenue is influenced by overall trading volumes, the number of stocks for which we act as a market maker, the trading volumes of those specific stocks and the trading performance of our proprietary trading activities.

 

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Gain on Sales of Loans and Securities, Net

Gain on sales of loans and securities, net decreased 27% to $16.0 million and 54% to $38.7 million for the three and nine months ended September 30, 2006 compared to the same periods in 2005, as shown in the following table (dollars in thousands):

 

     Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
       2006 vs. 2005       2006 vs. 2005  
         2006             2005         Amount     %     2006     2005     Amount     %  

Gain on sales of originated loans:

                

Mortgage loans

   $ 3,213     $ 12,371     $ (9,158 )   (74 )%   $ 9,032     $ 32,513     $ (23,481 )   (72 )%

Consumer loans(1)

     —         2,440       (2,440 )   (100 )%     180       14,634       (14,454 )   (99 )%
                                                    

Gain on sales of originated loans

     3,213       14,811       (11,598 )   (78 )%     9,212       47,147       (37,935 )   (80 )%

Loss on sales of loans held-for-sale, net

     (235 )     (543 )     308     (57 )%     (1,333 )     (1,442 )     109     (8 )%
                                                    

Gain on sales of loans, net

     2,978       14,268       (11,290 )   (79 )%     7,879       45,705       (37,826 )   (83 )%

Gain on sales of securities, net

     13,025       7,582       5,443     72  %     30,859       38,416       (7,557 )   (20 )%
                                                    

Total gain on sales of loans and securities, net

   $ 16,003     $ 21,850     $ (5,847 )   (27 )%   $ 38,738     $ 84,121     $ (45,383 )   (54 )%
                                                    

(1)   Consumer loans originated by our retail segment are sold to our institutional segment at an arm’s length transfer price. The gains (losses) associated with our retail segment were reclassified to discontinued operations and the amounts related to our institutional segment remained in continuing operations.

The decline in the total gain on sales of loans and securities, net during the three and nine months ended September 30, 2006 primarily was due to our lower sales of mortgage and consumer loans compared to the same periods in 2005. We retained a greater number of originated mortgage loans on the balance sheet in an effort to retain the customer relationship and drive growth in net operating interest income. Gain on sales of consumer loans was lower due to the sale of the consumer finance business in 2005. Lower gain on sales of securities, net resulted from lower sales volumes in the nine months ended September 30, 2006 compared to the same period last year. Higher gain on sales of securities, net resulted from higher sales volumes in the three months ended September 30, 2006 compared to the same period last year.

Other Revenue

Other revenue increased 44% to $33.0 million and 50% to $99.9 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increases were the result of higher payment for order flow from improved option and equity trading volumes, offset by decreases in proprietary fund revenue relating to the closure of certain of our proprietary funds. In addition, other revenue includes foreign exchange margin revenue, stock plan administration products revenue and other revenue ancillary to our retail customer transactions.

 

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Expense Excluding Interest

The components of expense excluding interest and the resulting variances are as follows (dollars in thousands):

 

    Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
  Variance  
      2006 vs. 2005       2006 vs. 2005  
    2006   2005     Amount   %     2006   2005   Amount   %  

Compensation and benefits

  $ 110,705   $ 103,084     $ 7,621   7 %   $ 352,334   $ 280,472   $ 71,862   26 %

Clearing and servicing

    62,500     46,930       15,570   33 %     189,926     132,720     57,206   43 %

Advertising and marketing development

    23,914     21,188       2,726   13 %     89,115     74,252     14,863   20 %

Communications

    25,576     18,210       7,366   40 %     84,818     54,650     30,168   55 %

Professional services

    20,741     16,703       4,038   24 %     71,715     53,168     18,547   35 %

Depreciation and amortization

    18,565     18,443       122   1 %     56,181     53,310     2,871   5 %

Occupancy and equipment

    22,150     16,249       5,901   36 %     63,082     50,673     12,409   24 %

Amortization of other intangibles

    12,087     4,382       7,705   176 %     35,391     13,751     21,640   157 %

Facility restructuring and other exit activities

    16,684     (469 )     17,153   *       19,315     495     18,820   *  

Other

    45,675     23,129       22,546   97 %     101,888     65,917     35,971   55 %
                                         

Total expense excluding interest

  $ 358,597   $ 267,849     $ 90,748   34 %   $ 1,063,765   $ 779,408   $ 284,357   36 %
                                         

*   Percentage not meaningful

Expense excluding interest increased 34% to $358.6 million and 36% to $1,063.8 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase in expense excluding interest primarily was driven by facility restructuring activities, higher trading volumes, a larger balance sheet and an increase in fraud related losses.

Compensation and Benefits

Compensation and benefits increased 7% to $110.7 million and 26% to $352.3 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. This increase resulted primarily from three factors: (1) higher numbers of employees in our service organization; (2) stock option expense(1); and (3) an increase in variable and incentive compensation. These increases in compensation are in line with the growth and performance of our business. We believe compensation and benefits as a percentage of revenue is a measure of our efficiency and the most relevant metric to assess this increase. This ratio declined from 25% and 23% for the three and nine months ended September 30, 2005 to 19% and 20% for the three and nine months ended September 30, 2006.

Clearing and Servicing

Clearing and servicing expense increased 33% to $62.5 million and 43% to $189.9 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. This increase is a result of higher trading volumes and higher loan balances during the period.

 

(1)   In July 2005 we adopted Statement of Financial Accounting Standard (“SFAS”) No. 123 (R), Share-Based Payment, which requires the expensing of stock options. Stock option expense was $6.2 million and $20.0 million for the three and nine months ended September 30, 2006. Stock option expense was $7.1 million for the three and nine months ended September 30, 2005.

 

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Communications

Communications expense increased 40% to $25.6 million and 55% to $84.8 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase is due to expenses associated with communications to our newly acquired customers from Harrisdirect and BrownCo. In addition, variable expenses such as quote services and trade confirmations increased with our increase in trading volume.

Professional Services

Professional services increased 24% to $20.7 million and 35% to $71.7 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase primarily is due to third party support services, including technology and transitional service agreements, associated with our acquisitions of Harrisdirect and BrownCo.

Amortization of Other Intangibles

Amortization of other intangibles increased 176% to $12.1 million and 157% to $35.4 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase in amortization expense primarily is due to the increase in customer-related intangible assets, which were created as a result of the Harrisdirect and BrownCo acquisitions.

Facility Restructuring and Other Exit Activities

Facility and restructuring costs were $16.7 million and $19.3 million for the three and nine months ended September 30, 2006, respectively. During the period, we relocated certain functions out of the state of California. This expense represents severance charges for those employees to whom we communicated our plans and who were terminated as part of this relocation in the third quarter, in addition to certain facility costs as a result of ceasing operations at these locations.

Other

Other expenses increased 97% to $45.7 million and 55% to $101.9 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. These increases were primarily due to fraud related losses during the third quarter of 2006 of $18.1 million, of which $10.0 million was identity theft related. The identity theft situations arose from recent computer viruses that attacked the personal computers of our customers, not from a breach of the security of our systems. We reimbursed customers for their losses through our Complete Protection Guarantee. These fraud schemes have impacted our industry as a whole. While we believe our systems remain safe and secure, we have implemented technological and operational changes to deter unauthorized activity in our customer accounts.

Other Income (Expense)

Other income (expense) decreased to an expense of $6.5 million and to an expense of $47.6 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005, as shown in the following table (dollars in thousands):

 

     Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
       2006 vs. 2005       2006 vs. 2005  
     2006     2005     Amount     %     2006     2005     Amount     %  

Other income (expense):

                

Corporate interest income

   $ 1,942     $ 3,409     $ (1,467 )   (43 )%   $ 6,091     $ 7,796     $ (1,705 )   (22 )%

Corporate interest expense

     (37,964 )     (13,783 )     (24,181 )   175  %     (114,586 )     (36,975 )     (77,611 )   210  %

Gain on sales and impairment of investments

     26,991       22,028       4,963     23  %     59,897       68,172       (8,275 )   (12 )%

Loss on early extinguishment of debt

     —         —         —       *       (703 )     —         (703 )   *  

Equity in income of investments and venture funds

     2,519       3,103       (584 )   (19 )%     1,701       7,142       (5,441 )   (76 )%
                                                    

Total other income (expense)

   $ (6,512 )   $ 14,757     $ (21,269 )   *     $ (47,600 )   $ 46,135     $ (93,735 )   *  
                                                    

*   Percentage not meaningful

 

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The other expense for the three and nine months ended September 30, 2006 primarily consisted of corporate interest expense resulting from the funding of the Harrisdirect and BrownCo acquisitions beginning in late 2005. Offsetting corporate interest expense was $27.0 million and $59.9 million for the three and nine months ended September 30, 2006, respectively, in gain on sales and impairment of investments. During the nine months ended September 30, 2006, we sold shares of our investments in Softbank Investment Corporation (“SBI”) and International Stock Exchange resulting in gains of $60.0 million. For the nine months ended September 30, 2005, our gain on sale of shares of SBI, TD AMERITRADE Holding Corporation and Archipelago Holdings, LLC was $68.1 million.

Income Tax Expense

Income tax expense from continuing operations increased $8.8 million or 15% and $59.3 million or 35% during the three and nine months ended September 30, 2006 compared to the same periods in 2005. The increase in income tax expense was related to the increase in pre-tax income over the comparable periods. Our effective tax rates for the three months ended September 30, 2006 and September 30, 2005 were 30.7% and 34.5%, respectively. The effective tax rate for the three months ended September 30, 2005 included a $2.1 million tax benefit related to the reversal of a valuation allowance related to a foreign subsidiary’s net operating loss deferred tax asset. Without this event, the effective tax rate would have been 35.8% for the three months ended September 30, 2005. The decrease in the 2006 tax rate compared to the adjusted 2005 tax rate is primarily due to (i) a continued decrease in our overall effective state tax rate due to our changing geographic footprint and (ii) a $7.6 million tax benefit arising from the favorable resolution of a tax issue related to pre-2002 earnings of a foreign subsidiary.

In prior years, we incurred significant losses in our international operations. In connection with these losses we recorded a deferred tax asset associated with the ability to carry these losses forward as a deduction against future income for income tax purposes. However, we provided a valuation allowance against a portion of this deferred tax asset since we determined that it was more likely than not that these tax benefits would not be realized. In recent periods, certain of these international operations have reached a level of profitability, which if sustained may require us to reverse all or some portion of the valuation allowance related to such international operations. The tax benefit from such a reversal would reduce our effective tax rate in the interim period in which it is recognized.

During the three months ended September 30, 2006, we filed tax returns and refund claims, which we refer to as the “tax claims”, in one of the tax jurisdictions in which we operate. The tax claims were filed in part as a result of recent favorable court decisions that we believe support the position taken in the tax claims. We have not yet recorded tax benefits related to the tax claims, the total amount of which could exceed $10 million, plus applicable interest. The tax benefit from the tax claims will be recognized if and when we determine that it is probable that the benefit will be realized. However, there can be no assurance that any portion of the tax benefit will be recognized.

Discontinued Operations

Our net gain (loss) from discontinued operations was $3.0 million and $2.3 million for the three and nine months ended September 30, 2006, respectively. During the nine months ended September 30, 2006 and 2005, our discontinued operations included operating results from our E*TRADE Professional Trading, LLC (“E*TRADE Professional”) agency business and in the third quarter we recognized a gain of approximately $2.8 million, net of tax. In the period ended September 30, 2005, discontinued operations also included operating losses from our consumer loan origination business and our E*TRADE Professional proprietary trading business, both of which were sold or discontinued during 2005.

Cumulative Effect of Accounting Change

The cumulative effect of accounting change of $1.6 million after tax ($2.8 million pre-tax) for the nine months ended September 30, 2005 resulted from the adoption of SFAS No. 123(R), Share-Based Payment and Staff Accounting Bulletin No. 107, Share-Based Payment, effective July 1, 2005, which required us to record compensation expense for stock options.

 

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Prior to our adoption of SFAS No. 123(R), we recorded compensation expense for restricted stock awards on a straight-line basis over their vesting period. If an employee forfeited the award prior to vesting, we reversed out the previously expensed amounts in the period of forfeiture. As required upon adoption of SFAS No. 123(R), we must base the accruals of compensation expense on the estimated number of awards for which the requisite service period is expected to be rendered. Actual forfeitures are no longer recorded in the period of forfeiture. The pre-tax credit of $2.8 million in cumulative effect of accounting change represents the amount by which compensation expense would have been reduced in periods prior to adoption of SFAS No. 123(R) for restricted stock awards outstanding on July 1, 2005 that are anticipated to be forfeited.

SEGMENT RESULTS REVIEW

Retail

Retail segment income increased 33% to $145.1 million and 82% to $511.9 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005, as shown in the following table (dollars in thousands, except for key metrics):

 

   

As of or for the

Three Months Ended
September 30,

  Variance  

As of or for the

Nine Months Ended
September 30,

  Variance
      2006 vs. 2005     2006 vs. 2005
    2006   2005   Amount     %   2006   2005   Amount     %

Retail segment income:

               

Net operating interest income after provision for loan losses

  $ 221,059   $ 112,107   $ 108,952     97 %   $ 655,685   $ 302,485   $ 353,200     117 %

Commission

    100,902     83,755     17,147     20 %     364,333     235,759     128,574     55 %

Service charges and fees

    28,790     26,933     1,857     7 %     83,517     86,683     (3,166 )   (4)%

Gain on sales of loans and securities, net

    10,608     17,534     (6,926 )   (40)%     28,293     51,746     (23,453 )   (45)%

Other revenue

    30,942     27,927     3,015     11 %     101,813     82,174     19,639     24 %
                                           

Net segment revenue

    392,301     268,256     124,045     46 %     1,233,641     758,847     474,794     63 %

Total segment expense

    247,227     158,936     88,291     56 %     721,742     478,279     243,463     51 %
                                           

Total retail segment income

  $ 145,074   $ 109,320   $ 35,754     33 %   $ 511,899   $ 280,568   $ 231,331     82 %
                                           

Key Metrics:

               

Retail client assets (dollars in billions)(1)

  $ 184.8   $ 106.4   $ 78.4     74 %   $ 184.8   $ 106.4   $ 78.4     74 %

Customer cash and deposits (dollars in billions)(1)

  $ 31.6   $ 19.4   $ 12.2     63 %   $ 31.6   $ 19.4   $ 12.2     63 %

DARTs

    135,130     93,876     41,254     44 %     160,589     87,599     72,990     83 %

Average commission per trade

  $ 11.95   $ 13.94   $ (1.99 )   (14)%   $ 12.10   $ 14.24   $ (2.14 )   (15)%

Average margin receivables (dollars in billions)

  $ 6.66   $ 2.27   $ 4.39     193 %   $ 6.76   $ 2.22   $ 4.48     202 %

Products per customer

    2.1     2.0     0.1     5 %     2.1     2.0     0.1     5 %

(1)   Total customer cash and deposits, as well as total retail client assets, have been re-presented to account for a methodology change in the metric to settlement date from trade date reporting as of December 31, 2005, which reduced both metrics by $564 million.

Our retail segment generates revenue from investing, trading, banking and lending relationships with retail customers. These relationships essentially drive five sources of revenue including net operating interest income; commission; service charges and fees; gain on sales of loans and securities, net; and other revenue. This segment also includes results from our stock plan administration products and services, as we are ultimately servicing a retail customer through these corporate relationships. Our geographically dispersed retail accounts grew 20% from September 30, 2005 to September 30, 2006. As of September 30, 2006, we had approximately 3.6 million active trading and investing accounts and 0.8 million active lending and deposit accounts.

The increase in retail segment income during the three and nine months ended September 30, 2006 compared to the same periods a year ago was due to an increase in net operating interest income after provision for loan losses and commission revenue, offset by lower gains on sales of loans and securities, net. Retail net

 

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operating interest income after provision for loan losses increased 97% to $221.1 million and 117% to $655.7 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Customer cash and deposits increased 63% at September 30, 2006 compared to September 30, 2005. Higher customer cash and deposit balances generally translate into a lower cost of funds as deposits increased in comparison to other borrowings. Average margin receivables increased 193% and 202% to $6.7 billion and $6.8 billion for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Higher margin balances generally translate into a higher interest rate earned on interest-earning assets. Net operating interest income growth included the impact of the Harrisdirect and BrownCo acquisitions.

Retail commission revenue increased 20% to $100.9 million and 55% to $364.3 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005, due to higher volumes (DARTs), offset by lower average commission per trade. The increase in DART volumes was the result of the Harrisdirect and BrownCo acquisitions as well as strong organic growth in domestic equity, international equity and option trades.

A shift in the composition of our retail customers who traded during the period resulted in a lower average commission per trade. In addition, during the first quarter of 2006, we extended a conversion-related free trade offer to the Harrisdirect customer base. These factors resulted in a 14% and 15% decrease in average commission per trade for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. Due to these factors, our 44% and 83% growth in DARTs for the three and six months ended September 30, 2006 respectively, equated to a 20% and 55% increase in retail commission revenue during the three and nine months ended September 30, 2006, respectively; however, we derive revenue not only from trades but also from other aspects of our relationship with our customers, especially customers who maintain deposits and free credits with us. As such, while retail commission revenue increased 20% and 55% during the three and nine months ended September 30, 2006, total retail segment income increased 33% and 82%, respectively.

Offsetting these increases were lower gains on the sales of loans and securities, net of $10.6 million for the three months ended September 30, 2006. In addition, service charges and fees decreased $3.2 million for the nine months ended September 30, 2006 compared to the same period in 2005. As our overall retail customer base became more engaged with us, an increased number of those customers exceeded the minimum activity levels required to avoid account maintenance fees.

Retail segment expense increased $88.3 million and $243.5 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The increase for the three months ended September 30, 2006 was primarily related to the $16.7 million restructuring charge in the third quarter of 2006 and the $18.1 million in increased fraud related expense as previously discussed.

 

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Institutional

Institutional segment income increased 83% to $78.1 million and 31% to $215.8 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005, as shown in the following table (dollars in thousands, except for key metrics):

 

     As of or for the
Three Months Ended
September 30,
    Variance    As of or for the
Nine Months Ended
September 30,
    Variance
       2006 vs. 2005      2006 vs. 2005
     2006     2005     Amount     %    2006     2005     Amount     %

Institutional segment income:

                 

Net operating interest income after provision for loan losses

   $ 121,530     $ 91,997     $ 29,533     32 %    $ 335,828     $ 272,583     $ 63,245     23 %

Commission

     32,704       30,523       2,181     7 %      112,438       87,352       25,086     29 %

Service charges and fees

     5,120       5,960       (840 )   (14)%      16,023       13,956       2,067     15 %

Principal transactions

     22,697       23,793       (1,096 )   (5)%      84,979       75,386       9,593     13 %

Gain on sales of loans and securities, net

     5,395       4,316       1,079     25 %      10,445       32,375       (21,930 )   (68)%

Other revenue

     2,771       2,901       (130 )   (4)%      6,358       8,412       (2,054 )   (24)%
                                                     

Net segment revenue

     190,217       159,490       30,727     19 %      566,071       490,064       76,007     16 %

Total segment expense

     112,122       116,823       (4,701 )   (4)%      350,262       325,120       25,142     8 %
                                                     

Total institutional segment income

   $ 78,095     $ 42,667     $ 35,428     83 %    $ 215,809     $ 164,944     $ 50,865     31 %
                                                     

Key Metrics:

                 

Total nonperforming loans, net as a % of gross loans held-for-investment

     0.24 %     0.13 %     *     0.11 %      0.24 %     0.13 %     *     0.11 %

Average revenue capture per 1,000 equity shares

   $ 0.382     $ 0.535     $ (0.153 )   (29)%    $ 0.339     $ 0.434     $ (0.095 )   (22)%

*   Percentage not meaningful

Our institutional segment generates earnings from balance sheet management activities, market-making and global execution and settlement services. Balance sheet management activities include purchasing loan receivables from the retail segment as well as third parties, and leveraging these loans and retail customer cash and deposit relationships to generate additional net operating interest income. Retail trading order flow is leveraged by the institutional segment to generate additional revenue for the Company.

Net operating interest income after provision for loan losses increased 32% to $121.5 million and 23% to $335.8 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. This increase primarily was a result of growth in interest-earning assets, which are funded primarily by retail customer cash and deposit balances. These customer balances were kept on-balance sheet as a low-cost source of funding and then utilized by the institutional segment either to purchase interest-earning assets or pay down wholesale liabilities.

The increase in institutional commissions is due to a more favorable trading environment and the continued leveraging of our integrated institutional model with higher retail order flow. We provide institutional customers with global execution and settlement services, as well as worldwide access to research provided by third parties, in exchange for commissions based on negotiated rates, which differ by customer.

The increase in net operating interest income after provision for loan losses and commission revenue was offset by a planned decrease in gain on sales of loans and securities, net. We evaluate our portfolio of securities available-for-sale in light of changing market conditions and where appropriate, take steps intended to optimize our overall economic position. Based on the current composition of our balance sheet, we determined that during the nine months ended September 30, 2006, it was not advantageous to sell securities at similar levels as the same period in the prior year.

The increase in expense for the nine months ended September 30, 2006 compared to the same period in 2005 was predominantly volume-related. Compensation and benefits expense increased due to increases in

 

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volume- and performance-based compensation and expensing of stock options. Clearing and servicing expense increased due to increased overall trading volumes and the increase in our loan portfolio.

BALANCE SHEET OVERVIEW

The following table sets forth the significant components of our consolidated balance sheet (dollars in thousands):

 

    

September 30,

2006

  

December 31,

2005

   Variance  
           2006 vs. 2005  

Assets:

        

Cash and equivalents(1)

   $ 1,471,489    $ 1,454,362    1  %

Trading securities

     151,835      146,657    4  %

Available-for-sale mortgage-backed and investment securities

     15,332,963      12,763,438    20  %

Loans held-for-sale

     208,633      87,371    139  %

Brokerage receivables, net

     7,230,960      7,174,175    1  %

Loans receivable, net

     23,215,444      19,424,895    20  %

Other assets(2)

     3,911,847      3,516,788    11  %
                

Total assets

   $ 51,523,171    $ 44,567,686    16  %
                

Liabilities and shareholders’ equity:

        

Deposits

   $ 22,319,364    $ 15,948,015    40  %

Securities sold under agreements to repurchase

     10,990,532      11,101,542    (1 )%

Brokerage payables

     7,399,279      7,342,208    1  %

Other borrowings

     4,206,922      4,206,996    (0 )%

Corporate debt(3)

     1,839,835      2,022,701    (9 )%

Accounts payable, accrued and other liabilities

     736,982      546,664    35  %
                

Total liabilities

     47,492,914      41,168,126    15  %

Shareholders’ equity

     4,030,257      3,399,560    19  %
                

Total liabilities and shareholders’ equity

   $ 51,523,171    $ 44,567,686    16  %
                

(1)   Includes “Cash and equivalents” and “Cash and investments required to be segregated under Federal or other regulations.”
(2)   Includes “Property and equipment, net”, “Goodwill”, “Other intangibles, net” and “Other assets.”
(3)   Includes “Senior notes”, “Mandatory convertible notes” and “Convertible subordinated notes.”

During the period, we re-aligned our balance sheet to consolidate several categories and changed the name of “Other borrowings by Bank subsidiary” to “Other borrowings.” Other borrowings include non-Bank subsidiary term notes previously classified in “Accounts payable, accrued and other liabilities.” Categories consolidated and related changes include:

 

    “Investment in Federal Home Loan Bank stock” was added to “Available-for-sale mortgage-backed and investment securities”;

 

    “Derivative assets” and “Accrued interest receivable” were added to “Other assets”; and

 

    “Derivative liabilities” was added to “Accounts payable, accrued and other liabilities.”

These categories were consolidated with other similar items in our balance sheet presentation. The notes to our consolidated financial statements continue to include detailed information about the individual items no longer listed on the face of the balance sheet.

 

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The increase in total assets was primarily the result of growth in loans receivable, net and brokerage receivables, net. The growth in brokerage receivables, net was driven in part from our conversion of Harrisdirect

customers as well as by growth from existing and new customers. The growth in loans receivable, net was the result of our continued focus on growing our residential mortgage loan portfolios, including one- to four-family mortgages and home equity loans.

The increase in total liabilities primarily was attributable to a $6.4 billion increase in deposits due to higher sweep deposit accounts and money market deposits resulting, in part, from our conversion of Harrisdirect customers, as well as from growth from existing and new customers. The increase in liabilities was partially offset by declines in securities sold under agreements to repurchase and other borrowings, which primarily was a result of our growth in deposits.

The conversion of Harrisdirect customers to the E*TRADE Financial platform during the first quarter of 2006 facilitated the transfer of customer brokerage receivables, deposits and customer brokerage payables from a third party provider. Customer brokerage receivables or margin loans of $0.8 billion were transferred to our balance sheet. In addition, sweep deposit balances of $2.7 billion and brokerage payables, more specifically free credits, of $1.3 billion were also moved to our balance sheet.

Loans Receivable, Net

Loans receivable, net are summarized as follows (dollars in thousands):

 

     September 30,
2006
    December 31,
2005
    Variance  
         2006 vs. 2005  

Real estate loans:

      

One- to four-family

   $ 8,912,645     $ 7,091,664     26  %

HELOC, second mortgage and other

     10,446,593       8,106,820     29  %

Consumer and other loans:

      

Recreational vehicle

     2,400,979       2,692,055     (11 )%

Marine

     683,166       752,645     (9 )%

Credit card

     198,022       188,600     5  %

Automobile

     102,968       235,388     (56 )%

Other

     185,755       97,436     91  %

Unamortized premiums, net

     355,224       323,573     10  %

Allowance for loan losses

     (69,908 )     (63,286 )   10  %
                  

Total loans receivable, net

   $ 23,215,444     $ 19,424,895     20  %
                  

Loans receivable, net increased 20% to $23.2 billion at September 30, 2006 from $19.4 billion at December 31, 2005. We continue to focus our growth in real estate loans while allowing our consumer loans to decline. We anticipate that our mortgage and HELOC portfolios will continue to increase over time, and we believe this will improve our credit risk profile. We anticipate that recreational vehicle and marine loan balances will continue to decline over time due to our sale of the E*TRADE Consumer Finance Corporation in 2005, and automobile loans will continue to decline due to our exit of the automobile origination business in 2004. Other loans include commercial loans which increased 103% to $179.2 million during the nine months ended September 30, 2006.

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of credit losses inherent in our loan portfolio as of the balance sheet date. The estimate of the allowance for loan losses is based on a variety of factors, including the composition and quality of the portfolio; delinquency levels and trends; probable expected losses for the next

 

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twelve months; current and historical charge-off and loss experience; current industry charge-off and loss experience; the condition of the real estate market and geographic concentrations within the loan portfolio; the interest rate climate as it affects adjustable-rate loans; and general economic conditions. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. In general, we believe the allowance for loan losses should be equal to at least twelve months of probable projected losses for all loan types. We believe this level is representative of probable losses inherent in the loan portfolio at the balance sheet date.

In determining the allowance for loan losses, we allocate a portion of the allowance to various loan products based on an analysis of individual loans and pools of loans. However, the entire allowance is available to absorb credit losses inherent in the total loan portfolio as of the balance sheet date.

The following table presents the allowance for loan losses by major loan category (dollars in thousands):

 

     Consumer & Other     Real Estate     Total  
     Allowance    Allowances as %
of Consumer and
Other Loans Receivable
    Allowance    Allowances as %
of Real Estate
Loans Receivable
    Allowance    Allowances as %
of Total
Loans Receivable
 

September 30, 2006

   $ 32,845    0.91 %   $ 37,063    0.19 %   $ 69,908    0.30 %

June 30, 2006

   $ 32,660    0.86 %   $ 34,461    0.20 %   $ 67,121    0.32 %

March 31, 2006

   $ 33,108    0.85 %   $ 31,401    0.20 %   $ 64,509    0.33 %

December 31, 2005

   $ 32,379    0.80 %   $ 30,907    0.20 %   $ 63,286    0.32 %

The following table provides an analysis of the allowance for loan losses for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2006     2005     2006     2005  

Allowance for loan losses, beginning of period

   $ 67,121     $ 55,418     $ 63,286     $ 47,681  

Provision for loan losses

     12,547       12,909       33,014       37,946  

Charge-offs

     (13,950 )     (13,037 )     (41,922 )     (40,347 )

Recoveries

     4,190       4,564       15,530       14,574  
                                

Net charge-offs

     (9,760 )     (8,473 )     (26,392 )     (25,773 )
                                

Allowance for loan losses, end of period

   $ 69,908     $ 59,854     $ 69,908     $ 59,854  
                                

Losses are recognized when it is probable that a loss will be incurred. Our policy is to charge-off closed-end consumer loans when the loan is 120 days delinquent or when we determine that collection is not probable. For first-lien mortgages, a charge-off is recognized when we foreclose on the property. For revolving loans, our policy is to charge-off loans when collection is not probable or the loan has been delinquent for 180 days.

During the nine months ended September 30, 2006, the allowance for loan losses increased by $6.6 million from the level at December 31, 2005. The increase primarily was due to growth in the real estate loan portfolio, which increased approximately $4.2 billion over the same period and is not indicative of a decline in overall credit quality.

Net charge-offs for the three and nine months ended September 30, 2006 compared to the same periods in 2005 increased by $1.3 million and $0.6 million, respectively. The overall increase was due to higher net charge-offs on real estate loans offset by lower net charge-offs on consumer loans. The increase in real estate loan charge-offs was due to the growth of the portfolio and the decrease in consumer loan charge-offs primarily was due to a decline in loan balances as we exited the consumer finance business in 2005. Annualized net charge-offs as a percentage of average loans receivable, net were 0.17% at September 30, 2006 compared to 0.20% at September 30, 2005.

 

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Nonperforming Assets

We classify loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. The following table shows the comparative data for nonperforming loans and assets (dollars in thousands):

 

    

September 30,

2006

  

December 31,

2005

Real estate loans

   $     49,117    $     27,635

Consumer and other loans

     5,785      7,019
             

Total nonperforming loans, net

     54,902      34,654

Real estate owned (“REO”) and other repossessed assets, net

     9,716      6,555
             

Total nonperforming assets, net

   $ 64,618    $ 41,209
             

Total nonperforming loans, net as a % of total gross loans held-for-investment

     0.24%      0.18%
             

Total allowance for loan losses as a percentage of total nonperforming loans, net

     127%      183%
             

We expect nonperforming loan levels to fluctuate over time due to portfolio growth, portfolio seasoning and resolution through collections, sales or charge-offs. The performance of any loan can be affected by external factors, such as economic conditions or factors particular to the borrower.

During the nine months ended September 30, 2006, our nonperforming assets, net increased $23.4 million from $41.2 million at December 31, 2005. The increase is attributed to an increase in nonperforming real estate loans and REO and other repossessed assets, net of $24.6 million, offset by a decrease in nonperforming consumer and other loans of $1.2 million. These trends are not the result of a deterioration or improvement in credit quality, but are reflective of our targeted growth in real estate loans and the targeted decrease in consumer loans.

The allowance as a percentage of total nonperforming loans, net decreased 56% during the nine months ended September 30, 2006. As our loan portfolio shifts to mortgage loans, where the risk of charge-off is generally less than the risk of charge-off on a consumer loan, the level of the allowance to nonperforming assets may continue to decrease.

In addition to nonperforming assets in the table above, we monitor loans where a borrower’s past credit history casts doubt on the borrower’s ability to repay a loan, whether or not the loan is delinquent (“Special Mention” loans). Special Mention loans represented $166.9 million and $127.2 million of the total loan portfolio at September 30, 2006 and December 31, 2005, respectively. These loans are actively monitored, continue to accrue interest and remain a component of the loans receivable balance. The increase in Special Mention loans was primarily due to an increase in the 30-day delinquency category of mortgage loans. Significant migration from this category to more serious delinquency classifications is not expected to occur.

 

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Available-for-Sale Mortgage-Backed and Investment Securities

Available-for-sale securities are summarized as follows (dollars in thousands):

 

     September 30,
2006
   December 31,
2005
   Variance  
           2006 vs. 2005  

Mortgage-backed securities:

        

Backed by U.S. government sponsored and Federal agencies

   $ 10,965,292    $ 9,427,521    16  %

Collateralized mortgage obligations and other

     1,032,541      995,891    4  %
                

Total mortgage-backed securities

     11,997,833      10,423,412    15  %

Investment securities:

        

Asset-backed securities

     2,024,935      1,365,754    48  %

Publicly traded equity securities:

        

Preferred stock

     398,388      288,365    38  %

Corporate investments

     36,387      147,400    (75 )%

FHLB stock

     193,750      198,700    (2 )%

Other

     681,670      339,807    101  %
                

Total investment securities

     3,335,130      2,340,026    43  %
                

Total available-for-sale securities

   $ 15,332,963    $ 12,763,438    20  %
                

Available-for-sale securities represented 30% and 29% of total assets at September 30, 2006 and December 31, 2005, respectively. Available-for-sale securities increased to $15.3 billion at September 30, 2006, primarily due to the growth in our mortgage-backed and asset-backed securities portfolio. We evaluate our available-for-sale securities in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall position. Based on this evaluation, we decided to grow our mortgage-backed and asset-backed securities portfolio during the current period.

As interest rates increase, the fair value of fixed-rate available-for-sale securities decreases and vice versa. The fair value of the portfolio will be adversely impacted in 2006 if long-term interest rates continue to rise. Net unrealized gains and losses in available-for-sale securities are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax.

Deposits

Deposits are summarized as follows (dollars in thousands):

 

     September 30,
2006
   December 31,
2005
   Variance  
           2006 vs. 2005  

Sweep deposit accounts

   $ 10,351,653    $ 7,733,267    34  %

Money market and savings accounts

     6,391,190      4,635,866    38  %

Certificates of deposit

     4,649,385      2,703,605    72  %

Brokered certificates of deposit

     566,988      484,612    17  %

Checking accounts

     360,148      390,665    (8 )%
                

Total deposits

   $ 22,319,364    $ 15,948,015    40  %
                

Deposits represented 47% and 39% of total liabilities at September 30, 2006 and December 31, 2005, respectively. Deposits increased $6.4 billion to $22.3 billion at September 30, 2006, driven by a $2.6 billion increase in sweep deposit accounts, a $1.8 billion increase in money market and savings accounts and a $1.9 billion increase in certificates of deposit.

The increase in sweep deposit accounts was driven primarily by the Harrisdirect and BrownCo conversions. Prior to the conversions, Harrisdirect customer cash balances were swept to a third party and not reflected on our

 

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balance sheet, and BrownCo customer cash balances were generally kept in free credits. Our other deposit products have shown significant growth as a result of our focused sales and retention efforts, as well as the overall impact of the E*TRADE Complete Intelligent Cash Optimizer. E*TRADE Complete Intelligent Cash Optimizer enables customers to better determine the optimal use of their funds and has resulted in higher money market and certificates of deposit balances. The sweep deposit accounts, money market accounts and certificates of deposit generally provide us the benefit of lower interest costs, compared with wholesale funding alternatives.

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $31.6 billion for the three and nine months ended Setpember 30, 2006. The total customer cash and deposits balance is summarized as follows (dollars in thousands):

 

     September 30,
2006
    December 31,
2005
    Variance  
         2006 vs. 2005  

Deposits

   $ 22,319,364     $ 15,948,015     40  %

Less: brokered certificates of deposit

     (566,988 )     (484,612 )   17  %
                  

Deposits excluding brokered certificates of deposit

     21,752,376       15,463,403     41  %

Free credits

     6,156,438       5,770,751     7  %

Customer cash balances held by third parties

     3,702,356       6,955,830     (47 )%
                  

Total customer cash and deposits

   $ 31,611,170     $ 28,189,984     12  %
                  

Corporate Debt

Corporate debt decreased to $1.8 billion at September 30, 2006 compared to $2.0 billion at December 31, 2005. The Company called the remaining $185.2 million principal amount of its 6.00% convertible subordinated notes due February 2007 (the “6.00% Notes”) during the nine months ended September 30, 2006. See “Liquidity and Capital Resources—Corporate Debt” below.

LIQUIDITY AND CAPITAL RESOURCES

Our liquidity and capital resources enable us to fund our operating activities, finance acquisitions and grow our assets. Cash flows are derived from capital market activities and our operations in the retail and institutional segments. The segment cash flows provide capital to fund growth in our regulated subsidiaries. The Company’s cash and equivalents balance increased to $1.2 billion for the period ended September 30, 2006.

Corporate Debt

During the nine months ended September 30, 2006, the Company called the remaining $185.2 million principal amount of its 6.00% convertible subordinated notes due February 2007 (the “6.00% Notes”). In April 2006, the Company completed the partial redemption that was originally announced in March 2006 and called the remaining $92.6 million principal amount of its 6.00% Notes. The table below shows the timing and impact of these calls (dollars and shares in millions):

 

     Debt
Redeemed
   Common
Stock
Shares
Issued
   Cash
Paid

First call in March 2006

        

March redemptions

   $ 36.3    1.5    $   —  

April redemptions

     56.3    2.4        0.9

Second call in April 2006(1)

     92.6    3.9      0.9
                  

Total redemptions

   $   185.2    7.8    $ 1.8
                  

(1)   All redemptions occurred in April.

 

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Our current senior debt ratings are Ba2 (positive outlook) by Moody’s Investor Service, BB- (stable) by Standard & Poor’s and BB (high) by Dominion Bond Rating Service (“DBRS”). The Company’s long-term deposit ratings are Baa3 by Moody’s Investor Service, BB+ (stable) by Standard & Poor’s and BBB (low) by DBRS. A significant change in these ratings may impact the rate and availability of future borrowings.

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries, other than Converging Arrows, Inc. (“Converging Arrows”), is limited by regulatory requirements. Converging Arrows is a subsidiary of the parent company. At September 30, 2006, Converging Arrows had $154.0 million of cash and investment securities available as a source of liquidity for the parent company. Converging Arrows is not restricted in its dealings with the parent company and may transfer funds to the parent company without regulatory approval. In addition to Converging Arrows, brokerage and banking subsidiaries may provide liquidity to the parent; however, they are restricted by regulatory guidelines.

The Bank is prohibited by regulations from lending to the parent company. At September 30, 2006, the Bank had approximately $151.5 million of capital available for dividend declaration without regulatory approval while still maintaining “well capitalized” status. The Bank is also required by Office of Thrift Supervision (“OTS”) regulations to maintain tangible capital of at least 1.50% of tangible assets. The Bank satisfied this requirement at September 30, 2006 and December 31, 2005.

Brokerage subsidiaries are required to maintain net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from customer transactions. At September 30, 2006 and December 31, 2005, all of our brokerage subsidiaries met their minimum net capital requirements. The Company’s broker-dealer subsidiaries had excess net capital of $669.8 million at September 30, 2006.

Other Sources of Liquidity

We maintain committed and uncommitted financing facilities with banks totaling $550.0 million to meet corporate liquidity needs and finance margin lending. There were no outstanding balances and the full $550.0 million was available under these lines at September 30, 2006 and December 31, 2005.

We rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase to provide liquidity for the Bank. At September 30, 2006, the Bank had approximately $8.2 billion in additional borrowing capacity.

Other Liquidity Matters

We currently anticipate that our available cash resources and credit will be sufficient to meet our anticipated working capital and capital expenditure requirements for at least the next 12 months. We may need to raise additional funds in order to support more rapid expansion, develop new or enhanced products and services, respond to competitive pressures, acquire businesses or technologies or take advantage of unanticipated opportunities.

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of our financial condition and results of operations requires us to make judgments and estimates that may have a significant impact upon the financial results of the Company. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management, which can materially impact reported results: allowance for loan losses and uncollectible margin loans; classification and valuation of certain investments; valuation and accounting for financial derivatives; estimates of effective tax rate; deferred taxes and valuation allowances; and valuation of goodwill and other intangibles. These are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2005.

 

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REQUIRED FINANCIAL DATA

This section provides an update to information presented in our Form 10-K required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” that has not been incorporated elsewhere into Management’s Discussion and Analysis. The table in this section includes Bank subsidiary information only.

Distribution of Assets, Liabilities and Shareholder’s Equity; Interest Rates and Operating Interest Differential

The following tables present average balance data and income and expense data for our banking operations, as well as the related interest yields and rates and interest spread (dollars in thousands):

 

     Three Months Ended September 30,  
     2006     2005  
     Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/Cost
    Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/Cost
 

Interest-earning banking assets:

                

Loans, net(1)

   $ 22,955,022    $ 364,744    6.36 %   $ 17,024,600    $ 232,004    5.45 %

Mortgage-backed and related available-for-sale securities

     12,068,052      159,199    5.28 %     9,059,130      97,537    4.31 %

Available-for-sale investment securities

     3,220,054      51,885    6.44 %     1,937,276      25,888    5.35 %

Trading securities

     114,806      2,600    9.06 %     186,377      2,792    5.99 %

Other

     44,209      571    5.12 %     95,714      719    2.98 %
                                

Total interest-earning banking assets(2)

     38,402,143      578,999    6.03 %     28,303,097      358,940    5.07 %
                        

Non-interest-earning banking assets

     522,228           528,215      
                        

Total banking assets

   $ 38,924,371         $ 28,831,312      
                        

Interest-bearing banking liabilities:

                

Retail deposits

   $ 20,992,962      141,035    2.67 %   $ 13,095,471      57,710    1.75 %

Brokered certificates of deposit

     618,681      7,453    4.78 %     540,575      4,815    3.53 %

Repurchase agreements and other borrowings

     11,586,260      150,837    5.09 %     9,510,214      91,520    3.77 %

FHLB advances

     3,583,663      43,950    4.80 %     4,093,294      40,914    3.91 %
                                

Total interest-bearing banking liabilities

     36,781,566      343,275    3.67 %     27,239,554      194,959    2.84 %
                        

Non-interest-bearing banking liabilities

     314,091           273,685      
                        

Total banking liabilities

     37,095,657           27,513,239      

Total banking shareholder’s equity

     1,828,714           1,318,073      
                        

Total banking liabilities and shareholder’s equity

   $ 38,924,371         $ 28,831,312      
                        

Excess of interest-earning banking assets over interest-bearing banking liabilities/net operating interest income

   $ 1,620,577    $ 235,724      $ 1,063,543    $ 163,981   
                                

Bank net operating interest:

                

Spread

         2.36 %         2.23 %

Margin (net yield on interest-earning banking assets)

         2.46 %         2.32 %

Ratio of interest-earning banking assets to interest-bearing banking liabilities

         104.41 %         103.90 %

Return on average:(3)(4)

                

Total banking assets

         1.03 %         0.96 %

Total banking shareholder’s equity

         21.87 %         21.06 %

Average equity to average total banking assets

         4.70 %         4.57 %

(1)   Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.
(2)   Amount includes a taxable equivalent increase in operating interest income of $5.3 million and $2.6 million for the three months ended September 30, 2006 and 2005, respectively.
(3)   Ratio calculations exclude discontinued operations.
(4)   Ratio calculations are based on stand alone Bank results.

 

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     Nine Months Ended September 30,  
     2006     2005  
     Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/Cost
    Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/Cost
 

Interest-earning banking assets:

                

Loans, net(1)

   $ 20,994,403    $ 949,513    6.03 %   $ 14,517,416    $ 569,191    5.23 %

Mortgage-backed and related available-for-sale securities

     11,451,932      432,077    5.03 %     9,139,878      285,366    4.16 %

Available-for-sale investment securities

     2,931,914      136,561    6.21 %     2,957,416      112,115    5.05 %

Trading securities

     131,885      8,194    8.28 %     308,240      9,631    4.17 %

Other

     46,489      1,561    4.44 %     57,363      1,095    2.56 %
                                

Total interest-earning banking assets(2)

     35,556,623      1,527,906    5.73 %     26,980,313      977,398    4.83 %
                        

Non-interest-earning banking assets

     487,802           467,642      
                        

Total banking assets

   $ 36,044,425         $ 27,447,955      
                        

Interest-bearing banking liabilities:

                

Retail deposits

   $ 19,664,315      346,602    2.36 %   $ 12,407,871      147,570    1.59 %

Brokered certificates of deposit

     539,508      18,262    4.53 %     429,568      10,818    3.37 %

Repurchase agreements and other borrowings

     10,680,195      391,460    4.83 %     9,995,414      261,492    3.45 %

FHLB advances

     3,161,930      108,696    4.53 %     3,026,553      86,358    3.76 %
                                

Total interest-bearing banking liabilities

     34,045,948      865,020    3.37 %     25,859,406      506,238    2.62 %
                        

Non-interest-bearing banking liabilities

     303,307           320,168      
                        

Total banking liabilities

     34,349,255           26,179,574      

Total banking shareholder’s equity

     1,695,170           1,268,381      
                        

Total banking liabilities and shareholder’s equity

   $ 36,044,425         $ 27,447,955      
                        

Excess of interest-earning banking assets over interest-bearing banking liabilities/net operating interest income

   $ 1,510,675    $ 662,886      $ 1,120,907    $ 471,160   
                                

Bank net operating interest:

                

Spread

         2.36 %         2.21 %

Margin (net yield on interest-earning banking assets)

      2.49 %         2.33 %

Ratio of interest-earning banking assets to interest-bearing banking liabilities

         104.44 %         104.33 %

Return on average:(3)(4)

                

Total banking assets

         1.02 %         0.99 %

Total banking shareholder’s equity

         21.63 %         21.43 %

Average equity to average total banking assets

         4.70 %         4.62 %

(1)   Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.
(2)   Amount includes a taxable equivalent increase in operating interest income of $12.9 million and $7.9 million for the nine months ended September 30, 2006 and 2005, respectively.
(3)   Ratio calculations exclude discontinued operations.
(4)   Ratio calculations are based on stand alone Bank results.

 

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GLOSSARY OF TERMS

Active Trader—The customer segment that includes those who execute 30 or more trades per quarter and have base pricing of $6.99 to $9.99 per trade.

Adjusted total assets—Bank only assets primarily composed of total assets plus/(less) unrealized losses (gains) on available-for-sale securities, less deferred tax assets, goodwill and certain other intangible assets.

Average commission per trade—Total retail segment commission revenue divided by total number of retail trades.

Average equity to total banking assets—Average total banking shareholder’s equity divided by average total banking assets.

Basis point—One hundredth of a percentage point.

Cash flow hedge—Financial derivative instrument designated in a hedging relationship that mitigates exposure to variability in expected future cash flows attributable to a particular risk.

Charge-off—The result of removing a loan or portion of a loan from an entity’s balance sheet because the loan is considered to be uncollectible.

Clearing and servicing expense—A predominantly variable expense associated with our trading products and the servicing expense associated with our loan products.

Compensation and benefits as a percentage of revenue—Total compensation and benefits expense divided by total net revenue.

Corporate investments—Primarily equity investments held at the parent company level that are not related to the ongoing business of the Company’s operating subsidiaries.

Customer cash and deposits—Customer cash, deposits, free credits and money market balances, including those held by third parties.

Daily average revenue trades (“DARTs”)—Total revenue trades in a period divided by the number of trading days during that period.

Derivative—A financial instrument or other contract the price of which is directly dependent upon the value of one or more underlying securities, interest rates or any agreed upon pricing index. Derivatives cover a wide assortment of financial contracts, including forward contracts, options and swaps.

E*TRADE Complete—An integrated investing, trading, banking and lending product that allows customers to manage their relationships with the Company through one account. E*TRADE Complete helps customers optimize cash and credit by utilizing tools designed to inform them of whether or not they are receiving the most appropriate rates for their cash and paying the most appropriate rates for credit.

Enterprise interest-bearing liabilities—Liabilities such as customer deposits, repurchase agreements, other borrowings and advances from the FHLB, certain customer credit balances and stock loan programs on which the Company pays interest; excludes customer money market balances held by third parties.

Enterprise interest-earning assets—Consists of the primary interest-earning assets of the Company and includes: loans receivable, mortgage-backed and available-for-sale securities, margin loans, stock borrow balances, and cash required to be segregated under regulatory guidelines that earn interest for the Company.

Enterprise net interest income—The taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense, stock conduit interest income and expense and interest earned on customer cash held by third parties.

 

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Enterprise net interest spread—The taxable equivalent rate earned on average enterprise interest-earning assets less the rate paid on average enterprise interest-bearing liabilities, excluding corporate interest-earning assets and liabilities, stock conduit and cash held by third parties.

Fair value hedge—Financial derivative instrument designated in a hedging relationship that mitigates exposure to changes in the fair value of a recognized asset or liability or a firm commitment.

Free credits—Balances held in Brokerage customer accounts arising from deposits of funds and sales of securities.

GAAP—Accounting principles generally accepted in the United States of America.

Interest-bearing banking liabilities—Liabilities such as customer deposits, repurchase agreements, other borrowings and advances from the FHLB on which the Company pays interest.

Interest-earning banking assets—Assets such as loans receivable, mortgage-backed and available-for-sale securities, trading securities and cash that earn interest for the Company.

Interest rate cap—An options contract which puts an upper limit on a floating exchange rate. The writer of the cap has to pay the holder of the cap the difference between the floating rate and the upper limit when that upper limit is breached. There is usually a premium paid by the buyer of such a contract.

Interest rate floor—An options contract which puts a lower limit on a floating exchange rate. The writer of the floor has to pay the holder of the floor the difference between the floating rate and the lower limit when that lower limit is breached. There is usually a premium paid by the buyer of such a contract.

Interest rate swaps—Contracts that are entered into primarily as an asset/liability management strategy to reduce interest rate risk. Interest rate swap contacts are exchanges of interest rate payments, such as fixed-rate payments for floating-rate payments, based on notional principal amounts.

Main Street Investor—The customer segment that includes those who execute less than 30 trades per quarter, hold less than $50,000 in assets in combined retail accounts and have base pricing of $12.99 per trade

Margin loans—The extension of credit to brokerage customers of the Company, where the loan is secured with securities owned by the customer.

Mass Affluent—The customer segment that includes those who execute less than 30 trades per quarter, hold $50,000 or more in assets in combined retail accounts and have base pricing of $9.99 per trade.

Net interest spread—The difference between the weighted-average yields earned on interest-earning assets and the weighted-average yields paid on interest-bearing liabilities.

Net Present Value of Equity (“NPVE”)—The present value of expected cash inflows from existing assets, minus the present value of expected cash outflows from existing liabilities, plus the expected cash inflows and outflows from existing derivatives and forward commitments. This calculation is performed for the Bank.

Nonperforming assets—Assets that do not earn income, including those originally acquired to earn income (delinquent loans) and those not intended to earn income (REO). Loans are classified as nonperforming when full and timely collection of interest and principal becomes uncertain or when the loans are 90 days past due.

Notional amount—The specified dollar amount underlying a derivative on which the calculated payments are based.

Operating margin—Income before other income (expense), income taxes, minority interest, discontinued operations and cumulative effect of accounting change.

 

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Options—Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to either purchase or sell the associated financial instrument at a set price during a period or at a specified date in the future.

Organic—Business related to new and existing customers as opposed to acquisitions (referred to as “core” in previous filings).

Principal transactions—Transactions that primarily consist of revenue from market-making activities.

Product—An account feature that generates revenue, such as a margin enabled account, or an account function that creates a deeper customer relationship, such as “Bill Pay.”

Products per customer—Average number of our products that a customer actively uses.

Real-estate owned repossessed assets (“REO”)—Ownership of real property by the Company, generally acquired as a result of foreclosure.

Repurchase agreement—An agreement giving the seller of an asset the right or obligation to buy back the same or similar securities at a specified price on a given date. These agreements are generally collateralized by mortgage-backed or investment-grade securities.

Retail deposits—Balances of retail customer cash held at the Bank; excludes brokered certificates of deposit.

Return on average total banking assets—Annualized Bank net income from continuing operations divided by average banking assets.

Return on average total banking shareholder’s equity—Annualized Bank net income from continuing operations divided by average banking shareholder’s equity.

Retail client assets—Market value of all client assets held by the Company including security holdings, customer cash and deposits and vested unexercised options.

Revenue growth—The difference between the current and prior comparable period total net revenue divided by the prior comparable period total net revenue.

Risk-weighted assets—Primarily computed by the assignment of specific risk-weightings assigned by the OTS to assets and off-balance sheet instruments for capital adequacy calculations. This calculation is for the Bank only.

Stock conduit—The borrowing of shares from a Broker-Dealer and subsequently lending the same shares to another Broker-Dealer netting a fee.

Sweep deposit accounts—Accounts with the functionality to transfer brokerage cash balances to and from an FDIC-insured money market account at the Bank.

Taxable equivalent interest adjustment—The operating interest income earned on certain assets is completely or partially exempt from federal and/or state income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparison of yields and margins for all interest-earning assets, the interest income earned on tax exempt assets in increased to make it fully equivalent to interest income on other taxable investments. This adjustment is done for the analytic purposes in the net enterprise interest income/spread calculation and is not made on the Consolidated Statement of Income, as that is not permitted under GAAP.

Tier 1 Capital—Adjusted equity capital used in the calculation of capital adequacy ratios at the Bank as required by the OTS. Tier 1 capital equals: total shareholder’s equity at the Bank, plus/(less) unrealized losses (gains) on available-for-sale securities and cash flow hedges, less deferred tax assets, goodwill and certain other intangible assets.

 

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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about our market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005 and as updated in this report. Market risk is our exposure to changes in interest rates, foreign exchange rates and equity and commodity prices. Our exposure to interest rate risk is primarily related to interest-earning assets and interest-bearing liabilities.

Interest Rate Risk

The management of interest rate risk is essential to profitability. Interest rate risk is our exposure to changes in interest rates. In general, we manage our interest rate risk by balancing variable-rate and fixed-rate assets, liabilities and derivatives in a way that reduces our overall exposure to changes in interest rates. This analysis is based on complex assumptions regarding maturities, market interest rates and customer behavior. Changes in interest rates, including the following, could impact interest income and expense:

 

    Interest-earning assets and interest-bearing liabilities may re-price at different times or by different amounts creating a mismatch.

 

    The yield curve may flatten or change shape affecting the spread between short- and long-term rates. Widening or narrowing spreads could impact net interest income.

 

    Market interest rates may influence prepayments resulting in maturity mismatches. In addition, prepayments could impact yields as premium and discounts amortize.

Exposure to market risk is dependent upon the distribution and composition of interest-earning assets, interest-bearing liabilities and derivatives. The differing risk characteristics of each product are managed to mitigate our exposure to interest rate fluctuations. At September 30, 2006, 92% of our total assets were interest-earning assets.

At September 30, 2006, approximately 60% of our total assets were residential mortgages and mortgage-backed securities. The values of these assets are sensitive to changes in interest rates, as well as expected prepayment levels. As interest rates increase, fixed rate residential mortgages and mortgage-backed securities tend to exhibit lower prepayments. The inverse is true in a falling rate environment.

Our liability structure consists of transactional deposit relationships, such as money market accounts; certificates of deposit; securities sold under agreements to repurchase; free credits; wholesale collateralized borrowings from the FHLB and other entities; and long term notes. Our transactional deposit accounts and free credits tend to be less rate-sensitive than wholesale borrowings. Agreements to repurchase securities and money market accounts re-price as interest rates change. Certificates of deposit re-price over time depending on maturities. FHLB advances and long-term notes generally have fixed rates.

Derivative Financial Instruments

We use derivative financial instruments to help manage our interest rate risk. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of the underlying notional amounts. Option products are utilized primarily to decrease the market value changes resulting from the prepayment dynamics of the mortgage portfolio, as well as to protect against increases in funding costs. The types of options employed include Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps mitigate the market risk associated with increases in interest rates while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates.

 

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Scenario Analysis

Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”) approach, the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce a NPVE figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 and 200 basis points. The NPVE method is used at the Bank level and not for the Company. The Bank has 82% and 79% of our interest-earning assets at September 30, 2006 and December 31, 2005, respectively, and holds 80% and 77% of our interest-bearing liabilities at September 30, 2006 and December 31, 2005, respectively. Interest-earning assets not included in the NPVE approach are floating-rate brokerage receivables and a small portfolio of trading securities. Interest-bearing liabilities not currently included in the analysis consist of brokerage payables and corporate level long-term debt.

The sensitivity of NPVE at September 30, 2006 and December 31, 2005 and the limits established by the Bank’s Board of Directors are listed below (dollars in thousands):

 

Parallel Change in

Interest Rates (bps)

   Change in NPVE     Board Limit  
   September 30, 2006    December 31, 2005    
       Amount           Percentage          Amount           Percentage      

+300

   $ 204,416     8 %    $ (490,045 )   (22 )%   (55 )%

+200

   $ 133,791     5 %    $ (298,476 )   (13 )%   (30 )%

+100

   $ 59,343     2 %    $ (115,244 )   (5 )%   (20 )%

–100

   $ (181,402 )   (7)%    $ (49,256 )   (2 )%   (20 )%

–200

   $ (586,807 )   (24)%    $ (382,924 )   (17 )%   (30 )%

Under criteria published by the Office of Thrift Supervision, the Bank’s overall interest rate risk exposure at September 30, 2006 was characterized as “moderate.” We actively manage our interest rate risk positions. As interest rates change, we will re-adjust our strategy and mix of assets, liabilities and derivatives to optimize our position. For example, a 100 basis points increase in rates may not result in a change in value as indicated above. The Bank’s Asset Liability Committee monitors the Bank’s interest rate risk position.

Mortgage Production Activities

Our current strategy is to retain more originated mortgage loans on the balance sheet, thus reducing current period income related to the sales of these loans. Holding mortgage assets on the balance sheet involves risks including exposure to interest rate fluctuations between the commitment and funding dates and prepayment risk. When mortgage loans prepay, mortgage origination costs are written off. Depending on the timing of the prepayment, these write-offs may result in lower than anticipated yields. The Bank’s Asset Liability Committee reviews estimates of the impact of changing market rates on loan production volumes and prepayments. This information is incorporated into our interest rate risk management strategy.

For mortgage loans intended to be sold, Interest Rate Lock Commitments (“IRLCs”) are considered derivatives with changes in fair value recorded in earnings. IRLCs are commitments issued to borrowers that lock in an interest rate now for a loan closing in one to three months. These locks, initially recorded with a fair value of zero, will fluctuate in value during the lock period as market interest rates change. IRLCs were valued as a $0.5 million and $1.6 million asset at September 30, 2006 and December 31, 2005, respectively.

 

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Table of Contents

PART I—FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INCOME

(In thousands, except per share amounts)

(Unaudited)

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    2006     2005     2006     2005  

Revenue:

       

Operating interest income

  $ 731,429     $ 424,114     $ 1,986,096     $ 1,148,384  

Operating interest expense

    (376,293 )     (207,101 )     (961,569 )     (535,532 )
                               

Net operating interest income

    355,136       217,013       1,024,527       612,852  

Provision for loan losses

    (12,547 )     (12,909 )     (33,014 )     (37,946 )
                               

Net operating interest income after provision for loan losses

    342,589       204,104       991,513       574,906  
                               

Commission

    133,606       114,278       476,771       323,111  

Service charges and fees

    33,910       32,893       99,540       100,639  

Principal transactions

    22,697       23,793       84,979       75,547  

Gain on sales of loans and securities, net

    16,003       21,850       38,738       84,121  

Other revenue

    32,961       22,918       99,932       66,596  
                               

Total non-interest income

    239,177       215,732       799,960       650,014  
                               

Total net revenue

    581,766       419,836       1,791,473       1,224,920  
                               

Expense excluding interest:

       

Compensation and benefits

    110,705       103,084       352,334       280,472  

Clearing and servicing

    62,500       46,930       189,926       132,720  

Advertising and market development

    23,914       21,188       89,115       74,252  

Communications

    25,576       18,210       84,818       54,650  

Professional services

    20,741       16,703       71,715       53,168  

Depreciation and amortization

    18,565       18,443       56,181       53,310  

Occupancy and equipment

    22,150       16,249       63,082       50,673  

Amortization of other intangibles

    12,087       4,382       35,391       13,751  

Facility restructuring and other exit activities

    16,684       (469 )     19,315       495  

Other

    45,675       23,129       101,888       65,917  
                               

Total expense excluding interest

    358,597       267,849       1,063,765       779,408  
                               

Income before other income (expense), income taxes, minority interest, discontinued operations and cumulative effect of accounting change

    223,169       151,987       727,708       445,512  

Other income (expense):

       

Corporate interest income

    1,942       3,409       6,091       7,796  

Corporate interest expense

    (37,964 )     (13,783 )     (114,586 )     (36,975 )

Gain on sales and impairment of investments

    26,991       22,028       59,897       68,172  

Loss on early extinguishment of debt

    —         —         (703 )     —    

Equity in income of investments and venture funds

    2,519       3,103       1,701       7,142  
                               

Total other income (expense)

    (6,512 )     14,757       (47,600 )     46,135  
                               

Income before income taxes, minority interest, discontinued operations and cumulative effect of accounting change

    216,657       166,744       680,108       491,647  

Income tax expense

    66,429       57,606       230,204       170,862  

Minority interest in subsidiaries

    —         —         —         58  
                               

Net income from continuing operations

    150,228       109,138       449,904       320,727  

Discontinued operations, net of tax:

       

Loss from discontinued operations

    —         (3,464 )     (721 )     (18,901 )

Gain (loss) on disposal of discontinued operations

    3,021       171       3,021       (2,420 )
                               

Gain (loss) from discontinued operations, net of tax

    3,021       (3,293 )     2,300       (21,321 )

Cumulative effect of accounting change, net of tax

    —         1,646       —         1,646  
                               

Net income

  $ 153,249     $ 107,491     $ 452,204     $ 301,052  
                               

Basic earnings per share from continuing operations

  $ 0.35     $ 0.30     $ 1.07     $ 0.88  

Basic earnings (loss) per share from discontinued operations

    0.01       (0.01 )     0.01       (0.06 )

Basic earnings per share from cumulative effect of accounting change

    —         0.00       —         0.00  
                               

Basic net earnings per share

  $ 0.36     $ 0.29     $ 1.08     $ 0.82  
                               

Diluted earnings per share from continuing operations

  $ 0.34     $ 0.29     $ 1.03     $ 0.85  

Diluted earnings (loss) per share from discontinued operations

    0.01       (0.01 )     0.00       (0.06 )

Diluted income per share from cumulative effect of accounting change

    —         0.00       —         0.00  
                               

Diluted net earnings per share

  $ 0.35     $ 0.28     $ 1.03     $ 0.79  
                               

Shares used in computation of per share data:

       

Basic

    423,736       367,342       420,148       366,215  

Diluted

    438,883       382,031       436,959       379,768  

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

(In thousands, except share amounts)

(Unaudited)

 

     September 30,
2006
    December 31,
2005
 

ASSETS

    

Cash and equivalents

   $ 1,199,638     $ 844,188  

Cash and investments required to be segregated under Federal or other regulations

     271,851       610,174  

Trading securities

     151,835       146,657  

Available-for-sale mortgage-backed and investment securities (includes securities pledged to creditors with the right to sell or repledge of $11,819,049 at September 30, 2006 and $11,792,684 at December 31, 2005)

     15,332,963       12,763,438  

Loans held-for-sale

     208,633       87,371  

Brokerage receivables, net

     7,230,960       7,174,175  

Loans receivable, net (net of allowance for loan losses of $69,908 at September 30, 2006 and $63,286 at December 31, 2005)

     23,215,444       19,424,895  

Property and equipment, net

     299,261       299,256  

Goodwill

     2,063,598       2,003,456  

Other intangibles, net

     498,743       532,108  

Other assets

     1,050,245       681,968  
                

Total assets

   $ 51,523,171     $ 44,567,686  
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Liabilities:

    

Deposits

   $ 22,319,364     $ 15,948,015  

Securities sold under agreements to repurchase

     10,990,532       11,101,542  

Brokerage payables

     7,399,279       7,342,208  

Other borrowings

     4,206,922       4,206,996  

Senior notes

     1,400,505       1,401,947  

Mandatory convertible notes

     439,330       435,589  

Convertible subordinated notes

     —         185,165  

Accounts payable, accrued and other liabilities

     736,982       546,664  
                

Total liabilities

     47,492,914       41,168,126  
                

Shareholders’ equity:

    

Common stock, $0.01 par value, shares authorized: 600,000,000; shares issued
and outstanding: 427,007,278 at September 30, 2006 and 416,582,164 at December 31, 2005

     4,270       4,166  

Additional paid-in capital (“APIC”)

     3,203,450       2,990,676  

Retained earnings

     1,032,634       580,430  

Accumulated other comprehensive loss

     (210,097 )     (175,712 )
                

Total shareholders’ equity

     4,030,257       3,399,560  
                

Total liabilities and shareholders’ equity

   $ 51,523,171     $ 44,567,686  
                

 

See accompanying notes to consolidated financial statements

 

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Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2006     2005     2006     2005  

Net income

   $ 153,249     $ 107,491     $ 452,204     $ 301,052  

Other comprehensive loss

        

Available-for-sale securities:

        

Unrealized gains (losses), net

     156,018       (19,961 )     (25,873 )     23,044  

Less impact of realized gains (transferred out of accumulated other comprehensive income) and included in net income, net

     (38,291 )     (14,066 )     (65,814 )     (61,552 )
                                

Net change from available-for-sale securities

     117,727       (34,027 )     (91,687 )     (38,508 )
                                

Cash flow hedging instruments:

        

Unrealized gains (losses), net

     (107,665 )     83,027       43,078       (15,384 )

Amortization of losses into operating interest expense related to de-designated cash flow hedges deferred in accumulated other comprehensive income, net

     827       8,622       5,907       34,271  
                                

Net change from cash flow hedging instruments

     (106,838 )     91,649       48,985       18,887  
                                

Foreign currency translation gains (losses)

     2,740       (2,631 )     8,317       (17,119 )
                                

Other comprehensive income (loss)

     13,629       54,991       (34,385 )     (36,740 )
                                

Comprehensive income

   $ 166,878     $ 162,482     $ 417,819     $ 264,312  
                                

 

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(In thousands)

(Unaudited)

 

    Shares Exchangeable
into Common Stock
  Common Stock     Additional
Paid-in
Capital
    Retained
Earnings
  Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 
    Shares   Amount   Shares     Amount          

Balance, December 31, 2005

  —     $ —     416,582     $ 4,166     $ 2,990,676     $ 580,430   $ (175,712 )   $ 3,399,560  

Net income

  —       —     —         —         —         452,204     —         452,204  

Other comprehensive loss

  —       —     —         —         —         —       (34,385 )     (34,385 )

Exercise of stock options and warrants, including tax benefit

  —       —     4,911       49       66,897       —       —         66,946  

Issuance of common stock upon conversion of 6% convertible debt

  —       —     7,772       78       183,333       —       —         183,411  

Issuance of common stock upon acquisition

  —       —     847       8       19,742       —       —         19,750  

Repurchases of common stock

  —       —     (3,543 )     (35 )     (82,739 )     —       —         (82,774 )

Issuance of restricted stock

  —       —     620       6       (6 )     —       —         —    

Cancellation of restricted stock

  —       —     (98 )     (1 )     1       —       —         —    

Retirement of restricted stock to pay taxes

  —       —     (84 )     (1 )     (2,001 )     —       —         (2,002 )

Amortization of deferred stock compensation to APIC under SFAS No. 123(R)

  —       —     —         —         27,618       —       —         27,618  

Other

  —       —     —         —         (71 )     —       —         (71 )
                                                     

Balance, September 30, 2006

  —     $ —     427,007     $ 4,270     $ 3,203,450     $ 1,032,634   $ (210,097 )   $ 4,030,257  
                                                     
    Shares Exchangeable
into Common Stock
  Common Stock     Additional
Paid-in
Capital
    Retained
Earnings
  Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 
    Shares     Amount   Shares     Amount          

Balance, December 31, 2004

  1,303     $ 13   369,624     $ 3,696     $ 2,215,674     $ 150,018   $ (141,199 )   $ 2,228,202  

Net income

  —         —     —         —         —         301,052       301,052  

Other comprehensive loss

  —         —     —         —         —           (36,740 )     (36,740 )

Exercise of stock options and warrants, including tax benefit

  —         —     7,302       73       68,483       —       —         68,556  

Issuance of common stock upon acquisition

  —         —     300       3       4,038       —       —         4,041  

Repurchases of common stock

  —         —     (4,548 )     (45 )     (58,170 )     —       —         (58,215 )

Issuance of restricted stock

  —         —     830       8       (8 )     —       —         —    

Cancellation of restricted stock

  —         —     (517 )     (5 )     5       —       —         —    

Retirement of restricted stock to pay taxes

  —         —     (32 )     —         (448 )     —       —         (448 )

Amortization of deferred stock compensation prior to adoption of SFAS No. 123(R), net of cancellations and retirements

  —         —     —         —         1,974       —       —         1,974  

Cumulative effect of accounting change

            (2,777 )         (2,777 )

Stock-based compensation under SFAS No. 123(R)

            8,608           8,608  

Other

  (3 )     —     3       —         42       —       —         42  
                                                       

Balance, September 30, 2005

  1,300     $ 13   372,962     $ 3,730     $ 2,237,421     $ 451,070   $ (177,939 )   $ 2,514,295  
                                                       

See accompanying notes to consolidated financial statements

 

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Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Nine Months Ended September 30,  
               2006                         2005            

Cash flows from operating activities:

    

Net income

   $ 452,204     $ 301,052  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Cumulative effect of accounting change, net of tax

     —         (1,646 )

Provision for loan losses

     33,014       37,946  

Depreciation and amortization (including discount amortization and accretion)

     215,171       265,686  

Gain on sales and impairment of investments

     (54,539 )     (144,168 )

Minority interest in subsidiaries and equity in income of investments and venture funds

     (1,701 )     (7,200 )

Non-cash facility restructuring costs and other exit activities

     11,489       3,764  

Stock-based compensation

     27,618       10,582  

Tax benefit from tax deductions in excess of compensation expense

     (23,121 )     (19,126 )

Other

     13,352       (9,349 )

Net effect of changes in assets and liabilities:

    

Decrease in cash and investments required to be segregated under Federal or other regulations

     352,724       527,443  

Increase in brokerage receivables

     (30,236 )     (733,025 )

Increase in brokerage payables

     19,186       133,776  

Proceeds from sales, repayments and maturities of loans held-for-sale

     1,095,150       5,610,773  

Purchases of loans held-for-sale

     (1,409,547 )     (3,096,313 )

Proceeds from sales, repayments and maturities of trading securities

     1,463,808       3,134,296  

Purchases of trading securities

     (1,480,586 )     (5,265,037 )

Other assets

     (229,085 )     37,672  

Accounts payable, accrued and other liabilities

     197,555       (118,572 )

Facility restructuring liabilities

     (13,568 )     (7,301 )
                

Net cash provided by operating activities

     638,888       661,253  
                

Cash flows from investing activities:

    

Purchases of available-for-sale mortgage-backed and investment securities

     (8,166,130 )     (12,368,805 )

Proceeds from sales, maturities of and principal payments on available-for-sale mortgage-backed and investment securities

     5,389,695       13,520,532  

Net increase in loans receivable

     (3,694,479 )     (6,007,625 )

Purchases of property and equipment

     (68,241 )     (58,302 )

Cash used in business acquisitions, net(1)

     (15,135 )     (5,737 )

Net cash flow from derivatives hedging assets

     (50,257 )     (26,414 )

Other

     20,459       20,778  
                

Net cash used in investing activities

   $ (6,584,088 )   $ (4,925,573 )
                

(1)   In 2006, cash used in business acquisitions was related to the BrownCo purchase price true-up based on the final acquisition balance sheet and acquisition of Retirement Advisors of America (“RAA”).

 

See accompanying notes to consolidated financial statements

 

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Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS—(Continued)

(In thousands)

(Unaudited)

 

     Nine Months Ended September 30,  
               2006                         2005            

Cash flows from financing activities:

    

Net increase in deposits

   $ 6,367,905     $ 2,267,717  

Advances from other long-term borrowings

     2,449,414       17,018,000  

Payments on advances from other long-term borrowings

     (2,561,616 )     (14,187,000 )

Net decrease in securities sold under agreements to repurchase

     (116,877 )     (831,856 )

Net increase (decrease) in other borrowed funds

     66,492       (14,941 )

Payments for redemption of 6% convertible notes

     (1,754 )     —    

Proceeds from issuance of senior notes

     —         447,452  

Proceeds from issuance of common stock from employee stock transactions

     43,825       48,299  

Tax benefit from tax deductions in excess of compensation expense recognition

     23,121       19,126  

Repurchases of common stock

     (82,774 )     (58,215 )

Proceeds from issuance of subordinated debentures and trust preferred securities

     44,900       20,000  

Net cash flow from derivatives hedging liabilities

     68,014       (14,148 )

Other

     —         (458 )
                

Net cash provided by financing activities

     6,300,650       4,713,976  
                

Increase in cash and equivalents

     355,450       449,656  

Cash and equivalents, beginning of period

     844,188       939,906  
                

Cash and equivalents, end of period

   $ 1,199,638     $ 1,389,562  
                

Supplemental disclosures:

    

Cash paid for interest

   $ 1,012,858     $ 547,932  

Cash paid for income taxes

   $ 112,778     $ 88,023  

Non-cash investing and financing activities:

    

Transfers from loans to other real estate owned and repossessed assets

   $ 39,509     $ 36,788  

Reclassification of loans held-for-sale to loans held-for-investment

   $ 124,817     $ 126,887  

Issuance of common stock to retire debentures

   $ 183,411     $ —    

 

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1—ORGANIZATION, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization—E*TRADE Financial Corporation (together with its subsidiaries, “E*TRADE” or the “Company”) is a global company offering a wide range of financial services to the consumer under the brand “E*TRADE Financial.” The Company offers investing, trading, banking and lending products and services to its retail and institutional customers.

Basis of PresentationThese consolidated financial statements have been prepared in accordance with GAAP for interim financial information and Regulation S-X, Article 10 under the Securities Exchange Act of 1934. They are unaudited and do not include all disclosures found in our annual financial statements. Management believes it has made all necessary adjustments so that the financial statements are presented fairly. The results of operations for the three and nine months ended September 30, 2006 may not be indicative of future results. Certain prior period items in these consolidated financial statements have been reclassified to conform to the current period presentation. As discussed in Note 2, the operations of certain businesses have been accounted for as discontinued operations in accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, results of operations from prior periods have been reclassified to discontinued operations. Unless noted, discussions herein pertain to the Company’s continuing operations.

These consolidated financial statements should be read in conjunction with the consolidated financial statements of E*TRADE Financial Corporation included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

New Income Statement Reporting Format—During the nine month period ended September 30, 2006, we modified the format of our consolidated income statement to a format that we believe provides a clearer picture of our financial performance and is more consistent with the common presentation found in the financial services industry. We re-ordered the revenue section by placing net operating interest income, which we previously referred to as net interest income, first, and non-interest income second. In addition, we updated our expense presentation to eliminate the remaining bank/brokerage lines. In conjunction with this change, we created a new expense category, “Clearing and servicing.” This new category includes trade clearing-related expense, previously included in “Commissions, clearance and floor brokerage” and most expenses previously included in “Servicing and other banking expenses.” We also consolidated “Fair value adjustments of financial derivatives” into the “Other” expense category. Information related to fair value adjustments of financial derivatives is detailed in Note 8 to the consolidated financial statements.

In particular, we report corporate interest income and expense separately from operating interest income and expense. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Our operating interest income and expense is generated from the operations of the Company and is a broad indicator of our success in our banking, lending and balance sheet management businesses. Our corporate debt, which is the primary source of the corporate interest expense has been used primarily to finance acquisitions, such as Harrisdirect and BrownCo and generally has not been downstreamed to any of our operating subsidiaries.

Similarly, we report gain on sales and impairment of investments separately from gain on sales of loans and securities, net. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Gain on sales of loans and securities, net are the result of activities in our operations, namely our lending and balance sheet management businesses. Gain on sales and impairment of investments relates to historical equity investments of the Company at the corporate level and are not related to the ongoing business of our operating subsidiaries.

 

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New Balance Sheet Reporting Format—We re-aligned our balance sheet to consolidate several categories and to change the name of “Other borrowings by Bank subsidiary” to “Other borrowings.” Other borrowings include non-Bank subsidiary term notes, previously classified in “Accounts payable, accrued and other liabilities.” Categories consolidated include the following:

 

    “Investment in Federal Home Loan Bank stock” was added to “Available-for-sale mortgage-backed and investment securities”;

 

    “Derivative assets” and “Accrued interest receivable” were added to “Other assets”; and

 

    “Derivative liabilities” was added to “Accounts payable, accrued and other liabilities.”

These categories were consolidated with other similar items in our balance sheet presentation. The notes to our consolidated financial statements include detailed derivative asset and liability information.

Use of Estimates—The financial statements were prepared in accordance with GAAP, which require management to make estimates and assumptions that affect the amounts reported in the financial statements and related notes for the periods presented. Actual results could differ from management’s estimates. Material estimates in which management believes near-term changes could reasonably occur include allowance for loan losses and uncollectible margin loans; classification and valuation of certain investments; valuation and accounting for financial derivatives; estimates of effective tax rates; deferred taxes and valuation allowances; valuation of goodwill and other intangibles; and valuation and expensing of share-based payments.

New Accounting Standards—Below are the new accounting pronouncements that relate to activities in which the Company is engaged.

SFAS No. 155—Accounting for Certain Hybrid Financial Instruments

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS 133 and 140. This statement establishes, among other things, the accounting for certain derivatives embedded in other financial instruments, which are referred to as hybrid financial instruments. The statement simplifies accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid financial instruments that contain an embedded derivative that otherwise would require bifurcation. The statement 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, or January 1, 2007 for the Company. The Company has not determined the impact of implementation but does not anticipate that this statement will have a material impact to the Company’s financial condition, results of operations or cash flows.

SFAS No. 156—Accounting for Servicing of Financial Assets

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets, an amendment of SFAS 140. This statement establishes, among other things, the accounting for all separately recognized servicing assets and liabilities. This statement amends SFAS No. 140 to require that all separately recognized servicing assets and liabilities be initially measured at fair value. An entity that uses derivative instruments to mitigate the risk inherent in servicing assets and liabilities may carry servicing assets and liabilities at fair value. The statement is effective at the beginning of an entity’s first fiscal year that begins after September 15, 2006, or January 1, 2007 for the Company. The Company has not determined the impact of implementation but does not anticipate that this statement will have a material impact to the Company’s financial condition, results of operations or cash flows.

SFAS No. 157—Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement establishes, among other things, a framework for measuring fair value and expands disclosure requirements as they relate to

 

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fair value measurements. The statement is effective at the beginning of an entity’s first fiscal year that begins after November 15, 2007 or January 1, 2008 for the Company. The Company is currently evaluating the impact this guidance will have on its financial condition, results of operations or cash flows.

FIN No. 48—Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement 109

In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement 109. The interpretation clarifies, among other things, the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements by mandating a consistent approach to recognizing income tax benefits, and applies to all tax positions accounted for in accordance with SFAS 109, Accounting for Income Taxes. Specifically, the interpretation requires a two prong approach be followed in connection with recognizing any financial statement benefit relating to income taxes. First, a tax position must be “more likely than not” of ultimately being sustained if challenged by taxing authorities before any tax benefit can be recognized. This threshold must be met assuming that the tax authorities will examine the tax position. Second, the amount of tax benefit related to any such tax position recorded in the financial statements is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement with the taxing authorities.

The interpretation also contains guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation will be effective for fiscal years beginning after December 15, 2006. The cumulative effect of applying the provisions of the interpretation will be reported as an adjustment to the opening balance of retained earnings as of January 1, 2007. The Company is in the process of determining the amount of the cumulative effect this interpretation will require or whether it will have a material effect on our financial condition.

NOTE 2—DISCONTINUED OPERATIONS

E*TRADE Professional Securities, LLC and E*TRADE Professional Trading, LLC

In May 2005, the Company closed E*TRADE Professional Securities, LLC, a unit that conducted proprietary trading operations. In December 2005, the Company decided to sell its professional agency business, E*TRADE Professional Trading, LLC. The Company executed a sale agreement on February 17, 2006 and settled this transaction on July 3, 2006. The Company recorded approximately $2.8 million in gain, net of tax, on the sale of this business during the three months ended September 30, 2006.

The following table summarizes the results of discontinued operations for the proprietary and agency trading businesses (dollars in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
         2006            2005             2006             2005      

Net revenue

   $   —      $ 2,982     $ 5,526     $ 18,766  
                               

Loss from discontinued operations

   $ —      $ (1,131 )   $ (1,181 )   $ (9,596 )

Income tax benefit

     —        (447 )     (460 )     (3,786 )
                               

Loss from discontinued operations, net of tax

   $ —      $ (684 )   $ (721 )   $ (5,810 )
                               

E*TRADE Consumer Finance Corporation

In October 2005, the Company completed the sale of the servicing and origination businesses of E*TRADE Consumer Finance Corporation. The exit of the servicing business did not qualify as a discontinued operation; however, the origination business did qualify as a discontinued operation. In September 2006, the Company finalized certain post sale contingencies with the purchaser which resulted in a $0.2 million gain, net of tax.

 

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