Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008.

or

 

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

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)

 

Securities Registered Pursuant to Section 12(b) of the Act:

(Title of each class and Name of exchange on which registered)

Common Stock—$0.01 par value—NASDAQ

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasonal issuer, as defined in Rule 405 of the Securities Act. Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act. Yes  ¨    No  x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x   Accelerated filer  ¨
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)   Smaller reporting company  ¨

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

At June 30, 2008, the aggregate market value of voting stock, comprised of the registrant’s common stock and shares exchangeable into common stock, held by nonaffiliates of the registrant was approximately $1.4 billion (based upon the closing price for shares of the registrant’s common stock as reported by the NASDAQ Global Select Market on that date). Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

Number of shares outstanding of the registrant’s common stock as of February 23, 2009: 572,045,762

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement relating to the Company’s 2009 Annual Meeting of Shareholders, to be filed hereafter (incorporated into Part III hereof).

 

 

 


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-K ANNUAL REPORT

For the Year Ended December 31, 2008

TABLE OF CONTENTS

 

PART I

         

Forward-Looking Statements

   ii

Item 1.

  

Business

   1
  

Overview

   1
  

Strategy

   1
  

Dispositions and Exit Activities

   2
  

Products and Services

   2
  

Customer Service

   3
  

Technology

   3
  

Competition

   4
  

Performance Measurement

   4
  

International Operations

   4
  

Regulation

   5

Item 1A.

  

Risk Factors

   6

Item 1B.

  

Unresolved Staff Comments

   14

Item 2.

  

Properties

   14

Item 3.

  

Legal Proceedings

   14

Item 4.

  

Submission of Matters to a Vote of Security Holders

   17

PART II

         

Item 5.

   Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities    18

Item 6.

  

Selected Consolidated Financial Data

   20

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    22
  

Overview

   22
  

Earnings Overview

   27
  

Segment Results Review

   40
  

Balance Sheet Overview

   44
  

Liquidity and Capital Resources

   48
  

Risk Management

   53
  

Concentrations of Credit Risk

   56
  

Summary of Critical Accounting Policies and Estimates

   65
  

Required Statistical Disclosure by Bank Holding Companies

   72
  

Glossary of Terms

   78

Item 7A.

  

Quantitative and Qualitative Disclosures about Market Risk

   82

Item 8.

  

Financial Statements and Supplementary Data

   85
  

Management Report on Internal Control Over Financial Reporting

   85
  

Reports of Independent Registered Public Accounting Firm

   86
  

Consolidated Statement of Income (Loss)

   88
  

Consolidated Balance Sheet

   89
  

Consolidated Statement of Comprehensive Income (Loss)

   90
  

Consolidated Statement of Shareholders’ Equity

   91
  

Consolidated Statement of Cash Flows

   93
  

Notes to Consolidated Financial Statements

   95
  

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

   95
  

Note 2—Business Combinations

   105

 

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Note 3—Discontinued Operations

   106
  

Note 4—Facility Restructuring and Other Exit Activities

   107
  

Note 5—Operating Interest Income and Operating Interest Expense

   109
  

Note 6—Fair Value Disclosures

   109
  

Note 7—Available-for-Sale Mortgage-Backed and Investment Securities

   115
  

Note 8—Loans, Net

   118
  

Note 9—Accounting for Derivative Financial Instruments and Hedging Activities

   121
  

Note 10—Property and Equipment, Net

   125
  

Note 11—Goodwill and Other Intangibles, Net

   126
  

Note 12—Other Assets

   127
  

Note 13—Deposits

   128
  

Note 14—Securities Sold Under Agreement to Repurchase and Other Borrowings

   130
  

Note 15—Corporate Debt

   132
  

Note 16—Accounts Payable, Accrued and Other Liabilities

   134
  

Note 17—Income Taxes

   134
  

Note 18—Shareholders’ Equity

   139
  

Note 19—Earnings (Loss) per Share

   140
  

Note 20—Employee Share-Based Payments and Other Benefits

   141
  

Note 21—Regulatory Requirements

   143
  

Note 22—Lease Arrangements

   145
  

Note 23—Commitments, Contingencies and Other Regulatory Matters

   145
  

Note 24—Segment and Geographic Information

   149
  

Note 25—Condensed Financial Information (Parent Company Only)

   154
  

Note 26—Quarterly Data (Unaudited)

   157

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    158

Item 9A.

  

Controls and Procedures

   158

Item 9B.

  

Other Information

   158

PART III

         

PART IV

         

Item 15.

  

Exhibits and Financial Statement Schedules

   158

Exhibit Index

   159

Signatures

   164

 

 

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.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements involving risks and uncertainties. These statements relate to our future plans, objectives, expectations and intentions. These statements may be identified by the use of words such as “expect,” “may,” “anticipate,” “intend,” “plan” and similar expressions. Our actual results could differ materially from those discussed in these forward-looking statements, and we caution that we do not undertake to update these statements. Factors that could contribute to our actual results differing from any forward-looking statements include those discussed under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report. The cautionary statements made in this report should be read as being applicable to all forward-looking statements wherever they appear in this report.

 

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ITEM 1. BUSINESS

OVERVIEW

E*TRADE Financial Corporation is a financial services company that provides online brokerage and related products and services primarily to individual retail investors, under the brand “E*TRADE Financial.” Our products and services include investor-focused banking, primarily sweep deposits and savings products, and asset gathering. Our competitive strategy is to attract and retain customers by emphasizing low-cost, ease of use and innovation, with delivery of our products and services primarily through online and technology-intensive channels.

Our corporate offices are located at 135 East 57th Street, New York, New York 10022. We were incorporated in California in 1982 and reincorporated in Delaware in July 1996. We have approximately 3,400 employees. We operate directly and through numerous subsidiaries many of which are overseen by governmental and self-regulatory organizations. Our most significant subsidiaries are described below:

 

   

E*TRADE Bank is a Federally chartered savings bank that provides investor-focused banking services to retail customers nationwide and deposit accounts insured by the Federal Deposit Insurance Corporation (“FDIC”);

 

   

E*TRADE Capital Markets, LLC (“ETCM”) is a registered broker-dealer and market-maker;

 

   

E*TRADE Clearing LLC is the clearing firm for our brokerage subsidiaries and is a wholly-owned operating subsidiary of E*TRADE Bank. Its main purpose is to transfer securities from one party to another; and

 

   

E*TRADE Securities LLC is a registered broker-dealer and the primary provider of brokerage services to our customers.

A complete list of our subsidiaries can be found in Exhibit 21.1.

We provide services primarily to customers in the U.S. through our website at www.etrade.com. We also offer, either alone or with our partners, branded retail websites outside of the U.S. the most significant of which are: Denmark, Estonia, Finland, France, Germany, Hong Kong, Iceland, the Netherlands, Norway, Singapore, Sweden, the United Arab Emirates and the United Kingdom.

In addition to our websites, we also provide services through our network of customer service representatives, relationship managers and investment advisors. We provide these services over the phone or in person through our 29 E*TRADE Financial Centers. Information on our website is not a part of this report.

STRATEGY

Our strategy is to profitably grow our retail customer franchise and mitigate the risks associated with our balance sheet. We plan to grow our retail customer franchise by offering online brokerage and related products and services, including investor-focused banking and asset gathering products and services. We believe we can accomplish this growth by appealing to retail investors, especially customers of traditional brokerages, who are attracted to our low-cost, easy to use and innovative capabilities.

Our plan to mitigate the risks associated with our balance sheet contains three core goals: reduce credit risk in our loan portfolio, reduce our level of corporate debt and reduce operating expenses. We believe that the successful completion of this plan will significantly improve our financial strength.

We are also focused on simplifying and streamlining the business by exiting and/or restructuring certain non-core operations. We believe these changes will better align our business with the retail investor.

 

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DISPOSITIONS AND EXIT ACTIVITIES

A key component of our strategy in 2008 was to exit and/or restructure certain non-core operations. We believe we made considerable progress toward achieving this long-term goal by selling our Canadian brokerage business, selling our equity shares in IL&FS Investsmart, Ltd.(1) (“Investsmart”) and exiting our retail mortgage lending business, which was our last remaining loan origination channel.

PRODUCTS AND SERVICES

We offer a wide range of products and services to assist our customers with their financial needs. Our primary retail products and services consist of:

 

   

Brokerage—includes automated order placement and execution of U.S. and international equities, currencies, futures, options, exchange-traded funds, mutual funds and bonds. We also offer quick transfer, wireless account access, extended hours trading, quotes, research and advanced planning tools; and

 

   

Banking—includes checking, savings, sweep, money market and certificates of deposit (“CD”) products that offer online bill pay, quick transfer, unlimited ATM transactions on eligible accounts and wireless account access.

Our institutional segment manages the balance sheet of the Company with a specific focus on managing credit risk. Our institutional segment also includes market-making activities which match buyers and sellers of securities from both the retail segment and unrelated third parties.

Retail

Our retail segment offers a full suite of financial products and services to retail customers including brokerage and banking products. The most significant of these products and services are as follows:

 

   

automated order placement and execution of U.S. equities, futures, options, exchange-traded funds and bond orders;

 

   

access to international equities in Canada, France, Germany, Hong Kong, Japan and the United Kingdom and foreign currencies, including the Canadian dollar, Euro, Hong Kong dollar, Yen and Sterling;

 

   

two-second execution guarantee on all Standard & Poor’s (“S&P”) 500 stocks and exchange-traded funds;

 

   

margin accounts allowing customers to borrow against their securities;

 

   

access to over 7,000 non-proprietary mutual funds;

 

   

educational services through the Internet, phone or in person and flexible advisory services, including full-service portfolio management;

 

   

no fee and no minimum individual retirement accounts;

 

   

FDIC-insured sweep deposit accounts that automatically transfer funds from customer brokerage accounts;

 

   

interest-earning checking, money market, savings and CD products with FDIC insurance; and

 

   

access to deposit account balances and transactions, through the Internet, phone or in person.

Retail customers are offered brokerage and banking products and services via our website, over the phone and in person. Customers have the ability to transfer funds quickly and easily among their brokerage and banking accounts, thereby giving them the opportunity to optimize the yield and liquidity of their funds.

 

(1) The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.

 

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In addition to the services above, our retail segment includes employee stock option management software and services which are provided to corporate customers. This software system facilitates the management of employee option plans, employee stock purchase plans and restricted stock plans, including necessary accounting and reporting functions. This business is a component of the retail segment since it serves as an introduction to E*TRADE for many retail customers who conduct equity option transactions as employees of our corporate customers, with our goal being that these individuals will also use our other products and services.

Institutional

The institutional segment includes the management of our balance sheet, focusing on asset allocation and managing credit, liquidity and interest rate risks. The retail segment originates margin receivables and customer deposits that are managed by the institutional segment.

Our institutional segment also includes market-making activities which match buyers and sellers of securities from both the retail segment and unrelated third parties. As a market maker, we take positions in securities and function as a wholesale trader by combining trading lots to match buyers and sellers of securities. Trading gains and losses result from these activities. Our revenues are influenced by overall trading volumes, the number of stocks for which we act as a market maker and the trading volumes and volatility of those specific stocks.

For additional statistical information regarding products and customers, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) beginning on page 22. Three years of segment financial performance and data can be found in the MD&A beginning on page 40 and in Note 24—Segment and Geographic Information of Item 8. Financial Statements and Supplementary Data beginning on page 149.

CUSTOMER SERVICE

We believe providing superior customer service is fundamental to our business. We strive to maintain a high standard of customer service by staffing the customer support team with appropriately trained personnel who are equipped to handle customer inquiries in a prompt yet thorough manner. Our customer service representatives utilize our proprietary web-based platform to provide customers with answers to their inquiries. We also have specialized customer service programs that are tailored to the needs of each customer segment.

We provide customer support through the following channels:

 

   

Financial Centers—we have 29 Financial Centers located in the U.S. where retail customers can go to service any of their needs while receiving face to face customer support.

 

   

Online—we have an online service center where customers can request services on their accounts and obtain answers to frequently asked questions. The online service center also provides customers with the ability to send a secure message to one of our customer service representatives.

 

   

Telephonic—we have a toll free number that connects customers to an automated phone system which will help ensure that they are directed to the appropriate department for their inquiry. We have been improving the expertise within our customer service team as the vast majority of our customer service representatives now hold a Series 7 license.

TECHNOLOGY

We believe our focus on being a technological leader in the financial services industry enhances our competitive position. This focus allows us to deploy a secure, scalable technology and back office platform that promotes innovative product development and delivery. We continued to invest in these critical platforms in 2008 by delivering advanced mobile capabilities with our Mobile Pro for Blackberry® offering, and by making

 

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numerous enhancements to our other advanced trading and research tools while still maintaining what we believe to be industry leading reliability and performance during unprecedented volatility in the marketplace.

COMPETITION

The online financial services market continues to evolve rapidly and we expect competition to continue to increase. Our retail segment competes with full commission brokerage firms, discount brokerage firms, online brokerage firms, Internet banks and traditional “brick & mortar” retail banks and thrifts. Some of these competitors also provide Internet trading and banking services, investment advisor services, touchtone telephone and voice response banking services, electronic bill payment services and a host of other financial products. Our institutional segment, in addition to the competitors above, competes with market-making firms, investment banking firms and other users of market liquidity in its quest for the least expensive source of funding.

Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Many also have greater name recognition, greater market acceptance and larger customer bases. In recent years, the financial services industry has become more concentrated, as companies involved in a broad range of financial services have been acquired, merged or have declared bankruptcy. During 2008, this trend accelerated considerably, as a significant number of U.S. financial institutions consolidated, were forced to merge, or received substantial government assistance. These developments could result in our remaining competitors having greater capital and other resources, such as the ability to offer a broader range of products and services.

We believe we can continue to attract customers by appealing to retail investors within large established financial institutions by providing them with low-cost, easy to use and innovative financial products and services. However, our exposure to the crisis in the residential real estate and credit markets has created some uncertainty surrounding the Company. These concerns, if not resolved, may make it more difficult to retain our current customer base as well as hinder our ability to attract new customers.

We also face intense competition in attracting and retaining qualified employees. Our ability to compete effectively in financial services will depend upon our ability to attract new employees and retain and motivate our existing employees while efficiently managing compensation related costs.

PERFORMANCE MEASUREMENT

We assess the performance of our business based on our primary customer segments, retail and institutional.

We consider multiple factors, including the competitiveness of our pricing compared to similar products and services in the market, the overall profitability of our businesses and customer relationships when pricing our various products and services. We manage the performance of our business using various customer activity and financial metrics, including daily average revenue trades (“DARTs”), net new customer assets, enterprise net interest spread, average enterprise interest-earning assets, nonperforming loans as a percentage of gross loans receivable, allowance for loan losses and allowance for loan losses as a percentage of nonperforming loans. The overall performance of our business is also based on the management of our expenses related to our various products and services. The same or similar products and services may be offered to both segments, utilizing the same infrastructure or in some circumstances, a single infrastructure may be used to support multiple products and services offered to our customers. As such, we do not separately disclose the costs associated with products and services sold or our general and administrative costs. All operating expenses incurred are integral to the operation of the business and are considered when evaluating the profitability of our business.

INTERNATIONAL OPERATIONS

We offer services in international markets directly through our website at www.etrade.com as well as through additional branded retail brokerage websites. During 2008, we sold our Canadian brokerage business and no longer offer brokerage services in Canada.

 

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See Note 24—Segment and Geographic Information of Item 8. Financial Statements and Supplementary Data for detailed information on non-U.S. geographic locations.

REGULATION

Our business is subject to regulation by U.S. federal and state regulatory agencies and securities exchanges and by various non-U.S. governmental agencies or regulatory bodies, securities exchanges and central banks, each of which has been charged with the protection of the financial markets and the protection of the interests of those participating in those markets. In light of the current conditions in the global financial markets and the global economy, regulators have increased their focus on the regulation of the financial services industry. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S., is possible in future periods. Any such action could have a materially adverse effect on our business, financial condition and results of operations.

Our regulators in the U.S. include, among others, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the New York Stock Exchange (“NYSE”), the National Association of Securities Dealers Automated Quotations (“NASDAQ”), the FDIC, the Federal Reserve, the Municipal Securities Rulemaking Board and the Office of Thrift Supervision (“OTS”). Additional legislation, regulations and rulemaking may directly affect our manner of operation and profitability. Our broker-dealers are registered with the SEC and are subject to regulation by the SEC and by self-regulatory organizations, such as the NYSE, the NASDAQ, FINRA and the securities exchanges of which each is a member, as well as various state regulators. Our banking entities are subject to regulation, supervision and examination by the OTS, the Federal Reserve and also, in the case of the Bank, the FDIC. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, capital structure, transactions with affiliates and conduct and qualifications of personnel. Our international broker-dealers are regulated by their respective local regulators such as the Financial Services Authority (“FSA”), and Securities & Futures Commission. For additional regulatory information, see Note 21—Regulatory Requirements of Item 8. Financial Statements and Supplementary Data beginning on page 143.

We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, available free of charge at our website as soon as reasonably practicable after they have been filed with the SEC. Our website address is www.etrade.com.

 

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ITEM 1A.    RISK FACTORS

Risks Relating to the Nature and Operation of Our Business

We have incurred significant losses and cannot assure that we will be profitable

We incurred a net loss of $511.8 million, or $1.00 loss per share, for the year ended December 31, 2008, due primarily to losses in our home equity portfolio. Although we have taken a significant number of steps to reduce our credit exposure, we likely will continue to suffer significant credit losses in 2009 and 2010. In late 2007, we experienced a substantial diminution of customer assets and accounts as a result of customer concerns regarding our credit related exposures. While we were able to stabilize and return our retail franchise to growth during 2008, it could take a significant amount of time to fully mitigate the credit issues in our loan portfolio and return to profitability.

We will continue to experience losses in our mortgage loan portfolio

At December 31, 2008, the principal balance of our home equity loan portfolio was $10.0 billion. During 2008, the allowance for loan losses in this portfolio increased by $374.7 million to $833.8 million, primarily due to a rapid deterioration in performance in the second half of 2007 and continuing into 2008. While losses on the one-to-four family loan portfolio are much smaller in scope than the losses on the home equity loan portfolio, and may be offset somewhat by the value of the real estate held upon foreclosure, the allowance for loan losses in this portfolio increased by $166.3 million to $185.1 million during 2008. As the crisis in the residential real estate and credit markets continues, we expect credit losses to continue at historically high levels. There can be no assurance that our provision for loan losses will be adequate if the residential real estate and credit markets continue to deteriorate beyond our expectations. We may be required under such circumstances to further increase our provision for loan losses, which could have an adverse effect on our regulatory capital position and our results of operations in future periods.

We could experience significant losses on other securities held on the balance sheet of E*TRADE Bank

At December 31, 2008, we held $920.5 million in amortized cost of collateralized mortgage obligations (“CMO”) on the consolidated balance sheet. While the majority of this portfolio remains AAA-rated, we incurred impairment charges of $95.0 million during 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. In the event that these securities have a further decline in credit quality, this could result in additional impairment charges which would have an adverse effect on our regulatory capital position and our results of operations in future periods.

Losses of customers and assets could destabilize the Company or result in lower revenues in future periods

During November 2007, well-publicized concerns about the Bank’s holdings of asset-backed securities led to widespread concerns about our continued viability. From the beginning of this crisis through December 31, 2007 when the situation stabilized, customers withdrew approximately $5.6 billion of net cash and approximately $12.2 billion of net assets from our bank and brokerage businesses. Many of the accounts that were closed belonged to sophisticated and active customers with large cash and securities balances. While we were able to stabilize and return our retail franchise to growth in 2008, concerns about our viability may recur, which could lead to destabilization and asset and customer attrition. If such destabilization should occur, there can be no assurance that we will be able to successfully rebuild our franchise by reclaiming customers and growing assets. If we are not successful, our revenues and earnings in future periods will be lower than we have experienced historically.

We have a large amount of debt

We have issued a substantial amount of high-yield debt, with restrictive financial covenants, in connection with the Citadel Limited Partnership (“Citadel”) transaction in which we issued a total of approximately $2.1

 

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billion of 12 1/2% springing lien notes in 2007 and 2008. The annual interest cost of these securities alone is approximately $257 million. Our total long-term debt is $3.2 billion and the expected annual interest cash outlay is approximately $342 million, $257 million of which we have the option to pay in the form of additional 12  1/2% springing lien notes through May 2010. Our ratio of debt (our senior debt and term loans) to equity (expressed as a percentage) was 106% at December 31, 2008. The degree to which we are leveraged could have important consequences, including (i) a substantial portion of our cash flow from operations is dedicated to the payment of principal and interest on our indebtedness, thereby reducing the funds available for other purposes; (ii) our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other corporate needs is significantly limited; and (iii) our substantial leverage may place us at a competitive disadvantage, hinder our ability to adjust rapidly to changing market conditions and make us more vulnerable in the event of a further downturn in general economic conditions or our business. If regulatory requirements change in the future to impose capital ratios at the holding company level, we could be required to significantly restructure our capital position. In addition, a significant reduction in revenues could have a material adverse affect on our ability to meet our obligations under our debt securities.

We are subject to investigations and lawsuits as a result of our losses from mortgage loans and asset-backed securities

In 2007, we recognized an increased provision expense totaling $640 million and asset losses and impairments of $2.45 billion, including the sale of our asset-backed securities portfolio to Citadel. As a result, various plaintiffs filed class actions and derivative lawsuits, which have subsequently been consolidated into one class action and one derivative lawsuit, alleging disclosure violations regarding our home equity, mortgage and securities portfolios during 2007. In addition, the SEC initiated an informal inquiry into matters related to our loan and securities portfolios. The defense of these matters has and will continue to entail considerable cost and will be time-consuming for our management. Unfavorable outcomes in any of these matters could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Many of our competitors have greater financial, technical, marketing and other resources

The financial services industry is highly competitive, with multiple industry participants competing for the same customers. Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Other of our competitors offer a more narrow range of financial products and services and have not been as susceptible to the disruptions in the credit markets that have impacted our Company, and therefore have not suffered the losses we have. The impact of competitors with superior name recognition, greater market acceptance, larger customer bases or stronger capital positions could adversely affect our revenue growth and customer retention. Our competitors may also be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can. Competitors may conduct extensive promotional activities, offering better terms, lower prices and/or different products and services or combination of products and services that could attract current E*TRADE customers and potentially result in price wars within the industry. Some of our competitors may also benefit from established relationships among themselves or with third parties enhancing their products and services.

The continuing turmoil in the global financial markets could reduce trade volumes and margin borrowing and increase our dependence on our more active customers who receive lower pricing

Online investing services to the retail customer, including trading and margin lending, account for a significant portion of our revenues. The continuing turmoil in the global financial markets could lead to changes in volume and price levels of securities and futures transactions which may, in turn, result in lower trading volumes and margin lending. In particular, a decrease in trading activity within our lower activity accounts or our accounts related to stock plan administration products and services would significantly impact revenues and increase dependence on more active trading customers who receive more favorable pricing based on their trade volume. A decrease in trading activity or securities prices would also typically be expected to result in a decrease

 

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in margin borrowing, which would reduce the revenue that we generate from interest charged on margin borrowing. More broadly, any reduction in overall transaction volumes would likely result in lower revenues and may harm our operating results because many of our overhead costs are fixed.

We depend on payments from our subsidiaries

We depend on dividends, distributions and other payments from our subsidiaries to fund payments on our obligations, including our debt obligations. Regulatory and other legal restrictions may limit our ability to transfer funds to or from our subsidiaries. Many of our subsidiaries are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to us, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations.

We rely heavily on technology, and technology can be subject to interruption and instability

We rely on technology, particularly the Internet, to conduct much of our activity. Our technology operations are vulnerable to disruptions from human error, natural disasters, power loss, computer viruses, spam attacks, unauthorized access and other similar events. Disruptions to or instability of our technology or external technology that allows our customers to use our products and services could harm our business and our reputation. In addition, technology systems, whether they be our own proprietary systems or the systems of third parties on whom we rely to conduct portions of our operations, are potentially vulnerable to security breaches and unauthorized usage. An actual or perceived breach of the security of our technology could harm our business and our reputation.

Vulnerability of our customers’ computers could lead to significant losses related to identity theft or other fraud and harm our reputation and financial performance

Because our business model relies heavily on our customers’ use of their own personal computers and the Internet, our business and reputation could be harmed by security breaches of our customers and third parties. Computer viruses and other attacks on our customers’ personal computer systems could create losses for our customers even without any breach in the security of our systems, and could thereby harm our business and our reputation. As part of our E*TRADE Complete Protection Guarantee, we reimburse our customers for losses caused by a breach of security of the customers’ own personal systems. Such reimbursements could have a material impact on our financial performance.

Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions

We permit customers to purchase securities on margin. A downturn in securities markets may impact the value of collateral held in connection with margin receivables and may reduce its value below the amount borrowed, potentially creating collections issues with our margin receivables. In addition, we frequently borrow securities from and lend securities to other broker-dealers. Under regulatory guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits. A sharp change in security market values may result in losses if counterparties to the borrowing and lending transactions fail to honor their commitments.

We may be unsuccessful in managing the effects of changes in interest rates and the enterprise interest-earning assets in our portfolio

Net operating interest income has become an increasingly important source of our revenue. Our ability to manage interest rate risk could impact our financial condition. Our results of operations depend, in part, on our level of net operating interest income and our effective management of the impact of changing interest rates and

 

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varying asset and liability maturities. We use derivatives to help manage interest rate risk. However, the derivatives we utilize may not be completely effective at managing this risk and changes in market interest rates and the yield curve could reduce the value of our financial assets and reduce net operating interest income. Among other items, we periodically enter into repurchase agreements to support the funding and liquidity requirements of our Bank. Several market participants have reduced or terminated their participation in the repurchase agreement market. If we are unsuccessful in maintaining our relationships with counterparties, we could recognize substantial losses on the derivatives we utilized to hedge repurchase agreements.

If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage

There has recently been significant consolidation in the financial services industry and this consolidation is likely to continue in the future. Should we be excluded from or fail to take advantage of viable consolidation opportunities, our competitors may be able to capitalize on those opportunities and create greater scale and cost efficiencies to our detriment.

We have acquired a number of businesses and, although currently constrained by the terms of our corporate debt, may continue to acquire businesses in the future. The primary assets of these businesses are their customer accounts. Our retention of these assets and the customers of businesses we acquire may be impacted by our ability to successfully continue to integrate the acquired operations, products (including pricing) and personnel. Diversion of management attention from other business concerns could have a negative impact. In the event that we are not successful in our continued integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition.

Risks associated with principal trading transactions could result in trading losses

A majority of our market-making revenues are derived from trading as a principal. We may incur trading losses relating to the purchase, sale or short sale of securities for our own account, as well as trading losses in our market maker stocks. From time to time, we may have large positions in securities of a single issuer or issuers engaged in a specific industry. Sudden changes in the value of these positions could impact our financial results.

Reduced spreads in securities pricing, levels of trading activity and trading through market makers could harm our market maker business

Computer-generated buy/sell programs and other technological advances and regulatory changes in the marketplace may continue to tighten securities spreads. Tighter spreads could reduce revenue capture per share by our market maker, thus reducing revenues for this line of business.

Advisory services subject us to additional risks

We provide advisory services to investors to aid them in their decision making and also provide full service portfolio management. Investment decisions and suggestions are based on publicly available documents and communications with investors regarding investment preferences and risk tolerances. Publicly available documents may be inaccurate and misleading, resulting in recommendations or transactions that are inconsistent with the investors’ intended results. In addition, advisors may not understand investor needs or risk tolerances, failures that may result in the recommendation or purchase of a portfolio of assets that may not be suitable for the investor. To the extent that we fail to know our customers or improperly advise them, we could be found liable for losses suffered by such customers, which could harm our reputation and business.

Our international operations subject us to additional risks and regulation, which could impair our business growth

We conduct business in a number of international locations, sometimes through joint venture and/or licensee relationships. Action or inaction in any of these operations, including the failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation.

 

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We have a significant deferred tax asset and cannot assure it will be fully realized

We had net deferred tax assets of $1.0 billion as of December 31, 2008. We did not establish a valuation allowance against our federal net deferred tax assets as of December 31, 2008 as we believe that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. In addition, a significant portion of the net deferred tax asset relates to a $2.3 billion federal tax loss carryforward, the utilization of which may be further limited in the event of certain material changes in the ownership of the Company.

Risks Relating to the Regulation of Our Business

We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices

The securities and banking industries are subject to extensive regulation. All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to sales practices and the suitability of recommendations to customers, possession and control of customer funds and securities, margin lending, execution and settlement of transactions and anti money-laundering. We are also subject to additional laws and rules as a result of our market maker operations.

Similarly, E*TRADE Financial Corporation and ETB Holdings, Inc., as savings and loan holding companies, and E*TRADE Bank, E*TRADE Savings Bank and United Medical Bank, as federally chartered savings banks, are subject to extensive regulation, supervision and examination by the OTS and, in the case of the savings banks, also the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.

If we fail to comply with applicable securities and banking laws, rules and regulations, either domestically or internationally, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business

The SEC, FINRA and other self-regulatory organizations and state securities commissions, among other things, can censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws. Regulatory agencies in countries outside of the U.S. have similar authority. The ability to comply with applicable laws and rules is dependent in part on the establishment and maintenance of a reasonable compliance system. The failure to establish and enforce reasonable compliance procedures, even if unintentional, could subject us to significant losses or disciplinary or other actions.

If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business

The SEC, FINRA, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and regulatory capital by banks. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC and suspension or expulsion by FINRA, and could ultimately lead to the firm’s liquidation. In the past, our broker-dealer subsidiaries have depended largely on capital contributions by us in order to comply with net capital requirements. If such net capital rules are changed or expanded, or if there is an unusually large charge

 

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against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock.

Similarly, the Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm a bank’s operations and financial statements. A bank must meet specific capital guidelines that involve quantitative measures of a bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors.

Quantitative measures established by regulation to ensure capital adequacy require a bank to maintain minimum amounts and ratios of Total and Tier 1 Capital to Risk-weighted Assets and of Tier 1 Capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, a bank must maintain higher Total and Tier 1 Capital to Risk-weighted Assets and Tier 1 Capital to adjusted total assets ratios.

As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities

We are required to file periodic reports with the OTS and are subject to examination by the OTS. The OTS also has certain types of enforcement powers over us, ETB Holdings, Inc. and certain of its subsidiaries, including the ability to issue cease-and-desist orders, force divestiture of the Bank and impose civil and monetary penalties for violations of federal banking laws and regulations or for unsafe or unsound banking practices. In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities. We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company. Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements. In 2007, the Company moved its subsidiary, E*TRADE Clearing, LLC to become an operating subsidiary of E*TRADE Bank, resulting in increased regulatory oversight and restrictions on the activities of E*TRADE Clearing, LLC.

We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act, but the OTS has not yet fully interpreted these provisions. Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature. We are also limited in our ability to invest in other savings and loan holding companies.

In addition, the Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new Bank subsidiaries and the commencement of new activities by Bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services.

 

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Risks Relating to Owning Our Stock

We are substantially restricted by the terms of our corporate debt

In June 2004, we issued an aggregate principal amount of $400 million of senior notes due June 2011. In September and November 2005, we issued an additional aggregate principal amount of $100 million of senior notes due June 2011, $600 million of senior notes due September 2013 and $300 million of senior notes due December 2015. In November 2007 and January 2008, we issued a total of $2.1 billion of 12 1/2% springing lien notes due 2017. The indentures governing these notes contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things:

 

   

incur additional indebtedness;

 

   

create liens;

 

   

pay dividends or make other distributions;

 

   

repurchase or redeem capital stock;

 

   

make investments or other restricted payments;

 

   

enter into transactions with our stockholders or affiliates;

 

   

sell assets or shares of capital stock of our subsidiaries;

 

   

receive dividend or other payments from our subsidiaries; and

 

   

merge, consolidate or transfer substantially all of our assets.

As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities. Each of these series of senior notes contain a limitation, subject to important exceptions, on our ability to incur additional debt if our Consolidated Fixed Charge Coverage Ratio is less than or equal to 2.50 to 1.0. As of December 31, 2008, our Consolidated Fixed Charge Coverage Ratio was (0.5) to 1.0. The terms of any future indebtedness could include more restrictive covenants.

We cannot assure that we will be able to remain in compliance with these covenants in the future and, if we fail to do so, that we will be able to obtain waivers from the appropriate parties and/or amend the covenants.

The interests of our largest shareholder may conflict with the interests of other shareholders

At December 31, 2008, Citadel owned approximately 89.4 million shares of our common stock, which represents approximately 16% of the outstanding shares. In addition, Citadel is our largest creditor through its ownership of approximately $2.1 billion of our corporate debt. Citadel is an independent entity with its own investors and is entitled to act in its own economic interest with respect to its equity and debt investments in E*TRADE. For example, following April 29, 2008, Citadel was generally free under the terms of the Investment Agreement to sell the equity securities it received under the Investment Agreement and any such sales may have a depressing effect on the trading price of our common stock. In addition, Citadel’s 12  1/2% springing lien notes contain restrictive covenants and as a holder of in excess of a majority of the springing lien notes, Citadel has a right to declare defaults and enforce remedies just like any other lender for so long as Citadel retains a majority of the springing lien notes. Finally, in pursuing its economic interests, Citadel may make decisions with respect to fundamental corporate transactions which may be different than the decisions of shareholders who own only common shares.

The market price of our common stock may continue to be volatile

From January 1, 2006 through December 31, 2008, the price per share of our common stock ranged from a low of $0.79 to a high of $27.76. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s

 

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securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. As discussed in Note 23—Commitments, Contingencies and Other Regulatory Matters in Item 8. Financial Statements and Supplementary Data, the Company is currently a party to litigation related to the decline in the market price of our stock, and such litigation could occur again in the future. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital and otherwise harm our business.

We may need additional funds in the future, which may not be available and which may result in dilution of the value of our common stock

In the future, we may need to raise additional funds via debt and/or equity instruments, which may not be available on favorable terms, if at all. If adequate funds are not available on acceptable terms, we may be unable to fund our plans for the growth of our business. In addition, if funds are available, the issuance of equity securities could significantly dilute the value of our shares of our common stock and cause the market price of our common stock to fall.

During the second half of 2008, the global financial markets were in turmoil and the equity and credit markets experienced extreme volatility, which caused already weak economic conditions to worsen. Continued turmoil in the global financial markets could further restrict our access to the public equity and debt markets.

In October 2008, we applied to participate in the Troubled Asset Relief Program (“TARP”) Capital Purchase Program established under the Emergency Economic Stabilization Act of 2008. To date, our application has not been approved or rejected. If our application is approved, the acceptance of this funding by us would result in significant dilution to the holders of our common stock as the terms of this program would require us to issue equity instruments to the federal government. In addition, the approval would likely be conditional upon additional capital raising activities by us, including possible transactions with existing security holders, which likely would result in further substantial dilution to the holders of our common stock. We expect that our participation in the TARP program will require bondholder consent and any additional capital raising activities may require stockholder approval. No assurance can be given that our TARP application will be approved or that we will receive bondholder consent or stockholder approval, if required. Recent announcements by the U.S. Treasury have indicated that there will be changes to the program going forward, and our application may be approved under a program with different terms than those of the current Capital Purchase Program. If our application is not approved, customers could view this as a negative assessment of our viability, which could in turn lead to destabilization and asset and customer attrition.

We have various mechanisms in place that may discourage takeover attempts

Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable. Such provisions include:

 

   

authorization for the issuance of “blank check” preferred stock;

 

   

provision for a classified Board of Directors (“Board”) with staggered, three-year terms;

 

   

the prohibition of cumulative voting in the election of directors;

 

   

a super-majority voting requirement to effect business combinations or certain amendments to our certificate of incorporation and bylaws;

 

   

limits on the persons who may call special meetings of shareholders;

 

   

the prohibition of shareholder action by written consent; and

 

   

advance notice requirements for nominations to the Board or for proposing matters that can be acted on by shareholders at shareholder meetings.

 

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Attempts to acquire control of the Company may also be delayed or prevented by our stockholder rights plan, which is designed to enhance the ability of our Board to protect shareholders against unsolicited attempts to acquire control of the Company that do not offer an adequate price to all shareholders or are otherwise not in the best interests of the Company and our shareholders. In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), and Delaware law may also discourage, delay or prevent someone from acquiring or merging with us.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

A summary of our significant locations at December 31, 2008 is shown in the following table. All facilities are leased, except for 165,000 square feet of our office in Alpharetta, Georgia. Square footage amounts are net of space that has been sublet or part of a facility restructuring.

 

Location

   Approximate Square Footage

Alpharetta, Georgia

   260,000

Arlington, Virginia

   140,000

Jersey City, New Jersey

   107,000

Sandy, Utah

   77,000

Menlo Park, California

   69,000

New York, New York

   53,000

All of our facilities are used by either our retail or institutional segments. All other leased facilities with space of less than 25,000 square feet are not listed by location. In addition to the significant facilities above, we also lease all of our 29 E*TRADE Financial Centers, ranging in space from approximately 2,500 to 13,000 square feet. We believe our facilities space is adequate to meet our needs in 2009.

 

ITEM 3. LEGAL PROCEEDINGS

On October 27, 2000, a complaint was filed in the Superior Court for the State of California, County of Santa Clara, entitled, “Ajaxo, Inc., a Delaware corporation, Plaintiff, versus E*TRADE GROUP, INC., a Delaware corporation; and Everypath, Inc., a California corporation; and Does 1 through 50, inclusively, Defendants.” Through this complaint, Ajaxo sought damages and certain non-monetary relief for the Company’s alleged breach of a non-disclosure agreement with Ajaxo pertaining to certain wireless technology offered to the Company by Ajaxo as well as damages and other relief against both the Company and defendant Everypath, Inc., for their alleged misappropriation of Ajaxo’s trade secrets. Following a jury trial, a judgment was entered in 2003 in favor of Ajaxo against the Company for $1.3 million dollars for breach of the Ajaxo non-disclosure agreement. Although the jury also found in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath, the trial court subsequently denied Ajaxo’s requests for additional damages and relief on these claims. Thereafter, all parties appealed, and on December 21, 2005, the California Court of Appeal affirmed the above-described award against the Company for breach of the nondisclosure agreement but remanded the case to the trial court for the limited purpose of determining what, if any, additional damages Ajaxo may be entitled to as a result of the jury’s previous finding in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath. Following the foregoing ruling by the Court of Appeal, defendant Everypath ceased operations and made an assignment for the benefit of its creditors in January, 2006. As a result, defendant Everypath is no longer defending the case. Although the Company paid Ajaxo the full amount due on the judgment against it above, the case, consistent with the rulings issued by the Court of Appeal, was remanded back to the trial court, and on May 30, 2008, a jury returned a verdict in favor of E*TRADE denying all claims raised and demands for damages against the Company by Ajaxo. Following the

 

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trial court’s filing on September 5, 2008, of entry of judgment in favor of E*TRADE, Ajaxo filed post trial motions asking the trial court to grant a new trial and to vacate its September 5, 2008, entry of judgment in favor of the Company. By order dated November 4, 2008, the court denied these motions, and on December 2, 2008, Ajaxo filed its notice of appeal.

On October 2, 2007, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company and its then Chief Executive Officer and Chief Financial Officer entitled, “Larry Freudenberg, Individually and on Behalf of All Others Similarly Situated, Plaintiff, versus E*TRADE Financial Corporation, Mitchell H. Caplan and Robert J. Simmons, Defendants.” By order dated July 17, 2008, the trial court consolidated the Freudenberg action with four other purported class actions, all of which were filed in the United States District Court for the Southern District of New York and which were based on the same facts and circumstances as the Freudenberg action. By the same July 17, 2008 order, the trial court appointed the “Kristen-Straxton Group” and Ira Newman co-lead plaintiffs and Brower Piven and Levi & Korsinski, respectively, as lead and co-lead plaintiffs’ counsel. Thereafter, on January 16, 2009, Plaintiffs served their “Consolidated Amended Class Action Complaint for Violations of the Federal Securities Laws.” In their amended complaint, Plaintiffs again name the Company’s former chief executive and financial officers as defendants as well as Dennis Webb, the Company’s former Capital Markets Division President. In their amended complaint, Plaintiffs allege causes of action for violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 against all defendants; and violations of Section 20(a) of the Exchange Act against the individual defendants. In specific, Plaintiffs contend, among other things, that the value of E*TRADE’s stock between April 19, 2006, and November 9, 2007, (the “class period”) was artificially inflated because defendants, among other things, issued materially false and misleading statements and failed to disclose that the Company was experiencing a rise in delinquency rates in its mortgage and home equity portfolios; failed to timely record an impairment on its mortgage and home equity portfolios; materially overvalued its securities portfolio, which includes assets backed by mortgages; and based on the foregoing, lacked a reasonable basis for the positive statements it made about the Company’s earnings and prospects. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest and attorneys’ fees and costs. By prior order of the court, Defendants are to file their motion to dismiss by April 2, 2009; and all parties are to complete briefing on Defendants’ motion to dismiss by August 17, 2009. The Company intends to vigorously defend itself against these claims.

On August 15, 2008, an action entitled, “Ronald M. Tate, Trustee of the Ronald M. Tate Trust Dtd 4/13/88, and George Avakian, an Individual, Plaintiffs, versus E*TRADE Financial Corporation, Mitchell H. Caplan, an Individual, and Robert J. Simmons, an Individual, Defendants” was filed in the United States District Court for the Southern District of New York. The Tate action is based on the same facts and circumstances, and contains the same claims, as the Freudenberg consolidated actions discussed above. By agreement of the parties and approval of the court, the Tate action has been consolidated with the Freudenberg consolidated actions for the purpose of pre-trial discovery.

Based upon the same facts and circumstances alleged in the Freudenberg class action complaint above, a verified shareholder derivative complaint was filed in United States District Court for the Southern District of New York on October 4, 2007, against the Company’s then Chief Executive Officer, President/Chief Operating Officer, Chief Financial Officer and individual members of its board of directors entitled, “Catherine Rubery, Derivatively on behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, R. Jarrett Lilien, Robert J. Simmons, George A. Hayter, Daryl Brewster, Ronald D. Fisher, Michael K. Parks, C. Catherine Raffaeli, Lewis E. Randall, Donna L. Weaver, and Stephen H. Willard, Defendants, -and- E*TRADE Financial Corporation, a Delaware corporation, Nominal Defendant.” Plaintiff alleges, among other things, causes of action for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violation of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The above shareholder derivative complaint has been consolidated with another shareholder derivative complaint brought in the same court and against the same named defendants entitled, “Marilyn Clark, Derivatively On Behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, et al., Defendants” (collectively, with the Rubery case, the “federal derivative actions”). Three similar derivative actions, based on the same facts and circumstances as the federal

 

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derivative actions but alleging exclusively state causes of action, have been filed in the Supreme Court of the State of New York, New York County. These three cases have been ordered consolidated in that court under the caption “In re: E*Trade Financial Corporation Derivative Litigation, Lead Index No. 07-603736” (the “state derivative actions”). By agreement of the parties and approval of the respective courts, proceedings in both these federal and state derivative actions will continue to trail those in the federal securities actions discussed above.

On April 2, 2008, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company entitled, “John W. Oughtred, Individually, and on Behalf of all Others Similarly Situated, Plaintiff, v. E*TRADE Financial Corporation and E*TRADE Securities, LLC, Defendants.” Plaintiff contends, among other things, that the Company committed various sales practice violations in the sale of certain auction rate securities to investors between April 2, 2003, and February 13, 2008 (the “class period”) by allegedly misrepresenting that these securities were highly liquid and safe investments for short term investing. On April 17, 2008, the trial court entered an order relieving the Company of its obligation to move, answer or otherwise respond to the complaint until such time as the court may deem appropriate. Thereafter, plaintiff Oughtred joined plaintiffs in twelve other actions involving auction rate securities (in which the Company is not named as defendant) in filing a motion seeking to centralize all 13 actions in the Southern District of New York or in the alternative, the Northern District of California. By order filed October 9, 2008, a United States Judicial Panel on Multi-District Litigation denied plaintiffs’ motion to transfer, and on December 18, 2008, Plaintiff filed his first amended class action complaint. The Company intends to vigorously defend itself against the claims raised in this complaint.

On October 11, 2006, a state class action entitled, “Nikki Greenberg, and all those similarly situated, plaintiffs, versus E*TRADE FINANCIAL Corporation, defendant” was filed in the Superior Court for the State of California, County of Los Angeles on behalf of all customers or consumers who allegedly made or received telephone calls from E*TRADE that were recorded without their knowledge or consent following a telephone call from plaintiff Greenberg to the Company’s Beverly Hills financial center on August 8, 2006, that was recorded during a brief period when the Company’s automated notice system was out of order. On February 7, 2008, class certification was granted and the class defined to consist of (1) all persons in California who received telephone calls from E*TRADE and whose calls were recorded without their consent within three years of October 11, 2006, and (2) all persons who made calls from California to the Beverly Hills financial center of the Company on August 8, 2006. In the interim, the Company has filed motions seeking to de-certify or further limit the defined class, and plaintiffs have filed competing motions seeking to expand it. The hearing of these motions, formerly set for September 19, 2008, is now scheduled to take place on March 6, 2009. The Company has denied the allegations of the complaint.

The SEC, in conjunction with various regional securities exchanges, is conducting an inquiry into the trading activities of certain specialist firms, including the Company’s subsidiary ETCM, on various regional exchanges in order to determine whether such firms executed proprietary orders in a given security prior to a customer order in the same security (a practice commonly known as “trading ahead”) during the period 1999—2005. ETCM was a specialist on the Chicago Stock Exchange during the period under review. The SEC has indicated that it will seek disgorgement, prejudgment interest, and penalties from any firm found to have engaged in trading ahead activity to the detriment of its customers during that time period. It is possible that such sanctions, if imposed against ETCM, could have a material impact on the financial results of the Company during the period in which such sanctions are imposed. The Company and ETCM are cooperating with the investigation.

On October 17, 2007, the SEC initiated an informal inquiry into matters related to the Company’s loan and securities portfolios. That inquiry is continuing. The Company is cooperating fully with the SEC in this matter.

Representatives of various states attorneys general have made informal inquiries regarding the auction rate securities held by the Company’s customers. The Company is cooperating with these inquiries, which are continuing.

 

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An unfavorable outcome in any matter that is not covered by insurance could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, even if the ultimate outcomes are resolved in the Company’s favor, the defense of such litigation could entail considerable cost or the diversion of the efforts of management, either of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business which could have a material adverse effect on its financial position, results of operations or cash flows.

The Company maintains insurance coverage that management believes is reasonable and prudent. The principal insurance coverage it maintains covers commercial general liability; property damage; hardware/software damage; cyber liability; directors and officers; employment practices liability; certain criminal acts against the Company; and errors and omissions. The Company believes that such insurance coverage is adequate for the purpose of its business. The Company’s ability to maintain this level of insurance coverage in the future, however, is subject to the availability of affordable insurance in the marketplace.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Price Range of Common Stock

The following table shows the high and low sale prices of our common stock as reported by the NASDAQ for the periods indicated:

 

     High    Low

2008:

     

First Quarter

   $ 5.48    $ 2.08

Second Quarter

   $ 4.53    $ 3.02

Third Quarter

   $ 4.05    $ 2.30

Fourth Quarter

   $ 3.30    $ 0.79

2007:

     

First Quarter

   $ 26.08    $ 21.11

Second Quarter

   $ 25.79    $ 20.82

Third Quarter

   $ 23.63    $ 9.92

Fourth Quarter

   $ 14.26    $ 3.15

The closing sale price of our common stock as reported on the NASDAQ on February 23, 2009 was $0.87 per share. At that date, there were 1,861 holders of record of our common stock.

Dividends

We have never declared or paid cash dividends on our common stock. The terms of our corporate debt currently prohibit the payment of dividends and will continue to for the foreseeable future.

Equity Compensation Plan Information

Refer to Note 21–Employee Shared-Based Payments and Other Benefits in Item 8. Financial Statements and Supplementary Data for equity compensation plan information.

 

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Performance Graph

The following performance graph shows the cumulative total return to a holder of the Company’s common stock, assuming dividend reinvestment, compared with the cumulative total return, assuming dividend reinvestment, of the S&P 500 and the S&P Super Cap Diversified Financials during the period from December 31, 2003 through December 31, 2008.

LOGO

 

     12/03    12/04    12/05    12/06    12/07    12/08

E*TRADE Financial Corporation

   100.00    118.18    164.90    177.23    28.06    9.09

S&P 500

   100.00    110.88    116.33    134.70    142.10    89.53

S&P Super Cap Diversified Financials

   100.00    111.86    121.54    149.91    126.36    57.18

 

  * $100 invested on 12/31/03 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.

 

 

*

Copyright © 2009, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. (www.researchdatagroup.com/S&P.htm)

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. Results of operations from these businesses have been reclassified to discontinued operations for all periods presented.

(Dollars in millions, shares in thousands, except per share and per trade amounts):

 

     Year Ended December 31,    Variance  
     2008     2007     2006    2005    2004    2008 vs. 2007  

Results of Operations:(1)(2)

               

Net operating interest income

   $ 1,268.0     $ 1,583.6     $ 1,385.5    $ 861.8    $ 624.3    (20 )%

Total net revenue

   $ 1,925.6     $ 161.7     $ 2,368.6    $ 1,647.9    $ 1,403.9    *  

Provision for loan losses

   $ 1,583.7     $ 640.1     $ 45.0    $ 54.0    $ 38.1    147 %

Income (loss) from continuing operations(3)

   $ (809.4 )   $ (1,442.3 )   $ 626.9    $ 427.3    $ 362.7    (44 )%

Cumulative effect of accounting changes(4)

   $ —       $ —       $ —      $ 1.6    $ —      *  

Net income (loss)

   $ (511.8 )   $ (1,441.8 )   $ 628.9    $ 430.4    $ 380.5    (65 )%

Basic earnings (loss) per share from continuing operations

   $ (1.58 )   $ (3.40 )   $ 1.49    $ 1.15    $ 0.99    (54 )%

Diluted earnings (loss) per share from continuing operations

   $ (1.58 )   $ (3.40 )   $ 1.44    $ 1.11    $ 0.94    (54 )%

Basic net earnings (loss) per share

   $ (1.00 )   $ (3.40 )   $ 1.49    $ 1.16    $ 1.04    (71 )%

Diluted net earnings (loss) per share

   $ (1.00 )   $ (3.40 )   $ 1.44    $ 1.12    $ 0.99    (71 )%

Weighted average shares—basic

     509,862       424,439       421,127      371,468      366,586    20 %

Weighted average shares—diluted(5)

     509,862       424,439       436,357      384,630      405,389    20 %

 

* Percentage not meaningful.

(1)

No cash dividends have been declared in any of the periods presented.

(2)

The amounts for year ended December 31, 2004 excludes the results from BrownCo and Harrisdirect acquisitions, which occurred during the fiscal year ended December 31, 2005.

(3)

In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. In 2006, the Company completed the sale of its professional agency trading business. In 2005, the Company exited the professional proprietary business and completed the sale of E*TRADE Consumer Finance Corporation. In 2004, the Company completed the sale of substantially all of the assets and liabilities of E*TRADE Access, Inc. The Company has reflected the results of these operations as discontinued operations for all periods presented.

(4)

In 2005, the Company recorded a credit of $1.6 million, net of tax, as a cumulative effect of accounting change, to reflect the amount by which compensation expense would have been reduced in periods prior to adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123(R) revised 2004, Share-Based Payment (“SFAS No. 123(R)”), for restricted stock awards outstanding on July 1, 2005.

(5)

For 2004, diluted earnings per share is calculated using the “if converted” method, which includes the additional dilutive impact assuming conversion of the Company’s subordinated convertible debt. Under the “if converted” method, the per share numerator excludes the interest expense and related amortization of offering costs from the convertible debt, net of tax, of $20.0 million. The denominator includes the shares issuable from the assumed conversion of the convertible debt of 25.8 million. For all other periods presented, the “if converted” method is not used as its effect would be anti-dilutive.

 

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(Dollars in millions):

 

     December 31,    Variance  
     2008    2007    2006    2005    2004    2008 vs. 2007  

Financial Condition:

                 

Available-for-sale mortgage-backed and investment securities

   $ 10,806.1    $ 11,255.0    $ 13,677.8    $ 12,564.7    $ 12,543.8    (4 )%

Margin receivables

   $ 2,791.2    $ 7,179.2    $ 6,828.4    $ 5,642.0    $ 1,965.5    (61 )%

Loans, net

   $ 24,451.9    $ 30,139.4    $ 26,656.2    $ 19,512.3    $ 11,785.0    (19 )%

Total assets

   $ 48,538.2    $ 56,845.9    $ 53,739.3    $ 44,567.7    $ 31,032.6    (15 )%

Deposits

   $ 26,136.2    $ 25,884.8    $ 24,071.0    $ 15,948.0    $ 12,303.0    1 %

Corporate debt

   $ 2,750.5    $ 3,022.7    $ 1,842.2    $ 2,022.7    $ 585.6    (9 )%

Shareholders’ equity

   $ 2,591.5    $ 2,829.1    $ 4,196.4    $ 3,399.6    $ 2,228.2    (8 )%

(Dollars in billions, except per trade amounts):

 

     At or For the Year Ended December 31,    Variance  
     2008    2007    2006    2005    2004    2008 vs. 2007  

Key Measures(1):

                 

Retail customer assets

   $ 112.2    $ 185.0    $ 191.3    $ 175.6    $ 98.0    (39 )%

Customer cash and deposits

   $ 32.3    $ 32.7    $ 33.0    $ 27.8    $ 18.2    (1 )%

Total daily average revenue trades

     188,116      177,900      153,146      95,209      80,951    6 %

Average commission per trade

   $ 10.88    $ 11.72    $ 11.97    $ 13.44    $ 15.21    (7 )%

End of period total accounts

     4,533,034      4,287,240      4,002,496      3,900,608      3,227,199    6 %

Enterprise net interest spread (basis points)(2)

     252      264      285      249      N/A    (5 )%

Enterprise interest-earning assets, average(2)

   $ 46.9    $ 56.1    $ 44.9    $ 32.0      N/A    (16 )%

Total employees (period end)

     3,249      3,757      4,126      3,439      3,320    (14 )%

 

(1)

Metrics have been represented to exclude activity from discontinued operations.

(2)

The enterprise net interest spread and enterprise interest-earning assets, average for 2004 are not presented as the information was not tracked on an enterprise level during that period.

The selected consolidated financial data should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data.

 

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ITEM 7. 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.

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 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

Strategy

Our strategy is to profitably grow our retail customer franchise and mitigate the risks associated with our balance sheet. We plan to grow our retail customer franchise by offering online brokerage and related products and services, including investor-focused banking and asset gathering products and services. We believe we can accomplish this growth by appealing to retail investors, especially customers of traditional brokerages, who are attracted to our low-cost, easy to use and innovative capabilities.

Our plan to mitigate the risks associated with our balance sheet contains three core goals: reduce credit risk in our loan portfolio, reduce our level of corporate debt and reduce operating expenses. We believe that the successful completion of this plan will significantly improve our financial strength.

We are also focused on simplifying and streamlining the business by exiting and/or restructuring certain non-core operations. We believe these changes will better align our business with the retail investor.

Key Factors Affecting Financial Performance

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

 

   

customer demand for financial products and services;

 

   

the weakness or strength of the residential real estate and credit markets;

 

   

the performance, volume and volatility of the equity and capital markets;

 

   

customer perception of the financial strength of our franchise;

 

   

market demand and liquidity in the secondary market for mortgage loans and securities; and

 

   

market demand and liquidity in the wholesale borrowings market, including securities sold and agreements to repurchase.

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 products and services;

 

   

our ability to assess and manage credit risk;

 

   

our ability to assess and manage interest rate risk; and

 

   

disciplined expense control and improved operational efficiency.

 

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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 Year Ended December 31,     Variance  
     2008     2007     2006     2008 vs. 2007  

Customer Activity Metrics(1):

        

Retail customer assets (dollars in billions)

   $ 112.2     $ 185.0     $ 191.3     (39 )%

Net new customer assets (dollars in billions)(2)

   $ 5.4     $ (11.3 )   $ 3.2     *  

Customer cash and deposits (dollars in billions)

   $ 32.3     $ 32.7     $ 33.0     (1 )%

Total daily average revenue trades

     188,116       177,900       153,146     6 %

Average commission per trade

   $ 10.88     $ 11.72     $ 11.97     (7 )%

End of period total accounts

     4,533,034       4,287,240       4,002,496     6 %

Company Financial Metrics(1):

        

Corporate cash (dollars in millions)

   $ 434.9     $ 312.4     $ 244.4     39 %

E*TRADE Bank excess risk-based capital

   $ 714.7     $ 435.1     $ 134.2     64 %

Allowance for loan losses (dollars in millions)

   $ 1,080.6     $ 508.2     $ 67.6     113 %

Allowance for loan losses as a % of nonperforming loans

     114.70 %     121.44 %     90.52 %   (6.74 )%

Nonperforming loans as a % of gross loans receivable

     3.69 %     1.37 %     0.28 %   2.32 %

Enterprise net interest spread (basis points)

     252       264       285     (5 )%

Enterprise interest-earning assets (average in billions)

   $ 46.9     $ 56.1     $ 44.9     (16 )%

 

* Percentage not meaningful.

(1)

Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.

(2)

For the year ended December 31, 2008, net new customer assets were $6.4 billion excluding the sale of Retirement Advisors of America (“RAA”).

Customer Activity Metrics

 

   

Changes in retail customer assets are an indicator of the value of our relationship with the customer. An increase in retail customer 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, which declined substantially in 2008.

 

   

Net new customer assets are total inflows to all new and existing customer accounts less total outflows from all closed and existing customer accounts and are a general indicator of the use of our products and services by existing and new customers.

 

   

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

 

   

DARTs are the predominant driver of commission revenue from our retail customers.

 

   

Average commission per trade is an indicator of changes in our customer mix, product mix and/or product pricing. As a result, this metric is impacted by both the mix between our retail domestic and international businesses and the mix between active traders, mass affluent and main street customers.

 

   

End of period total accounts is an indicator of the Company’s ability to attract and retain customers.

Company Financial Metrics

 

   

Corporate cash is an indicator of the liquidity at the parent company. It is the primary source of capital above and beyond the capital deployed in our regulated subsidiaries.

 

   

E*TRADE Bank excess risk-based capital is the excess capital that E*TRADE Bank has compared to the regulatory minimum well-capitalized threshold and is an indicator of E*TRADE Bank’s ability to absorb future loan losses.

 

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Allowance for loan losses is an estimate of the losses inherent in our loan portfolio as of the balance sheet date and is typically equal to the expected charge-offs in our loan portfolio over the next twelve months.

 

   

Allowance for loan losses as a percentage of nonperforming loans is a general indicator of the adequacy of our allowance for loan losses. Changes in this ratio are also driven by changes in the mix of our loan portfolio.

 

   

Nonperforming loans receivable as a percentage of gross loans receivable is an indicator of the performance of our total loan portfolio.

 

   

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

 

   

Enterprise interest-earning assets, in conjunction with our enterprise net interest spread, are indicators of our ability to generate net operating interest income.

Significant Events in 2008

Strengthening Our Core Asset – the Retail Customer

One of our key strategic objectives for 2008 was to strengthen our retail customer base and ensure the credit issues in our balance sheet did not negatively impact our customer base. We believe we have made significant progress in this area throughout 2008. Highlights of our progress during the year ended December 31, 2008 are as follows:

 

   

Opened 1,032,000 gross new accounts and produced 246,000 net new accounts;

 

   

Net new customer asset flows of $5.4 billion ($6.4 billion excluding the sale of RAA);

 

   

Customer cash and deposit balances decreased slightly to $32.3 billion; and

 

   

Total DARTs of 188,000, up 6% from the prior year.

Execution of Our Capital Plan

 

   

E*TRADE Bank had excess risk-based capital (excess to the regulatory minimum well-capitalized threshold) of $714.7 million, including $650 million of capital contributed by the parent company, E*TRADE Financial Corporation;

 

   

We had corporate cash of $434.9 million; and

 

   

We completed four key non-core asset sales resulting in net proceeds of approximately $750 million: the corporate aircraft-related assets; RAA; the Canadian brokerage business; and our equity shares in Investsmart(1).

Exit of the Direct Retail Lending Business

We announced the exit of our direct retail lending business, which was our last remaining loan origination channel (we exited our wholesale mortgage lending channel in 2007). Therefore, the results of operations of the entire direct retail lending business are reported as discontinued operations on our consolidated statement of income (loss) for all periods presented. In future periods, we plan to partner with a third party company to provide access to real estate loans for our customers.

Retirement of Corporate Debt

In November 2008, we retired the entire balance of our $450 million 6.125% subordinated notes due 2019. The notes were part of the mandatory convertible debt securities issued in 2005 and were retired in connection

 

(1) The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.

 

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with the issuance of 25 million shares of our common stock at $18 per share. Additionally, we exchanged $120.8 million in principal of our senior notes through debt for equity exchanges.

Completion of Citadel Investment

In January 2008, the Company issued an additional $150.0 million of springing lien notes in accordance with the terms of the agreement with Citadel. This was the final note issuance under the agreement with Citadel and brought the total springing lien notes outstanding to $1.9 billion in principal(1). In connection with this issuance, the Company received $150.0 million in cash. Additionally, the Company issued to Citadel the remaining 46.7 million shares of common stock that had been required to be issued under the agreement.

Enhancements to our Retail Investor Focused Products and Services

 

 

 

We introduced E*TRADE Mobile Pro, which offers wireless customers access to their E*TRADE accounts. Mobile Pro offers BlackBerry® smartphone users real-time streaming stock and options quotes, the ability to trade equities and options and brokerage and bank account cash transfers, among other features.

 

   

We began offering expanded tools and services, including improved charting capabilities and redesigned our “Global Markets,” “US Markets,” and “Market News” pages. We also began offering customization, expanded our mutual fund center with research capabilities and improved charting and analytics for Power E*TRADE Pro.

 

   

We launched Retirement QuickPlan, which provides a quick assessment of an individual’s or family’s retirement savings and investing plan as well as guidelines to get on track with personal retirement goals.

Ranked #1 Online Broker by SmartMoney Magazine

For the second year in a row, SmartmoneyTM ranked the Company as the #1 Online Discount Broker. The Company earned five out of five stars in the Research, Trading Tools, Banking Service and Mutual Funds and Investment Products categories.

Significant Events in 2007

Citadel Investment of $2.5 Billion Including Sale of Asset-Backed Securities Portfolio

The operating environment during 2007, particularly during the second half of the year, was extremely challenging as our exposure to the crisis in the residential real estate and credit markets adversely impacted our financial performance and led to a disruption in our customer base. As a result, we believe it was necessary to obtain a significant infusion of cash, which would in turn stabilize our balance sheet and our customer base.

On November 29, 2007, we entered into an agreement to receive a $2.5 billion cash infusion from Citadel. In consideration for the cash infusion, Citadel received three primary items: substantially all of our asset-backed securities portfolio, 84.7 million shares of common stock (2) in the Company and approximately $1.8 billion in 12 1/2% springing lien notes(3). We believe this transaction provided timely stability for our business and helped alleviate customer concerns.

 

(1) The $1.9 billion in principal does not include the $121.0 million of capitalized interest in November 2008, which resulted in $2.1 billion in principal of springing lien notes outstanding to Citadel as of December 31, 2008.
(2) The 84.7 million shares of common stock were issued in increments: 14.8 million upon initial closing in November 2007; 23.2 million upon Hart-Scott-Rodino Antitrust Improvements Act approval in December 2007; and 46.7 million shares are expected to be issued in the first quarter of 2008 as the Company has received all necessary regulatory approvals.

(3)

Included in the $1.8 billion issuance is $186 million of 12 1/2% springing lien notes in exchange for $186 million of the Company’s senior notes that were owned by Citadel. The $1.8 billion in 12 1 /2% springing lien notes includes $100 million in notes issued to BlackRock in connection with the transaction. The $1.8 billion in 12 1/2% springing lien notes represents the amount outstanding as of December 31, 2007 and does not include the additional $150 million of springing lien notes issued in January 2008 in accordance with the terms of the agreement with Citadel.

 

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Launch of Global Trading Platform

We launched our Global Trading Platform, which provides the ability to buy, sell and hold foreign equities in local currencies to investors who seek liquidity and diversity in their portfolios. Our U.S. customers now have access to foreign stocks and currencies in six major international markets: Canada, France, Germany, Hong Kong, Japan and the United Kingdom.

Introduction of the Max-Rate Checking Account

E*TRADE Bank introduced a Max-Rate Checking Account which features an annual percentage yield up to 3.25%, unlimited check writing and free online bill pay, among other benefits.

Ranked #1 Premium Broker by SmartMoney Magazine

SmartMoney Magazine recognized the Company as the #1 “premium broker” in its 2007 broker survey. SmartMoney noted the Company for its improved service, new global trading capabilities, intuitive trade tools and easy search capabilities and numerous banking products.

Summary Financial Results

Income Statement Highlights for the Year Ended December 31, 2008 (dollars in millions, except per share amounts)

 

     Year Ended December 31,     Variance  
     2008     2007     2008 vs. 2007  

Net operating interest income

   $ 1,268.0     $ 1,583.6     (20 )%

Total net revenue

   $ 1,925.6     $ 161.7     *  

Provision for loan losses

   $ 1,583.7     $ 640.1     147 %

Commission revenue

   $ 515.6     $ 663.6     (22 )%

Fees and service charges revenue

   $ 200.0     $ 230.6     (13 )%

Operating margin

   $ (948.3 )   $ (2,052.2 )   (54 )%

Net loss from continuing operations

   $ (809.4 )   $ (1,442.3 )   (44 )%

Net loss

   $ (511.8 )   $ (1,441.8 )   (65 )%

Diluted net loss per share from continuing operations

   $ (1.58 )   $ (3.40 )   (54 )%

Diluted net loss per share

   $ (1.00 )   $ (3.40 )   (71 )%

 

* Percentage not meaningful.

The continued deterioration in the residential real estate and credit markets, as well as the nearly unprecedented turmoil in the global financial markets, had a significant impact on our financial performance during 2008. The losses in our institutional segment caused by this deterioration more than offset the strong underlying performance of our retail segment, resulting in a net loss from continuing operations of $809.4 million for the year ended December 31, 2008. Our retail customer base showed positive growth trends during the year, including the addition of approximately 246,000 net new accounts and net inflows of customer assets of approximately $5.4 billion. We believe these are indications that our retail segment has not only stabilized, but has returned to modest growth.

 

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Balance Sheet Highlights (dollars in billions)

 

     December 31,     Variance  
     2008     2007     2008 vs. 2007  

Total assets

   $ 48.5     $ 56.8     (15 )%

Total enterprise interest-earning assets

   $ 45.0     $ 52.3     (14 )%

Loans, net and margin receivables as a percentage of enterprise interest-earning assets

     63 %     71 %   (8 )%

Retail deposits and customer payables as a percentage of enterprise interest-bearing liabilities

     70 %     61 %   9 %

The decrease in total assets was attributable primarily to a decrease of $5.7 billion in loans, net and a decrease of $4.4 billion in margin receivables. These decreases were partially offset by an increase in cash and equivalents and cash and investments required to be segregated under federal or other regulations of $2.9 billion. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to maintain excess regulatory capital at E*TRADE Bank as we focus on mitigating the credit risk inherent in our loan portfolios. During the year ended December 31, 2008, we increased our excess risk-based capital at E*TRADE Bank by 64% to $714.7 million compared to prior year. In connection with this strategy and the Citadel Investment, we have updated our secondary market purchase policies to prohibit the acquisition of asset-backed securities, collateralized debt obligations (“CDO”) and certain other instruments with a high level of credit risk through January 1, 2010.

EARNINGS OVERVIEW

2008 Compared to 2007

We had a net loss from continuing operations of $809.4 million for the year ended December 31, 2008. The loss for the year ended December 31, 2008 was due principally to an increase in our provision for loan losses of $943.6 million to $1.6 billion. In addition, we incurred losses of $153.8 million, net of hedges, on our preferred stock in Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) during the period ended December 31, 2008. The losses in our institutional segment, which included both of these items, more than offset our retail segment income, which was $608.1 million for the year ended December 31, 2008.

In the second quarter of 2008, we made the decision to sell our Canadian brokerage business and we decided to close our direct retail lending business. As a result, the financial results for both the Canadian brokerage business and the direct retail lending business have been reported in discontinued operations for all periods presented. Additionally, we re-defined “Total net revenue” by removing “Provision for loan losses” and separately stating it as its own line item and reclassified hedge ineffectiveness recorded in accordance with SFAS No. 133, as amended Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), from “Other operating expense” to the “Gain (loss) on loans and securities, net” line item.

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 the performance in our banking and balance sheet management businesses. Our corporate debt, which is the primary source of our corporate interest expense, has been issued primarily in connection with the Citadel Investment and past acquisitions, such as Harrisdirect and BrownCo.

Similarly, we report gain (loss) on sales of investments, net separately from gain (loss) on 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 (loss) on loans and

 

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securities, net is the result of activities in our operations, namely our balance sheet management business, including impairment on our available-for sale mortgage-backed and investment securities portfolio. Gain (loss) on sales of investments, net 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, operating expense, other income (expense) and income tax expense (benefit).

Revenue

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

 

           Variance  
     Year Ended December 31,     2008 vs. 2007  
     2008     2007     Amount     %  

Revenue:

        

Operating interest income

   $ 2,469,940     $ 3,523,055     $ (1,053,115 )   (30 )%

Operating interest expense

     (1,201,934 )     (1,939,456 )     737,522     (38 )%
                          

Net operating interest income

     1,268,006       1,583,599       (315,593 )   (20 )%
                          

Commission

     515,551       663,642       (148,091 )   (22 )%

Fees and service charges

     199,956       230,567       (30,611 )   (13 )%

Principal transactions

     84,882       102,180       (17,298 )   (17 )%

Loss on loans and securities, net

     (195,483 )     (2,465,474 )     2,269,991     (92 )%

Other revenue

     52,684       47,212       5,472     12 %
                          

Total non-interest income (expense)

     657,590       (1,421,873 )     2,079,463     *  
                          

Total net revenue

   $ 1,925,596     $ 161,726     $ 1,763,870     *  
                          

 

* Percentage not meaningful

Total net revenue increased to $1.9 billion for the year ended December 31, 2008 compared to 2007. This increase was primarily due to the $2.2 billion loss on the sale of our asset-backed securities portfolio for the year ended December 31, 2007.

Net Operating Interest Income

Net operating interest income decreased 20% to $1.3 billion for the year ended December 31, 2008 compared to December 31, 2007. Net operating interest income is earned primarily through holding credit balances, which include margin, real estate and consumer loans, and by holding customer cash and deposits, which are a low cost source of funding. The decrease in net operating interest income was due primarily to the planned decline in enterprise interest-earning assets during 2008.

 

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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, yields and rates and has been prepared on the basis required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in thousands):

 

    Year Ended December 31,  
    2008     2007     2006  
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield /
Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield /
Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield /
Cost
 

Enterprise interest-earning assets:

                 

Loans, net(1)

  $ 27,761,938   $ 1,587,838   5.72 %   $ 30,887,047   $ 1,986,034   6.43 %   $ 22,193,663   $ 1,364,873   6.15 %

Margin receivables

    5,833,592     278,213   4.77 %     7,033,559     502,149   7.14 %     6,531,533     464,540   7.11 %

Available-for-sale mortgage-backed securities

    9,455,415     435,926   4.61 %     12,425,346     650,891   5.24 %     11,543,546     590,512   5.12 %

Available-for-sale investment securities

    141,176     9,359   6.63 %     3,946,334     259,898   6.59 %     2,886,506     183,125   6.34 %

Trading securities

    350,500     23,632   6.74 %     110,829     11,507   10.38 %     132,454     11,388   8.60 %

Cash and cash equivalents(2)

    2,546,275     60,550   2.38 %     718,298     34,391   4.79 %     927,650     42,039   4.53 %

Stock borrow and other

    762,497     53,669   7.04 %     960,124     69,262   7.21 %     661,367     44,878   6.79 %
                                         

Total enterprise interest-earning assets(3)

    46,851,393     2,449,187   5.22 %     56,081,537     3,514,132   6.27 %     44,876,719     2,701,355   6.02 %
                             

Non-operating interest-earning assets(4)

    5,002,291         5,417,418         5,038,884    
                             

Total assets

  $ 51,853,684       $ 61,498,955       $ 49,915,603    
                             

Enterprise interest-bearing liabilities:

                 

Retail deposits:

                 

Money market and savings accounts

  $ 11,635,073     369,925   3.18 %   $ 10,565,100     464,084   4.39 %   $ 5,806,811     231,602   3.99 %

Sweep deposit accounts

    9,904,692     39,971   0.40 %     11,044,185     102,131   0.92 %     10,393,857     87,714   0.84 %

Certificates of deposit

    3,258,954     137,394   4.22 %     4,509,699     224,649   4.98 %     3,851,463     183,828   4.77 %

Checking accounts

    907,957     19,665   2.17 %     390,077     5,689   1.46 %     355,403     3,347   0.94 %

Brokered certificates of deposit

    976,097     48,893   5.01 %     512,485     25,402   4.96 %     535,835     24,726   4.61 %

Customer payables

    4,288,776     29,649   0.69 %     5,707,211     67,485   1.18 %     5,882,532     62,049   1.05 %

Repurchase agreements and other borrowings

    7,736,906     318,291   4.11 %     12,261,145     643,382   5.25 %     10,980,134     549,085   5.00 %

Federal Home Loan Bank (“FHLB”) advances

    4,667,436     218,940   4.69 %     7,071,762     364,442   5.15 %     3,488,184     165,545   4.75 %

Stock loan and other

    1,075,551     18,615   1.73 %     1,298,312     39,739   3.06 %     1,067,726     34,317   3.21 %
                                         

Total enterprise interest-bearing liabilities

    44,451,442     1,201,343   2.70 %     53,359,976     1,937,003   3.63 %     42,361,945     1,342,213   3.17 %
                             

Non-operating interest-bearing liabilities(5)

    4,706,266         4,002,648         3,756,673    
                             

Total liabilities

    49,157,708         57,362,624         46,118,618    

Total shareholders’ equity

    2,695,976         4,136,331         3,796,985    
                             

Total liabilities and shareholders’ equity

  $ 51,853,684       $ 61,498,955       $ 49,915,603    
                             

Excess of enterprise interest-earning assets over enterprise interest-bearing liabilities/Enterprise net interest income/Spread

  $ 2,399,951   $ 1,247,844   2.52 %   $ 2,721,561   $ 1,577,129   2.64 %   $ 2,514,774   $ 1,359,142   2.85 %
                                         

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

 

     Year Ended December 31,  
     2008     2007     2006  

Enterprise net interest income(6)

   $ 1,247,844     $ 1,577,129     $ 1,359,142  

Taxable equivalent interest adjustment

     (9,120 )     (30,867 )     (19,297 )

Customer cash held by third parties and other(7)

     29,282       37,337       45,670  
                        

Net operating interest income

   $ 1,268,006     $ 1,583,599     $ 1,385,515  
                        

 

(1)

Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.

(2)

Includes segregated cash balances.

(3)

Amount includes a taxable equivalent increase in operating interest income of $9.1 million, $30.9 million and $19.3 million for 2008, 2007 and 2006, respectively.

(4)

Non-operating interest-earning assets consist of property and equipment, net, goodwill, other intangibles, net and other assets that do not generate operating interest income. Some of these assets generate corporate interest income.

(5)

Non-operating interest-bearing liabilities consist of corporate debt, accounts payable, accrued and other liabilities that do not generate operating interest expense. Some of these liabilities generate corporate interest expense.

(6)

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.

(7)

Includes interest earned on average customer assets of $3.2 billion, $3.9 billion and $3.6 billion for the years ended December 31, 2008, 2007 and 2006, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions. Other consists of net operating interest earned on average stock conduit assets of $1.3 million and $303.5 million for the years ended December 31, 2007 and 2006, respectively. There were not any stock conduit assets at December 31, 2008.

 

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     Year Ended December 31,  
     2008     2007     2006  

Enterprise net interest:

      

Spread

   2.52 %   2.64 %   2.85 %

Margin (net yield on interest-earning assets)

   2.66 %   2.81 %   3.03 %

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

   105.40 %   105.10 %   105.94 %

Return on average:

      

Total assets

   (0.99 )%   (2.34 )%   1.26 %

Total shareholders’ equity

   (18.98 )%   (34.86 )%   16.56 %

Average equity to average total assets

   5.20 %   6.73 %   7.61 %

Average enterprise interest-earning assets decreased 16% to $46.9 billion for the year ended December 31, 2008 compared to 2007, primarily the result of a decrease in our available-for-sale portfolio, margin receivables and loans, net, offset by an increase in cash and equivalents. Average available-for-sale mortgage-backed and investment securities decreased 41% to $9.6 billion for the year ended December 31, 2008 compared to 2007. This decrease was primarily due to the sale of certain mortgage-backed securities in the first quarter of 2008 and the sale of our asset-backed securities portfolio towards the end of the fourth quarter of 2007. Average margin receivables decreased 17% to $5.8 billion for the year ended December 31, 2008 compared to 2007. We believe this decrease was due to customers deleveraging and reducing their risk exposure given the substantial volatility in the financial markets. Average loans, net decreased 10% to $27.8 billion for the year ended December 31, 2008 compared to 2007 as a result of our focus on growing the one- to four-family loan portfolio in the first and second quarters of 2007. Beginning in the second half of 2007, we altered our strategy and halted the focus on growing the balance sheet. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio.

Average enterprise interest-bearing liabilities decreased 17% to $44.5 billion for the year ended December 31, 2008 compared to 2007. The decrease in average enterprise interest-bearing liabilities was primarily due to a decrease in repurchase agreements and other borrowings, FHLB advances and customer payables. Average repurchase agreements and other borrowings decreased 37% to $7.7 billion for the year ended December 31, 2008 compared to 2007. Average FHLB advances decreased 34% to $4.7 billion for the year ended December 31, 2008 compared to 2007. Repurchase agreements and other borrowings are the primary wholesale funding sources for our loans, net and available-for-sale securities portfolios. The decreases in these balances were the result of paying down these liabilities as we decreased the size of our balance sheet during 2008. Average customer payables decreased 25% to $4.3 billion for the year ended December 31, 2008 compared to 2007, which was related primarily to the sale of our Canadian brokerage business during the third quarter of 2008.

Enterprise net interest spread decreased by 12 basis points to 2.52% for the year ended December 31, 2008 compared to 2007. This decrease was driven in part by an atypical spread among two key benchmark interest rates: federal funds and the London Interbank Offered Rate (“LIBOR”). The majority of our interest-earning assets and liabilities are linked, either directly or indirectly, to these benchmark interest rates. We believe this spread will return to more normalized levels in future periods. In addition, we plan to reduce the rates paid on our Complete Savings Account to be more consistent with current market rates. We believe the combined impact of these two items will result in a modest increase to our net interest spread in future periods.

 

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Operating interest income and operating interest expense reflect income and expense on hedges that qualify for hedge accounting under SFAS No. 133, as amended. The following table shows the income (expense) on hedges that are included in operating interest income and expense (dollars in thousands):

 

     Year Ended December 31,     Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Operating interest income:

        

Operating interest income, gross

   $ 2,443,886     $ 3,509,453     $ (1,065,567 )   (30 )%

Hedge income

     26,054       13,602       12,452     92 %
                          

Operating interest income

     2,469,940       3,523,055       (1,053,115 )   (30 )%
                          

Operating interest expense:

        

Operating interest expense, gross

     (1,127,026 )     (1,936,256 )     809,230     (42 )%

Hedge expense

     (74,908 )     (3,200 )     (71,708 )   *  
                          

Operating interest expense

     (1,201,934 )     (1,939,456 )     737,522     (38 )%
                          

Net operating interest income

   $ 1,268,006     $ 1,583,599     $ (315,593 )   (20 )%
                          

 

* Percentage not meaningful

Commission

Commission revenue decreased 22% to $515.6 million for the year ended December 31, 2008, compared to the same period in 2007. This decrease was due almost entirely to a decrease of $142.6 million, or 99%, in our institutional commission revenue as a result of the exit of our institutional brokerage operations. Commission revenue from our retail segment, which is the sole source of commission revenue in future periods, remained stable for the year ended December 31, 2008 declining by only 1% compared to 2007. The primary factors that affect our retail 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 relative number of executed trades in these businesses impacts average commission per trade. Each business also has different trade types (e.g. equities, options, fixed income, exchange-traded funds, contract for difference 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.

DARTs increased 6% to 188,116 for the year ended December 31, 2008 compared to 2007. Our U.S. DART volume increased 5% and our international DARTs grew by 9% for the year ended December 31, 2008 compared to 2007, driven entirely by organic growth. In addition, option-related DARTs as a percentage of our total U.S. DARTs represented 15% and 16% of U.S. trading volume for the periods ending December 31, 2008 and 2007, respectively.

Average commission per trade decreased 7% to $10.88 for the year ended December 31, 2008 compared to 2007. The decrease was primarily a function of the product and customer mix. The overall poor performance of the equity markets for the year ended December 31, 2008 disproportionately impacted higher commission products, such as corporate services transactions and mutual funds. Main Street Investors, who generally have a higher commission per trade, traded less during the period compared to Active Traders and Mass Affluent customers, who generally have a lower commission per trade. Customer appreciation, win-back and other promotional campaigns also contributed to the decrease in average commission per trade.

Fees and Service Charges

Fees and service charges decreased 13% to $200.0 million for the year ended December 31, 2008 compared to 2007. This decrease was primarily due to a lower order flow revenue, advisory management fees and CDO

 

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management fees. The decrease in advisory management fees was primarily due to our sale of RAA. The decrease in CDO management fees was due to the sale of our collateral management agreements during the first quarter of 2008.

Principal Transactions

Principal transactions decreased 17% to $84.9 million for the year ended December 31, 2008 compared to 2007. The decrease in principal transactions resulted from lower institutional trading volumes. 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 performance of our proprietary trading activities.

Loss on Loans and Securities, Net

Loss on loans and securities, net was $195.5 million and $2.5 billion for the year ended December 31, 2008 and 2007, respectively, as shown in the following table (dollars in thousands):

 

     Year Ended December 31,     Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Loss on sales of loans, net

   $ (783 )   $ (14,343 )   $ 13,560     (95 )%
                          

Gain (loss) on securities and other investments

     40,289       (2,911 )     43,200     *  

Loss on asset-backed securities sale to Citadel

     —         (2,241,031 )     2,241,031     *  

Loss on impairment

     (102,909 )     (168,739 )     65,830     (39 )%

Loss on trading securities, net

     (134,297 )     (33,441 )     (100,856 )   302 %

Hedge ineffectiveness

     2,217       (5,009 )     7,226     *  
                          

Loss on securities, net

     (194,700 )     (2,451,131 )     2,256,431     (92 )%
                          

Loss on loans and securities, net

   $ (195,483 )   $ (2,465,474 )   $ 2,269,991     (92 )%
                          

 

* Percentage not meaningful

The loss on loans and securities, net during the year ended December 31, 2008 was due principally to losses on our preferred stock in Fannie Mae and Freddie Mac, which experienced record price declines and volatility during the third quarter of 2008. Based upon our concerns about continuing market instability, all of our positions were liquidated during the third quarter of 2008, resulting in a pre-tax loss of $153.8 million, net of hedges, that was recognized in loss on trading securities, net.

We recognized $95.0 million of impairment on certain securities in our CMO portfolio during the year ended December 31, 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods. In addition, we recognized $7.7 million of impairment related to the funds held in the Reserve Funds’ Primary Fund. For additional information about the Primary Fund, refer to Liquidity and Capital Resources on page 48.

The loss on loans and securities, net during the year ended December 31, 2007 was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.

Other Revenue

Other revenue increased 12% to $52.7 million for the year ended December 31, 2008 compared to 2007. The increase in other revenue was due to income from the cash surrender value of Bank-Owned Life Insurance (“BOLI”), which was entered into during the third quarter of 2007.

 

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Provision for Loan Losses

Provision for loan losses increased $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the year ended December 31, 2008, we also experienced deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in virtually all key markets; growing inventories of unsold homes; rising foreclosure rates; sustained contraction in the availability of credit; and a severe downturn in the economy. While we do believe the provision for loan losses will be at historically high levels in future periods, we do not expect those levels to be in excess of those incurred in 2008.

Operating Expense

The components of operating expense and the year-over-year variances are as follows (dollars in thousands):

 

          Variance  
     Year Ended December 31,    2008 vs. 2007  
     2008    2007    Amount     %  

Compensation and benefits

   $ 383,385    $ 434,785    $ (51,400 )   (12 )%

Clearing and servicing

     185,082      270,199      (85,117 )   (32 )%

Advertising and market development

     175,250      138,675      36,575     26 %

Communications

     96,792      98,347      (1,555 )   (2 )%

Professional services

     94,070      99,193      (5,123 )   (5 )%

Occupancy and equipment

     85,766      85,189      577     1 %

Depreciation and amortization

     82,483      83,198      (715 )   (1 )%

Amortization of other intangibles

     35,746      40,472      (4,726 )   (12 )%

Impairment of goodwill

     —        101,208      (101,208 )   *  

Facility restructuring and other exit activities

     29,502      27,183      2,319     9 %

Other

     122,139      195,384      (73,245 )   (37 )%
                        

Total operating expense

   $ 1,290,215    $ 1,573,833    $ (283,618 )   (18 )%
                        

 

* Percentage not meaningful.

Operating expense decreased 18% to $1.3 billion for the year ended December 31, 2008 compared to 2007. The decrease in expense excluding interest was driven primarily by decreases in compensation and benefits, clearing and servicing, impairment of goodwill and other expense. These decreases were offset slightly by an increase in advertising and market development expense.

Compensation and Benefits

Compensation and benefits decreased 12% to $383.4 million for the year ended December 31, 2008 compared to 2007. The decrease resulted primarily from lower salary expense due to a reduction in our employee base and decreased variable compensation during the year ended December 31, 2008 when compared to 2007.

Clearing and Servicing

Clearing and servicing expense decreased 32% to $185.1 million for the year ended December 31, 2008 compared to 2007. This decrease is related primarily to the exit of our institutional brokerage operations, which resulted in lower clearing expenses.

 

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Advertising and Market Development

Advertising and market development expense increased 26% to $175.3 million for the year ended December 31, 2008 compared to 2007. This planned increase was aimed at restoring customer confidence as well as expanded efforts to promote our products and services to retail investors.

Impairment of Goodwill

Impairment of goodwill was $101.2 million for the year ended December 31, 2007. This impairment represents the entire amount of goodwill associated with our balance sheet management business, which had a significant decline in fair value during the fourth quarter of 2007. There was no such impairment for the year ended December 31, 2008.

Facility Restructuring and Other Exit Activities

Facility restructuring and other exit activities expense was $29.5 million for the year ended December 31, 2008. These costs were due primarily to the exit of certain facilities during the year ended December 31, 2008. Slightly offsetting the restructuring expense is the gain on the sale of RAA of $2.8 million which was recorded in the second quarter of 2008.

Other

Other expense decreased 37% to $122.1 million for the year ended December 31, 2008 compared to 2007, which was primarily due to items that are not expected to recur in future periods. During the first quarter of 2008, we sold our corporate aircraft related assets, which resulted in a $23.7 million gain on sale. During the second quarter of 2008, we realized approximately $13 million of insurance recoveries of fraud losses incurred in prior periods as well as other recoveries to legal reserves. The decrease is also due to $35.1 million in expense recorded for certain legal and regulatory matters for the year ended December 31, 2007.

Other Income (Expense)

Other income (expense) increased to an expense of $330.6 million for 2008 compared to an expense of $123.1 million for 2007, as shown in the following table (dollars in thousands):

 

     Year Ended
December 31,
    Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Other income (expense):

        

Corporate interest income

   $ 7,210     $ 5,755     $ 1,455     25 %

Corporate interest expense

     (362,160 )     (172,482 )     (189,678 )   110 %

Gain (loss) on sales of investments, net

     (4,230 )     35,980       (40,210 )   (112 )%

Gain (loss) on early extinguishment of debt

     10,084       (19 )     10,103     *  

Equity in income of investments and venture funds

     18,462       7,665       10,797     141 %
                          

Total other income (expense)

   $ (330,634 )   $ (123,101 )   $ (207,533 )   169 %
                          

 

* Percentage not meaningful.

Total other income (expense) for the year ended December 31, 2008 consisted primarily of corporate interest expense resulting from our corporate debt, which included the springing lien notes, senior notes and mandatory convertible notes. Corporate interest expense increased 110% to $362.2 million for the year ended December 31, 2008 compared to 2007, primarily due to the interest expense on the springing lien notes that were issued in the fourth quarter of 2007 and first quarter of 2008. During 2008, our wholly owned subsidiary, E*TRADE Mauritius, sold its equity shares in Investsmart for proceeds of approximately $145 million, which

 

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resulted in a gain on sale of $22.3 million recorded in equity in income of investments and venture funds. During 2007, we sold our investments in E*TRADE Australia and E*TRADE Korea, which resulted in $37.0 million in gain on sales of investments, net.

The gain on early extinguishment of debt is primarily due to a gain of $21.5 million recognized on the exchange of our senior notes for shares of our common stock for the year ended December 31, 2008. The gain of $21.5 million is offset by a loss of $10.8 million related to the early extinguishment of FHLB advances and a loss of $0.6 million on the prepayment of debt related to the sale of the corporate aircraft.

Income Tax Benefit

The income tax benefit from continuing operations was $469.5 million and $732.9 million for the years ended December 31, 2008 and 2007, respectively. Our effective tax rate for 2008 was (36.7)% compared to (33.7)% for 2007. For additional information, see Note 17—Income Taxes to the consolidated financial statements.

Our 2008 effective tax rate included a number of tax benefits and expenses which were incremental to the amount of tax accrued based on the statutory tax rates in the jurisdictions in which we operate. The most significant items are summarized in the following table (dollars in millions):

 

     Year Ended
December 31, 2008

Tax Expense

Incremental tax benefits

  

Tax exempt income

   $ 10.2

FIN 48 settlements and reversals

     14.0

Low income housing tax credits

     2.4
      

Total tax benefits

     26.6

Incremental tax expenses

  

Non-deductible officer’s compensation

     1.6

Sweden valuation allowance

     7.3

Removal of foreign earnings from permanently reinvested

     1.8

Tax rate differential of international operations

     7.9

Non-deductible portion of interest expense on springing lien notes

     24.6
      

Total tax expense

     43.2
      

Incremental tax expense

   $ 16.6
      

The Company expects the 2009 effective tax rate to increase when compared to the tax rates for 2008. More specifically, we expect the 2009 effective tax rate to be based on a pro-forma effective tax rate of approximately 37-38% plus an additional fixed amount of income tax expense between $25 and $30 million.

During the year ended December 31, 2008 we did not provide for a valuation allowance against our federal deferred tax assets. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we did conclude that a valuation allowance was required, the resulting loss would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. As of December 31, 2008, we had net deferred tax assets of $1.0 billion.

We did not establish a valuation allowance against our federal deferred tax assets as of December 31, 2008 as we believe that it is more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we will be able to realize our deferred tax assets in the future. We

 

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reviewed the estimated future taxable income for our retail and institutional segments separately and determined that our net operating losses in 2007 and 2008 were due solely to the credit losses in our institutional segment. We believe these losses were caused by the crisis in the residential real estate and credit markets which significantly impacted our asset-backed securities and home equity loan portfolios in 2007 and continued to generate credit losses in 2008. We estimate that these credit losses will continue in future periods; however, we ceased the business activities which we believe are the root cause of these losses. Therefore, while we do expect credit losses to continue in future periods, we do expect these amounts to decline when compared to our credit losses in 2007 and 2008. Our retail segment generated substantial book taxable income for each of the last six years and we estimate that it will continue to generate taxable income in future periods at a level sufficient enough to generate taxable income for the Company as a whole. We consider this to be significant, objective evidence that we will be able to realize our deferred tax assets in the future.

Our analysis of the need for a valuation allowance recognizes that we are in a cumulative book taxable loss position as of the three-year period ended December 31, 2008, which is considered significant, objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, we believe we are able to rely on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.

The crisis in the residential real estate and credit markets has created significant volatility in our results of operations. This volatility is isolated almost entirely to our institutional segment. Our forecasts for this segment include assumptions regarding our estimate of future expected credit losses, which we believe to be the most variable component of our forecasts of future taxable income. We believe this variability could create a book loss in our overall results for an individual reporting period while not significantly impacting our overall estimate of taxable income over the period in which we expect to realize our deferred tax assets. Conversely, we believe our retail segment will continue to produce a stable stream of income which we believe we can reliably estimate in both individual reporting periods as well as over the period in which we estimate we will realize our deferred tax assets.

In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. In addition, a significant portion of the net deferred tax asset relates to a $2.3 billion federal tax loss carryforward, the utilization of which may be further limited in the event of certain material changes in the ownership of the Company. We will continue to monitor and update our assumptions and forecasts of future taxable income and assess the need for a valuation allowance.

 

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Income from Discontinued Operations, Net of Tax

During the year ended December 31, 2008, we sold our Canadian brokerage business to Scotiabank. The sale resulted in proceeds of approximately $515 million, including $54 million in repatriation of capital prior to the close and a pre-tax gain of $429.0 million. We also exited our direct retail lending business, which was our last remaining loan origination channel (we exited our wholesale mortgage lending channel in 2007). Therefore, the results of operations of our Canadian brokerage business, including the gain on sale, and the entire direct retail lending business are reported as discontinued operations on our consolidated statement of income (loss) for all periods presented. The following table outlines the components of discontinued operations (dollars of thousands):

 

     Years Ended
December 31,
    Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Lending loss, net of tax

   $ (6,235 )   $ (21,612 )   $ 15,377     (71 )%

Canada income, net of tax

     10,910       22,195       (11,285 )   (51 )%

Canada—gain on disposal, net of tax

     268,798       —         268,798     *  

Canada—tax benefit of excess tax basis over book basis

     24,121       —         24,121     *  
                          

Income from discontinued operations, net of tax

   $ 297,594     $ 583     $ 297,011     *  
                          

 

* Percentage not meaningful.

The benefit of excess tax basis over book basis is related to our Canadian brokerage business, which resulted from the difference between the tax and financial reporting bases of the business. We recognized this difference in the second quarter of 2008 because a commitment to sell the Canadian brokerage business was in place. The sale of the Canadian brokerage business was completed in the third quarter of 2008 for a gain of $268.8 million, net of tax.

2007 Compared to 2006

Income (loss) from continuing operations was a loss of $1.4 billion for the year ended December 31, 2007 compared to income of $626.9 million for the year ended December 31, 2006. The loss from continuing operations for the year ended December 31, 2007 was due principally to the $2.2 billion loss on the sale of our asset-backed securities portfolio and an increase in our provision for loan losses of $595.1 million to $640.1 million. These losses in our institutional segment more than offset the increase in our retail segment income, which increased $91.3 million to $794.4 million for the year ended December 31, 2007 compared to 2006.

Revenue

Net Operating Interest Income

Net operating interest income increased 14% to $1.6 billion for the year ended December 31, 2007 compared to 2006. The increase in net operating interest income was due primarily to the increase in enterprise interest-earning assets. Average enterprise interest-earning assets increased 25% to $56.1 billion for the year ended December 31, 2007 compared to 2006. Average loans, net grew 39% to $30.9 billion for the year ended December 31, 2007 compared to 2006 as a result of our focus on growing the one- to four-family loan portfolio in the first and second quarters of 2007. Beginning in the second half of 2007, we altered our strategy and halted the focus on growing the balance sheet.

Average enterprise interest-bearing liabilities increased 26% to $53.4 billion for the year ended December 31, 2007 compared to 2006. The increase in average enterprise interest-bearing liabilities was primarily in retail deposits. Average retail deposits increased 30% to $26.5 billion for the year ended December 31, 2007 compared to 2006. Increases in average retail deposits were driven by growth in the Complete Savings Account.

 

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Enterprise net interest spread decreased by 21 basis points to 2.64% for the year ended December 31, 2007 compared to 2006. This decrease was primarily the result of a challenging interest rate environment throughout 2007 as well as growth in our Complete Savings Account, which pays a higher interest rate than the majority of our other deposit products.

Commission

Commission revenue increased 11% to $663.6 million for the year ended December 31, 2007 compared to 2006, which was driven by an increase of $61.8 million, or 13%, in our retail commission revenue.

DARTs increased 16% to 177,900 for the year ended December 31, 2007 compared to 2006. Our U.S. DART volume increased 13% for the year ended December 31, 2007 compared to 2006. Our international DARTs grew by 42% for the year ended December 31, 2007 compared to 2006, driven entirely by organic growth. In addition, option-related DARTs further increased as a percentage of total U.S. DARTs and represented 16% of trading volume versus 13% in 2006.

Average commission per trade decreased 2% to $11.72 for the year ended December 31, 2007 compared to 2006. The decrease was primarily a function of the mix of customers. Main Street Investors, who generally have a higher commission per trade, traded less during the period compared to Active Traders and Mass Affluent, who generally have a lower commission per trade. Customer appreciation and win-back campaigns, particularly in the fourth quarter of 2007, also contributed to the decrease in average commission per trade.

Fees and Service Charges

Fees and service charges increased 5% to $230.6 million for the year ended December 31, 2007 compared to 2006. This increase was due to an increase in order flow payment, advisor management fees, foreign currency margin revenue, fixed income product revenue and mutual fund fees, partially offset by a decrease in account maintenance fees and mortgage servicing fees.

Principal Transactions

Principal transactions decreased 7% to $102.2 million for the year ended December 31, 2007 compared to 2006. The decrease in principal transactions resulted from lower institutional trading volumes.

Gain (Loss) on Loans and Securities, Net

Gain (loss) on loans and securities, net was a loss of $2.5 billion for the year ended December 31, 2007 compared to a gain of $21.2 million for the same period in 2006. The decline in the total gain (loss) on loans and securities, net during 2007 was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.

Other Revenue

Other revenue increased 36% to $47.2 million for the year ended December 31, 2007 compared to 2006. The increase in other revenue was due to income from the cash surrender value of BOLI, an increase in fees earned in connection with distribution of shares during initial public offerings and software consulting fees from our Corporate Services business.

Provision for Loan Losses

Provision for loan losses increased $595.1 million to $640.1 million for the year ended December 31, 2007 compared to 2006. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio in the second half of 2007.

 

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Operating Expense

Operating expense increased 19% to $1.6 billion for 2007 compared to 2006. The increase in expense excluding interest was driven primarily by increases in clearing and servicing, advertising and market development, impairment of goodwill and other expense.

Compensation and Benefits

Compensation and benefits increased 1% to $434.8 million for the year ended December 31, 2007 compared to 2006. The slight increase resulted primarily from increased benefit costs offset slightly by lower incentive based compensation in the current year.

Clearing and Servicing

Clearing and servicing expense increased 11% to $270.2 million for the year ended December 31, 2007 compared to 2006. This increase is due primarily to higher loan balances during the period, which resulted in higher servicing costs, and increased trading activity, which resulted in higher clearing expenses.

Advertising and Market Development

Advertising and market development expense increased 31% to $138.7 million for the year ended December 31, 2007 compared to 2006. This planned increase is a result of expanded efforts to promote our products and services to retail investors.

Impairment of Goodwill

Impairment of goodwill was $101.2 million for the year ended December 31, 2007. This impairment represents the entire amount of goodwill associated with our balance sheet management business, which had a significant decline in fair value during the fourth quarter of 2007.

Facility Restructuring and Other Exit Activities

Facility restructuring and other exit activities expense was $27.2 million for the year ended December 31, 2007. The majority of this expense was incurred during the fourth quarter of 2007 and was driven primarily by the shut down of the international portion of our institutional brokerage business.

Other

Other expense increased 51% to $195.4 million for the year ended December 31, 2007 compared to 2006. The increase for the year ended December 31, 2007 is due primarily to higher expense for certain legal and regulatory matters and higher FDIC premiums.

Other Income (Expense)

Other income (expense) increased 71% to $123.1 million for 2007 compared to 2006. Total other income (expense) for the year ended December 31, 2007 consisted primarily of corporate interest expense which increased 13% to $172.5 million, compared to 2006. The interest expense was partially offset by the sale of our investments in E*TRADE Australia and E*TRADE Korea, which resulted in $37.0 million in gain on sales of investments, net. During 2006, we sold shares of our investments in Softbank Investment Corporation and International Securities Exchange Holdings, Inc. resulting in gains of $71.7 million.

Income Tax Expense (Benefit)

The income tax benefit from continuing operations was $732.9 million for the year ended December 31, 2007 compared to an income tax expense of $305.4 million for the same period in 2006. Our effective tax rate for

 

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2007 was (33.7)% compared to 32.8% for 2006. For additional information, see Note 17—Income Taxes to the consolidated financial statements.

Discontinued Operations

Our income from discontinued operations, net of tax was $0.6 million for the year ended December 31, 2007 compared to $1.9 million for the same period in 2006. During 2007 and 2006, discontinued operations included operating results from our Canadian brokerage business and our direct retail lending business. During 2006, discontinued operations also included the results from our professional agency business, E*TRADE Professional Trading, LLC.

SEGMENT RESULTS REVIEW

Retail

The following table summarizes retail financial and key metrics for the periods ended December 31, 2008, 2007 and 2006 (dollars in thousands, except for key metrics):

 

     Year Ended December 31,    Variance  
      2008 vs. 2007  
     2008     2007     2006    Amount     %  

Retail segment income:

           

Net operating interest income

   $ 829,707     $ 962,557     $ 870,462    $ (132,850 )   (14 )%

Commission

     514,736       520,216       458,463      (5,480 )   (1 )%

Fees and service charges

     200,726       218,682       202,037      (17,956 )   (8 )%

Gain (loss) on loans and securities, net

     (78 )     180       3,414      (258 )   *  

Other revenue

     38,463       40,653       35,357      (2,190 )   (5 )%
                                 

Net segment revenue

     1,583,554       1,742,288       1,569,733      (158,734 )   (9 )%

Total segment expense

     975,488       947,864       866,568      27,624     3 %
                                 

Total retail segment income

   $ 608,066     $ 794,424     $ 703,165    $ (186,358 )   (23 )%
                                 

Key Metrics(1):

           

Retail customer assets (dollars in billions)

   $ 112.2     $ 185.0     $ 191.3    $ (72.8 )   (39 )%

Net new customer assets (dollars in billions)(2)

   $ 5.4     $ (11.3 )   $ 3.2    $ 16.7     *  

Customer cash and deposits (dollars in billions)

   $ 32.3     $ 32.7     $ 33.0    $ (0.4 )   (1 )%

DARTs

     188,116       177,900       153,146      10,216     6 %

Average commission per trade

   $ 10.88     $ 11.72     $ 11.97    $ (0.84 )   (7 )%

End of period margin debt (dollars in billions)

   $ 2.8     $ 7.0     $ 6.8    $ (4.2 )   (60 )%

End of period total accounts

     4,533,034       4,287,240       4,002,496      245,794     6 %

 

* Percentage not meaningful.

(1)

Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.

(2)

For the year ended December 31, 2008, net new customer assets were $6.4 billion excluding the sale of RAA.

Our retail segment generates revenue from brokerage and banking relationships with retail customers. These relationships essentially drive five sources of revenue: net operating interest income; commission; fees and service charges; gain (loss) on loans and securities, net; and other revenue. Other revenue includes results from our stock plan administration products and services, as we ultimately service retail customers through these corporate relationships.

2008 Compared to 2007

During the fourth quarter of 2007, we experienced a disruption in our customer base which caused a decline in the core drivers of our retail segment, including: net new accounts, customer cash and deposits, DARTs,

 

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margin debt and retail customer assets. We believe this disruption was due to the uncertainty surrounding the Company in connection with the credit related losses in our institutional segment. While we anticipate credit related losses will be at historically high levels in future periods, primarily in our home equity loan portfolio, we believe our retail customer base has stabilized. During the year ended December 31, 2008, our retail customer base showed positive growth trends, including adding almost 246,000 net new accounts and growth in net new customer assets of approximately $5.4 billion ($6.4 billion excluding the sale of RAA). We believe these are indications that our retail segment has not only stabilized but has returned to modest growth.

Retail segment income decreased 23% to $608.1 million for the year ended December 31, 2008 compared to 2007. This was due primarily to a decrease in net operating interest income and an increase in total segment expense.

Retail net operating interest income decreased 14% to $829.7 million for the year ended December 31, 2008 compared to 2007. This decrease was driven primarily by a decrease in margin debt as well as the above market rate on our Complete Savings Account. We plan to reduce the rate on this product in future periods which we believe will result in an improvement to retail net operating interest income.

Retail commission revenue decreased 1% to $514.7 million for the year ended December 31, 2008 compared to 2007. The slight decrease in commission revenue was primarily the result of a decrease in average commission per trade of 7%, offset by an increase in DARTs of 6%.

Retail segment expense increased 3% to $975.5 billion for the year ended December 31, 2008 compared to 2007. This increase related primarily to our planned growth in marketing spend as we expanded efforts to promote our products and services to retail investors.

As of December 31, 2008, we had approximately 2.6 million active brokerage accounts, 1.0 million active stock plan accounts and 0.9 million active banking accounts. For the years ended December 31, 2008 and 2007, our retail brokerage products contributed 67% for both years, and our banking products contributed 28% and 27%, respectively, of total retail net revenue. All other products contributed less than 10% of total retail net revenue for the years ended December 31, 2008 and 2007.

2007 Compared to 2006

Retail segment income increased 13% to $794.4 million for the year ended December 31, 2007 compared to 2006. The increase in retail segment income during the year ended December 31, 2007 compared to 2006 was due to an increase in net operating interest income and commission revenue, offset by lower gain on sales of loans and securities, net.

Retail net operating interest income increased 11% to $962.6 million for the year ended December 31, 2007 compared to 2006. This increase was driven by customer cash and deposits, which generally translate into a lower cost of funds. The growth in customer cash and deposits during the first three quarters of 2007 was largely offset by the decline in customer cash during the fourth quarter of 2007.

Retail commission revenue increased 13% to $520.2 million for the year ended December 31, 2007 compared to 2006. The increase in commission revenue was primarily the result of increased trading volumes in the overall domestic equity market and in our international commissions.

Retail segment expense increased 9% to $947.9 million for the year ended December 31, 2007 compared to 2006. This increase related to our targeted growth in marketing spend as we expanded efforts to promote our products and services to retail investors.

As of December 31, 2007, we had approximately 2.5 million active brokerage accounts, 1.1 million active stock plan accounts and 0.8 million active banking accounts. For the years ended December 31, 2007 and 2006, our retail brokerage products contributed 67% and 69%, respectively, and our banking products contributed 27% and 25%, respectively, of total retail net revenue. All other products contributed less than 10% of total retail net revenue for the years ended December 31, 2007 and 2006.

 

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Institutional

The following table summarizes institutional financial and key metrics for the periods ended December 31, 2008, 2007 and 2006 (dollars in thousands, except for key metrics):

 

     Year Ended December 31,     Variance  
     2008 vs. 2007  
     2008     2007     2006     Amount     %  

Institutional segment income (loss):

          

Net operating interest income

   $ 438,299     $ 621,042     $ 515,053     $ (182,743 )   (29 )%

Commission

     815       143,426       138,613       (142,611 )   (99 )%

Fees and service charges

     8,422       21,619       25,366       (13,197 )   (61 )%

Principal transactions

     84,882       102,180       110,136       (17,298 )   (17 )%

Gain (loss) on loans and securities, net

     (195,405 )     (2,465,654 )     17,786       2,270,249     (92 )%

Other revenue

     14,271       7,093       244       7,178     101 %
                                  

Net segment revenue

     351,284       (1,570,294 )     807,198       1,921,578     *  

Provision for loan losses

     1,583,666       640,078       44,970       943,588     147 %

Total segment expense

     323,969       636,237       461,078       (312,268 )   (49 )%
                                  

Total institutional segment income (loss)

   $ (1,556,351 )   $ (2,846,609 )   $ 301,150     $ 1,290,258     (45 )%
                                  

Key Metrics(1):

          

Nonperforming loans as a % of gross loans receivable

     3.69 %     1.37 %     0.28 %     —       2.32 %

Allowance for loan losses (dollars in millions)

   $ 1,080.6     $ 508.2     $ 67.6     $ 572.4     113 %

Allowance for loan losses as a % of nonperforming loans

     114.70 %     121.44 %     90.52 %     —       (6.74 )%

 

* Percentage not meaningful

(1)

Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.

Our institutional segment generates revenue from balance sheet management activities and market-making activities. Balance sheet management activities include managing loans previously purchased 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.

2008 Compared to 2007

As a result of our exposure to the credit crisis in the residential real estate and credit markets, our institutional segment incurred a loss of $1.6 billion for the year ended December 31, 2008. The loss was driven primarily by an increase in our provision for loan losses for our loan portfolio of $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007.

Net operating interest income decreased 29% to $438.3 million for the year ended December 31, 2008 compared to 2007. The decrease in net operating interest income was due primarily to the decrease in average enterprise interest-earning assets of 16% to $46.9 billion as of December 31, 2008 compared to 2007.

Institutional commission revenue decreased to $0.8 million for the year ended December 31, 2008 compared to 2007. The decrease was a result of the exit of our institutional brokerage operations.

Fees and service charges revenue decreased 61% to $8.4 million for the year ended December 31, 2008 compared to 2007. The decrease is primarily the result of a decrease in CDO management fees, which are no longer a revenue stream due to the sale of our collateral management agreements during the first quarter of 2008.

 

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The total loss on loans and securities, net during year ended December 31, 2008 was due principally to losses on our preferred stock in Fannie Mae and Freddie Mac, which experienced record price declines and volatility during the third quarter of 2008. Based upon our concerns about continuing market instability, all of our positions were liquidated during the third quarter of 2008, resulting in a pre-tax loss of $153.8 million, net of hedges, that was recognized in loss on trading securities, net.

In addition, we recognized $95.0 million of impairment on certain securities in our CMO portfolio during the year ended December 31, 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods.

Provision for loan losses increased $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the year ended December 31, 2008, we also experienced deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in virtually all key markets; growing inventories of unsold homes; rising foreclosure rates; sustained contraction in the availability of credit; and a severe downturn in the economy. While we do believe the provision for loan losses will be at historically high levels in future periods, we do not expect those levels to be in excess of those incurred in 2008.

Total institutional segment expense decreased 49% to $324.0 million for the year ended December 31, 2008 compared to 2007. This decrease was due primarily to the goodwill impairment recorded for the year ended December 31, 2007 associated with our balance sheet management business. There was also a decline in our clearing expense related to the exit of our institutional brokerage operations, as well as a reduction in corporate overhead expenses, the majority of which are allocated to the institutional segment.

2007 Compared to 2006

As a result of our exposure to the credit crisis in the residential real estate and credit markets, our institutional segment incurred a loss of $2.8 billion for the year ended December 31, 2007. The loss was driven primarily by losses in our asset-backed securities portfolio of approximately $2.5 billion as well as provision for loan losses for our loan portfolio of $640.1 million for the year ended December 31, 2007.

Net operating interest income increased 21% to $621.0 million for the year ended December 31, 2007 compared to 2006. The increase in net operating interest income was due primarily to the increase in average interest-earning assets of 25% to $56.1 as of December 31, 2007.

Institutional commission revenue increased 3% to $143.4 million for the year ended December 31, 2007 compared to 2006. The increase was due to higher trading volumes as a result of volatility in global equity markets.

Fees and service charges revenue decreased 15% to $21.6 million for the year ended December 31, 2007 compared to 2006. The decrease for the year ended December 31, 2007 is related to a $4.5 million decline in service fee income as a result of lower rates and lower home equity, credit card and CDO management fees.

Gain (loss) on loans and securities, net decreased to a loss of $2.5 billion for the year ended December 31, 2007. This decline was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.

Provision for loan losses increased $595.1 million to $640.1 million for the year ended December 31, 2007 compared to the same period in 2006. This increase was largely due to the deterioration in the performance of our home equity loan portfolio.

 

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Total institutional segment expense increased 38% to $636.2 million for the year ended December 31, 2007 compared to 2006 and was due primarily to the impairment of goodwill associated with the decline in fair value of our balance sheet management business during the fourth quarter of 2007. The increase was also driven by the expenses associated with certain legal and regulatory matters.

BALANCE SHEET OVERVIEW

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

 

     December 31,    Variance  
      2008 vs. 2007  
     2008    2007    Amount     %  

Assets:

          

Cash(1)

   $ 4,995,447    $ 2,113,075    $ 2,882,372     136 %

Trading securities

     55,481      130,018      (74,537 )   (57 )%

Available-for-sale mortgage-backed and investment securities

     10,806,094      11,255,048      (448,954 )   (4 )%

Margin receivables

     2,791,168      7,179,175      (4,388,007 )   (61 )%

Loans, net

     24,451,852      30,139,382      (5,687,530 )   (19 )%

Investment in FHLB stock

     200,892      338,585      (137,693 )   (41 )%

Other assets(2)

     5,237,281      5,690,654      (453,373 )   (8 )%
                        

Total assets

   $ 48,538,215    $ 56,845,937    $ (8,307,722 )   (15 )%
                        

Liabilities and shareholders’ equity:

          

Deposits

   $ 26,136,246    $ 25,884,755    $ 251,491     1 %

Wholesale borrowings(3)

     11,735,056      16,379,197      (4,644,141 )   (28 )%

Customer payables

     3,753,332      5,514,675      (1,761,343 )   (32 )%

Corporate debt

     2,750,532      3,022,698      (272,166 )   (9 )%

Accounts payable, accrued and other liabilities

     1,571,553      3,215,547      (1,643,994 )   (51 )%
                        

Total liabilities

     45,946,719      54,016,872      (8,070,153 )   (15 )%

Shareholders’ equity

     2,591,496      2,829,065      (237,569 )   (8 )%
                        

Total liabilities and shareholders’ equity

   $ 48,538,215    $ 56,845,937    $ (8,307,722 )   (15 )%
                        

 

(1)

Includes balance sheet line items cash and equivalents and cash and investments required to be segregated under federal or other regulations.

(2)

Includes balance sheet line items property and equipment, net, goodwill, other intangibles, net and other assets.

(3)

Includes balance sheet line items securities sold under agreements to repurchase and other borrowings.

The decrease in total assets was attributable primarily to a decrease of $5.7 billion in loans, net and a decrease of $4.4 billion in margin receivables for the period ended December 31, 2008 compared to 2007. These decreases were partially offset by an increase in cash of $2.9 billion. The decrease in loans, net is due to our strategy of reducing balance sheet risk and halting our previous focus on growing the balance sheet. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to maintain excess regulatory capital at E*TRADE Bank as we focus on strengthening our capital position. We believe the decrease in our margin receivables is due to customers deleveraging and reducing their risk exposure due to the volatility in the financial markets and is not due to a specific issue with the terms or competitiveness of our margin product.

The decrease in total liabilities was attributable primarily to a decrease of $4.6 billion in wholesale borrowings, a decrease in customer payables of $1.8 billion and a decrease of $1.6 billion in accounts payable, accrued and other liabilities for the period ended December 31, 2008 compared to 2007. Repurchase agreements

 

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and other borrowings are the primary wholesale funding sources for our loans, net and available-for-sale securities portfolios. The decreases in these balances were the result of paying down these liabilities as we decreased the size of our balance sheet during 2008. The decrease in our customer payables is related primarily to the sale of our Canadian brokerage business during the year ended December 31, 2008. In addition, stock loan, which is reported within the accounts payable, accrued and other liabilities line item, decreased $1.7 billion to $0.3 billion at December 31, 2008 compared to 2007.

Available-for-Sale Mortgage-Backed and Investment Securities

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

 

          Variance  
     December 31,    2008 vs. 2007  
     2008    2007    Amount     %  

Mortgage-backed securities:

          

Backed by U.S. Government sponsored and federal agencies

   $ 10,110,813    $ 9,330,129    $ 780,684     8 %

Collateralized mortgage obligations and other

     602,376      1,123,255      (520,879 )   (46 )%
                        

Total mortgage-backed securities

     10,713,189      10,453,384      259,805     2 %
                        

Investment securities:

          

Municipal bonds

     79,606      314,348      (234,742 )   (75 )%

Publicly traded equity securities:

          

Preferred stock(1)

     —        371,404      (371,404 )   *  

Corporate investments

     498      1,271      (773 )   (61 )%

Other

     12,801      114,641      (101,840 )   (89 )%
                        

Total investment securities

     92,905      801,664      (708,759 )   (88 )%
                        

Total available-for-sale securities

   $ 10,806,094    $ 11,255,048    $ (448,954 )   (4 )%
                        

 

* Percentage not meaningful.

(1)

On January 1, 2008, the Company elected the fair value option for preferred stock in accordance with SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”). As a result of this election, preferred stock was classified on the balance sheet as trading securities during 2008; however, during the third quarter of 2008, all preferred stock positions were sold.

Available-for-sale securities represented 22% and 20% of total assets at December 31, 2008 and 2007, respectively. Available-for-sale securities decreased 4% to $10.8 billion at December 31, 2008 compared to December 31, 2007, due primarily to the sale of certain mortgage-backed securities in the first half of 2008, offset by the purchase of highly-rated securities backed by U.S. Government sponsored and federal agencies in the second half of 2008. All mortgage-backed securities backed by U.S. Government sponsored and federal agencies are AAA-rated.

 

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Margin Receivables

The margin receivables balance is a component of the margin debt balance, which is reported as a key retail metric of $2.8 billion and $7.0 billion at December 31, 2008 and 2007, respectively. The total margin debt balance is summarized as follows (dollars in thousands):

 

           Variance  
     December 31,     2008 vs. 2007  
     2008    2007     Amount     %  

Margin receivables

   $ 2,791,168    $ 7,179,175     $ (4,388,007 )   (61 )%

Margin held by third parties and other

     20,676      81,669       (60,993 )   (75 )%

Margin held by the Canadian brokerage business(1)

     —        (274,180 )     274,180     *  
                         

Margin debt

   $ 2,811,844    $ 6,986,664     $ (4,174,820 )   (60 )%
                         

 

* Percentage not meaningful.

(1)

Margin held by the Canadian brokerage business prior to its sale was excluded as it is part of discontinued operations.

We believe the decrease in our margin receivables is due to customers deleveraging and reducing their risk exposure given the substantial volatility in the financial markets and is not due to an issue with the terms or competitiveness of our margin product.

Loans, Net

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

 

           Variance  
     December 31,     2008 vs. 2007  
     2008     2007     Amount     %  

Loans held-for-sale

   $ —       $ 100,539     $ (100,539 )   *  

One- to four-family

     12,979,844       15,506,529       (2,526,685 )   (16 )%

Home equity

     10,017,183       11,901,324       (1,884,141 )   (16 )%

Consumer and other loans:

        

Recreational vehicle

     1,570,116       1,910,454       (340,338 )   (18 )%

Marine

     424,595       526,580       (101,985 )   (19 )%

Commercial

     214,084       272,156       (58,072 )   (21 )%

Credit card

     85,851       90,764       (4,913 )   (5 )%

Other

     4,024       23,334       (19,310 )   (83 )%

Unamortized premiums, net

     236,766       315,866       (79,100 )   (25 )%

Allowance for loan losses

     (1,080,611 )     (508,164 )     (572,447 )   113 %
                          

Total loans, net

   $ 24,451,852     $ 30,139,382     $ (5,687,530 )   (19 )%
                          

 

* Percentage not meaningful.

Loans, net decreased 19% to $24.5 billion at December 31, 2008 from $30.1 billion at December 31, 2007. This decline was due primarily to our strategy of reducing balance sheet risk and halting our previous focus on growing the balance sheet. We do not expect to grow our loan portfolio for the foreseeable future. In addition, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio.

In 2007, we entered into a credit default swap (“CDS”) on $4.0 billion of our first-lien residential real estate loan portfolio through a synthetic securitization structure. As of December 31, 2008, the balance of the loans

 

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covered by the CDS was $2.9 billion. A CDS provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. The CDS provides protection for losses in excess of $4.0 million, but not to exceed approximately $30.3 million. In addition, our regulatory risk-weighted assets were reduced as a result of this transaction because we transferred a portion of our credit risk to an unaffiliated third party. During the year ended December 31, 2008, we recognized $1.6 million in losses on the portion of the loans covered under the CDS. We have not yet realized any recoveries from the CDS; however, the estimated recoveries from the CDS for the next twelve months were $13.9 million at December 31, 2008, which is reflected in the allowance for loan losses.

Deposits

Deposits are summarized as follows (dollars in thousands):

 

          Variance  
     December 31,    2008 vs. 2007  
     2008    2007    Amount     %  

Money market and savings accounts

   $ 12,692,729    $ 10,028,115    $ 2,664,614     27 %

Sweep deposit accounts

     9,650,431      10,112,123      (461,692 )   (5 )%

Certificates of deposit

     2,363,385      4,156,674      (1,793,289 )   (43 )%

Checking accounts

     991,477      495,618      495,859     100 %

Brokered certificates of deposit

     438,224      1,092,225      (654,001 )   (60 )%
                        

Total deposits

   $ 26,136,246    $ 25,884,755    $ 251,491     1 %
                        

Deposits represented 57% and 48% of total liabilities at December 31, 2008 and 2007, respectively. Deposits increased $0.3 billion to $26.1 billion at December 31, 2008 compared to December 31, 2007, driven by a $2.7 billion increase in money market and savings accounts. This increase was offset by a decrease in certificates of deposit and brokered certificates of deposits by $2.4 billion. Deposits 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 $32.3 billion and $32.7 billion at December 31, 2008 and 2007, respectively. The total customer cash and deposits balance is summarized as follows (dollars in thousands):

 

           Variance  
     December 31,     2008 vs. 2007  
     2008     2007     Amount     %  

Deposits

   $ 26,136,246     $ 25,884,755     $ 251,491     1 %

Less: brokered certificates of deposit

     (438,224 )     (1,092,225 )     654,001     (60 )%
                          

Deposits excluding brokered certificates of deposit

     25,698,022       24,792,530       905,492     4 %

Customer payables

     3,753,332       5,514,675       (1,761,343 )   (32 )%

Customer cash balances held by third parties and other

     2,805,101       3,286,212       (481,111 )   (15 )%

Customer cash balances held by the Canadian brokerage business(1)

     —         (883,222 )     883,222     *  
                          

Total customer cash and deposits

   $ 32,256,455     $ 32,710,195     $ (453,740 )   (1 )%
                          

 

* Percentage not meaningful.

(1)

Customer cash balances held by the Canadian brokerage business prior to its sale were excluded as it is part of discontinued operations.

 

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Wholesale Borrowings

Wholesale borrowings, which consist of securities sold under agreements to repurchase and other borrowings are summarized as follows (dollars in thousands):

 

          Variance  
     December 31,    2008 vs. 2007  
     2008    2007    Amount     %  

Securities sold under agreements to repurchase

   $ 7,381,279    $ 8,932,693    $ (1,551,414 )   (17 )%
                        

FHLB advances

   $ 3,903,600    $ 6,967,406    $ (3,063,806 )   (44 )%

Subordinated debentures

     427,328      435,830      (8,502 )   (2 )%

Other

     22,849      43,268      (20,419 )   (47 )%
                        

Total other borrowings

   $ 4,353,777    $ 7,446,504    $ (3,092,727 )   (42 )%
                        

Total wholesale borrowings

   $ 11,735,056    $ 16,379,197    $ (4,644,141 )   (28 )%
                        

Wholesale borrowings represented 26% and 30% of total liabilities at December 31, 2008 and 2007, respectively. The decrease in other borrowings of $3.1 billion for the period ended December 31, 2008 was due primarily to a decrease in FHLB advances. Securities sold under agreements to repurchase coupled with FHLB advances are the primary wholesale funding sources of the Bank. As a result, we expect these balances to fluctuate over time as our deposits and our interest-earning assets fluctuate.

Corporate Debt

Corporate debt is summarized as follows (dollars in thousands):

 

          Variance  
     December 31,    2008 vs. 2007  
     2008    2007    Amount     %  

Senior notes

   $ 1,144,662    $ 1,272,742    $ (128,080 )   (10 )%

Springing lien notes

     1,605,870      1,304,391      301,479     23 %

Mandatory convertible notes

     —        445,565      (445,565 )     *
                        

Total corporate debt

   $ 2,750,532    $ 3,022,698    $ (272,166 )   (9 )%
                        

 

* Percentage not meaningful.

Corporate debt decreased to $2.8 billion at December 31, 2008 compared to $3.0 billion at December 31, 2007, primarily due to the retirement of the $450 million in mandatory convertible notes during the fourth quarter of 2008 and a decline in senior notes of $121 million in principal related to debt for equity exchanges. Offsetting these decreases was an additional $150.0 million of 12 1/2% springing lien notes issued to Citadel in the first quarter of 2008 and the issuance of $121 million of 12 1/2% springing lien notes in satisfaction of the November 2008 interest payment on these notes.

LIQUIDITY AND CAPITAL RESOURCES

We have established liquidity and capital policies. The objectives of these policies are to support the successful execution of our business strategies while ensuring ongoing and sufficient liquidity through the business cycle. These policies are especially important during periods of stress in the financial markets, which have been ongoing since the fourth quarter of 2007 and will likely continue for the foreseeable future. During the fourth quarter of 2007, we experienced a disruption in our customer base, which caused a significant decline in customer deposits. We believe this disruption was due to uncertainty in connection with the credit related losses in our institutional segment. Deposits are the primary source of liquidity for E*TRADE Bank, so this sudden and rapid decline created a substantial amount of liquidity risk. We followed our existing liquidity policies and

 

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contingency plans and successfully met our liquidity needs during this extraordinary period. We believe that our ability to meet liquidity needs during this time validates the effectiveness of the liquidity policies and contingency plans. While the liquidity risk associated with our customer deposits remains at historically high levels, we believe the current level of risk is substantially lower than it was during the fourth quarter of 2007.

Capital is generated primarily through our business operations and our capital market activities. During the second half of 2007, our institutional segment incurred a significant amount of losses as a result of its exposure to the crisis in the residential real estate and credit markets. Consequently, this segment required a significant capital infusion during the fourth quarter of 2007. The Company raised $2.5 billion in cash from Citadel, the majority of which was used to provide capital to the institutional segment. While this segment continues to have exposure to the crisis in the residential real estate and credit markets, our retail segment remains profitable and continues to generate capital through retained earnings.

We maintain capital in excess of regulatory minimums at our regulated subsidiaries, the most significant of which is E*TRADE Bank. As of December 31, 2008, we held $714.7 million of risk-based capital at E*TRADE Bank in excess of the regulatory minimum level required to be considered “well capitalized.”

We raised additional capital in 2008 by issuing shares of common stock in exchange for existing corporate debt, primarily our senior notes, commonly referred to as “3(a)9 exchanges.” We completed several 3(a)9 exchanges in the first half of 2008, which resulted in a retirement of $120.8 million of existing corporate debt. We did not complete any of these transactions during the second half of 2008 as the relative prices of our common stock and corporate debt made it unattractive to do so.

In addition, we raised approximately $750 million in cash through non-core asset sales, including the sale of our Canadian brokerage business and our equity shares in Investsmart(1).

We believe the combination of the capital generated in the transactions detailed above, the excess capital held at E*TRADE Bank and the capital that continues to be generated in our retail segment will be sufficient to meet our capital needs for at least the next twelve months.

During the fourth quarter of 2008, we applied to the U.S. Treasury for funding under the TARP Capital Purchase Program. Our application remains under active consideration and we cannot predict when a final decision will be reached. We estimate this program could provide up to approximately $800 million in new preferred equity, at rates substantially discounted to current market rates. If our application is approved, it would likely be conditional upon additional capital raising activities by us, including possible transactions with existing security holders. Our ability to issue preferred equity under the TARP program would be dependent upon receiving approval from certain of our bond holders and possibly our shareholders. While we do not believe we need this capital to fund our operations, it does have the potential to significantly improve the capital position of both E*TRADE Bank and the parent company, which would enhance our ability to maintain the balance sheet at its current level.

 

(1)

The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.

 

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Corporate Cash

Corporate cash is the primary source of liquidity at the parent company and is available to invest in our regulated subsidiaries. We define corporate cash as cash held at the parent company as well as cash held in certain subsidiaries that can distribute cash to the parent company without any regulatory approval. The components of corporate cash as of December 31, 2008 and 2007 are as follows (dollars in thousands):

 

     December 31,    Variance  
     2008    2007    2008 vs. 2007  

Parent company cash

   $ 216,535    $ 251,663    $ (35,128 )

Converging Arrows, Inc. and other cash(1)

     218,318      60,701      157,617  
                      

Total corporate cash(2)

   $ 434,853    $ 312,364    $ 122,489  
                      

 

(1)

Converging Arrows, Inc. and other consists of corporate subsidiaries that can distribute cash to the parent company without any regulatory approval and includes E*TRADE Mauritius.

(2)

Total corporate cash at December 31, 2008 includes $45.3 million that we invested in The Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.

Parent company cash decreased $35.1 million to $216.5 million as of December 31, 2008 when compared to December 31, 2007. The cash received from the sale of the Canadian brokerage business was offset by the $500 million in capital infusions made to E*TRADE Bank during the second half of 2008. The $157.6 million increase in cash to $218.3 million at Converging Arrows, Inc. and other as of December 31, 2008 when compared to December 31, 2007 was due almost entirely to the sale of E*TRADE Mauritius’ equity shares in Investsmart.

Cash and Equivalents

The consolidated cash and equivalents balance increased by $2.1 billion to $3.9 billion at December 31, 2008 compared to 2007. The majority of this balance is cash held in regulated subsidiaries, primarily our Bank and Brokerage, outlined as follows:

 

     December 31,    Variance  
     2008     2007    2008 vs. 2007  

Corporate cash

   $ 434,853     $ 312,364    $ 122,489  

Bank subsidiaries

     3,220,232       691,826      2,528,406  

Brokerage subsidiaries

     339,716       768,677      (428,961 )

Other corporate cash

     5,356       5,377      (21 )

Less:

       

Cash reported in Other assets(1)

     (146,308 )     —        (146,308 )
                       

Total consolidated cash

   $ 3,853,849     $ 1,778,244    $ 2,075,605  
                       

 

(1)

Cash reported in other assets at December 31, 2008 consists of cash that we invested in The Reserve Funds’ Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.

The cash held in our regulated subsidiaries serves as a source of liquidity for those subsidiaries and is not a primary source of capital for the parent company.

Cash and Equivalents Held in the Reserve Fund

At December 31, 2008, we held cash in The Reserve Funds’ Primary Fund (“the Fund”) of $146.3 million, which is included as a receivable in other assets line item on the balance sheet. On September 16, 2008, the Fund reported that its shares had fallen below the standard of $1 per share, which is commonly referred to as “breaking the buck.” Prior to the fund “breaking the buck,” we submitted a redemption request for our entire balance in the

 

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fund. The following table details our cash held in the Fund at the date the Fund was reported as “breaking the buck” and at December 31, 2008 (dollars in thousands):

 

               Variance  
     December 31,
2008
   September 15,
2008
   December 31, 2008 vs.
September 15, 2008
 

Corporate cash

   $ 45,273    $ 230,326    $ (185,053 )

Bank subsidiaries

     82,645      420,456      (337,811 )

Brokerage subsidiaries

     18,390      93,559      (75,169 )
                      

Total cash held in the Fund

   $ 146,308    $ 744,341    $ (598,033 )
                      

On October 31, 2008 and December 3, 2008, the Fund made a distribution to its investors of approximately $26 billion and $14 billion, respectively. We received $377.7 million and $209.2 million, respectively, in connection with these distributions. On December 3, 2008, the Reserve indicated that they are required to distribute the remaining assets of the Fund ratably among the holders of outstanding shares, irrespective of whether the investor made a redemption request before or after the Fund “breaking the buck.” The statement indicated, assuming a pro-rata distribution, the net asset value per share would be $0.985. As a result of that statement, we no longer believe it is probable that we will receive the full amount of our remaining position in the Fund; therefore, we recorded an impairment charge of $11.2 million(1) related to this investment. The impairment charge of $3.5 million related to our corporate cash was included in gain (loss) on sales of investments, net line item. The impairment charge of $7.7 million related to our banking and brokerage subsidiaries is included in gain (loss) on loans and securities, net line item. The remaining amount of $146.3 million, net of the $11.2 million impairment charge, that we invested in the Fund is included as a receivable in the other assets line item.

On February 26, 2009, the Reserve announced that it had adopted a Plan of Liquidation for the orderly liquidation of the assets of the Fund. Under the terms of the plan, which is subject to the supervision of the SEC, the Reserve will continue to make interim distributions up to $0.9172 per share. The Reserve indicated in this announcement that they were taking this approach in order to provide liquidity to investors without prejudicing the legal rights and remedies of any shareholder’s claims. This announcement does not change our belief that we will receive the full amount of our remaining position upon the ultimate distribution of the fund; however, we cannot state with certainty that we will not ultimately incur additional loss on our remaining position. In addition, we believe it will take a significant amount of time to eventually receive these funds.

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries, other than Converging Arrows, Inc. (“Converging Arrows”) and E*TRADE Mauritius, a wholly-owned subsidiary of Converging Arrows, is limited by regulatory requirements.

Any loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements. At December 31, 2008, E*TRADE Bank had approximately $714.7 million of risk-based capital above the “well capitalized” level. In the current credit environment, we plan to keep this significant amount of excess risk-based capital at E*TRADE Bank in order to enhance our ability to absorb credit losses while still maintaining “well capitalized” status. However, events beyond management’s control, such as a continued deterioration in residential real estate and credit markets, could adversely affect future earnings and E*TRADE Bank’s ability to meet its future capital requirements.

The Company’s broker/dealer subsidiaries are subject to capital requirements determined by their respective regulators. At December 31, 2008 and 2007, all of our brokerage subsidiaries met their minimum net capital requirements. The Company’s broker-dealer subsidiaries had excess net capital of $717.6(2) million at December 31, 2008. While we cannot assure that we would obtain regulatory approval to withdraw any of this excess net capital, $619.4 million is available for dividend while still maintaining a capital level above regulatory “early warning” guidelines.

 

(1)

The impairment charge was calculated based on the Company’s investment balance as of September 15, 2008 (the day the Fund “broke the buck”), which totaled $744.3 million.

(2)

The excess net capital of the broker dealer subsidiaries included $620.7 million of excess net capital at E*TRADE Clearing, which is a subsidiary of E*TRADE Bank and is also included in the excess risk-based capital of E*TRADE Bank.

 

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Other Sources of Liquidity

We also maintain $325.0 million in uncommitted financing to meet margin lending needs. At December 31, 2008, there were no outstanding balances, and the full $325.0 million was available.

We rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase, to provide liquidity for the Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. At December 31, 2008, the Bank had approximately $9.8 billion in additional borrowing capacity with the FHLB.

We have the option to make interest payments on our springing lien notes in the form of either cash or additional springing lien notes through May 2010. During the second quarter of 2008, we elected to make our first interest payment of approximately $121 million in cash. During the fourth quarter of 2008, we elected to make our second interest payment of $121 million in the form of additional springing lien notes. We expect to make our next three interest payments, which equates to all interest payments on the springing lien notes through May 2010 in the form of additional springing lien notes. The November 2010 payment is the first interest payment we are required to pay in cash.

Corporate Debt

Our current senior debt ratings are B2 by Moody’s Investor Service, B (developing) by S&P and B (high) by Dominion Bond Rating Service (“DBRS”). The Company’s long-term deposit ratings are Ba3 by Moody’s Investor Service, BB- (developing) by S&P and BB by DBRS. A significant change in these ratings may impact the rate and availability of future borrowings.

Off-Balance Sheet Arrangements

We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our customers and to reduce our own exposure to interest rate risk. These arrangements include firm commitments to extend credit and letters of credit. Additionally, we enter into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For additional information on each of these arrangements, see Item 8. Financial Statements and Supplementary Data.

Contractual Obligations and Commitments

The following summarizes our contractual obligations at December 31, 2008 and the effect such obligations are expected to have on our liquidity and cash flow in future periods (dollars in thousands):

 

     Payments Due by Period     
     Less Than 1 Year    1-3 Years    3-5 years    Thereafter    Total

Certificates of deposit and brokered certificate of deposit (1)(2)

   $ 2,231,375    $ 383,955    $ 108,450    $ 189,624    $ 2,913,404

Securities sold under agreements to repurchase(2)

     4,780,262      1,422,058      274,437      1,174,948      7,651,705

Other borrowings(2)(3)

     2,020,693      377,537      645,919      2,407,125      5,451,274

Corporate debt(4)

     341,698      1,100,039      1,019,459      3,343,954      5,805,150

Operating lease payments(5)

     35,108      52,498      30,332      47,458      165,396

Purchase Obligations(6)

     71,317      20,287      4,429      1,889      97,922

FIN 48 liabilities

     5,036      15,500      4,122      45,916      70,574
                                  

Total contractual obligations

   $ 9,485,489    $ 3,371,874    $ 2,087,148    $ 7,210,914    $ 22,155,425
                                  

 

(1)

Does not include sweep deposit accounts, money market and savings accounts or checking accounts as there are no maturities and /or scheduled contractual payments.

(2)

Includes annual interest based on the contractual features of each transaction, using market rates at December 31, 2008. Interest rates are assumed to remain at current levels over the life of all adjustable rate instruments.

(3)

For mandatorily redeemable preferred securities included in other borrowings, does not assume early redemption under current conversion provisions.

(4)

Includes annual interest payments; does not assume early redemption under current call provisions. See Note 15—Corporate Debt for further details.

(5)

Includes facilities restructuring leases and excludes estimated future sublease income.

(6)

Includes purchase obligations for goods and services covered by non-cancelable contracts and contracts including cancellation fees. Excluded from the table are purchase obligations expected to be settled in cash within one year of the end of the reporting period.

 

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As of December 31, 2008, the Company had $2.5 billion of unused lines of credit available to customers under home equity lines of credit and $0.5 billion of unused credit card and commercial lines. As of December 31, 2008, the Company had no commitments to originate, purchase or sell loans. The Company had a commitment to purchase and sell securities of $0.8 billion and $1.8 billion, respectively. The Company also had equity funding commitments of $9.7 million as of December 31, 2008, based on investment plans of venture capital funds, low income housing tax credit partnerships and joint ventures. Additional information related to commitments and contingent liabilities is detailed in Note 23—Commitments, Contingencies and Other Regulatory Matters.

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 regulatory capital needs at our Bank, reduce holding company debt, 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.

RISK MANAGEMENT

As a financial services company, we are exposed to risks in every component of our business. The identification and management of existing and potential risks are the keys to effective risk management. Our risk management framework, principles and practices support decision-making, improve the success rate for new initiatives and strengthen the organization. Our goal is to balance risks and rewards through effective risk management. Risks cannot be completely eliminated; however, we do believe risks can be identified and managed within the Company’s risk tolerance.

Our businesses expose us to the following four major categories of risk that often overlap:

 

   

Credit Risk—Credit risk is the risk of loss resulting from adverse changes in the ability or willingness of a borrower or counterparty to meet the agreed-upon terms of their financial obligations.

 

   

Liquidity Risk—Liquidity risk is the risk of loss resulting from the inability to meet current and future cash flow and collateral needs.

 

   

Interest Rate Risk—Interest rate risk is the risk of loss from adverse changes in interest rates, which could cause fluctuations in our long-term earnings or in the value of the Company’s net assets.

 

   

Operational Risk—Operational risk is the risk of loss resulting from fraud, inadequate controls or the failure of the internal controls process, third party vendor issues, processing issues and external events.

We also are subject to other risks that could impact our business, financial condition, results of operations or cash flows in future periods. See Part I—Item 1A. Risk Factors.

We manage risk through a governance structure involving the various boards, senior management and several risk committees. We use management level risk committees to help ensure that business decisions are executed within our desired risk profile. A variety of methodologies and measures are used to monitor, quantify, assess and forecast risk. Measurement criteria, methodologies and calculations are reviewed periodically to assure that risks are represented appropriately. Risks are managed and controlled under policies and related limits that are approved by the Board of Directors and delegated to senior management.

The Finance and Risk Oversight Committee, which was established in the second quarter of 2008 and consists of members of the Board of Directors, monitors the risk process and significant risks throughout the

 

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Company. In addition to this committee, various enterprise risk committees and departments throughout the Company aid in the identification and management of risks, including:

 

   

Asset Liability Committee—E*TRADE Bank’s Asset Liability Committee (“ALCO”) has primary responsibility for managing liquidity risk and interest rate risk and reviews balance sheet trends, market interest rate and sensitivity analyses.

 

   

Credit Risk Committee—The Credit Risk Committee monitors asset quality trends, evaluates market conditions, determines the adequacy for allowance of loan losses, establishes underwriting standards, approves large credit exposures, approves large portfolio purchases and delegates credit approval authority.

We use various departments throughout the Company to aid in the identification and management of risks. These departments include internal audit, compliance, finance, legal, treasury, credit and enterprise risk management. Risk reporting occurs at the business or operating units and is aggregated across the Company through the enterprise risk management process.

Credit Risk Management

Our primary sources of credit risk are our loan and securities portfolios, where it results from extending credit to customers and purchasing securities, respectively. The degree of credit risk associated with our loans and securities varies based on many factors including the size of the transaction, the credit characteristics of the borrower, features of the loan product or security, the contractual terms of the related documents and the availability and quality of collateral. Credit risk is one of the most common risks in financial services and is one of our most significant risks.

Credit risk is monitored by our Credit Risk Committee. The Credit Risk Committee uses detailed tracking and analysis to measure credit performance and reviews and modifies credit policies as appropriate.

Housing Market Conditions

Conditions in the residential real estate and credit markets, which deteriorated sharply during 2007, continued to be extremely challenging during 2008. The significant and abrupt evaporation of secondary market liquidity for various types of mortgage loans, particularly home equity loans, has decreased the overall availability of housing credit. As a result, many borrowers, particularly those in markets with declining housing prices, have been unable to refinance existing loans. This combination of a decline in the availability of credit and a decline in housing prices creates significant credit risk in our loan portfolio, particularly in our home equity loan portfolio.

Loss Mitigation

Given the deterioration in the performance of our loan portfolio, particularly in our home equity loan portfolio, we formed a special credit management team to focus on the mitigation of potential losses in the home equity loan portfolio.

This team’s primary focus is reducing our exposure to open home equity lines. As of December 31, 2007, we had $6.3 billion of unused lines of credit available under home equity lines of credit. Through a variety of strategies, including voluntary line closures, automatically freezing lines on all delinquent accounts, and freezing lines on loans with materially reduced home equity, we have reduced this amount to $2.5 billion as of December 31, 2008.

The team has several other initiatives either in progress or in development which are focused on mitigating losses in our home equity loan portfolio. Those initiatives include improving collection efforts and practices of our servicers as well as increasing our loss recovery efforts to minimize the level of loss on a loan that goes to charge-off.

 

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We also initiated a loan modification program that resulted in an insignificant number of minor modifications in 2008. Based on the programs we now have in place, we expect the number of modifications to increase significantly in 2009 when compared to 2008. On February 18, 2009, the U.S. Department of the Treasury announced the Homeowner Affordability and Stability Plan. The primary focus of this plan is to create requirements and provide incentives to modify mortgages with the goal of avoiding foreclosure. We are analyzing the details of this recently announced program and do not yet know whether it would have a significant impact on our current loan modification programs.

In addition, we continue to review our purchased mortgage loan portfolio in order to identify loans to be repurchased by the originator. Our review is primarily focused on identifying loans with early payment defaults, violations of transaction representations and warranties, or material misrepresentation on the part of the seller. Any loans identified with these deficiencies are submitted to the original seller for repurchase. During the year ended December 31, 2008, approximately $105.6 million of loans were repurchased by the original sellers.

Underwriting Standards—Originated Loans

During the second half of 2007, we exited our wholesale mortgage origination channel and no longer originate loans through brokers. During the second quarter of 2008, we exited our retail mortgage origination business, which represented our last remaining loan origination channel.

We did not originate any loans during the second half of 2008. Prior to the exit of our retail mortgage origination business in the second quarter of 2008, we did originate approximately $158 million in one- to four-family loans during the first half of 2008. These loans were predominantly prime credit quality first-lien mortgage loans secured by a single-family residence.

We priced our loans primarily based on the risk elements inherent in the loan. We evaluated criteria such as, but not limited to: borrower credit score, loan-to-value ratio (“LTV”), documentation type, occupancy type and other risk elements. In the first quarter of 2008, we further adjusted our loan origination practices and pricing to significantly curtail originations of higher risk loans, particularly home equity loans with Fair Isaac Credit Organization (“FICO”) scores below 700 or a combined loan-to-value ratio (“CLTV”) greater than 80%.

Our underwriting guidelines were established with a focus on both the credit quality of the borrower as well as the adequacy of the collateral securing the loan. We designed our underwriting guidelines so that our one- to four-family loans were salable in the secondary market. These guidelines included limitations on loan amount, LTV ratio, debt-to-income ratio, documentation type and occupancy type. We also required borrowers to obtain mortgage insurance on higher loan-to-value first lien mortgage loans.

As of December 31, 2008, we did not offer any mortgage loan products to our customers. In the future, we expect to partner with a third party company to provide access to real estate loans for our customers.

Underwriting Standards—Purchased Loans

In the second half of 2007, we altered our business strategy and halted the focus on growing the balance sheet. As a result, we did not purchase loans during the year ended December 31, 2008 and we do not anticipate purchasing a significant amount of loans for the foreseeable future. However, we have significantly tightened our underwriting policies for any future loan purchases that do occur. These criteria focus on limiting the acquisition of loans with a high risk of credit loss and require the exclusion of loans with the following attributes: second lien; home equity line of credit; CLTV ratio above 80%; FICO score below 700 at time of origination; and documentation type is not full documentation.

 

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Liquidity Risk Management

Liquidity risk is monitored and managed primarily by the ALCO. We have in place a comprehensive set of liquidity and funding policies that are intended to maintain our flexibility to address liquidity events specific to us or the market in general.

We believe liquidity risk management is especially important during periods of stress in the financial markets. During the fourth quarter of 2007, we experienced a disruption in our customer base, which caused a significant decline in customer deposits. These deposits are the primary source of liquidity for E*TRADE Bank, so this sudden and rapid decline created a substantial amount of liquidity risk. We followed our existing liquidity policies and contingency plans and successfully met our liquidity needs during this extraordinary period. We believe that our ability to meet liquidity needs during this time validates the effectiveness of our liquidity policies and contingency plans.

See Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources for additional information.

Interest Rate Risk Management

Interest rate risks are monitored and managed by the ALCO. The analysis of interest sensitivity to changes in market interest rates under various scenarios is reviewed by ALCO. The scenarios assume both parallel and non-parallel shifts in the yield curve. See Item 7A. Quantitative and Qualitative Disclosures about Market Risk for additional information about our interest rate risks.

Operational Risk Management

Operational risks exist in most areas of the Company from clearing to customer service. While we make every effort to protect against failures in the internal controls system, no system is completely fail proof.

Loss of company and customer assets due to fraud represents one of our most significant operational risks. Fraud losses typically result from unauthorized use of customer and corporate funds and resources. We monitor customer transactions and use scoring tools which prevent a significant number of fraudulent transactions on a daily basis. However, new techniques and strategies are constantly being developed by perpetrators to commit fraud. In order to minimize this threat, we offer our customers various security measures, including a token based security system. This token creates a unique password which changes every sixty seconds and must be used along with the customer’s self-selected password to access their account. We believe this system is an extremely effective tool for preventing unauthorized access to a customer’s account.

The failure of a third party vendor to adequately meet its responsibilities could result in financial loss and impact our reputation. The Vendor Risk Management group monitors our vendor relationships and arrangements. The vendor risk identification process includes evaluating contracts, renewal options and vendor performance. To ensure the financial soundness of providers, we conduct financial reviews of our large providers. In addition, onsite operational audits are conducted annually for significant providers.

Processing issues and external events may result in opportunity loss depending on the situation. These types of losses include issues resulting from human error, equipment failures, significant weather events or other related types of events. External events resulting in actual losses could be due to Internet performance issues, litigation, change in public policy and our reputation.

CONCENTRATIONS OF CREDIT RISK

Loans

We track and review many factors to predict and monitor credit risk in our loan portfolios, which are primarily made up of loans secured by residential real estate. These factors, which are documented at the time of

 

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origination, include: borrowers’ debt-to income ratio, borrowers’ credit scores, housing prices, documentation type, occupancy type, and loan type. We also review estimated current LTV ratios when monitoring credit risk in our loan portfolios. In economic conditions in which housing prices generally appreciate, we believe that loan type, LTV ratios and credit scores are the key factors in determining future loan performance. In the current housing market with declining home prices and less credit available for refinance, we believe the LTV ratio becomes a more important factor in predicting and monitoring credit risk.

We believe certain categories of loans inherently have a higher level of credit risk due to characteristics of the borrower and/or features of the loan. Two of these categories are sub-prime and option ARM loans. As a general matter, we do not originate or purchase these loans to hold on our balance sheet; however, in the normal course of purchasing large pools of real estate loans, we invariably ended up acquiring a de minimis amount of sub-prime loans. As of December 31, 2008, sub-prime(1) real estate loans represented less than one-fifth of one percent of our total real estate loan portfolio and we held no option ARM loans.

As noted above, we believe loan type, LTV ratios and borrowers’ credit scores are key determinants of future loan performance. Our home equity loan portfolio is primarily second lien loans(2) on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. We believe home equity loans with a CLTV of 90% or higher or a FICO score below 700 are the loans with the highest levels of credit risk in our portfolios.

The breakdowns by LTV/CLTV and FICO score of our two main loan portfolios, one-to four-family and home equity, are as follows (dollars in thousands)(3):

 

    One- to
Four-Family
  Home Equity

LTV/CLTV at Origination(4)

  December 31,
2008
    December 31,
2007
  December 31,
2008
    December 31,
2007

<=70%

  $ 5,647,650     $ 6,666,212   $ 3,126,274     $ 3,628,619

70% – 80%

    7,008,860       8,450,977     1,822,797       2,086,277

80% – 90%

    162,966       202,133     3,312,332       3,871,249

>90%

    160,368       187,207     1,755,780       2,315,179
                           

Total

  $ 12,979,844     $ 15,506,529   $ 10,017,183     $ 11,901,324
                           

Average LTV/CLTV at loan origination(5)

    68.8 %       79.1 %  

Average estimated current LTV/CLTV(6)

    90.1 %       99.7 %  
    One- to
Four-Family
  Home Equity

FICO at Origination

  December 31,
2008
    December 31,
2007
  December 31,
2008
    December 31,
2007

>=720

  $ 8,680,892     $ 10,373,807   $ 6,005,837     $ 6,992,793

719 – 700

    1,750,294       2,089,014     1,591,380       1,898,924

699 – 680

    1,342,967       1,585,613     1,379,218       1,668,427

679 – 660

    784,449       943,538     595,776       757,016

659 – 620

    412,514       503,573     432,862       566,030

<620

    8,728       10,984     12,110       18,134
                           

Total

  $ 12,979,844     $ 15,506,529   $ 10,017,183     $ 11,901,324
                           

 

(1)

Defined as borrowers with FICO scores less than 620 at the time of origination.

(2) Approximately 14% of the home equity portfolio is in the first lien position. For home equity loans that are in a second lien position, we also hold the first lien position on the same residential real estate property for less than 1% of the loans in this portfolio.

(3)

Average estimated current LTV/CLTV at December 31, 2007 is not shown as the data is not readily available.

(4)

CLTV at origination calculations for home equity are based on drawn balances.

(5)

Average LTV/CLTV at loan origination calculations for home equity are based on undrawn balances.

(6)

The average estimated current LTV ratio reflects the outstanding balance at the balance sheet date, divided by the estimated current property value. Current property values are estimated using the most recent property value data available to us. For properties in which we did not have an updated valuation, we utilized home price indices to estimate the current property value.

 

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In addition to the factors described above, we monitor credit trends in loans by acquisition channel and vintage, which are summarized below as of December 31, 2008 and 2007 (dollars in thousands):

 

     One- to
Four-Family
   Home Equity

Acquisition Channel

   December 31,
2008
   December 31,
2007
   December 31,
2008
   December 31,
2007

Purchased from a third party

   $ 10,646,324    $ 12,904,759    $ 8,873,156    $ 10,638,021

Originated by the Company

     2,333,520      2,601,770      1,144,027      1,263,303
                           

Total real estate loans

   $ 12,979,844    $ 15,506,529    $ 10,017,183    $ 11,901,324
                           
     One- to
Four-Family
   Home Equity

Vintage Year

   December 31,
2008
   December 31,
2007
   December 31,
2008
   December 31,
2007

2003 and prior

   $ 577,408    $ 844,670    $ 754,054    $ 901,240

2004

     1,309,985      1,669,492      990,138      1,156,867

2005

     2,695,718      3,084,336      2,426,000      2,790,423

2006

     4,890,407      5,829,146      4,668,721      5,760,906

2007

     3,475,661      4,078,885      1,161,667      1,291,888

2008

     30,665      —        16,603      —  
                           

Total real estate loans

   $ 12,979,844    $ 15,506,529    $ 10,017,183    $ 11,901,324
                           

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 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; the overall availability of housing credit; 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. We believe our allowance for loan losses at December 31, 2008 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):

 

    One- to Four-Family     Home Equity     Consumer and Other     Total  
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
 

December 31, 2008

  $ 185,163   1.42 %   $ 833,835   8.19 %   $ 61,613   2.65 %   $ 1,080,611   4.23 %

December 31, 2007

  $ 18,831   0.12 %   $ 459,167   3.79 %   $ 30,166   1.05 %   $ 508,164   1.66 %

 

(1)

Allowance as a percentage of loans receivable is calculated based on the gross loans receivable for each respective category.

 

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During the year ended December 31, 2008, the allowance for loan losses increased by $572.4 million from the level at December 31, 2007. This increase was driven primarily by the increase in the allowance allocated to the home equity loan portfolio, which began to deteriorate during the second half of 2007. During the year ended December, 31 2008, we also experienced deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in virtually all key markets; growing inventories of unsold homes; rising foreclosure rates; sustained contraction in the availability of credit; and a severe downturn in the economy. While we do believe the provision for loan losses will be at historically high levels in future periods, we do not expect those levels to be in excess of those incurred in 2008.

The following table provides an analysis of the allowance for loan losses and net charge-offs for the past five years (dollars in thousands):

 

    Year Ended December 31,  
    2008     2007     2006     2005     2004  

Allowance for loan losses, beginning of period

  $ 508,164     $ 67,628     $ 63,286     $ 47,681     $ 37,847  

Provision for loan losses

    1,583,666       640,078       44,970       54,016       38,121  

Allowance acquired through acquisitions(1)

    —         —         —         —         1,547  

Charge-offs:

         

One- to four-family

    (137,974 )     (5,661 )     (616 )     (936 )     (186 )

Home equity

    (820,201 )     (168,163 )     (15,372 )     (3,929 )     (1,464 )

Recreational vehicle

    (59,396 )     (32,566 )     (25,253 )     (20,592 )     (18,419 )

Marine

    (14,278 )     (8,766 )     (6,463 )     (8,009 )     (6,003 )

Credit card

    (10,854 )     (11,608 )     (11,371 )     (17,286 )     (10,313 )

Other

    (312 )     (915 )     (2,768 )     (6,095 )     (13,956 )
                                       

Total charge-offs

    (1,043,015 )     (227,679 )     (61,843 )     (56,847 )     (50,341 )
                                       

Recoveries:

         

One- to four-family

    455       476       167       234       —    

Home equity

    8,244       4,368       822       526       310  

Recreational vehicle

    16,371       15,771       11,959       7,848       9,088  

Marine

    4,849       4,591       4,091       3,960       3,225  

Credit card

    782       957       750       380       141  

Other

    1,095       1,974       3,426       5,488       7,743  
                                       

Total recoveries

    31,796       28,137       21,215       18,436       20,507  
                                       

Net charge-offs

    (1,011,219 )     (199,542 )     (40,628 )     (38,411 )     (29,834 )
                                       

Allowance for loan losses, end of period

  $ 1,080,611     $ 508,164     $ 67,628     $ 63,286     $ 47,681  
                                       

Net charge-offs to average loans receivable outstanding

    3.64 %     0.65 %     0.18 %     0.26 %     0.30 %
                                       

 

(1)

Acquisition of credit card portfolio in 2004.

 

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

 

    December 31,  
    2008     2007     2006     2005     2004  
    Amount   %(1)     Amount   %(1)     Amount   %(1)     Amount   %(1)     Amount   %(1)  

One- to four- family

  $ 185,163   51.3 %   $ 18,831   51.3 %   $ 7,760   41.7 %   $ 4,858   37.0 %   $ 2,812   32.3 %

Home equity

    833,835   39.6       459,167   39.4       31,671   45.3       26,049   42.3       15,183   31.9  

Consumer and other loans:

                   

Recreational vehicle

    36,896   6.2       12,622   6.3       11,077   8.8       13,465   14.1       11,343   22.4  

Marine

    8,339   1.7       4,171   1.7       3,648   2.5       4,590   3.9       4,116   6.3  

Commercial

    4,063   0.9       2,407   0.9       1,635   0.9       669   0.5       22   —    

Credit card

    11,786   0.3       10,123   0.3       10,611   0.5       11,714   1.0       9,078   1.8  

Other

    529   0.0       843   0.1       1,226   0.3       1,941   1.2       5,127   5.3  
                                                           

Total consumer and other loans

    61,613   9.1       30,166   9.3       28,197   13.0       32,379   20.7       29,686   35.8  
                                                           

Total allowance for loan losses

  $ 1,080,611   100.0 %   $ 508,164   100.0 %   $ 67,628   100.0 %   $ 63,286   100.0 %   $ 47,681   100.0 %
                                                           

 

(1)

Represents percentage of loans receivable in category to total loans receivable, excluding premium (discount).

Loan 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 credit cards, our policy is to charge-off loans when collection is not probable or the loan has been delinquent for 180 days. Our policy for one- to four-family loan charge-offs prior to January 1, 2008 was to recognize a charge-off when we foreclosed on the property. For home equity loans, our policy prior to January 1, 2008 was to charge-off loans when we foreclosed on the property or when the loan had been delinquent for 180 days. As of January 1, 2008, we adjusted our charge-off policy mainly for loans in the process of foreclosure. Our updated policy for both one- to four-family and home equity loans is to assess the value of the property when the loan has been delinquent for 180 days or is in bankruptcy, regardless of whether or not the property is in foreclosure, and charge-off the amount of the loan balance in excess of the estimated current property value. As a result of this change, nonperforming loans included a $73.5 million write down as of December 31, 2008.

 

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Net charge-offs for the year ended December 31, 2008 compared to the same period in 2007 increased by $811.7 million. The overall increase was primarily due to higher net charge-offs on home equity loans, which was driven mainly by the same factors as described above. The continued pressure in the residential real estate market, specifically home price depreciation combined with tighter mortgage lending guidelines, could lead to a higher level of charge-offs in future periods. The following graph illustrates the net charge-offs by quarter:

LOGO

Nonperforming Assets

We classify loans as nonperforming when they are 90 days past due. The following table shows the comparative data for nonperforming loans and assets (dollars in thousands):

 

    December 31,  
    2008     2007     2006     2005     2004  

One- to four-family

  $ 593,075     $ 181,315     $ 33,588     $ 17,393     $ 8,009  

Home equity

    341,255       229,523       32,216       9,568       2,755  

Consumer and other loans:

         

Recreational vehicle

    2,353       2,235       2,579       2,826       1,416  

Marine

    1,248       1,130       1,439       873       908  

Credit card

    4,146       3,769       3,795       2,858       2,999  

Other

    45       470       1,093       462       848  
                                       

Total consumer and other loans

    7,792       7,604       8,906       7,019       6,171  
                                       

Total nonperforming loans

    942,122       418,442       74,710       33,980       16,935  

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

    108,105       45,895       12,904       6,555       5,367  
                                       

Total nonperforming assets, net

  $ 1,050,227     $ 464,337     $ 87,614     $ 40,535     $ 22,302  
                                       

Nonperforming loans receivable as a percentage of gross loans receivable

    3.69 %     1.37 %     0.28 %     0.17 %     0.15 %

One- to four-family allowance for loan losses as a percentage of one- to four-family nonperforming loans receivable

    31.22 %     10.39 %     23.10 %     27.93 %     35.11 %

Home equity allowance for loan losses as a percentage of home equity nonperforming loans receivable

    244.34 %     200.05 %     98.31 %     272.25 %     551.11